Question

Now consider firms that produce new scientific discoveries (not shirts!) that generate a positive externality because other firms can build on their findings.  

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 externality affect the equilibrium price and quantity of scientific discoveries, relative to the case where firms consider the externality?

Answer 1

a)

This is an example of positive production externality. Positive externalities are side effects of production which are not taken into account by the market system. These positive effects reduce the cost of production of other firms. Hence, the supply curve will shift right.

Firm must increase its output level if it consider the external effects or if these effects internalized.

following is the diagram:

In the above diagram, the output level rises from Q1 to Q2 if these external effects are considered. it would be beneficial for society as a whole.

b)

Other firms would find that their costs are high enough to restrict the output level. Hence, when externalities are not realized fully, there would be a high level of price and low level of output.

In the case of an individual firm that creates scientific research, the consideration of externality would raise the price of scientific research and the level of research would also rise correspondingly.