Private vs. Social Returns: Education vs. Innovation

Fairly early in microeconomics you learn that the problem with externalities is that the marginal social cost and the marginal private cost need not be the same, and this is the source of problems. The same goes for marginal social benefit and marginal private benefit.

The classic example is pollution. Firms empty the dumpsters at the plant because the two costs are the same (and they pass the costs on to buyers of the final product as part of the price). Firms typically don’t adequately deal with smokestack pollution because the two costs diverge, and the buyers may be able to use markets to avoid the higher marginal social cost, so the firm does not pass those along.

But, what about innovation? In this case, the marginal private benefit to an inventor is how much they make from their invention, and the marginal social benefit is how much society gets from their invention. In equilibrium, they’d be the same. But with innovation, there’s usually knowledge spillovers. This is a positive externality to society (e.g., you did not have to invent Snapchat to benefit from it), but it’s a negative to innovators (e.g., Yik Yak, the killer social app for SUU students in Fall 2015 never turned a profit before being shut down).

This is a big deal in macroeconomics: technological progress is the key to improved living standards, and it won’t happen if too much of the marginal benefit is shifted from the innovator to society.† This is why economists think patents are a good thing: although the optimal length is poorly understood, patents help push marginal private benefit up towards marginal social benefit.

But, what about education. Here’s Bryan Caplan:

When we look at countries around the world, a year of education appears to raise an individual’s income by 8 to 11 percent. By contrast, increasing education across a country’s population by an average of one year per person raises the national income by only 1 to 3 percent. In other words, education enriches individuals much more than it enriches nations.

How is this possible? Credential inflation: As the average level of education rises, you need more education to convince employers you’re worthy of any specific job.

So, what’s the implication? Students like you want more invested in education because you’re the primary beneficiary. But society should not buy into that argument because their rates of return on that investment are not that high.

† This is a measurable problem with the appropriate data, and a subject of some research in macroeconomics.