Which of the following is a potential drawback of using subsidies to correct positive externalities?

• A. They can lead to a welfare gain from overconsumption
• B. They always achieve the socially optimal quantity
• C. They are costless to implement
• D. They can create budgetary costs and misallocate resources

Answer: (D)

Subsidies for positive externalities are meant to raise the private benefit to move quantity closer to the social optimum. A key drawback is the cost to whoever funds the subsidy—the government must raise revenue or incur debt, which creates budgetary costs and can crowd out other spending. If the subsidy is not designed or targeted well, it can misallocate resources, rewarding the wrong activities or overshooting the social goal. Administrative and information costs further raise the expense and can prevent the subsidy from achieving the desired level. So budgetary costs and potential misallocation are the central downsides.

Subsidies don’t guarantees the socially optimal quantity, and they aren’t costless to implement, so those statements don’t hold. They also aren’t inherently a sure source of welfare gains from overconsumption; improper sizing could cause inefficiency, but that isn’t the reason subsidies are criticized.