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Hotspots: Basic Research: Externalities

A negative externality is like an additional cost that occurs not to the buyer or producer, but to a third party or third parties.  Thus the marginal cost to society is higher is said to be higher than the marginal cost to the individual.  Thus a market will produce the good in question at levels above the socially optimal unless the government acts to make the cost to the involved parties more reflective of the socail cost by imposing a tax or tariff on the good.  Notice that the marginal cost curve of society is shifted upwards from the individuals curve, but the tax or tariff acts to offset the overproduction by raising the price and reducing the demand for the good.

A positive externality can be thought of as shifting the cost curve down or shifting the value curve up (and in this case making it more elastic).  The good is therefore under funded and under produced for the amount of social benefit it creates.  The appropriate government response is therefore some type of subsidy to producers or buyers of the good.  This increases demand for the item and raises production to socially desirable levels.

Back to Internet Subsidy.