Question

Goods that are accompanied by negative externalities are priced lower than is socially ideal. But, oddly, goods that are accompanied by positive externalities are also priced lower than is socially ideal. Explain this apparent paradox.

Answer 1

A product accompanied by positive externality has a higher private marginal benefit (PMB) than the social marginal benefit (SMB). So, those goods are underproduced as maximization of private gains rather than social gains is the focus of production decision. To remedy this, government gives a subsidy (for example) in order to increase the production of goods with positive externality to the extent of external marginal benefit. Now both quantity and price are higher at a new equilibrium. That is, the equilibrium price at private benefit was lower. This is illustrated in the graph below:

Price P is lower than socially ideal P*.

Similarly, in the case of negative externality too price is lower than is socially ideal. This is so because the social cost of producing these goods is higher than the private cost. There is overproduction of goods with negative externality as only private costs are considered. Here a government action like tax will increase the cost of production (thereby price) and decrease the quantity produced to a socially optimal level. In other words, price when private costs were considered was lower. Now, after a deterrent, price is higher and quantity lower. The following graph illustrates the mechanism of controlling a negative externality:

Price P is lower than socially ideal P*.

In conclusion, all costs and benefits should be internalized by consumption and production decisions in an economy or else, there will be underproduction of goods with positive externality and overproduction of those with negative externality. And price will be always lower than socially ideal