Why might private firms in a market economy under invest 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, 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—beneficial spillovers to a third party, or parties—of the new idea or product as well as the private benefits received by the firm that developed the new technology.

Imagine a hypothetical company, Big Drug Company, which is planning its research and development, or 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 estimated interests rates for borrowing this money. You can see these calculations in the graph below. The downward-sloping $\text{DPrivate}$start text, D, P, r, i, v, a, t, e, end text 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 that society also values. If we add the spillover benefits society enjoys to the firm’s private demand for financial capital, we can draw $\text{DSocial}$start text, D, S, o, c, i, a, l, end text, which is above $\text{DPrivate}$start text, D, P, r, i, v, a, t, e, end text on the graph.

If there were a way for the firm to fully monopolize 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 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 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, $\text{DPrivate}$start text, D, P, r, i, v, a, t, e, end text, is based on the profits—private benefits—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—a positive externality that contributes to the social benefit of the drug.

If Big Drug were able to gain 100% of social returns instead of other companies, its demand for financial capital would shift to the demand curve $\text{DSocial}$start text, D, S, o, c, i, a, l, end text, and it 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 $\text{DPrivate}$start text, D, P, r, i, v, a, t, e, end text and $\text{DSocial}$start text, D, S, o, c, i, a, l, end text.

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 may become infected. When a number of homes in a neighborhood are modernized, updated, and restored, it increases the value of not only those homes but the value of other properties in the neighborhood 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.

The graph below shows the market for flu shots. The market demand curve $\text{DMarket}$start text, D, M, a, r, k, e, t, end text for flu shots reflects only the marginal private benefit, or 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, or MPC, of producing the vaccinations. The equilibrium quantity of flu shots produced in the market—where MPB is equal to MPC—is $\text{QMarket}$start text, Q, M, a, r, k, e, t, end text and the price of flu shots is $\text{PMarket}$start text, P, M, a, r, k, e, t, end text.

Spillover benefits do exist in this market, though—those who chose 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 given by $\text{DSocial}$start text, D, S, o, c, i, a, l, end text. Because the MPB is greater than the MSB, we see that the socially optimal level of flu shots is greater than the market quantity—$\text{QSocial}$start text, Q, S, o, c, i, a, l, end text exceeds $\text{QMarket}$start text, Q, M, a, r, k, e, t, end text. The corresponding price of flu shots—if the market were to produce $\text{QSocial}$start text, Q, S, o, c, i, a, l, end text—would be at $\text{PSocial}$start text, P, S, o, c, i, a, l, end text. Unfortunately, the marketplace does not recognize this positive externality, and flu shots are 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 were exactly equal to the per-unit spillover benefits—would increase market equilibrium to a quantity of $\text{QSocial}$start text, Q, S, o, c, i, a, l, end text and a price of $\text{PSocial}$start text, P, S, o, c, i, a, l, end text where MSB equals MSC. Suppliers of the flu shots would receive payment of $\text{PSocial}$start text, P, S, o, c, i, a, l, end text per vaccination, while consumers of flu shots would redeem the voucher and only pay a price of $\text{PSubsidy}$start text, P, S, u, b, s, i, d, y, end text. When the government uses a subsidy in this way, the socially optimal quantity of vaccinations is produced.