Question

4) Now consider firms that produce new scientific discoveries (not shirts!) that generate a positive externality because other firms can build on their fin dings. a. Draw supply and demand curves when firms treat future scientific advances as an externality and show how they would change if firms were to instead consider the externality as part of their benefits. b. How does failing to consider the externalities affect the equilibrium price and quantity of scientific discoveries, relative to the case where firms consider the externality?

Answer 1

(a)

(i) When (positive) externalities in consumption are considered, the socially optimal outcome is at intersection of marginal social benefit (MSB) and marginal cost (MC) curves, where MSB lies to the right of marginal private benefit (MPB) curve. In following graph, optimal outcome is at point A where MSB intersects MC with price P0 and quantity Q0.

(ii) However, if firms consider future benefits as their own benefits, the socially optimal outcome is at intersection of marginal private benefit (MPB) and marginal social cost (MSC) curves, where MSC lies to the right of MC curve. In following graph, optimal outcome is at point B where MPB intersects MSC with price P1 and quantity Q1.

(b)

When no externalities are considered, market equilibrium is at point C where MPB intersects MC with price P2 and quantity Q2. Price will be higher and quantity will be lower in contrast to case (a-ii) (P2 > P1 and Q2 < Q1), and price will be lower and quantity will be lower in contrast to case (a-i) (P2 < P0 and Q2 < Q0).