a. [20 marks] Describe three different sources of market failures in knowledge production that make market production suboptimal and justify government intervention in research and development (R&D).Market failures in knowledge production In the production of knowledge there are at least three potential sources of market failures that make market production suboptimal (Arrow 2015): 1. Asymmetric information: research inputs only produce knowledge with uncertainty and the effort and quality of researchers cannot be perfectly observed, leading to information asymmetries between inventor/entrepreneur and investor. 2. Appropriability: the production of knowledge requires large fixed costs, but once it has been created, its use by one firm does not preclude others from using it. E.g., a journalist cannot prevent an original piece of information he/she reveals from being repeated by colleagues. -+ This lowers the inventor's incentive to produce knowledge as it makes it difficult to recover the cost of production. 3. Knowledge spillovers: knowledge production involves a positive externality: Ideas today are input into inventions tomorrow. The social value of new ideas is higher than the benefit to the inventor. 20 /20Market failures in knowledge production At the same time, there could also be overproduction of knowledge for 2 reasons: 1. R&D Races: inventors do not account for the fact that their R&D lowers the expected return of others trying to invent the same product. "Races" to enter the market first therefore occur. 2. Business stealing effect: a new invention may simply steal market shares from other firms without generating any social benefit. E.g., a new treatment for heart disease that is only a small improvement relative to existing drugs being sold might capture nearly the entire market even though the marginal social value of the new treatment could be relatively small. Even accounting for these 2 negative externalities, the literature tends to agree that the social returns to innovation are much higher than private returns (Bloom et al. 2013; Jones and Summers 2020).Market failures justify a public role in R&D The government has two levers to address market failures in knowledge production: Reduce the cost of research through: 1. Tax credits; 2. Research grants; 3. Expansion of the supply of specialized workers; 4. Encouragement of research partnerships. Increase expected revenues from research: 1, Increasing payoffs through the award of prizes; 2. Temporarily increase market power through the patent system