New Jersey is the most densely populated state in the country, lying along the northeastern corridor, an area of almost continuous development stretching from Washington, D.C., to Boston. Yet a drive through New Jersey reveals a surprising feature: acre upon acre of farmland, growing everything from corn to pumpkins to the famous Jersey tomatoes. This situation is no accident: starting in 1961, New Jerseyans have voted in a series of measures that subsidize farmers to permanently preserve their farmland rather than sell it to developers. By 2013, the Green Acres Program, administered by the state, had preserved over 640,000 acres of open space.

Why have New Jersey citizens voted to raise their own taxes to subsidize the preservation of farmland? Because they believe that preserved farmland in an already heavily developed state 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 New Jersey 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 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 neighboring residents, who have no right to influence how the farmland is disposed of.

Figure 16-4 illustrates society’s problem. The marginal social cost of preserved farmland, shown by the MSC curve, is the additional cost imposed on society by an additional acre 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 acres are preserved and there is plenty of land available for development, the profit that could be made from selling an acre to a developer is small. But as the number of preserved acres 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 neighbors—when an additional acre of farmland is preserved. The curve is downward sloping because as more farmland is preserved, the benefit to society of preserving another acre falls.

As Figure 16-4 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 acre. At the socially optimal point, Q_OPT acres of farmland are preserved.

The market alone will not provide Q_OPT acres of preserved farmland. Instead, in the market outcome no acres 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 acres to developers.

Because farmers bear the entire cost of preservation but gain none of the benefits, an inefficiently low quantity of acres will be preserved in the market outcome.

This is clearly inefficient because at zero acres preserved, the marginal social benefit of preserving an acre of farmland is $20,000. So how can the economy be induced to produce Q_OPT acres 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 16-4, is equal to the marginal social benefit of preserved farmland at the socially optimal level, Q_OPT —that is, $10,000 per acre.

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

In the overall U.S. 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 today’s economy, the greatest sources of technology spillovers are major universities and research institutes.

In technologically advanced countries such as 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.

One of the best known and most successful research clusters is the Research Triangle in North Carolina, anchored by Duke University and the University of North Carolina, several other universities and hospitals, and companies such as IBM, Pfizer, and Qualcomm. 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 in New Jersey, major universities and their research activities are subsidized by government. In fact, government policy makers in 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.