Final answer:
Private demand curves reflect only the private benefits to individuals, excluding positive externalities. Social benefits spillover to third parties and to capture these, subsidies can be used to reduce the production costs for firms, shifting the supply curve and increasing output to a socially optimal level.
Step-by-step explanation:
The student's question revolves around the concept of external benefits and how they affect social and private demand curves. In economics, when external benefits are present, they signify additional value to society that is not reflected in the private demand curve. The private demand curve shows the benefits to consumers who purchase a product, but it does not account for the additional benefits to others not directly involved in the transaction—these are called positive externalities.
For example, in the case of fuel-efficient cars, the private demand might show a certain level of output based on the private benefits to consumers, such as cost savings on gas. However, there are social benefits too, like reduced pollution, which benefit third parties and are not considered in the private demand. To reflect the true optimal level of output, which includes these positive externalities, the true demand curve would lie above the private demand curve. To achieve a socially optimal level of output, government interventions such as subsidies can be used to lower the marginal cost for firms, leading to increased production of goods with positive externalities.
The subsidy essentially shifts the supply curve downwards by the amount of the subsidy, reducing the cost of production for the firm and allowing the market equilibrium quantity to increase to the socially desirable level, Q_social. This is depicted in a graph where the subsidy is represented by the vertical distance between the original supply curve and the new supply curve, which intersects the social demand curve at Q_social.