Lecture Notes: External Benefits and Pigouvian Subsidies

Introduction to External Benefits

• External Benefit: A benefit received by individuals who are not directly involved in the consumption or production of a good/service.

  • Example: Flu shots.
    • Getting vaccinated reduces the probability of spreading the flu, benefiting others.

• Problem with External Benefits:

  • Individuals bear the full cost of the good but do not receive all the benefits.
  • Result: Social value exceeds private value, leading to under-supply.

Graphical Analysis

• Axes:

  • Horizontal: Quantity of Vaccine
  • Vertical: Price and Costs

• Market Equilibrium vs. Efficient Equilibrium:

  • Market equilibrium reflects only private benefits.
  • Efficient Equilibrium: Includes social benefits (higher than private benefits).
  • Result: Efficient equilibrium quantity is greater than market equilibrium quantity.

• External Benefit in Flu Shots:

  • Social value of a flu shot exceeds its private cost.
  • Leads to valuable transactions not taking place, causing deadweight loss.

Addressing Underuse with Pigouvian Subsidy

• Undersupply in Market Equilibrium:

  • Occurs when social value > private value.

• Solution: Pigouvian Subsidy

  • Purpose: Align market equilibrium with efficient equilibrium.
  • Method: Shift demand curve upwards by subsidizing the good.
  • Implementation:
    • Set subsidy equal to external benefit.
    • Reduces consumer costs, increasing their willingness to pay.
    • Ensures private value + subsidy matches social value.

Key Conclusions

• Goods with external benefits result in too low output at market equilibrium.
• Efficient output includes all benefits, including those to bystanders.
  • Consumers/Producers: Less likely to pay for bystander benefits.
• Pigouvian Subsidy:
  • Ensures market production aligns with social optimal level.
  • Lowers consumer costs, increases perceived value.
  • Properly set, matches market equilibrium with efficient equilibrium.

Summary

• Markets with external benefits are undersupplied because social value exceeds private value.
• Implementing a Pigouvian subsidy helps increase the consumption to an efficient level by matching market equilibrium to efficient equilibrium.