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IAI Actuarial Core Principles · Business Economics · Supply-side policies and their impact on businesses

The government gives a subsidy to firms for research and development. The rationale based on externalities is that:

R&D generates positive externalities, as knowledge spills over to other firms and society, so social benefit exceeds private benefit. Left alone, firms under-invest. A subsidy reduces the private cost and moves R&D toward the socially optimal level, which also raises long-run productive capacity.

  1. AFirms' private return from R&D exceeds the social return, so subsidies reduce over-investment
  2. BSocial benefits from R&D, such as knowledge spillovers, exceed private benefits, so firms under-invest without supportCorrect
  3. CR&D is a public good and so firms will invest too much without support
  4. DR&D spending reduces the output gap and so must be restricted
  5. Subsidies raise the marginal private cost of R&D to the social level

Explanation

R&D creates positive externalities because other firms benefit from knowledge spillovers. Private returns are lower than social returns, leading to under-investment. A subsidy lowers private cost and moves investment toward the socially efficient level. Options claiming over-investment reverse the logic.

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