Technical Change, Pecuniary Externality and the Market Failure

A simple general equilibrium model of a small open economy has been employed to show that even the complete and competitive market may fail to produce a Pareto efficient outcome under the condition of changing technology. Price taking firms can affect prices they face, NOT what others face, by changing their technology or technique of production. If the wage elasticity of a firm's demand for labor is different from unity, which is quite likely, then there will be an appropriation problem because of the pecuniary externality of the change. Firms will either over- appropriate or under-appropriate their social contribution of the technological or technical change, and thus the market fails. Firms with elastic labor demand will under-introduce and firms with inelastic labor demand will over-introduce labor saving technical change relative to the social optimum, which itself can cause unemployment. A provision of R & D tax/subsidy based on payroll changes is shown to be a second best policy that corrects the market failure with a small dead weight loss. This policy does not require any tax collection or subsidy payment and may be used by state and local governments to correct technological market failure at local level