To achieve social optimum when there is a positive externality, the government would typically

• A. do nothing
• B. subsidize consumption to raise quantity
• C. tax consumption to reduce quantity
• D. prohibit production entirely

Answer: (B)

When a positive externality exists, the social benefit of consuming one more unit is higher than the private benefit realized by the consumer. In a free market, people consider only their private benefit, so the quantity consumed is too low relative to the social optimum. Subsidizing consumption lowers the price buyers pay and effectively raises the private value they attach to consuming each additional unit by the subsidy amount. This nudges demand upward, moving the market quantity toward where the social marginal benefit equals the marginal cost. In short, the subsidy internalizes the external benefit and increases output to the socially optimal level. Doing nothing, taxing consumption, or prohibiting production would not correct the underconsumption caused by the positive externality.