Positive Externalities and Public Goods – Comprehensive Study Notes

13.1 Investments in Innovation

  • LEARNING OBJECTIVES

    • Identify the positive externalities of new technology.
    • Explain the difference between private benefits and social benefits and give examples of each.
    • Calculate and analyze rates of return.

  • KEY IDEAS

    • Market competition can incentivize innovation by allowing firms to earn above-normal profits through cheaper production or products with desirable characteristics.
    • Temporary competitive edge: firms often enjoy above-normal profits only briefly before competitors imitate.
    • High R&D costs and risk: example of pharmaceutical development is costly and time-consuming; even if successful, imitators may copy the idea, limiting lasting profits.
    • Numerous historical inventors faced limited private rewards relative to social benefits (e.g., Eli Whitney, Thomas Edison, Gordon Gould, Alan Turing).
    • A substantial share of total economic benefits of innovations accrues to others beyond the inventing firm; private returns are only part of social gains.

  • PRIVATE VS SOCIAL BENEFITS

    • Private benefits: profits to the firm that develops the technology.
    • Social benefits: private benefits plus the spillovers and positive externalities enjoyed by other firms, households, and society.
    • Positive externalities are spillovers that benefit others, not just the investing firm.

  • POSITIVE EXTERNALITIES OF NEW TECHNOLOGY: BIG DRUG EXAMPLE (FIG. 13.2)

    • The firm’s private demand for financial capital is DPrivate; when spillovers exist, society’s demand is DSocial, which lies above DPrivate.
    • If borrowing costs are 8%, the firm would finance $30 million based on private benefits, but society would optimally borrow $52 million at the same rate.
    • If the firm could capture the entire social benefit, its demand would equal DSocial and borrow $52 million.
    • If the firm captures only a fraction of social benefits (e.g., 50%), its borrowing lies between DPrivate and DSocial.
    • Table 13.1 (Return and Demand for Capital, Big Drug):
    • At rate of return r = 2%, DPrivate = $72 million, DSocial = $84 million
    • r = 4%, DPrivate = $52 million, DSocial = $72 million
    • r = 6%, DPrivate = $38 million, DSocial = $62 million
    • r = 8%, DPrivate = $30 million, DSocial = $52 million
    • r = 10%, DPrivate = $26 million, DSocial = $44 million

  • HUMAN CAPITAL: INVESTMENT IN EDUCATION

    • Upfront costs in education are analogous to other investments; higher education increases future productivity and earnings.
    • PRIVATE rate of return to college is estimated around 10–15% in the United States.
    • TABLE 13.2 (Usual Weekly Earnings, Q4 2021):
    • Less than a High School Degree: $651
    • High School Degree, No College: $831
    • Bachelor's Degree or Higher: $1,467
    • These earnings advantages are typically private rates of return to education.
    • SOCIAL RETURNS TO EDUCATION: economists like George Psacharopoulos find positive social rate of return; health, crime, environment, and democratic governance improvements are commonly cited external benefits (per Walter McMahon).
    • Societal subsidies for primary, secondary, and higher education reflect these positive externalities.

  • OTHER POSITIVE EXTERNALITIES OF TECHNOLOGY

    • Vaccinations: protect individuals and reduce transmission, generating spillovers.
    • Home modernization: increases property values beyond the individual homeowner’s gains.
    • Market policies can subsidize or incentivize activities that generate spillovers (e.g., vaccination subsidies).

  • SUBSIDIES AND PUBLIC POLICY RESPONSES TO POSITIVE EXTERNALITIES

    • Government policy can help the innovator capture a larger share of social benefits to move toward the socially optimal level of investment.
    • Substantial example: flu shot market with spillovers; MSB > MPB; MSB is the Social Benefit Curve; MPB is Market Private Benefit Curve.
    • Public policy tool: subsidy equal to the marginal social benefit minus the marginal private benefit can raise demand to the socially optimal level where MSB = MSC (here, MSC = MPC if no spillover costs).
    • Outcome: With a subsidy, QSocial vaccinations is achieved; suppliers receive PSocial; consumers pay PSubsidy.

  • SOCIETAL CHANGE AS AN INNOVATION OUTCOME (CARLOTA PEREZ)

    • Past turning points (railroads, mass production) caused initial job/wealth shifts but eventually led to greater well-being and growth.
    • ICT revolution holds potential for positive environmental externalities: digital experiences reduce reliance on fossil fuels and enable new models (car sharing, rental-reuse networks, new manufacturing methods).
    • ICT has created megafirms (e.g., Amazon, Apple) with significant influence, but environmental and societal benefits persist alongside employment shifts.
    • Regulation and investment in human capital can manage transitions as industries mature.

13.2 How Governments Can Encourage Innovation

  • LEARNING OBJECTIVES

    • Explain the effects of intellectual property rights on social and private rates of return.
    • Identify three U.S. government policies and explain how they encourage innovation.

  • INTELLECTUAL PROPERTY RIGHTS (IPR)

    • Purpose: guarantee innovators exclusive rights to new products or processes.
    • Patents: exclusive legal right to make, use, or sell an invention for a limited time (typically 20 years).
    • Copyrights: exclusive rights over works of literature, music, film/video, and pictures (duration varies by law).
    • Example: a pharmaceutical patent on a new drug lasts 20 years; without patent protection, competition could erode profits quickly.
    • Public discussion: Mickey Mouse copyright term extension Act (1998) extended copyrights from 75 to 95 years after publication and from 50 to 70 years after death for individuals; affects roughly 400,000 works.
    • Patents are imperfect: in many cases inventors capture only one-third to one-half of the total economic value; some innovations (biotech, semiconductors) may see patents as less relevant; some ideas cannot be patented (e.g., organizational methods, certain processes); 20-year patent life is a political/market compromise.
    • Limitations of IP: patents may cover too much or be granted too easily; prolific patenting (e.g., Xerox) can over-protect improvements.

  • POLICY OPTIONS TO ENCOURAGE INNOVATION

    • Policy #1: Government Spending on R&D

    • Direct funding of R&D in colleges, universities, nonprofit labs, private firms, or government labs.

    • Pros: technology broadly available; cons: costs taxpayers; can reflect political priorities.

    • LINK IT UP references to NASA and USDA research initiatives.

    • Table 13.3 (Sources of U.S. R&D Funding, 2018):

      • Federal government: $129.6B, 21.4%
      • Industry: $426.0B, 70.3%
      • Universities and colleges: $20.7B, 3.4%
      • Nonprofits: $25.0B, 4.1%
      • Nonfederal government: $4.8B, 0.8%
      • Total: $606.1B

    • Note: In the 1960s, the federal government funded about two-thirds of R&D; over time, industry funding has risen; government often focuses on areas where private sector is less active; political decisions influence project selection.

    • Policy #2: Tax Breaks for R&D (R&E Tax Credit)

    • Reduces taxes for firms based on R&D activity; intended to incentivize private investment in R&D without direct government control over projects.

    • Treasury: each dollar of foregone tax revenue via the R&E Credit leads to at least a dollar (and possibly up to ~$2–$2.96) in additional R&D spending by firms.

    • LINK IT UP for more information on the R&E Tax Credit.

    • Policy #3: Cooperative Research

    • Collaboration among government-funded universities/academies and private firms to spur innovation.

    • Example: NIH-supported research contributed about $69B to GDP and supported ~7 million jobs in 2011; NIH remains a leading sponsor of medical research; AFRI (Agriculture and Food Research Initiative) funds USDA-driven projects applying science to agricultural problems.

    • Cooperation can create new industries and accelerate product innovation.

13.3 Public Goods

  • LEARNING OBJECTIVES

    • Identify a public good using nonexcludable and non-rival criteria.
    • Explain the free rider problem.
    • Identify several sources of public goods.

  • DEFINITION AND CHARACTERISTICS OF A PUBLIC GOOD

    • Public goods are nonexcludable and nonrival:
    • Nonexcludable: it is costly or impossible to exclude someone from using the good.
    • Nonrival: one person’s use does not reduce availability to others.
    • Examples: national defense protects everyone; police and public health funding; many public goods have spillovers, but not all spillovers justify public provision.
    • Private goods (e.g., pizza) are excludable and rival; you can prevent others from consuming your private good.

  • PUBLIC GOODS AND POSITIVE EXTERNALITIES

    • Positive externalities often accompany public goods (e.g., police protection, public health funding).
    • Not all goods with positive externalities are public goods (education can be provided by private firms yet generate spillovers).
    • Patents attempt to turn some inventions into private goods by making them excludable and rival for a period.

  • FREE RIDER PROBLEM

    • Nonexcludability creates a free rider problem: individuals may let others pay for the public good, then benefit without paying themselves.
    • Prisoner’s Dilemma analogy: two individuals may both choose not to contribute, leading to no public good even though cooperation would yield a better outcome.
    • Policy response: taxation and collective provision via law can require everyone to contribute, overcoming the free rider problem.
    • Alternatives to pure taxation: private funding via advertising (radio) and subscription models (satellite radio) where some public goods are financed privately; mixed models include free access with fees for certain uses (e.g., city parks with paid parking or permit fees).

  • COMMON RESOURCES AND THE “TRAGEDY OF THE COMMONS”

    • Some goods are nonexcludable and rivalrous (common resources): e.g., queen conch harvesting in the Caribbean.
    • Problems: overharvesting due to open access leads to depletion.
    • Solutions: licenses, harvest limits, shorter seasons; catch shares allocate a portion of a total allowable catch to fishermen to slow the race-to-fish.
    • Governance example: the United States effectively banned conch harvesting since 1986 due to depletion.
    • Ostrom’s alternative to the “tragedy of the commons”: localized cooperation and governance can sustain common resources when those who benefit most are near the resource.
    • Ostrom’s perspective highlights that governance by nearby users can outperform top-down regulation in some contexts.

  • POSITIVE EXTERNALITIES IN PUBLIC HEALTH PROGRAMS

    • Life expectancy has risen dramatically over the 20th and early 21st centuries due to clean water, sanitation, behavioral changes, and medical advances (immunizations, antibiotics).
    • Immunizations reduce illness transmission and generate spillovers; public health measures and vaccines reflect public goods characteristics and externalities.
    • Public health investments rely on a mix of government funding and private initiative; immunizations exemplify how public goods and externalities justify government involvement.

  • THE BENEFITS OF VOYAGER I (REVIEWED AS CONTEXT FOR EXTERNALITIES)

    • Voyager I’s technological spillovers illustrate how government-supported R&D leads to broad social benefits beyond the original mission.
    • However, benefits are not evenly distributed across society; wealthier or more tech-accessible groups tend to gain more quickly, raising concerns about inequality in technology access (as discussed by Tyler Cowen in Average Is Over).

  • CONNECTIVE THEMES FOR EXAM PREP

    • The private sector underinvests in some technologies due to spillovers and risk; governments can intervene via IP rights, R&D funding, tax incentives, and collaborative research.
    • Public goods, free rider problems, and common-pool resources require different policy tools, including taxation, subsidies, property rights, and community governance.
    • Positive externalities are central to evaluating social vs private returns; recognizing externalities can justify subsidies or public provision to achieve socially optimal outcomes.

  • SUMMARY FORMULAS AND KEY EXPRESSIONS

    • Social vs private demand for capital in the presence of externalities:
    • D{ ext{Private}}(r)\neq D{ ext{Social}}(r)
    • In the Big Drug example at i=8\%, private financing: 30\text{ million}; social optimum: 52\text{ million}.
    • Rate of return table (illustrative):
    • For each rate r\in{2\%,4\%,6\%,8\%,10\%}, have
      • D_{ ext{Private}}(r) = {72, 52, 38, 30, 26}\text{ (million)}
      • D_{ ext{Social}}(r) = {84, 72, 62, 52, 44}\text{ (million)}
    • Public vs private goods definitions:
    • Public good: nonexcludable and nonrival.
    • Private good: excludable and rival.
    • Government policy levers: patents, direct R&D spending, R&D tax credits, cooperative research.

  • KEY FIGURES AND DATES TO REMEMBER

    • Voyager I launched: 1977; entered interstellar space: 2012.
    • GPS maintenance cost: about 19\text{ billion/year}; US businesses would lose about 1\text{ billion/day} without GPS.
    • Patents and copyright terms: patent life ~20\text{ years}; Mickey Mouse copyright term extension Act (1998) extended protection by ~20 years for copyrights.
    • U.S. R&D funding (2018): total 606.1B; government share 21.4\%; industry share 70.3\%; universities 3.4\%; nonprofits 4.1\%; nonfederal government 0.8\%.
    • Education earnings (2021 data, quarterly): Less than HS 651/week; HS diploma no college 831/week; Bachelor's or higher 1,467/week.
    • Life expectancy in U.S.: ~47 years (1900); ~79 years (2015); ~77 years (2020, COVID-19 impact).
    • Public health immunizations and environmental health improvements are major sources of positive externalities.

  • CONNECTIONS TO PREVIOUS CONTENT

    • Positive externalities link to environmental economics (spillovers to third parties).
    • The concept of social vs private returns connects to discussions of market failure and the role of government in providing public goods.
    • Intellectual property rights balance private incentives and social welfare, a recurring theme in discussions of innovation policy.

  • PRACTICAL AND ETHICAL IMPLICATIONS

    • Policy design must balance encouraging innovation with avoiding excessive monopoly power or misallocation of resources.
    • Investment in human capital yields high private and social returns but requires public funding and equitable access to education.
    • Managing common resources requires effective governance to avoid overuse and depletion while respecting local knowledge and incentives.

  • OPEN QUESTIONS FOR REVIEW

    • How large should government involvement be in high-risk, high-reward R&D projects?
    • When do patents hinder innovation by overly concentrating control in one firm?
    • How can public goods provision be funded efficiently to minimize deadweight loss from free riding?