Stretching from Niagara Falls through Hamilton and the Greater Toronto Area, the Golden Horseshoe region is probably the most densely populated region in the country, containing a large portion of Canada’s industry and about 9 million residents. Yet a drive through this region reveals a surprising feature: farm after farm, growing everything from corn to peaches to the famous Niagara grapes for ice wine. This situation is not an accident: the federal and provincial governments have passed laws that give tax subsidies to farmers who permanently preserve their farmland rather than sell it to developers. These subsidies have helped preserve thousands of hectares of open space.

Why have Canadian citizens raised their own tax burden to subsidize the preservation of farmland? Because they believe that preserved farmland in an already heavily developed area provides external benefits, such as natural beauty, access to fresh food, and the conservation of wild bird populations. In addition, preservation alleviates the external costs that come with more development, such as pressure on roads, water supplies, and municipal services—and, inevitably, more pollution.

In this section we’ll explore the topics of external benefits and positive externalities. They are, in many ways, the mirror images of external costs and negative externalities. Left to its own, the market will produce too little of a good (in this case, preserved Ontario farmland) that confers external benefits on others. But society as a whole is better off when policies are adopted that increase the supply of such a good.

Preserved farmland yields both benefits and costs to society. In the absence of government intervention, the farmer who wants to sell his or her land incurs all the costs of preservation—namely, the forgone profit to be made from selling the farmland to a developer. But the benefits of preserved farmland accrue not to the farmer but to neighbouring residents, who have no right to influence how the farmland is disposed of.²

Figure 16-7 illustrates society’s problem. The marginal social cost of preserved farmland, shown by MSC, is the additional cost imposed on society by an additional hectare of such farmland. This represents the forgone profits that would have accrued to farmers if they had sold their land to developers. The line is upward-sloping because when very few hectares are preserved and there is plenty of land available for development, the profit that could be made from selling a hectare to a developer is small. But as the number of preserved hectares increases and few are left for development, the amount a developer is willing to pay for them, and therefore the forgone profit increases as well.

The MSB curve represents the marginal social benefit of preserved farmland. It is the additional benefit that accrues to society—in this case, the farmer’s neighbours—when an additional hectare of farmland is preserved. The curve is downward sloping because as more farmland is preserved, the benefit to society of preserving another hectare falls. As Figure 16-7 shows, the socially optimal point, O, occurs when the marginal social cost and the marginal social benefit are equalized—here, at a price of $10 000 per hectare. At the socially optimum point, Q_OPT hectares of farmland are preserved.

The market alone will not provide Q_OPT hectares of preserved farmland. Instead, in the market outcome no hectares will be preserved; the level of preserved farmland, Q_MKT, is equal to zero. That’s because farmers will set the marginal social cost of preservation—their forgone profits—at zero and sell all their hectares to developers.³ Because farmers bear the entire cost of preservation but gain none of the benefits, an inefficiently low quantity of farmland will be preserved in the market outcome.

This is clearly inefficient because at zero hectares preserved, the marginal social benefit of preserving a hectare of farmland is $20 000. So how can the economy be induced to produce Q_OPT hectares of preserved farmland, the socially optimal level? The answer is a Pigouvian subsidy: a payment designed to encourage activities that yield external benefits. The optimal Pigouvian subsidy, as shown in Figure 16-7, is equal to the marginal social benefit of preserved farmland at the socially optimal level, Q_OPT—that is, $10 000 per hectare.

So Canadians are indeed implementing the right policy to raise their social welfare—taxing themselves in order to provide subsidies for farmland preservation.

In the overall Canadian economy, the most important single source of external benefits is the creation of knowledge. In high-tech industries such as semiconductors, software design, green technology, and bioengineering, innovations by one firm are quickly emulated and improved upon by rival firms. Such spreading of knowledge across individuals and firms is known as a technology spillover. In the modern economy, the greatest sources of technology spillovers are major universities and research institutes.

In technologically advanced countries such as Canada, the United States, Japan, the United Kingdom, Germany, France, and Israel, there is an ongoing exchange of people and ideas among private industries, major universities, and research institutes located in close proximity. The dynamic interplay that occurs in these research clusters spurs innovation and competition, theoretical advances, and practical applications. (See the Business Case at the end of the chapter for more on research clusters.)

One of Canada’s best known and most successful research clusters is located in the so-called Technology Triangle of Kitchener, Waterloo, and Cambridge, anchored by several universities and colleges, the Perimeter Institute, the Institute for Quantum Computing, a number of other research parks and incubators, plus companies such as BlackBerry, OpenText, and Google. Ultimately, these areas of technology spillover increase the economy’s productivity and raise living standards.

But research clusters don’t appear out of thin air. Except in a few instances in which firms have funded basic research on a long-term basis, research clusters have grown up around major universities. And like farmland preservation, major universities and their research activities are subsidized by government. In fact, government policy-makers in technologically advanced countries have long understood that the external benefits generated by knowledge, stemming from basic education to high-tech research, are key to the economy’s growth over time.