Question

Why are spillover costs and spillover benefits also called negative and positive externalities? Show graphically how a tax can correct for a negative externality and how a subsidy to producers can correct for a positive externality. How does a subsidy to consumers differ from a subsidy to producers in correcting for a positive externality?

Answer 1

• Why are spillover costs and spillover benefits also called negative and positive externalities?
  Spillovers are generally not intentional. In that context, a spillover cost is a situation where there is overconsumption owing to the fact that people neglect the external social cost(Marignal private cost > Marginal social cost). Hence these are negative externalities.
  On the other hand, a spillover benefir is a positive externality because, where the marginal social cost is greater than the marginal private cost. Hence, third parties are getting more for what they haven't paid.
  
• Show graphically how a tax can correct for a negative externality and how a subsidy to producers can correct for a positive externality.
  For a spillover cost, to correct for the overconsumption , a tax is imposed which equals the external marginal cost(marginal social cost). As a result the quantity supplied curve shifts to the left, and intersects with the demand curve, where Marginal social cost = Marginal private cost. Hence, this is now a socially optimal efficiency [Cost of production to firms increase ,hence output decreases ]
  [See graph below]
  
  Marginal Social Cost Price Marginal Private Cost P2 Social Efficiency Tax P1 K Demand = Private marginal benefit = Social marginal benefit Q2 Q1 Quantity Negative Externality Correction
  
  
  In the case of a spillover benefit, when subsidies are provided on a good to the producers, the price level of the good falls. This increases consumption among the consumers. Thus, earlier when Quantity supplied equalled Quantity demanded, there was a positive externality as social marginal benefit > social marginal cost but the introduction of a subsidy increased the demand (shifted towards right), which intersects with the supply curve at the point of social efficiency[Social marginal benefit = social marginal cost]. [ Cost of production to firms decrease, hence output increases]
  [See graph below]
  
  Price Supply =Private marginal cost = Social marginal cost Social Efficiency P2 P1 Demand Marginal Private benefit Marginal Social benefit (after subsidy) Q1 Q2 Quantity
  
  
• How does a subsidy to consumers differ from a subsidy to producers in correcting for a positive externality?
  While correcting for a positive externality, a subsidy to consumers would raise the price level. Whereas a subsidy to producers for correcting a positive externality would lower the price level.