♪ [music] ♪
- [Prof. Alex Tabarrok]
In previous videos,
we've emphasized
that a price is a signal
wrapped up in an incentive,
and that prices
coming out of free markets
coordinate individual actions
in just such a way
that the outcome
looks as if it were created
by a benevolent invisible hand.
We've shown how price controls
can impede this process.
And what we want to show now
is that even with the free market,
sometimes the price isn't right.
In particular,
when we have externalities --
external costs,
and external benefits,
which I'll define more
in just a few minutes --
then the price isn't right.
So what we want to do in this video
is show both the causes
and the consequences
of external costs
and external benefits.
Let's get going.
Let's begin with the rise
of the super bugs.
These are bacteria which are now
resistant to our antibiotics.
Before the age of the antibiotic,
even a simple skin cut
or a bruise or scrape
could kill people
due to the infection.
And people
who were more seriously injured,
for example in battle,
most of them died
not because of their battle wounds,
but because of infection
which took place after the wound,
because of the wound.
In the 20th century,
the miracle of antibiotics
meant that far, far fewer people
died from these infections.
But that miracle
is now coming to an end,
as our antibiotics
are no longer as effective
as they once were.
Why is this happening?
Well, part of the problem
is that no antibiotic
is always 100% effective.
And bacteria,
like people, are diverse.
They have different strengths
and different weaknesses.
The bacteria which are
not killed by an antibiotic --
which happen to have
certain characteristics
which make them strong
against that antibiotic --
those bacteria
propagate and survive
and become more dominant.
So, the evolutionary process
has led to resistance.
We, however, are not
entirely innocent in this process.
Resistance has been helped
by the overuse of antibiotics.
So why are antibiotics overused?
The fundamental reason
is that users get all the benefits
but do not bear all of the costs
of antibiotic use.
Each use of an antibiotic
creates a small increase
in bacterial resistance,
at least in a probabilistic sense.
But bacteria don't stay
in one place or one body.
They spread
throughout the environment
and indeed throughout that world.
So an increase, that cost,
that increase in bacterial resistance
is a cost borne by everyone,
not just the user
of the antibiotic.
We can think of using an antibiotic
as creating a little bit of pollution,
of polluting the environment
with more resistant
and stronger bacteria.
This is true when somebody,
for example,
uses an antibiotic
when they have a virus
which the antibiotic
doesn't help with,
rather than
when they have bacteria.
That's a cost.
It's a cost because
that use of the antibiotic
then generates more resistance,
and that resistance
spreads around the world.
Farmers who use antibiotics,
not to combat disease
in their livestock,
but to help
the livestock grow faster,
also create more
bacterial resistance.
But that resistance
is something they don't include
in their calculus of costs.
They don't pay attention
to those costs
which are borne by other people.
When antibiotic users
ignore the external costs
of their choices,
we get overuse.
Since some costs are ignored
by the decision makers,
we get overuse of antibiotics.
Okay, well,
with that as an introduction,
let's define some terms.
Private cost --
this is the cost paid
by the consumer or the producer.
External cost --
this is a cost paid by bystanders,
by people other than
the consumer or the producer.
It's a cost paid by people
other than those
who are buying or selling
in this particular market.
The social cost
is the cost to everyone --
the cost when we take into account
consumers, producers
and bystanders.
In other words,
it's the private cost
plus the external cost.
Externalities --
this is simply another word
for external costs
or external benefits.
We'll talk more about
external benefits in a future talk.
In other words, externalities
is just another word
for costs or benefits
that fall on bystanders.
When there are
significant external costs
or external benefits,
a market will not
maximize social surplus.
Now, remember we showed earlier
that a market maximizes
consumer surplus
plus producer surplus.
That's always true
for a free market.
However, what we've just learned
is that an external cost
is a cost that falls on bystanders,
not on consumers or producers.
So social surplus,
which is consumer surplus
plus producer surplus
plus bystander surplus --
that's ultimately
really what we care about.
We care about not just
about consumers and producers,
we care about everyone
including bystanders.
So we want
to maximize social surplus.
However,
when there are significant
external costs or benefits,
the market is not going to
maximize social surplus.
It's going to maximize
consumer surplus
plus producer surplus.
But that's not everything.
When the costs
and the benefits to bystanders
are not counted,
then we're not going to
maximize social surplus.
In fact, we can say things
a little bit more precisely,
and we'll do that next
with a supply and demand diagram.
Okay, here's our standard diagram
with the quantity of antibiotics
on the horizontal axis
and prices and costs
on the vertical axis.
As usual, the equilibrium is found
where demand intersects supply,
or where quantity demanded
is equal to quantity supplied.
Now the key point here
is that the supply curve
is based on private cost --
basically the cost
of producing the antibiotic.
But there's another cost.
Every time an antibiotic
is produced and consumed
there's a cost
of bacterial resistance,
a cost borne by all of us,
by bystanders.
There's an external cost
and that is not taken
into account by the suppliers.
So this external cost
doesn't go into the price.
Nevertheless,
what we really care about
is the social cost
of antibiotic use,
not just the cost
of producing the antibiotic,
but also the cost
of actually using it,
including the external cost.
So, the market equilibrium,
the market quantity,
is found where the market
demand and supply curves intersect.
But the true efficient equilibrium,
the equilibrium
we would like to be at,
is where the demand curve
intersects the social cost curve.
So, the efficient quantity
is less than the market quantity,
thus we have overuse.
The market doesn't
take into account
all of the costs of antibiotic use
so we get overuse
relative to
the efficient equilibrium.
Now we can actually show this
in another way.
Let's look at the value
of the marginal unit,
the value of the unit,
the market unit,
the last unit the market produces.
What's the private value,
what's the value of this unit?
Well, it's given by the height
of the demand curve.
Now, what is the cost
of that marginal unit,
of that last unit consumed?
Well, the private cost is given
by the private supply curve,
but the social cost is given
by the much higher social cost curve.
So notice on that last unit,
the cost of that last unit
is much larger than the value.
That's the sense
in which we have overuse.
We don't really want
to produce this last unit
because the cost
is greater than the value.
Indeed, if we don't
want to produce this unit,
we don't to produce any unit
where the social cost
is greater than the value.
So in other words,
this area right here
is a deadweight loss.
These are the units
for which the social cost
is greater than the private value.
Therefore, these are the units
we don't want to produce --
this is the deadweight loss
and this is the overuse
of the antibiotic.
What conclusions can we make?
When there are external costs,
output should be reduced
to maximize social surplus.
Another way of thinking about this
is for determining
the efficient level of output,
who bears the cost is irrelevant.
The fact that these costs
are borne by bystanders
is irrelevant --
we want to take
into account all costs,
not just the cost to the suppliers.
The problem is,
is that when other people
bear some
of the cost of production,
the price is too low.
Not all of the costs
are reflected in the price.
As a result, the price
is sending the wrong signal.
It's incentivizing
too much production.
Because the price is too low,
antibiotic users
purchase too many antibiotics
and we get overuse.
The solution to this,
or one solution to this,
is in what's called a Pigouvian tax --
a tax on a good
with external costs.
Let's take a look
at how that works.
The idea of a Pigouvian tax,
after the economist Arthur Pigou
first talked about these ideas,
is pretty simple.
The market equilibrium
is down here.
The efficient equilibrium is here.
The problem is that the suppliers
aren't taking into account
all the costs of their production.
They're not taking into account
these external costs.
So how could we get
these suppliers
to take into account all
of the costs of their production?
Well, one way
of doing it is to tax them.
A Pigouvian tax
equal to the external cost
makes the private cost
plus the tax,
the total private cost,
equal to the social cost.
Let's remember
how we can analyze a tax.
Remember that one of the ways
to analyze a tax
is to shift the supply curve up
by the amount of the tax.
So, if we impose
a tax on the suppliers
equal to the external cost
the supply curve will shift up
until the private cost plus the tax
is equal to the social cost.
In this case,
we will now have
the efficient equilibrium
will be the same
as the market equilibrium.
The market
will internalize the externality.
All of the costs,
private cost plus the tax
equal to the external cost,
will come to be
reflected in the price.
And because all of the costs
are reflected in the price,
consumers will buy
the efficient quantity of the good.
So, that's one way to handle
an external cost problem.
In the next couple of lectures
we'll be talking
about external benefits,
and we'll also illustrate
some other ways
in which externalities
can be handled.
- [Narrator]
If you want to test yourself
click “Practice Questions.”
Or, if you're ready to move on
just click “Next Video.”
♪ [music] ♪