What is a Positive Externality?

February 10, 20237 min read
What is a Positive Externality?
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Key Takeaways:

  • A positive externality occurs when an unrelated party benefits from an action, often to produce or consume a product or service.
  • Externalities can be positive or negative.
  • Governments and companies can take financial and social steps to remedy negative externalities.

An “externality” is an indirect benefit or cost to an uninvolved party, caused by another party’s activity. In investing, decisions are constantly made that affect people who are not directly involved in the transactions. Here is an exploration of the externality concept, with a focus on positive externalities, and what they can mean in the investing space and beyond.

What is Positive Externality?

An externality is essentially a byproduct of a primary process and can be positive or negative. A positive externality is a benefit a third party enjoys due to an economic transaction. Society also stands to gain since the benefit usually extends to others as well.

For example, a company’s research and development efforts can be considered a positive externality. R&D can improve a company’s performance and lift society’s overall knowledge levels. For employers, this can mean increased production or a reduction in employee training and development costs.

While those who reap benefits from positive externalities without paying are deemed “free riders,” it may be in society’s best interest to encourage such beneficiaries to consume goods that produce significant external advantages. As an example, private treatment for contagious disorders can be beneficial to others, although no pay is required from beneficiaries.

Why Are Positive Externalities Important to the Economy?

Positive externalities occur when there are gains on private and social levels. They can have a major impact on national policy and public sentiment, as well as investing.

Government policy. Through subsidizing goods and services that produce spillover benefits, and increases in supply and demand, the government can promote positive externalities. Generally, correcting externalities – turning them into positives — to achieve socially desirable outcomes results in new laws, ordinances, regulations, and programs.

Public sentiment. Positive externalities are mainly beneficial to society as a whole and are to be encouraged whenever possible. In turn, such benefits can be far-reaching and lead to even greater production and consumption.

Investing. Because negative externalities tend to improve investing firms’ positions, investments are frequently associated with them. After all, investors generally like it when production of a good or service has a negative effect on third parties – in this case, their rivals.

However, some experts contend that positive externalities present under-leveraged investment opportunities. Identifying companies that benefit from a positive externality such as commitment to diversity can ultimately be advantageous to investors. This is especially true if it is done before the companies are more broadly recognized.

What are Some Examples of Positive Externalities?

With regard to transactions involving goods or services, positive externalities can occur on the production or consumption side.

In production, a positive externality occurs when the development of a good or service results in a benefit for society at large, an individual, or another enterprise or government body. Here, the “producer” receives no additional compensation for providing societal benefits.

An example of this occurs when a technology company makes a novel software system that becomes widely adopted by other enterprises, which can then improve their own productivity. Another example is the construction of an airport, which benefits the public because people can use airport services for convenient accessibility to where they wish to go.

A positive production externality also occurs when a company offers complimentary cardiopulmonary resuscitation (CPR) courses to managers in case an employee requires on-site medical assistance. Such training has the potential added benefit of saving lives away from work.

With consumption, a positive externality can happen when a person or entity consumes a good or service if the consumption benefits an unrelated third party. As an example, consider a situation in which people opt to bike or walk to work rather than use their own vehicles or public transportation. This helps reduce air pollution, which is a societal benefit.

As another example, consider a scenario in which a student finishes an undergraduate degree in accounting and goes to work for a nonprofit that provides food and temporary shelter for un-housed people. Through the accountant’s efforts, the organization’s finances remain in order, allowing the community to continue to benefit from the organization’s services.

Positive vs. Negative Externalities

Basically, a positive externality occurs when a benefit spills over. In contrast, a negative externality occurs when a cost spills over.

It is a fact that most externalities are negative. They occur when social costs outweigh private costs. For example, say a business decides to slash expenditures and generate more profits by putting in place new operations that are deleterious to the environment. Costs related to expanded operations are offset by returns that exceed the costs. However, the harm to the environment increases overall costs to the economy and society.

Other examples of negative externalities include:

  • Water pollution production. To illustrate, say a plant that makes laundry detergent dumps industrial waste into an area lake, which becomes polluted. Those who use the lake for water consumption risk contamination exposure, which can cause health problems.
  • Noise consumption. An individual who resides near a clutch of restaurants blasts music from their vehicle while parked in their driveway. Such disruption could cause the restaurants to lose customers.
  • Secondhand smoke consumption. Secondhand smoke exists anytime a person who is smoking exhales and contributes smoke to an environment in which other people are around. This can cause health issues on those individuals.

How Do Externalities Affect a Company’s Decisions and Operations?

Most experts agree companies should consider the possible effect on externalities when making organizational decisions. Take, for example, a company developing new software products or services. Like externalities, systems do not exist in isolation from other systems. Decisions made will affect other systems, as well as the environment. That is particularly true where interdependencies exist across multiple systems.

As another example, companies evaluating production externalities should factor in the residual effects of byproducts, disposal of unused items, and how they will dispose obsolete equipment. They must also do their best to project future outcomes, such as deciding how best to dispose of waste not yet generated.

Should Investors Consider Externalities?

Whether their holdings are traditional or alternative, investors should also consider the externalities their decisions potentially create. As it is, many investors intentionally invest in companies that have a positive impact on the environment or society in general. Their externality concerns commonly stem from a desire to produce an improved future for all.

Because concern about commonalities and successful trading are not mutually exclusive, such investors still seek optimized returns. One way to accomplish this is through the diversification of a portfolio by incorporating alternative assets such as real estate and art, which are not directly subjected to the volatility of public markets.

Alternatives and Portfolio Diversification

Traditional portfolio asset allocation envisages a 60% public stock and 40% fixed income allocation. However, a more balanced 60/20/20 or 50/30/20 split, incorporating alternative assets, may make a portfolio less sensitive to public market short-term swings.

Real estate, private equity, venture capital, digital assets, precious metals and collectibles are among the asset classes deemed “alternative investments.” Broadly speaking, such investments tend to be less connected to public equity, and thus offer potential for diversification. Of course, like traditional investments, alternatives do entail a degree of risk.

In some cases, this risk can be greater than that of traditional investments.

This is why these asset classes were traditionally accessible only to an exclusive base of wealthy individuals and institutional investors buying in at very high minimums — often between $500,000 and $1 million.

These people were considered to be more capable of weathering losses of that magnitude, should the investments underperform. However, that meant the potentially exceptional gains these investments presented were also limited to these groups.

To democratize these opportunities, Yieldstreet has opened a number of carefully curated alternative investment strategies to all investors. While the risk is still there, the company offers help in capitalizing on areas such as real estate, legal finance, art finance and structured notes — as well as a wide range of other unique alternative investments.

Moreover, investors can get started with a relatively small amount of capital. Yieldstreet has opportunities across a broad range of asset classes, offering a variety of yields and durations, with minimum investments as low as $10000.

In Summary

Investment decisions nearly always affect others, hopefully more positively than negatively. Investors would do well to consider externalities, particularly positive ones, before taking positions in stocks, bonds, or alternatives.

All securities involve risk and may result in significant losses. Alternative investments involve specific risks that may be greater than those associated with traditional investments; are not suitable for all clients; and intended for experienced and sophisticated investors who meet specific suitability requirements and are willing to bear the high economic risks of the investment. Investments of this type may engage in speculative investment practices; carry additional risk of loss, including possibility of partial or total loss of invested capital, due to the nature and volatility of the underlying investments; and are generally considered to be illiquid due to restrictive repurchase procedures. These investments may also involve different regulatory and reporting requirements, complex tax structures, and delays in distributing important tax information.