I n t h I s c h a p t e r y o u w I l L

internalizing the externality
because it gives
buyers and sellers in the market an incentive to take account of the external effects
of their actions. Aluminum producers would, in essence, take the costs of pollution
into account when deciding how much aluminum to supply because the tax now
makes them pay for these external costs. Later in this chapter we consider other
ways in which policymakers can deal with externalities.
P O S I T I V E E X T E R N A L I T I E S I N P R O D U C T I O N
Although in some markets the social cost of production exceeds the private cost, in
other markets the opposite is the case. In these markets, the externality benefits
bystanders, so the social cost of production is less than the private cost. One ex-
ample is the market for industrial robots.
“All I can say is that if being a leading manufacturer 
means being a leading polluter, so be it.”
i n t e r n a l i z i n g a n e x t e r n a l i t y
altering incentives so that people
take account of the external effects of
their actions

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2 1 0
PA R T F O U R
T H E E C O N O M I C S O F T H E P U B L I C S E C T O R
C A S E S T U D Y
THE DEBATE OVER TECHNOLOGY POLICY
How large are technology spillovers, and what do they imply for public policy?
This is an important question because technological progress is the key to why
living standards rise from generation to generation. Yet it is also a difficult ques-
tion on which economists often disagree.
Some economists believe that technology spillovers are pervasive and that
the government should encourage those industries that yield the largest
spillovers. For instance, these economists argue that if making computer chips
Robots are at the frontier of a rapidly changing technology. Whenever a firm
builds a robot, there is some chance that it will discover a new and better design.
This new design will benefit not only this firm but society as a whole because the
design will enter society’s pool of technological knowledge. This type of positive
externality is called a 
technology spillover.
The analysis of positive externalities is similar to the analysis of negative ex-
ternalities. Figure 10-3 shows the market for robots. In this case, the social cost of
production is less than the private cost reflected in the supply curve. In particular,
the social cost of producing a robot is the private cost less the value of the technol-
ogy spillover. Therefore, the social planner would choose to produce a larger quan-
tity of robots than the private market does.
In this case, the government can internalize the externality by subsidizing the
production of robots. If the government paid firms a subsidy for each robot pro-
duced, the supply curve would shift down by the amount of the subsidy, and this
shift would increase the equilibrium quantity of robots. To ensure that the market
equilibrium equals the social optimum, the subsidy should equal the value of the
technology spillover.
Quantity
of Robots
0
Price
of Robot
Q
OPTIMUM
Demand
(private value)
Supply (private cost)
Social cost
Q
MARKET
Value of
technology
spillover
Equilibrium
Optimum
F i g u r e 1 0 - 3
T
ECHNOLOGY
S
PILLOVERS AND
THE
S
OCIAL
O
PTIMUM
.
In the
presence of a positive externality
to production, the social cost of
producing robots is less than the
private cost. The optimal quantity
of robots, 
Q
OPTIMUM
, is therefore
larger than the equilibrium
quantity, 
Q
MARKET
.

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C H A P T E R 1 0
E X T E R N A L I T I E S
2 1 1
yields greater spillovers than making potato chips, then the government should
use the tax laws to encourage the production of computer chips relative to the
production of potato chips. Government intervention in the economy that aims
to promote technology-enhancing industries is called