To correct for a positive externality, the government should

• A. impose a per-unit tax equal to the marginal external cost
• B. pay a subsidy equal to the marginal external benefit
• C. set a price ceiling on the good
• D. provide a lump-sum transfer unrelated to output

Answer: (B)

When a good creates benefits for others that aren’t counted by the market, the private benefit is too low relative to the social benefit, so the market underproduces. The way to fix this is to subsidize the good by an amount per unit equal to the marginal external benefit. This subsidy raises the private marginal benefit up to the level of the social marginal benefit, encouraging more production or consumption until the social optimum is reached.

The subsidy works because it internalizes the externality: producers or buyers receive extra payoff per unit that reflects the extra benefit to society, aligning private incentives with social welfare. At the socially optimal quantity, the additional benefit to society from an extra unit is fully accounted for in decision-making.

Why the other options don’t fit: a per-unit tax would dampen production and worsen underproduction, which is appropriate for negative externalities but not for positive ones; a price ceiling distorts the market and creates shortages without addressing the external benefit; a lump-sum transfer not tied to output doesn’t change incentives to produce or consume the good and therefore doesn’t correct the externality.