The Positive Externalities of New Technology

Will private firms in a market economy under invest in research and technology? If a firm builds a factory or buys a piece of equipment, the firm receives all the economic benefits that result from the investments. However, when a firm invests in new technology, the private benefits, or profits, that the firm receives are only a portion of the overall social benefits. The social benefits of an innovation take into account the value of all the positive externalities of the new idea or product, whether enjoyed by other companies or society as a whole, as well as the private benefits received by the firm that developed the new technology. As you learned in Environmental Protection and Negative Externalities, positive externalities are beneficial spillovers to a third party, or parties.

Consider the example of the Big Drug Company, which is planning its R&D budget for the next year. Economists and scientists working for Big Drug have compiled a list of potential research and development projects and estimated rates of return. (The rate of return is the estimated payoff from the project.) Figure 1 shows how the calculations work. The downward-sloping D_Private curve represents the firm’s demand for financial capital and reflects the company’s willingness to borrow to finance research and development projects at various interest rates. Suppose that this firm’s investment in research and development creates a spillover benefit to other firms and households. After all, new innovations often spark other creative endeavors that society also values. If we add the spillover benefits society enjoys to the firm’s private demand for financial capital, we can draw D_Social that lies above D_Private.

If there was a way for the firm to fully monopolize those social benefits by somehow making them unavailable to the rest of us, the firm’s private demand curve would be the same as society’s demand curve. According to Figure 1 and Table 1, if the going rate of interest on borrowing is 8%, and the company can receive the private benefits of innovation only, then the company would finance $30 million. Society, at the same rate of 8%, would find it optimal to have $52 million of borrowing. Unless there is a way for the company to fully enjoy the total benefits, then it will borrow less than the socially optimal level of $52 million.

Big Drug’s original demand for financial capital (D_Private) is based on the profits received by the firm. However, other pharmaceutical firms and health care companies may learn new lessons about how to treat certain medical conditions and are then able to create their own competing products. The social benefit of the drug takes into account the value of all the positive externalities of the drug. If Big Drug were able to gain this social return instead of other companies, its demand for financial capital would shift to the demand curve D_Social, and it would be willing to borrow and invest $52 million. However, if Big Drug is receiving only 50 cents of each dollar of social benefits, the firm will not spend as much on creating new products. The amount it would be willing to spend would fall somewhere in between D_Private and D_Social.

Why Invest in Human Capital?

The investment in anything, whether it is the construction of a new power plant or research in a new cancer treatment, usually requires a certain upfront cost with an uncertain future benefit. The investment in education, or human capital, is no different. Over the span of many years, a student and her family invest significant amounts of time and money into that student’s education. The idea is that higher levels of educational attainment will eventually serve to increase the student’s future productivity and subsequent ability to earn. Once the numbers are crunched, does this investment pay off for the student?

Almost universally, economists have found that the answer to this question is a clear “Yes.” For example, several studies of the return to education in the United States estimate that the rate of return to a college education is approximately 10%. Data in Table 2, from the U.S. Bureau of Labor Statistics’ Usual Weekly Earnings of Wage and Salary Workers, Third Quarter 2014, demonstrate that median weekly earnings are higher for workers who have completed more education. While these rates of return will beat equivalent investments in Treasury bonds or savings accounts, the estimated returns to education go primarily to the individual worker, so these returns are private rates of return to education.

What does society gain from investing in the education of another student? After all, if the government is spending taxpayer dollars to subsidize public education, society should expect some kind of return on that spending. Again, economists like George Psacharopoulos have found that, across a variety of nations, the social rate of return on schooling is also positive. After all, positive externalities exist from investment in education. While not always easy to measure, according to Walter McMahon, the positive externalities to education typically include better health outcomes for the population, lower levels of crime, a cleaner environment and a more stable, democratic government. For these reasons, many nations have chosen to use taxpayer dollars to subsidize primary, secondary, and higher education. Education clearly benefits the person who receives it, but a society where most people have a good level of education provides positive externalities for all.

Other Examples of Positive Externalities

Although technology may be the most prominent example of a positive externality, it is not the only one. For example, being vaccinated against disease is not only a protection for the individual, but it has the positive spillover of protecting others who may become infected. When a number of homes in a neighborhood are modernized, updated, and restored, not only does it increase the value of those homes, but the value of other properties in the neighborhood may increase as well.

The appropriate public policy response to a positive externality, like a new technology, is to help the party creating the positive externality receive a greater share of the social benefits. In the case of vaccines, like flu shots, an effective policy might be to provide a subsidy to those who choose to get vaccinated.

Figure 2 shows the market for flu shots. The market demand curve D_Market for flu shots reflects only the marginal private benefits (MPB) that the vaccinated individuals receive from the shots. Assuming that there are no spillover costs in the production of flu shots, the market supply curve is given by the marginal private cost (MPC) of producing the vaccinations.

The equilibrium quantity of flu shots produced in the market, where MPB is equal to MPC, is Q_Market and the price of flu shots is P_Market. However, spillover benefits exist in this market because others, those who chose not to purchase a flu shot, receive a positive externality in a reduced chance of contracting the flu. When we add the spillover benefits to the marginal private benefit of flu shots, the marginal social benefit (MSB) of flu shots is given by D_Social. Because the MPB is greater than MSB, we see that the socially optimal level of flu shots is greater than the market quantity (Q_Social exceeds Q_Market) and the corresponding price of flu shots, if the market were to produce Q_Social, would be at P_Social. Unfortunately, the marketplace does not recognize the positive externality and flu shots will go under produced and under consumed.

So how can government try to move the market level of output closer to the socially desirable level of output? One policy would be to provide a subsidy, like a voucher, to any citizen who wishes to get vaccinated. This voucher would act as “income” that could be used to purchase only a flu shot and, if the voucher was exactly equal to the per-unit spillover benefits, would increase market equilibrium to a quantity of Q_Social and a price of P_Social where MSB equals MSC. Suppliers of the flu shots would receive payment of P_Social per vaccination, while consumers of flu shots would redeem the voucher and only pay a price of P_Subsidy. When the government uses a subsidy in this way, the socially optimal quantity of vaccinations is produced.