In the presence of a positive externality, how does a free market typically allocate resources compared to the social optimum?

• A. Provision is lower than socially optimal.
• B. Provision is higher than socially optimal.
• C. Provision is equal to social optimum.
• D. Provision is unrelated to externalities.

Answer: (A)

When there is a positive externality, the total benefit to society from an extra unit is greater than the private benefit felt by the person making the decision. The market only takes private benefits into account, so the quantity chosen by buyers and sellers is where private marginal benefit equals private marginal cost. That quantity is smaller than the social optimum, where social marginal benefit equals social marginal cost. Therefore, provision in a free market is lower than what would be best for society. This gap is why subsidies or public provision are sometimes used to raise the quantity toward the social optimum.