External Benefits

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.