POSITIVE EXTERNALITIES

OF PRODUCTION
 POSITIVE EXTERNALITIES OF PRODUCTION
When firms produce and sell output private benefits are created
But production can generate positive spill offer effects – positive externalities or external benefits
These external benefits are enjoyed by third parties – those who are outside of the market
For example when a firm trains workers it incurs a private cost – the cost of the training. If workers leave
the firm and join another firm, this firm enjoys the private benefit of the greater efficiency of the trained
worker but does not incur the private cost of training the worker. This is a positive externality of
production for the new firm.
A firm can invest in research and development of new technology. The firm incurs the private cost of the
investment and, for example, enjoys the private benefit in the form of higher productivity, lower average
cost and greater profit. But this new technology could also be used by other firms which have not incurred
the private cost of the investment but can enjoy the private benefits of an increase in productivity (output
per worker per hour) from utilising the new technology.
POSITIVE EXTERNALITIES OF PRODUCTION ARE TREATED AS NEGATIVE COSTS THUS MSC
< MPC
Because of the positive externalities the marginal private cost for these firms is greater than the marginal
social cost.
 WELFARE LOSS
In this example we will focus on the external benefits of research and development by a firm and how
this leads to loss welfare loss for society if left to the free market.
The private optimum level of investment in R&D is set by the firm where MPC=MPB. In other words
where the addition to total private cost of the next unit of R&D is equal to the addition to the total
private benefit gained form the next unit.
However, the private level of investment in R&D, Qp in the diagram below, is not the social optimum
level of R&D, because firms do not take into account the positive spill over effects of R&D when
making decisions on the quantity of R&D.
 WELFARE LOSS
The marginal private cost incurred by the firm is greater than the marginal social cost. The firm choses
to set output of R&D at the private optimum level where MPC=MPB, Qp in the diagram below. But
the social optimum level, where society maximises its welfare, is Qs, where MSC=MSB. In other
words at this level of output the addition to total social cost from the next unit is equal to the addition
to total social benefit from the next unit.
On all units between Qp and Qs marginal social benefit is greater than marginal social cost – the
benefit to society on each unit between Qp and Qs is greater than the cost of the resources necessary to
produce the next unit. Therefore, on all units between Qp and Qs there is a POTENTIAL WELFARE
GAIN. The total monetary value of the welfare loss, or sometimes described as the potential welfare
gain, is represented by the shaded triangle.
 WHY THE ECONOMY SUFFERS THROUGH LACK OF INVESTMENT IN R&D
As we have seen, left to the free market, the market fails to realise an allocatively efficient
outcome.
The private optimum quantity of research and development is less that the social optimum quantity
of R&D.
There is a misallocation of resources. Too few resources are allocated to R&D thus society does
not maximise its welfare
There is a welfare loss due to the under provision of investment in R&D
The economy is not enjoying all the potential external benefits from investment in R&D
Without sufficient levels of R&D productivity is lower, thus average costs are higher and prices
therefore higher than they would be if there were to be more investment in R&D.
Also the country would not be as internationally competitive – expenditure on imports would be
higher (a leakage from the circular flow of income) and revenue earned on the sale of exports
would be lower (an injection into the circular flow).
Thus the trade deficit (monetary value of exports – monetary value of imports (X-M) would be
higher. Output from the exporting industries would be lower thus employment in the industries
would be lower.
Prices would be higher, thus consumer surplus lower than it could be with greater investment in
R&D. If prices are higher real income is lower – purchasing power of income is lower.
 CORRECTION OF MARKET FAILURE
Government intervention to correct market failure will need to encourage greater investment in R&D.
The government could pay a subsidy to firms when they carry out R&D. This in effect reduces the cost on R&D and thus will lead
to greater investment by firms.
Evaluation of subsidy:
There is an opportunity cost associated with the payment of subsidies. This is government expenditure that cannot now be spent on
for example, health, educational and transport infrastructure. It is possible that the society’s welfare might be better served investing
in these alternatives rather than on subsidies. Remember the government, like everybody else, faces the economic problem: it has
unlimited wants but scarce resources thus government must prioritise, it has too make choices between competing wants.
The government must assess which firms are best able to maximise the benefit of the subsidy and provide the quality of R&D
required.
The government must use scarce resources (land, labour, capital) to monitor the industries receiving the subsidies to ensure the
subsidies are being used for research and are used effectively. This represents an additional cost that the taxpayer must fund.
It is very difficult to access the value of external benefits and therefore likely that the subsidy will be too high or too low to generate
the right level of quantity of R&D. Thus too few or too many resources will be allocated to R&D and society’s welfare will not be
maximised. The monetary value of the subsidy must equal the value of the external benefit.
Alternatives to subsidies
The government must assess the level of subsidy correctly if it is to achieve a socially optimum outcome and maximise society’s
welfare. The MPC curve must shift down to the right amount so that MPC + the subsidy = MSB.
The government could make payments directly to universities to carry out R&D. Universities will also have to be monitored. Or it
could set up directly research facilities, employing workers directly to carry out R&D.
 HOMEWORK
Essay:
Explain why, left to the free market, positive externalities generated by production, will lead to a misallocation of
resources and a welfare loss. (10)
Write an introduction.
In your explanations define the key terms.
Use lots of economic terminology.
Give a couple of examples of positive externalities of production.
Ensure your chains of reasoning are logical, coherent and complete.
Write a few lines as a conclusion to your essay in which you refer back to the question .
E.g. ‘As I have explained, left to the free market, the existence of positive externalities of production means that at
the private optimum level of output MSB > MSC. Too few resources will be allocated to the production of the good
and the market will fail to realise the social optimum level of output, where society’s welfare is maximised’.
The key directive word in the question is ‘Explain’, so you do not need to evaluate.
Research and structure your essay before you write it – use your text book and websites such as tutor2u. Do not rely
solely on the power point.