Positive Externalities of Innovation
Technology and innovation provide companies with a competitive edge and
generate positive externalities. Read this text to explore why private
firms in a market economy might underinvest in research and technology.
This reading will enhance your understanding of positive externalities.
Innovation often benefits many people, not just the person or company that innovated.
The Positive Externalities of New Technology
Why do private firms in a market economy underinvest in research and technology?
Think about it this way. 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 the firm receives are only a portion of the overall social benefits.
The social benefits of innovation consider the value of all of the positive externalities – beneficial spillovers to a third party, or parties – of the new idea or product in addition to the private benefits the firm received from developing the new technology.
Imagine a hypothetical company, Big Drug Company, which is planning its research and development (R&D) budget for the next year. Economists and scientists working for Big Drug have compiled a list of financial capital necessary for potential R&D projects and the estimated interest rates for borrowing this money. You can see these calculations in the graph below. The downward-sloping DPrivate curve represents the company's demand for financial capital to support R&D projects at various interest rates.
Now, suppose Big Drug's investment in R&D creates a spillover benefit to other firms and households – new innovations often spark other creative endeavors society values. If we add the spillover benefits society enjoys to the firm's private demand for financial capital, we can draw DSocial, which is above DPrivate on the graph.
If there were a way for the firm to fully monopolize social benefits by 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 the graph and table below, if the going rate of interest on borrowing is 8% and the company can receive only the private benefits of innovation, then the company would finance $30 million. Society, at the same rate of 8%, would find it optimal to borrow $52 million. Unless there is a way for the company to fully enjoy the total benefits, it will borrow less than the socially optimal level of $52 million.
Figure 1
Return and Demand for Capital
| Interest rate | DPrivate, in millions | DSocial, in millions |
|---|---|---|
| 2% | $72 | $84 |
| 4% | $52 | $72 |
| 6% | $38 | $62 |
| 8% | $30 | $52 |
| 10% | $26 | $44 |
Big Drug's original demand for financial capital, DPrivate, is based on the profits or private benefits the firm received. However, other pharmaceutical firms and healthcare companies may learn new lessons about how to treat certain medical conditions and will be able to create their own competing products. This positive externality contributes to the social benefit of the drug.
If Big Drug could gain 100% of social returns instead of other companies, its demand for financial capital would shift to the demand curve. DSocial would be willing to borrow and invest $52 million. If Big Drug received 50% of the social returns, the firm would not spend as much on creating new products. The amount it would be willing to spend would fall somewhere in between DPrivate and DSocial.
Other Examples of Positive Externalities
Although technology may be the most prominent example of how innovation creates positive externalities, it is not the only one.
For example, being vaccinated against disease not only protects the individual; it has the positive spillover of protecting others who would have become infected. When several homes in a neighborhood are modernized, updated, and restored, it increases the value of those homes and the value of other properties in the neighborhood.
The appropriate public policy response to a positive externality, like a new technology, is to help the party that is 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 subsidize those who get vaccinated.
The graph below shows the market for flu shots. The market demand curve DMarket for flu shots only reflects the marginal private benefit, or MPB, that the vaccinated individuals receive from the shots. Assuming there are no spillover costs in the production of flu shots, the market supply curve is given by the marginal private cost, or MPC, of producing the vaccinations. The equilibrium quantity of flu shots produced in the market – where MPB equals MPC – is QMarket, and the price of flu shots is PMarket.
Spillover benefits do exist in this market – those who decide not to purchase a flu shot still 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, or MSB, of flu shots is DSocial. Because the MPB is greater than the MSB, we see that the socially optimal level of flu shots is greater than the market quantity – QSocial exceeds QMarket. The corresponding price of flu shots – if the market were to produce QSocial – would be at PSocial. Unfortunately, the marketplace does not recognize this positive externality, and flu shots are underproduced and under-consumed.
Figure 2
How can the government move the market level of output closer to the socially desirable level of output? One policy is to provide a subsidy, like a voucher, to any citizen who gets vaccinated. This voucher would act as income used to purchase only a flu shot. If the voucher is exactly equal to the per-unit spillover benefits, it will increase market equilibrium to a quantity of QSocial and a price of PSocial, where MSB equals MSC. Suppliers of the flu shots would receive payment of PSocial per vaccination, while consumers of flu shots would redeem the voucher and only pay a price of PSubsidy. When the government uses a subsidy in this way, the socially optimal quantity of vaccinations is produced.
Self-Check Questions
- Are positive externalities reflected in market demand curves? Why or why not?
No. A market demand curve reflects only the private benefits of those who are consuming the product. Positive externalities are benefits that spill over to third parties, so they create social benefits and are not captured by a market – or private benefit-demand curve.
- Samsung's R&D investment in digital devices has increased profits by 20%. Is this a private or social benefit?
Clearly, Samsung is benefiting from the investment, so the 20% increase in profits is a private benefit. If Samsung is unable to capture all of the benefits – perhaps because other companies quickly copy and produce close substitutes – then Samsung's investment will produce social benefits as well.
The Gizmo Company is planning to develop new household gadgets. The table below shows the company's demand for financial capital for the R&D of these gadgets based on the expected rate of interest on borrowing. Now, let's say every investment would have an additional 5% social benefit – that is, an investment that pays at least a 6% return to the Gizmo Company will pay at least an 11% return for society as a whole; an investment that pays at least 7% for the Gizmo Company will pay at least 12% for society as a whole, and so on. Answer the questions that follow based on this information.
| Interest rate | Financial capital in $ millions |
|---|---|
| 10% | $100 |
| 9% | $102 |
| 8% | $108 |
| 7% | $118 |
| 6% | $133 |
| 5% | $153 |
| 4% | $183 |
| 3% | $223 |
- If the going interest rate is 9%, how much will Gizmo invest in R&D if it receives only the private benefits of this investment?
Assume that the interest rate is still 9%. How much will the firm invest if it also receives the social benefits of its investment? Hint: Take into account an additional 5% return on all levels of investment.
Answer 1: $102 million.
Answer 2: If the interest rate is 9% and the firm can capture the 5% return to society, the firm would invest as if its effective interest rate is 4% – it will invest $183 million.
- The Junkbuyers Company travels from home to home, looking for opportunities to buy items that would otherwise be put out with the garbage that the company can resell or recycle. Which will be larger, the private or the social benefits?
When the Junkbuyers Company purchases something for resale. Presumably, both the buyer and the seller benefit – otherwise, they would not need to make the transaction. However, the company also reduces the amount of garbage produced, which saves money for households and/or for the city that disposes of garbage. So, the social benefits are larger than the private benefits.
Review Questions
- In what ways do company investments in research and development create positive externalities?
- Will the demand for borrowing and investing in R&D be higher or lower if there are no external benefits?
Problems
HighFlyer Airlines wants to build new airplanes with greatly increased cabin space. This will allow HighFlyer Airlines to give passengers more comfort and sell more tickets at a higher price. However, redesigning the cabin means rethinking many other elements of the airplane as well, like the placement of engines and luggage and the most efficient shape of the plane for moving through the air.
HighFlyer Airlines has developed a list of possible methods to increase cabin space, along with estimates of how these approaches would affect costs of operating the plane and sales of airline tickets. Based on these estimates, the table below shows the value of R&D projects that provide at least a certain private rate of return. Use the data to answer the following questions.
| Private rate of return | Value of R&D |
|---|---|
| 12% | $100 |
| 10% | $200 |
| 8% | $300 |
| 6% | $400 |
| 4% | $500 |
If the opportunity cost of financial capital for HighFlyer Airlines is 6%, how much should the firm invest in R&D?
Assume that the social rate of return for R&D is an additional 2% on top of the private return; that is, an R&D investment that had a 7% private return to HighFlyer Airlines would have a 9% social return. How much investment is socially optimal at the 6% interest rate?
Key Points
- If inventors received a greater share of the broader social benefits for their work, they would have a greater incentive to seek out new inventions.
- Positive externalities are beneficial spillovers to a third party or parties.
- Private benefits are the dollar value of all benefits of a new product or process invented by a company that can be captured by the investing company.
- Social benefits are the dollar value of all benefits of a new product or process invented by a company that can be captured by other firms and by society as a whole.
Source: Khan Academy, https://www.khanacademy.org/economics-finance-domain/microeconomics/market-failure-and-the-role-of-government/innovation/a/positive-externalities-of-innovation
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