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♪ [music] ♪

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- [Prof. Alex Tabarrok]
In previous videos,

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we've emphasized
that a price is a signal

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wrapped up in an incentive,

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and that prices
coming out of free markets

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coordinate individual actions

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in just such a way
that the outcome

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looks as if it were created
by a benevolent invisible hand.

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We've shown how price controls
can impede this process.

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And what we want to show now

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is that even with the free market,

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sometimes the price isn't right.

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In particular,
when we have externalities --

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external costs,
and external benefits,

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which I'll define more
in just a few minutes --

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then the price isn't right.

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So what we want to do in this video

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is show both the causes
and the consequences

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of external costs
and external benefits.

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Let's get going.

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Let's begin with the rise
of the super bugs.

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These are bacteria which are now
resistant to our antibiotics.

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Before the age of the antibiotic,

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even a simple skin cut
or a bruise or scrape

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could kill people
due to the infection.

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And people
who were more seriously injured,

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for example in battle,

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most of them died

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not because of their battle wounds,

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but because of infection
which took place after the wound,

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because of the wound.

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In the 20th century,

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the miracle of antibiotics
meant that far, far fewer people

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died from these infections.

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But that miracle
is now coming to an end,

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as our antibiotics

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are no longer as effective
as they once were.

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Why is this happening?

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Well, part of the problem

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is that no antibiotic
is always 100% effective.

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And bacteria,
like people, are diverse.

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They have different strengths
and different weaknesses.

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The bacteria which are
not killed by an antibiotic --

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which happen to have
certain characteristics

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which make them strong
against that antibiotic --

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those bacteria
propagate and survive

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and become more dominant.

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So, the evolutionary process
has led to resistance.

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We, however, are not
entirely innocent in this process.

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Resistance has been helped
by the overuse of antibiotics.

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So why are antibiotics overused?

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The fundamental reason

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is that users get all the benefits

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but do not bear all of the costs
of antibiotic use.

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Each use of an antibiotic

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creates a small increase
in bacterial resistance,

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at least in a probabilistic sense.

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But bacteria don't stay
in one place or one body.

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They spread
throughout the environment

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and indeed throughout that world.

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So an increase, that cost,
that increase in bacterial resistance

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is a cost borne by everyone,

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not just the user
of the antibiotic.

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We can think of using an antibiotic

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as creating a little bit of pollution,

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of polluting the environment

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with more resistant
and stronger bacteria.

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This is true when somebody,
for example,

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uses an antibiotic
when they have a virus

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which the antibiotic
doesn't help with,

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rather than
when they have bacteria.

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That's a cost.

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It's a cost because
that use of the antibiotic

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then generates more resistance,

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and that resistance
spreads around the world.

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Farmers who use antibiotics,

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not to combat disease
in their livestock,

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but to help
the livestock grow faster,

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also create more
bacterial resistance.

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But that resistance
is something they don't include

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in their calculus of costs.

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They don't pay attention

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to those costs
which are borne by other people.

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When antibiotic users

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ignore the external costs
of their choices,

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we get overuse.

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Since some costs are ignored
by the decision makers,

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we get overuse of antibiotics.

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Okay, well,
with that as an introduction,

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let's define some terms.

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Private cost --

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this is the cost paid
by the consumer or the producer.

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External cost --

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this is a cost paid by bystanders,

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by people other than
the consumer or the producer.

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It's a cost paid by people
other than those

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who are buying or selling

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in this particular market.

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The social cost
is the cost to everyone --

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the cost when we take into account

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consumers, producers
and bystanders.

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In other words,

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it's the private cost
plus the external cost.

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Externalities --

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this is simply another word
for external costs

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or external benefits.

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We'll talk more about
external benefits in a future talk.

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In other words, externalities
is just another word

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for costs or benefits
that fall on bystanders.

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When there are
significant external costs

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or external benefits,

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a market will not
maximize social surplus.

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Now, remember we showed earlier

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that a market maximizes
consumer surplus

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plus producer surplus.

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That's always true
for a free market.

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However, what we've just learned

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is that an external cost
is a cost that falls on bystanders,

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not on consumers or producers.

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So social surplus,
which is consumer surplus

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plus producer surplus
plus bystander surplus --

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that's ultimately
really what we care about.

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We care about not just
about consumers and producers,

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we care about everyone
including bystanders.

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So we want
to maximize social surplus.

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However,

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when there are significant
external costs or benefits,

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the market is not going to
maximize social surplus.

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It's going to maximize
consumer surplus

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plus producer surplus.

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But that's not everything.

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When the costs
and the benefits to bystanders

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are not counted,

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then we're not going to
maximize social surplus.

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In fact, we can say things
a little bit more precisely,

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and we'll do that next
with a supply and demand diagram.

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Okay, here's our standard diagram

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with the quantity of antibiotics
on the horizontal axis

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and prices and costs
on the vertical axis.

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As usual, the equilibrium is found

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where demand intersects supply,

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or where quantity demanded
is equal to quantity supplied.

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Now the key point here

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is that the supply curve
is based on private cost --

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basically the cost
of producing the antibiotic.

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But there's another cost.

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Every time an antibiotic
is produced and consumed

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there's a cost
of bacterial resistance,

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a cost borne by all of us,
by bystanders.

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There's an external cost

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and that is not taken
into account by the suppliers.

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So this external cost
doesn't go into the price.

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Nevertheless,
what we really care about

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is the social cost
of antibiotic use,

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not just the cost
of producing the antibiotic,

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but also the cost
of actually using it,

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including the external cost.

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So, the market equilibrium,
the market quantity,

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is found where the market
demand and supply curves intersect.

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But the true efficient equilibrium,

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the equilibrium
we would like to be at,

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is where the demand curve
intersects the social cost curve.

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So, the efficient quantity

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is less than the market quantity,
thus we have overuse.

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The market doesn't
take into account

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all of the costs of antibiotic use

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so we get overuse

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relative to
the efficient equilibrium.

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Now we can actually show this
in another way.

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Let's look at the value
of the marginal unit,

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the value of the unit,
the market unit,

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the last unit the market produces.

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What's the private value,
what's the value of this unit?

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Well, it's given by the height
of the demand curve.

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Now, what is the cost
of that marginal unit,

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of that last unit consumed?

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Well, the private cost is given
by the private supply curve,

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but the social cost is given
by the much higher social cost curve.

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So notice on that last unit,

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the cost of that last unit
is much larger than the value.

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That's the sense
in which we have overuse.

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We don't really want
to produce this last unit

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because the cost
is greater than the value.

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Indeed, if we don't
want to produce this unit,

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we don't to produce any unit

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where the social cost
is greater than the value.

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So in other words,

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this area right here
is a deadweight loss.

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These are the units

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for which the social cost
is greater than the private value.

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Therefore, these are the units
we don't want to produce --

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this is the deadweight loss

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and this is the overuse
of the antibiotic.

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What conclusions can we make?

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When there are external costs,

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output should be reduced
to maximize social surplus.

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Another way of thinking about this

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is for determining
the efficient level of output,

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who bears the cost is irrelevant.

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The fact that these costs
are borne by bystanders

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is irrelevant --

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we want to take
into account all costs,

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not just the cost to the suppliers.

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The problem is,
is that when other people

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bear some
of the cost of production,

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the price is too low.

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Not all of the costs
are reflected in the price.

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As a result, the price
is sending the wrong signal.

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It's incentivizing
too much production.

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Because the price is too low,

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antibiotic users
purchase too many antibiotics

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and we get overuse.

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The solution to this,
or one solution to this,

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is in what's called a Pigouvian tax --

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a tax on a good
with external costs.

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Let's take a look
at how that works.

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The idea of a Pigouvian tax,

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after the economist Arthur Pigou
first talked about these ideas,

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is pretty simple.

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The market equilibrium
is down here.

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The efficient equilibrium is here.

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The problem is that the suppliers

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aren't taking into account
all the costs of their production.

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They're not taking into account
these external costs.

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So how could we get
these suppliers

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to take into account all
of the costs of their production?

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Well, one way
of doing it is to tax them.

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A Pigouvian tax
equal to the external cost

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makes the private cost
plus the tax,

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the total private cost,
equal to the social cost.

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Let's remember
how we can analyze a tax.

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Remember that one of the ways
to analyze a tax

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is to shift the supply curve up
by the amount of the tax.

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So, if we impose
a tax on the suppliers

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equal to the external cost

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the supply curve will shift up

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until the private cost plus the tax

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is equal to the social cost.

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In this case,

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we will now have
the efficient equilibrium

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will be the same
as the market equilibrium.

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The market
will internalize the externality.

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All of the costs,

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private cost plus the tax
equal to the external cost,

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will come to be
reflected in the price.

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And because all of the costs
are reflected in the price,

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consumers will buy
the efficient quantity of the good.

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So, that's one way to handle
an external cost problem.

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In the next couple of lectures

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we'll be talking
about external benefits,

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and we'll also illustrate
some other ways

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in which externalities
can be handled.

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- [Narrator]
If you want to test yourself

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click “Practice Questions.”

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Or, if you're ready to move on
just click “Next Video.”

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♪ [music] ♪