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  • Positive Externality (External Economy)

Corrective Subsidies for Positive Externalities

A corrective subsidy, also known as a Pigouvian subsidy, is a government payment to producers or consumers to encourage an activity that generates positive externalities. The ideal subsidy is equal to the marginal external benefit at the socially optimal quantity. By providing this subsidy, the government effectively internalizes the externality, aligning the private benefit with the social benefit, and incentivizing the market to produce at the socially efficient level.

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  • The graph below illustrates the market for a good that generates a significant external benefit for society. The 'MC' curve represents the marginal cost of production, the 'MPB' curve represents the marginal private benefit to consumers, and the 'MSB' curve represents the marginal social benefit, which includes both private and external benefits. The market, left to itself, produces at quantity Qm. To correct for the market failure and achieve the socially optimal output level, Q*, what is the value of the per-unit subsidy that the government should implement?

    [Image of a standard supply and demand graph for a positive externality. The x-axis is 'Quantity' and the y-axis is 'Price/Benefit/Cost'. There is an upward-sloping Marginal Cost (MC) curve. There are two downward-sloping benefit curves: a lower Marginal Private Benefit (MPB) curve and a higher Marginal Social Benefit (MSB) curve. The intersection of MC and MPB defines the market equilibrium at price P_m and quantity Q_m. The intersection of MC and MSB defines the social optimum at price P_s and quantity Q_s. The vertical distance between MSB and MPB at Q_s is labeled as the 'Optimal Subsidy'. For the purpose of this question, assume the following values: Q_m = 800, P_m = $30. Q_s = 1000, P_s = $35. At Q_s=1000, the value on the MPB curve is $25.]

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