If there are positive externalities, what is generally true about market outcomes?

• A. The market produces the optimal quantity.
• B. The market underproduces the good; government can subsidize to increase consumption.
• C. The market overproduces the good.
• D. The market achieves efficiency without intervention.

Answer: (B)

Positive externalities create an underallocation of resources in a free market. When the social benefit from the good exceeds the private benefit that buyers and sellers consider, the private decision rule—where private marginal benefit equals private marginal cost—produces a quantity below the socially optimal level. In other words, the market underproduces relative to what society would benefit from.

A government subsidy helps correct this by effectively lowering the price to buyers or increasing the revenue to producers, so private incentives align more closely with the social benefits. This encourages more production and consumption toward the socially optimal quantity, improving overall welfare.

If there were no externalities, or if the externality were negative (where social costs exceed private costs), the market might properly allocate resources or would require taxes or regulations to curb overproduction. Here, the positive externality scenario points to underproduction and a subsidy as a reasonable corrective measure.