External Benefits

What can the flu teach us about economics and externalities? In this video, we go over how vaccines produce positive externalities that help people stay healthy. When someone receive the vaccine, they pass along the positive benefits of the vaccine to others, generating positive externalities. However, when someone gets a vaccine, they bear all of the costs and only reap some of the benefits of the vaccine. The social value is larger than the private value, resulting in an an undersupply of flu shots. One solution to this problem is a Pigouvian subsidy — a subsidy on a good with external benefits.

Microeconomics Course: http://mruniversity.com/courses/principles-economics-microeconomics

Ask a question about the video: http://mruniversity.com/courses/principles-economics-microeconomics/flu-shot-positive-externalities-pigovian-subsidy#QandA

Next video: http://mruniversity.com/courses/principles-economics-microeconomics/externalities-command-and-control

♪ [music] ♪

- [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."

♪ [music] ♪