External Benefits

Summary

In this video, Alex Tabarrok explains the concept of external benefits, focusing on how they impact market equilibrium. Using the example of flu shots, he illustrates how individuals receive less benefit from the shot compared to the social benefit it generates. This leads to underconsumption, resulting in a deadweight loss. To correct this market inefficiency, Tabarrok suggests a Pigouvian subsidy, which shifts the demand curve to match the social value. By setting the subsidy equal to the external benefit, the market can reach an efficient equilibrium.

Takeaways

• 💉 External benefits are benefits received by people other than the consumers or producers involved in the market transaction.
• 🦠 A flu shot is an example of a good with external benefits, as it reduces the chance of spreading the flu to others, not just the vaccinated person.
• 💵 The problem with goods that have external benefits, like flu shots, is that the individual bears all the costs but only receives some of the benefits.
• 📈 The social value of a flu shot is higher than the private value, which leads to an under-supply in the market.
• 📊 In a market equilibrium without intervention, the quantity of flu shots is lower than what is socially optimal due to the external benefits not being fully accounted for.
• 🔵 The social value of the last flu shot consumed at market equilibrium exceeds its cost, indicating underuse and resulting in a deadweight loss.
• ⚖️ One method to address underuse in goods with external benefits is through a Pigouvian subsidy.
• 🤑 A Pigouvian subsidy shifts the demand curve up by reducing the cost to consumers, encouraging them to buy more of the good.
• 🎯 When the subsidy is set equal to the external benefit, the market equilibrium aligns with the efficient equilibrium, correcting the underuse.
• ✅ The key conclusion is that when a good has external benefits, the market produces too little of it, but a properly set subsidy can help achieve the efficient level of output.

Q & A

What is an external benefit?

An external benefit is a benefit received by people other than the consumers or producers involved in a market transaction. It refers to a positive effect on bystanders.

Can you provide an example of an external benefit?

A common example is a flu shot. When one person gets vaccinated, it reduces the likelihood that they will transmit the flu to others, benefiting those who haven't been vaccinated.

Why does a flu shot generate external benefits?

A flu shot reduces the likelihood of both the individual and others contracting the flu. The vaccinated person bears the full cost of the vaccine but doesn’t capture all the benefits, as others indirectly benefit from reduced transmission.

What is the problem with the market equilibrium for goods with external benefits like flu shots?

The market equilibrium leads to an under-supply of goods with external benefits because the consumers only consider their own private benefits and not the wider social benefits.

What is the difference between private and social value in the context of a flu shot?

The private value refers to the benefit the individual receives from the flu shot, like avoiding the flu. The social value includes both the private value and the additional benefit to others, like reducing the spread of the flu.

What happens when the social value is higher than the private value for a good?

When the social value is higher than the private value, the good is undersupplied in the market, resulting in a deadweight loss. Fewer transactions happen than are socially optimal.

What is deadweight loss in the context of external benefits?

Deadweight loss refers to the valuable transactions that do not occur because the market produces too little of a good that has external benefits, like flu shots.

What is a Pigouvian subsidy and how does it address underuse of goods with external benefits?

A Pigouvian subsidy is a government payment that encourages consumption of goods with external benefits. It raises demand by reducing the effective cost to consumers, aligning the private value with the social value.

How does a Pigouvian subsidy correct the market equilibrium?

The subsidy increases the private value of the good by the amount of the external benefit, shifting demand up. When set correctly, the market equilibrium becomes efficient, with supply and consumption matching the social optimum.

What is the main takeaway about the relationship between external benefits and market equilibrium?

The key takeaway is that markets undersupply goods with external benefits because individuals don’t consider the benefits to bystanders. A Pigouvian subsidy can correct this by incentivizing more consumption, aligning the market equilibrium with the socially efficient level.

Outlines

00:00

💉 Understanding External Benefits and Flu Shots

In this talk, Alex Tabarrok introduces the concept of external benefits, which are advantages experienced by people other than the consumers or producers directly involved in a market transaction. A flu shot is used as a prime example of an external benefit, as it not only reduces the chance of illness for the person vaccinated but also for others by lowering the transmission of the flu. The issue arises because the vaccinated individual bears all the costs (financial and discomfort) but does not reap all the benefits. The societal value of flu shots exceeds the individual value, leading to an under-supply of vaccines. A diagram is proposed to illustrate the gap between the market equilibrium (where only private benefits are considered) and the efficient equilibrium (where both private and social benefits are considered). The talk emphasizes that more flu shots would be socially beneficial because the value of the shots outweighs their cost. However, due to the market's failure to account for external benefits, underuse and deadweight loss occur.

05:01

💸 Pigouvian Subsidies: Correcting Market Inefficiencies

Tabarrok continues by explaining how to address the under-supply of goods with external benefits, such as flu shots. He introduces the Pigouvian subsidy, a tool designed to increase consumption by lowering the cost for consumers. If the subsidy is set equal to the external benefit, it shifts the demand curve up, aligning the private value (now including the subsidy) with the social value, resulting in a market equilibrium that matches the efficient equilibrium. This solution works because it incentivizes more consumption by reducing the personal cost and increasing perceived value. The overall takeaway is that in cases where social value exceeds private value, a Pigouvian subsidy can correct the market's inefficiency, leading to optimal levels of production and consumption. The subsidy effectively balances the market by incorporating the benefits experienced by bystanders into the economic decision-making of the market participants.

Keywords

💡External benefit

An external benefit is a positive effect experienced by third parties, not directly involved in a transaction. In the video, the flu shot is an example, as it not only protects the person receiving the vaccine but also reduces the likelihood of others catching the flu. The concept is central to the video, as it explains why goods with external benefits, like vaccines, are undersupplied in the market.

💡Flu shot

The flu shot is used as an example of a product that creates external benefits. When someone receives a flu shot, it not only protects them from getting the flu but also reduces the chance of others getting it. This illustrates the idea of external benefits and how the social value of such a product is higher than its private value.

💡Social value

Social value refers to the total benefit a good or service provides to society, including both private benefits to the consumer and external benefits to others. In the video, the social value of the flu shot is higher than the private value because it benefits the individual and others who are less likely to catch the flu.

💡Private value

Private value is the benefit that a consumer receives directly from consuming a good or service. In the case of the flu shot, the private value is the reduced risk of the individual contracting the flu. However, the private value is less than the social value, as it does not account for the external benefits to others.

💡Market equilibrium

Market equilibrium is the point where the quantity supplied equals the quantity demanded. In the video, it is explained that at the market equilibrium for flu shots, the quantity is too low because the private value does not reflect the full social value, leading to underuse of the product.

💡Deadweight loss

Deadweight loss refers to the loss of economic efficiency that occurs when the equilibrium quantity of a good is not achieved. In the video, the underuse of flu shots due to external benefits results in a deadweight loss because there are valuable transactions (additional flu shots) that do not take place.

💡Pigouvian subsidy

A Pigouvian subsidy is a financial incentive designed to encourage the consumption of goods that create external benefits. The video suggests that to correct the underuse of flu shots, a Pigouvian subsidy could be applied to reduce the cost of flu shots, encouraging more people to get vaccinated.

💡Demand curve

The demand curve represents the relationship between the price of a good and the quantity demanded. In the video, the demand curve for flu shots only reflects the private benefits, not the external benefits. A Pigouvian subsidy is discussed as a way to shift the demand curve upward to reflect the full social value.

💡Efficient equilibrium

The efficient equilibrium is the quantity of goods produced and consumed when all social costs and benefits are considered, leading to the most efficient allocation of resources. In the context of the flu shot, the efficient equilibrium is higher than the market equilibrium because it takes into account the external benefits.

💡Underuse

Underuse occurs when the quantity of a good consumed is less than the socially optimal level. The video explains that flu shots are underused in the market because the private value is lower than the social value, leading to fewer vaccinations than would be ideal for society.

Highlights

External benefits are the mirror image of external costs.

An external benefit is a benefit received by people other than the consumers or producers in the market.

Vaccines like flu shots create external benefits by reducing the likelihood of transmitting the flu to others.

The social value of a flu shot is higher than the private value, leading to an under-supply in the market.

Individuals bear the full cost of flu shots but only receive part of the benefit, as some benefits go to others in society.

The efficient equilibrium in a market with external benefits is higher than the market equilibrium.

At the market equilibrium, there is a deadweight loss because there are valuable transactions that do not take place.

A Pigouvian subsidy is a solution to underuse in markets with external benefits.

Subsidizing flu shots increases demand by reducing the cost to consumers.

The subsidy should be set equal to the external benefit to ensure the market equilibrium aligns with the efficient equilibrium.

When external benefits are present, the private value is lower than the social value, leading to underproduction.

The goal of a subsidy is to increase consumption of goods with external benefits by lowering costs for consumers.

A correctly set Pigouvian subsidy aligns the private and social values of a good.

Subsidies ensure that market equilibrium matches the efficient level of production for goods with external benefits.

External benefits require subsidies to account for the value they provide to society beyond just the individual consumer.

Transcripts

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- [Alex Tabarrok] In this talk, we'll be looking at

the other type of externality, the external benefit.

We'll be able to move quite quickly,

because external benefits are just the mirror image

or flip side of external costs.

An external benefit is a benefit received by people

other than the consumers or producers

trading in the market.

In other words, an external benefit is a benefit to bystanders.

Let me give you an example, a flu shot.

Vaccines create external benefits,

because when one person gets, let's say, a flu shot

that reduces not only

the probability that they're going to get the flu

but the probability that other people will get the flu as well

because the person who gets the flu shot

is less likely to transmit the flu to other people.

In fact, when one person gets the flu shot,

that reduces the expected number of people who get the flu

by more than one.

What's the problem?

The problem is that the vaccinated person

bears all of the cost of the shot.

They have to pay for the shot.

They got to get the slight pin prick in their arm

and so forth.

They bear all of the cost, but they only receive

some of the benefits.

What this means is that the social value of the flu shot

is larger than the private value,

and we get an under-supply of flu shots.

Let's show that in a diagram.

Let's draw our diagram, quantity of vaccine

on the horizontal axis, price and costs on the vertical axis.

We get the usual market equilibrium.

The issue here, is that this demand curve

includes the private benefits of the flu shot.

So most of what is in this demand curve is

going to be the fact that people don't themselves

want to get the flu, so they value the flu shot

because it means they have a lesser probability

of getting the flu.

People, however, are going to be probably less willing

to pay for other people's benefits.

When one person gets the flu shot, that means that person is

less likely to transmit the flu to other people,

but the individual who gets the flu shot is less likely to be willing

to pay for those other benefits.

In other words, there's also an external benefit of the flu shot.

The external benefit means that the social value of one person

getting the flu shot is higher than the private value.

As a result, the efficient equilibrium

is larger than the market equilibrium.

We want to consume more flu shots

because the social value is higher than the private value.

Indeed, take a look at the last flu shot

consumed at the market equilibrium.

That last flu shot has a high social value.

It's social value is given by the blue line right here.

That's the social value of the last flu shot consumed

in the market equilibrium.

But what's the cost?

The cost of that flu shot is much less than the value.

It doesn't matter who gets the value.

What the point is is that the value of that flu shot,

whether it's going to the consumer of the flu shot

or whether it's going to other people

who are less likely to get the flu,

that social value exceeds the cost.

We would like to have more flu shots.

We want to have flu shots

so long as the value exceeds the cost.

That means that the market equilibrium,

we have underuse and a deadweight loss.

This area is valuable transactions

which do not take place.

That's the analysis of an external benefit.

The social value is higher than the private value,

so we get too few flu shots.

We get deadweight loss. We get underuse.

Can you guess one method of dealing with underuse

in the market equilibrium of a good with external benefits?

When we had external costs, remember, we had overuse,

or one solution to that was a tax called a Pigouvian tax

on the product for which there was an external cost.

Flipping it around, when we have underuse,

one solution to that is a Pigouvian subsidy.

Now, do you remember how we analyze a subsidy?

What a subsidy does, we can analyze it

as a shift up in the demand curve.

We're going to reduce the cost to the consumers,

so that's going to increase their willingness

to pay for this product.

For example, if we reduce the cost to consumers

of getting a flu shot, we subsidize flu shots,

then that's going to increase a demand for flu shots.

We'll set the subsidy to be the same level

as the external benefit.

Then, what does the Pigouvian subsidy do?

It shifts the demand curve up until we get to the point

where the private value plus the subsidy,

so now that's the total value to the consumer,

is equal to the social value.

With a correctly set subsidy,

a subsidy equal in size of the external benefit,

the market equilibrium will

once again be the efficient equilibrium.

What conclusions can we make?

When a good has external benefits,

output of the market equilibrium is too low.

The way to think about this is,

for determining the efficient level of output

we want to include everyone's benefits,

including the benefits to bystanders.

The people in the market, however,

the consumers and the producers in the market,

they're not likely to be willing to pay for the benefits

to bystanders as much as

they're willing to pay for benefits to themselves.

As a result, the social value exceeds the private value,

and we get undersupplied.

We'd like to have more of the good produced

because the social value is higher than the private cost,

but we don't because the private value is lower

than the social value.

What's a solution? One solution is a Pigouvian subsidy.

A Pigouvian subsidy is simply a subsidy

on a good with external benefits.

If we set the size of the subsidy equal

to the external benefit,

then the market equilibrium will coincide

with the efficient equilibrium.

The subsidy is a way of getting people to consume more.

It lowers their costs.

Therefore, it increases the value that consumers place on the good.

It gets them to consume more,

and if we set the subsidy equal to the external benefits,

the market equilibrium will be the same

as the efficient equilibrium.

- [Announcer] If you want to test yourself

click "Practice Questions."

Or, if you're ready to move on, just click "Next Video."

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