To counteract the positive externality where firms benefit from workers trained by their competitors, governments can implement subsidies or offer tax incentives. This policy encourages companies to invest in employee training by partially compensating them for the costs, which helps address the market's tendency to underinvest in such activities.

Subsidies and Tax Incentives for Employee Training

The implementation of subsidies for positive externalities often faces significant practical challenges. A primary difficulty is ensuring that the subsidized activity, such as a particular form of employee training, is of a sufficient type and quality to generate the desired benefits for other firms and society, a task more complex than administering a simple corrective tax.

Implementation Challenges of Subsidies for Externalities

A Pigouvian subsidy is an economic instrument designed to correct for positive externalities. By providing a payment to the decision-maker, the subsidy encourages activities that generate benefits for third parties, thereby aligning the private benefit with the greater social benefit.

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Positive external effects arise from decisions where the social benefit is greater than the private benefit, or where the private cost exceeds the social cost. [1, 2, 3, 7] This divergence is problematic because it leads to a misallocation of resources; since decision-makers are not compensated for the benefits conferred upon others, they will underinvest in or perform too little of these socially beneficial activities. [6, 8, 10]

Positive Externalities: Social vs. Private Benefit

To cite the ebook, use The CORE Econ Team 2023 The Economy 2.0: Microeconomics Open access e-text https://core-econ.org/the-economy/.

To cite a unit, use The CORE Econ Team 2023 The Economy 2.0: Microeconomics Open access e-text https://core-econ.org/the-economy/ Unit [unit number] (url).

CORE Econ - The Economy 2.0: Microeconomics

Firms may underinvest in training employees because of a positive externality. If a trained worker is later hired by a different company, the new employer gains the benefit of the worker's skills without having contributed to the training costs. Because the original firm is not compensated for this external benefit, its private incentive to invest in comprehensive training is reduced, leading to a level of training that is below what is socially optimal. [7, 9]

Underinvestment in Employee Training as a Positive Externality

A firm's investment in research and development (R&D) can generate positive externalities when the knowledge gained benefits other firms or society as a whole. [9, 15] Since the innovating firm cannot capture the full value of these widespread benefits (known as knowledge spillovers), its private incentive to invest is less than the total social benefit, leading to underinvestment in R&D from a societal perspective. [7, 13, 14]

Underinvestment in R&D as a Positive Externality

A community irrigation project illustrates how positive externalities can lead to the underprovision of public goods due to the free-rider problem. [1, 2, 3] An individual farmer who contributes to the project creates a benefit for all other farmers but does not receive direct payment for this action. [1, 6] This creates an incentive for each farmer to wait for others to contribute, which can result in an equilibrium where no one contributes and the socially beneficial project is not undertaken. [5]

Free-Riding in a Public Irrigation Project

Just as with negative externalities, it is generally infeasible to utilize the legal system to ensure people are compensated for the positive impacts their actions have on others. [4] This difficulty arises because, to enforce such compensation, a court would need to determine the precise value of the benefit to each individual third party, which is often an insurmountable informational challenge. [4]

Impracticality of Legal Compensation for Positive Externalities

Pigouvian Subsidies for Positive Externalities

An economic scenario can be introduced with the example of a beekeeper who produces honey and makes it available for sale at a consistent price per kilogram.

Beekeeper and Honey Production Scenario

Public goods often arise from activities that generate positive externalities. This occurs when an individual's action, while costly to them, provides a benefit to many others. For example, when a single farmer contributes to an irrigation system or a country acts to lower carbon emissions, the resulting benefits are shared by the wider community or all nations, respectively.

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