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

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the other type of externality, 
the external benefit.

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We'll be able to move 
quite quickly,

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because external benefits 
are just the mirror image

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or flip side of external costs.

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An external benefit is a benefit
received by people

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other than the consumers 
or producers

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trading in the market.

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

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Let me give you an example, 
a flu shot.

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Vaccines create external benefits,

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

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that reduces not only

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the probability that they're going 
to get the flu

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

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because the person 
who gets the flu shot

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is less likely to transmit
the flu to other people.

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In fact, when one person 
gets the flu shot,

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that reduces the expected 
number of people who get the flu

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by more than one.

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What's the problem?

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The problem is that 
the vaccinated person

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bears all of the cost of the shot.

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They have to pay for the shot.

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They got to get the slight 
pin prick in their arm

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and so forth.

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They bear all of the cost, 
but they only receive

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some of the benefits.

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

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is larger than the private value,

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and we get an under-supply 
of flu shots.

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Let's show that in a diagram.

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Let's draw our diagram, 
quantity of vaccine

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

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We get the usual 
market equilibrium.

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The issue here, is that 
this demand curve

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includes the private benefits 
of the flu shot.

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So most of what is 
in this demand curve is

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going to be the fact that 
people don't themselves

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

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because it means they have 
a lesser probability

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of getting the flu.

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People, however, are going to be
probably less willing

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to pay for other people's benefits.

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

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less likely to transmit the flu 
to other people,

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

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to pay for those other benefits.

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

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The external benefit means that 
the social value of one person 


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getting the flu shot 
is higher than the private value.

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As a result, 
the efficient equilibrium

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is larger than the market equilibrium.

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We want to consume more flu shots

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because the social value
is higher than the private value.

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Indeed, take a look at 
the last flu shot

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consumed at 
the market equilibrium.

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That last flu shot has
a high social value.

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

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

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in the market equilibrium.

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But what's the cost?

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

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It doesn't matter who
gets the value.

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

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

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or whether it's going 
to other people

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who are less likely to get the flu,

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that social value exceeds the cost.

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We would like to have more flu shots.

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We want to have flu shots

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so long as the value exceeds the cost.

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That means that the market equilibrium,

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we have underuse and a deadweight loss.

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This area is valuable transactions

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which do not take place.


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That's the analysis 
of an external benefit.

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The social value is higher than
the private value,

NOTE Paragraph

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so we get too few flu shots.

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We get deadweight loss.
We get underuse.

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Can you guess one method of
dealing with underuse

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in the market equilibrium 
of a good with external benefits?

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

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

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on the product for which 
there was an external cost.

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Flipping it around, 
when we have underuse,

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one solution to that is 
a Pigouvian subsidy.

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Now, do you remember 
how we analyze a subsidy?

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What a subsidy does, 
we can analyze it

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as a shift up in the demand curve.

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

NOTE Paragraph

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so that's going 
to increase their willingness

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to pay for this product.

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For example, if we reduce 
the cost to consumers

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of getting a flu shot, 
we subsidize flu shots,

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

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We'll set the subsidy to be 
the same level

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as the external benefit.

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Then, what does 
the Pigouvian subsidy do?

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

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where the private value 
plus the subsidy,

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

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is equal to the social value.

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With a correctly set subsidy,

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a subsidy equal in size 
of the external benefit,

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the market equilibrium will

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once again be 
the efficient equilibrium.

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What conclusions can we make?

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When a good has external benefits, 


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output of the market equilibrium 
is too low.

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The way to think about this is,

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for determining 
the efficient level of output

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we want to include 
everyone's benefits,

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including the benefits 
to bystanders.

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The people in the market, however,

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the consumers and the producers 
in the market,

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

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to bystanders as much as

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they're willing to pay 
for benefits to themselves.

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

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and we get undersupplied.

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We'd like to have more of 
the good produced

NOTE Paragraph

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because the social value 
is higher than the private cost,

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but we don't because 
the private value is lower

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than the social value.

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

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A Pigouvian subsidy is simply 
a subsidy

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on a good with external benefits.

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If we set the size 
of the subsidy equal

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to the external benefit,

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then the market equilibrium 
will coincide

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with the efficient equilibrium.

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

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It lowers their costs.

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

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It gets them to consume more,

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

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the market equilibrium 
will be the same

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as the efficient equilibrium.

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- [Announcer] If you want 
to test yourself

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click "Practice Questions."

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Or, if you're ready to move on, 
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