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Studying for a test? Prepare with these 5 lessons on Consumer and producer surplus.
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Let's think about the market for a certain type of bush or certain type of tree that people can plant in their gardens. Here's our quantity of that tree planted planted each year, 1 million, 2 million, maybe this is nationwide, these are fairly large numbers, for a particular type of tree ... 4 million and so forth and so on, and then here, let me put the price. So this is the quantity, quantity per year planted in our country, and over here, this is going to be our dollars per tree. Dollars per tree. Maybe this is $10, this is $20, this is $30, this is $40, and our marginal cost curve or our supply curve would look, just to even get that first tree planted to get someone to plant it, grow it and then replant it in your garden, you're going to have to pay them at least $10. Each incremental tree's going to get a little bit more expensive, so our marginal cost curve will look something like that. That's our marginal cost or supply curve. Our demand curve, that very first tree, someone's going to get a huge benefit from it, and then each incremental tree, people might get a little bit lower and lower benefit, so it might look something like this. Our demand curve might will look like that. Demand ... And this is the market for a certain nice tree ... Nice tree. If you just let the market happen the way it's happening right over here, we get to a very natural equilibrium quantity, it looks like it's about 2.7 million trees planted per year, and our equilibrium price is about $20 per tree. We generate all of this total surplus that's split essentially between the consumers, the people who are buying the trees, and the people who are producing the trees. Now, let's say that a research study comes out and this particular breed of trees, the nice tree, it turns out has all of these benefits to it. Let's say that it's somehow related to pest control. Maybe all the pests that people don't like, when they eat this bark, they go away or something like that. The mosquitos go away and you get less disease. Let's say it also improves air quality. Air quality. And let's say on top of that, it's just nice-looking, so even if it's not your tree, you pass it by in the neighborhood and it just calms your nerves, it just makes you feel better about the world. They are just nice to look at ... to look at. This study that these researchers conduct, they determine that the benefit of all of these things; of the pest control, the air quality and just the aesthetic benefit of society at large, comes out over the life of a tree to $10 a tree. It is $10 per tree, per tree benefit. They're essentially saying that above and beyond the benefit that the owner of the garden get, there's a societal, there's an external benefit, and so you can imagine we're not talking about positive externalities. There's an external benefit of planting the tree that amounts to $10 per tree. How would we factor that in? How do we determine if just given this equilibrium price and quantity, whether we really are, we do really have the optimal number of trees in society? In the last few videos, we had a negative externality. We had an external cost. So we added that cost to the cost curve. Now we have an external benefit. We have a positive externality. We can add this benefit to the marginal benefit curve. Essentially, this is the benefit that the buyers of the tree are getting, and to that, let's add the benefit that society is getting. Society is getting $10 more benefit, so this 4 millionth tree, or it's actually a little bit lower, looks like about the 3.5 millionth tree, there's $10 of benefit, but if you combine it with society's benefit, so another $10, you would get up here. You'd essentially, and this first tree, it looks like it's almost $50 of benefit, but if you add society's benefit, it's actually closer to $60 of benefit. You're essentially taking this demand curve and you're shifting it up by $10. When you are factoring in the benefit, when you are factoring in the benefit to society. So, that up there. You could call this the marginal benefit plus the external ... plus the external benefit curve. It's factoring in all of the benefit that society is getting by these trees planted. When you look at that curve, you get a slightly different equilibrium price. You get a slightly different equilibrium price. The equilibrium price goes all the way out here. Now the equilibrium price goes up to this. The equilibrium price looks closer, instead of $20, at $27 and the quantity actually produced actually looks closer to 3.3 million. If we just let the market happen without factoring in this benefit in some way, we're essentially leaving on the table all of this surplus that could have happened. If we just let the market settle in on its natural price and equilibrium and equilibrium quantity, equilibrium price and equilibrium quantity, we're going to produce this 2.7 million. The total benefit to society is going to be this whole curve, or you could say society's benefit is going to be this right over here. The consumer's benefit is going to be this part right over here, actually this part all the way over here because our equilibrium prices gets right over there, and then the producer's surplus is this, is that right over there. But we're leaving some societal benefit on the table. If you think of it from society's point of view, you can view this orange area as a dead weight loss. We're leaving that on the table if we don't somehow create an incentive for more of these trees to be produced. In this situation, a way to make the optimal quantity reproduce, in order for society to get this surplus, what they could do is, in the case of a negative externality, we imposed a tax that factors in the the negative externality, now we could put some type of a subsidy. We could say if you plant a tree, if someone plants a tree, plants a tree buys and plants one of these trees, you will get a $10 tax credit. $10 tax credit. So it's essentially saying whoever plants one of these trees, their taxes are going to be $10 lower than what they would have otherwise had paid. Essentially they're saying whatever benefit you were going to get from the tree, we're going to give you $10 more benefit for that. You're essentially making sure that the optimal quantity is being produced. In that circumstance, you're essentially giving all of the marginal benefit, that extra $10 benefit, you're giving it to the people who are planting the trees. Essentially all of this, all of this becomes their benefit as well because they are going to get the $10. The good thing is at least that positive surplus is going to someone. It's not being lost. You're not giving up. You're not giving up on this orange area right over there.