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Not all externalities are negative. A positive externality occurs when an activity provided a benefit to someone other than the person doing the activity. Suppose, for example, that the owner of a home in a historic city district renovates and beautifies the property. The owner benefits, but so do neighbors. If the home is of historic importance, there may even be economic benefits for the community—people on walking tours who patronize local shops where they’re in the neighborhood, that kind of thing. The neighbors’ enjoyment and the shops’ increased sales are positive externalities. Another example: suppose you get vaccinated against some dangerous and highly transmissible illness. You benefit, but so do all the people who won’t get sick because you won’t be passing the illness on to them. Other people’s health is an externality of the business you do with the vaccinating clinic.
What’s the problem?
With positive externalities, the problem isn’t how to prevent them but how to encourage the behavior that generates them. How can a homeowner be encouraged to renovate their home? How can people be encouraged to get vaccinated. As with negative externalities, there are ways of incentivizing the desired behavior in minimally intrusive ways. A Pigouvian subsidy is money paid to someone in proportion to the positive externality associated with their behavior. Cities will sometimes cover the cost of home improvements that benefit the community—not just renovations of historic homes but also low-water landscaping and other water-conservation measures. Vaccines are often available free or at very low cost because the government subsidizes them. As with a Pigouvian tax, the goal is to internalize the externality as much as possible. The externality is positive, this means rewarding the behavior in proportion to its social benefit.
Network externalities
One kind of positive externality deserves special mention. A network externality is a benefit enjoyed by users of a shared technology, a benefit that increases as other users adopt the same technology. The first telephone users may have enjoyed the novelty of the new gadget in their home, but the only people they could call were the few others who also owned phones. As more people had telephones installed, however, those early adopters got much more use out of their phones. The same effect can be observed with social media and other online services. Membership on social media platform is not very valuable when there are few users. The same membership becomes more valuable when there are lots of users.
How do firms who want to sell goods and services associated with network externalities get through the phase where their product is not very appealing, to the phase where it is? A time-tested strategy is to offer the product at a steep discount, or even for free, at first. The firm has to have deep reserves of cash to cover its costs during this phase, so with this kind of market there is a high barrier to entry. But if the firm can hang on until the product becomes popular, it can start raising the price. Or it can continue to make the product available for free but eliminate certain features—and then get users to pay for a “deluxe, improved” version that has them. This phenomenon is called platform decay.
