Market and public provision in the presence of human capital externalities

Abstract

For many goods and services, such as health, education, legal services, police protection, the cost incurred by an individual supplier for providing quality is affected by the human capital of her colleagues. The paper shows that this human capital externality is crucial to determine whether such goods and services should be privately or publicly provided. Public and private provisions give individuals different incentives to acquire human capital, and the paper shows that either may be socially preferable, depending on the nature of the human capital externality: private provision of the final goods and services gives stronger incentives to human capital acquisition (and may therefore be socially preferable) if own human capital and one's colleagues' human capital are substitutes, and if suppliers with high human capital benefit more than suppliers with low human capital from their colleagues' human capital, but not excessively so.