Scenario 2: In the market for really good ideas, ideas that will dramatically change the world for the better, the private benefit of one more good idea is $1M. The marginal social benefit is $100M. Would a tax or a subsidy be more appropriate for this externality?

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Scenario 2: In the market for really good ideas, ideas that will dramatically change the world for the better, the private benefit of one more good idea is $1M. The marginal social benefit is $100M. Would a tax or a subsidy be more appropriate for this externality?

BlackTom AI · Accepted Answer

Question restatement: In a market for really good ideas, the private benefit of one more good idea is $1M, while the marginal social benefit is $100M. The task is to decide whether a tax or a subsidy would be more appropriate for this externality.

Option: subsidy (the provided answer).

Analysis of the scenario: The situation describes a positive externality, where the social benefit of an additional idea far exceeds the private benefit realized by the individual or firm creating the idea. Specifically, private benefit = $1M, social benefit = $100M, so the external benefit is $99M per idea. When social benefit exceeds private benefit, there is underproduction from the standpoint of social welfare because the entity producing the idea does not capture enough of the value it creates for society.

Why a subsidy aligns with the externality: A subsidy lowers the private cost or increases the private payoff of producing an additional idea, effectively moving the private benefit closer to the social benefit. By subsidizing idea production, the market is incentivized to produce more ideas than it would in a purely private-cost world, addressing the underproduction caused by the positive externality and improving overall welfare.

Why not a tax in this context: A tax would raise the private cost of producing ideas, reducing quantities even further. Since the externality is beneficial to society (positive externality), imposing a tax would worsen the misalignment between private incentives and social welfare and further reduce the level of idea production that society benefits from.

Given the magnitude of the external benefit ($99M larger at the margin) relative to private benefit, the intervention should encourage production to reach the socially optimal level. A subsidy specifically targets this underproduction by enhancing the private incentive to generate ideas, thereby incorporating more of the social value into private decision-making.

Summary thought: In the presence of a substantial positive externality where social benefits dwarf private benefits, policies that encourage production (like subsidies) are theoretically appropriate to internalize the externality, whereas taxes would have the opposite effect by disincentivizing production.

ECON&201 15109 What Are Positive Externalities?

Scenario 2: In the market for really good ideas, ideas that will dramatically change the world for the better, the private benefit of one more good idea is $1M. The marginal social benefit is $100M. Would a tax or a subsidy be more appropriate for this externality?

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