Question

Explain how a subsidy can increase economic efficiency in he case of a positive externality, illustrating the answer with a diagram.

Answer 1

A positive externality increases marginal (private) benefit (MB) by the amount of unit external benefit, to marginal social benefit (MSB). The MSB curve lies to the right of MB curve, since unit external benefit is positive.

In unregulated market equilibrium, MB is equated with MC, and in social optimal, MSB is equated with MC. The socially optimal price is higher than, and output is higher than, the unregulated market price and output. This causes a social efficiency loss. When a subsidy is provided (to consumers), they increase demand, which shifts MB curve rightward. If the unit subsidy is equal to the unit external benefit, then the efficiency loss is eliminated and market output is equal to socially optimal output.

In following graph, market equilibrium is at point A where MB and MC intersect with market price P0 and output Q0. The social optimum outcome is at point B where MSB intersects MC with higher price P1 and higher output Q1. Unless externality is internalized, efficiency loss is area ABC. But when a unit subsidy equals the vertical distance BD, market outcome and efficient outcome are identical and the efficiency loss is eliminated.