What are positive externalities? A case study of online Universities

This post will describe what a positive externality is, and how the market for a University is inefficient because of them.  When deciding to go to an University you have to weigh several factors in your decision making process.  One of the most important of these factors is price.  As the price gets higher, you will see less and less students willing to go to University, which results in our typical downward sloping demand curve.  Likewise, Universities are willing to supply more education if they receive more money for providing their services.  This results in a typical supply and demand graph shown to the right.  However, this graph doesn't tell the whole story.  After receiving an education, graduates will be able to get a better job, and contribute more to society and the general economy then they would be able to otherwise, this results
in a social benefit, that needs to be accounted for in the market.

Since the first graph only accounted for the private benefit to the individual, a new demand curve must be drawn that accounts for the external benefit to society.  To use an example, imagine if someone became a nurse. This individual would work towards improving the health of society, arguably a societal benefit.  However, it is possible this didn't factor into the original decision making process of the graduate, who was only looking for a better job.  In economics we call this a positive externality, some benefit that occurs to a third that is not accounted for in the market.  We can safely argue that saving the life of Mr. Smith (an example) didn't enter into the original construction of the demand curve, so we will add that in now, to account for this positive externality.  This is shown below:

The reason it shifts to the right/up is because the externality is positive.  Since improving health is a good thing, we should be willing to pay a higher price in order to get an education.  You can see that the new equilibrium point results in both a higher equilibrium price and equilibrium quantity.  Next, we will show that not accounting for this externality results in a deadweight loss.

Each area has now been labeled to show the associated surplus.  This is going to get a little tricky so pay attention.  The consumer surplus for each scenario is:

student (inefficient)=c+b
university (inefficient)=a
society (inefficient)=g+d
The reason societal surplus gets counted is because lives are still saved with less nurses (or people getting an education) only less of them are saved then would be efficient.

student (efficient)=c
university (efficient)=a+b+d+e
society (efficient)=g+f

Now if you look carefully at those two situations, in the inefficient market we don't capture e or f in our total surplus.  This makes it a deadweight loss, and as economists we hate deadweight loss.

So as a society, what can we do about a positive externality?  One example is financial aid, or discounted tuition.  Scholarships and grants would also reduce the price paid by students so that they would consume the efficient quantity of education.  Any of these tools could be used by our government to shift the private demand curve to the right so that it matches the social demand curve.

As an individual it is in your best interest to pursue an education.  Numerous studies have shown that the more educated you are, the higher your lifetime earnings will be.  Do your best to the Universities you are interested in before making a choice.  Attending University is an important commitment.