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Factoring in external benefits. Created by Sal Khan.
Video transcript
Let's think about the market for a certain type of bush or a certain type of tree that people can plant in their gardens. Here is our quantity of that tree planted each year 1 mln, 2 mln, maybe this is nationwide, these are fairly large numbers for a particular type of tree. 4 mln and so forth and so on... And then, let me put the price. This is the quantity per year planted in our country. And over here, this is going to be our dollars per tree. And maybe this is ten dollars, this is twenty, this is thirty, this is forty. 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, and grow it, and then replant it in your garden you are gonna have to pay them at least ten dollars. And then each incremental tree is getting a little bit more expensive and so our marginal cost curve will look something like that. That's our marginal cost or supply curve. And then our demand curve. That very first tree, someone is gonna get a huge benefit from it. And then each incremental tree, people might get a little bit lower and lower benefits, so it might look something like this. Our demand curve will look like that. Demand. 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 mln trees planted per year. Our equilibrium price is about twenty dollars 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 it has all of these benefits to it. Let's say that it is 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 mosquitoes go away and you get less disease. Let's say it also improves 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 neighbourhood and it just calms your nerves and makes you feel better about the world. So they are just nice to look at. And this study that this researchers conducted, they determined 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 ten dollars a tree. So it is ten dollars per tree benefit. So they are essentially saying that above and beyond the benefit that the owner of the garden gets, there is a societal, there is an external benefit. So you can imagine, when we are talking about positive externalities. There is an external benefit of planting the tree that amounts to ten dollars per tree. So how would we factor that in? How do we determine if, just given this equilibrium price and quantity, whether we do really have the optimum numer of trees in society? In the last few videos we had the negative externality. We had an external cost and so we added that cost to the cost curve. Now we have an external benefit. We have a positive externality. So 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. So society is getting ten dollars more benefit. So these 4 mln of trees or it's actually a little bit lower, it looks like about 3.5 mln, there is ten dollars of benefit. But if you combine it with society's benefit, so another ten dollars, you would get up here. At this frst tree it looks almost fifty dollars of benefit, but if you add society's benefit, it is actually closer to sixty dollars of benefit. And so you are essentially taking this demand curve and you are shifting it up by ten dollars when you are factoring in the benefit to society. You could call this the marginal benefit plus the external benefit curve. So it's factoring in all of the benefit that society is getting by these trees planted. But when you look at that curve, you get a slightly different equilibrium price. The equilibrium price goes all the way out here. So now the equilibrium price goes up to this. Equilibrium price looks closer. Instead of twenty dollars, it's twenty seven dollars and the quantity actually produced looks closer to 3.3 mln. If we just let the market happen without factoring in this benefit in some way, we are essentially leaving on the table all of this surplus that could have happened. If we just let the market settle in on its natural equilibrium price and equilirium quantity, we are gonna produce this 2.7 mln. And so the total benefit to society is going to be this whole curve. Or you could say,the society's benefit is going to be this right over here. The consumers' benefit is going to be this part right over here. Actually, this part all the way over here, because our equilibrium prices get right over there. The producers' surplus is that right over there. But we are leaving some societal benefit on the table. If you think about it from society's point of view, you can view this orange area as the deadweight loss. We are 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 produced in order for society get this surplus, what they could do is... in the case of a negative externality we imposed a tax that factors in the negative externality ... now we could put some type of a subsidy. We could say:"Hey, if you plant a tree, buy and plant some of these trees, you will get a ten dolar tax credit." So it's essentially saying, whoever plants one of these trees their taxes are going to be ten dollars lower than what they would have otherwise had paid. Essentially, they are saying:"Look, whatever benefit you are gonna get from the tree, we are gonna give you ten dollars more benefit for that." And so you are essentially making sure that the optimal quantity is being produced. In that circumstance, you are essentially giving all of the marginal benefit, that extra ten benefit, you are giving it to the people are planting the trees. All of this becomes their benefit as well, because they are going to get the ten dollars. But the good thing is at least that positive surplus is oing to someone. It's not being lost. You are not giving up on this orange area right over there.