Final answer:
A subsidy lowers the marginal private costs in order to align them with the marginal social costs, promoting production of fuel-efficient cars to the socially desirable amount. It bridges the gap caused by externalities, ensuring efficient production and alignment of social costs and benefits.
Step-by-step explanation:
When considering how a subsidy affects the production of fuel-efficient cars, we look at the relationship between the marginal social benefit and marginal social cost. Since the marginal private costs are greater than the marginal social costs, and the marginal private benefits are equal to the marginal social benefits, a subsidy helps to bridge this gap. The subsidy effectively lowers the marginal private costs to be more in line with the marginal social costs, encouraging firms to produce more. This increase in production can move the quantity of fuel-efficient cars produced from a purely market-based equilibrium quantity to a socially desirable amount.
The application of a subsidy allows the efficient production of goods by aligning the private costs with the social costs, which may differ due to externalities not accounted for in the market price. In the case of fuel-efficient cars, subsidies can help to internalize the positive externalities, thus allowing the market to reflect the true social cost of production.
By subsidizing the production of fuel-efficient cars, the government effectively makes the social benefit of increased production align with the social cost, resulting in efficient production which is socially preferred. This also ensures that the social benefits received from producing a good are in line with the social costs of production.