Correcting Positive Externalities

Idea

To correct a positive externality, the government tries to internalise the external benefit so that the free-market quantity moves from $Q_m$ up towards the social optimum $Q_s$ . Two instruments are used: a subsidy and direct provision.

Mechanism

Subsidy to producers. A per-unit subsidy equal to the marginal external benefit at $Q_s$ shifts the marginal-private-cost curve down from $MPC$ to $MPC - \text{subsidy}$ . The new equilibrium, where $MPB = MPC - \text{subsidy}$ , coincides with $Q_s$ ; consumption rises to the social optimum, the price consumers pay falls, and the deadweight welfare loss is eliminated.
Direct provision. The government finances and supplies the good itself — Singapore’s public schools, for instance — letting it set the quantity and a low price directly to raise consumption of the merit good.

Diagram

Subsidy to internalise a positive consumption externality. A per-unit subsidy equal to the MEB at Qs shifts MPC down to MPC − subsidy; the new private equilibrium MPB = MPC − subsidy coincides with the social optimum Qs, raising consumption and eliminating the deadweight loss.

Considerations

A neutral catalogue of the trade-offs:

Lack of information. Both instruments require the government to know the monetary value of the $MEB$ (for the subsidy) or the socially optimal quantity and price (for direct provision). Mis-estimation leaves the externality mis-priced and can create fresh allocative inefficiency.
Opportunity cost of the budget. Subsidies and direct provision both draw on a limited budget with many competing uses, so sustained spending carries an opportunity cost across other microeconomic and macroeconomic priorities.
X-inefficiency in direct provision. Because the government is not profit-maximising, it may lack the incentive to minimise costs or to innovate, so a directly provided good can be produced above least cost and at lower quality than a private firm would deliver.