An Introduction to Externalities
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0:02 - 0:05♪ [music] ♪
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0:10 - 0:14- [Alex] In previous videos, we've
emphasized that a price is a signal -
0:14 - 0:19wrapped up in an incentive and that prices
coming out of free markets coordinate -
0:19 - 0:26individual actions in just such a way that
the outcome looks as if it were created by -
0:26 - 0:32a benevolent invisible hand. We've shown
how price controls can impede the price -
0:32 - 0:37and what we want to show now is that even
with the free market sometimes the price -
0:37 - 0:43isn't right. In particular, when we have
externalities, external cost, and external -
0:43 - 0:48benefits, which I'll define more in just a
few minutes, then the price isn't right. -
0:49 - 0:53So what we want to do in this video is
show both the causes and the consequences -
0:53 - 0:58of external costs and external benefits.
Let's get going. -
1:01 - 1:06Let's begin with the rise of the super
bugs. These are bacteria which are now -
1:06 - 1:12resistant to our antibiotics. Before the
age of the antibiotic, even a simple skin -
1:13 - 1:18cut or a bruise or scrape could kill
people due to the infection. And people -
1:18 - 1:23who are more seriously injured, for
example, in battle most of them died not -
1:23 - 1:27because of their battle wounds, but
because of infection which took place -
1:28 - 1:30after the wound, because of the wound.
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1:30 - 1:36In the 20th century, the miracle of
antibiotics meant that far, far fewer -
1:36 - 1:42people died from these infections. But
that miracle is now coming to an end, as -
1:42 - 1:49our antibiotics are no longer as effective
as they once were. Why is this happening? -
1:49 - 1:55Part of the problem is that no antibiotic
is always 100% effective. And -
1:55 - 1:59bacteria, like people, are diverse. They
have different strengths and different -
1:59 - 2:01weaknesses.
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2:01 - 2:05The bacteria which are not killed by an
antibiotic which happen to have certain -
2:06 - 2:11characteristics which make them strong
against that antibiotic. Those bacteria -
2:11 - 2:17propagate and survive and become more
dominant. So, the evolutionary process has -
2:17 - 2:20led to resistance.
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2:20 - 2:26We however, are not entirely innocent in
this process. Resistance has been helped -
2:26 - 2:33by the overuse of antibiotics. So why are
antibiotics overused? The fundamental -
2:33 - 2:37reason is that users get all the benefits
but do not bear all of the -
2:38 - 2:44costs of antibiotic use. Each use of an
antibiotic creates a small increase in -
2:44 - 2:48bacterial resistance, at least in a
probabilistic sense. But bacteria don't -
2:49 - 2:53stay in one place or one body, they spread
throughout the environment and indeed -
2:53 - 2:58throughout that world. So an increase that
cost, that increase in bacterial -
2:58 - 3:05resistance is a cost borne by everyone,
not just the user of the antibiotic. -
3:05 - 3:10We can think of using an antibiotic as
creating a little bit of pollution, of -
3:10 - 3:15polluting the environment with more
resistant and stronger bacteria. This is -
3:15 - 3:20true when somebody, for example, uses an
antibiotic when they have a virus which -
3:20 - 3:24the antibiotic doesn't help with rather
than when they have bacteria. That's a -
3:24 - 3:31cost. It's a cost because that use of the
antibiotic then generates more resistance -
3:31 - 3:36and that resistance spreads around the
world. Farmers who use antibiotics not to -
3:36 - 3:42combat disease in their livestock but to
help the livestock grow faster, also -
3:42 - 3:49create more bacterial resistance. But that
resistance is something they don't include -
3:49 - 3:54in their calculus of cost. They don't pay
attention to those costs which are borne -
3:54 - 3:56by other people.
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3:56 - 4:01When antibiotic users ignore the external
cost -
4:01 - 4:06of their choices we get overuse. Since
some costs are ignored by the decision -
4:07 - 4:12makers we get overuse of antibiotics.
Okay, well, with that as an introduction, -
4:13 - 4:15let's define some terms. Private cost:
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4:15 - 4:21this is the cost paid by the consumer or
the producer. External cost: -
4:21 - 4:26this is a cost paid by bystanders, by
people other than the consumer or the -
4:26 - 4:32producer. It's a cost paid by people other
than those who are buying or selling in -
4:32 - 4:35this particular market. The social cost
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4:35 - 4:41is the cost to everyone. The cost when
we take into account consumers, producers -
4:41 - 4:48and bystanders. In other words, it's the
private cost plus the external cost. -
4:48 - 4:49Externalities:
-
4:49 - 4:54this is simply another word for external
cost or external benefits. We'll talk -
4:55 - 4:59more about external benefits in a future
talk. In other words, externalities is -
4:59 - 5:05just another word for cost or benefits
that fall on bystanders. -
5:05 - 5:10When there are significant external costs
or external benefits a market will not -
5:10 - 5:15maximize social surplus. Now, remember we
showed earlier that a market maximizes -
5:15 - 5:21consumer surplus plus producer surplus.
That's always true for a free market. -
5:21 - 5:27However, what we've just learned is that
an external cost is a cost that falls on -
5:27 - 5:33bystanders, not on consumers or producers.
So, social surplus which is consumer -
5:33 - 5:38surplus plus producer surplus plus
bystander surplus. That's ultimately -
5:39 - 5:42really what we care about. We care about
not just about consumers and producers, we -
5:43 - 5:49care about everyone including bystanders.
So we want to maximize social surplus. -
5:50 - 5:54However, when there are significant
external costs or benefits, the market is -
5:54 - 5:58not going to maximize social surplus. It's
going to maximize consumer surplus plus -
5:59 - 6:02producer surplus. But that's not
everything. When the -
6:02 - 6:08costs and the benefits to bystanders
are not counted, then we're not going to -
6:08 - 6:13maximize social surplus. In fact, we can
say things a little bit more precisely, -
6:14 - 6:18and we'll do that next with a supply and
demand diagram. Okay, here's our standard -
6:19 - 6:22diagram with the quantity of antibiotics
on the horizontal axis and prices and -
6:22 - 6:27costs on the vertical axis. As usual, the
equilibrium is found where demand -
6:27 - 6:32intersects supply, where quantity demanded
is equal to quantity supplied. Now the key -
6:32 - 6:38point here is that the supply curve is
based on private cost, basically the -
6:38 - 6:42cost of producing the antibiotic. But
there's another cost. -
6:42 - 6:49Every time an antibiotic is produced and
consumed there's a cost of bacterial -
6:49 - 6:55resistance. A cost borne by all of us, by
bystanders. There's an external cost and -
6:55 - 7:02that is not taken into account by the
suppliers. So this external cost doesn't -
7:02 - 7:08go into the price. Nevertheless, what we
really care about is the social cost of -
7:08 - 7:13antibiotic use, not just the cost of
producing the antibiotic but also the cost -
7:13 - 7:19of actually using it, including the
external cost. So, the market equilibrium, -
7:19 - 7:24the market quantity, is found where the
market demand and supply curves intersect. -
7:24 - 7:30But the true efficient equilibrium, the
equilibrium we would like to be at, is -
7:30 - 7:35where the demand curve intersects the
social cost curve. So, the efficient -
7:35 - 7:42quantity is less than the market quantity,
thus we have overuse. -
7:42 - 7:49The market doesn't take into account all
of the costs of antibiotic use so we get -
7:49 - 7:55overuse relative to the efficient
equilibrium. Now we can actually show this -
7:55 - 8:00in another way. Let's look at the value of
the marginal unit, -
8:00 - 8:05the value of the unit, the market unit,
the last unit the market produces. What's -
8:05 - 8:10the private value, what's the value of
this unit? Well, it's given by the height -
8:10 - 8:16of the demand curve. Now, what is the cost
of that marginal unit, of that last unit -
8:16 - 8:21consumed? Well, the private cost is given
by the private supply curve, but the -
8:21 - 8:29social cost is given by the much higher
social cost curve. So notice on that last -
8:29 - 8:36unit, the cost of that last unit is much
larger than the value. That's the sense in -
8:36 - 8:38which we have overuse.
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8:38 - 8:44We don't really want to produce this last
unit because the cost is greater than the -
8:44 - 8:49value. Indeed, if we don't want to produce
this unit, we don't to produce any unit -
8:49 - 8:55where the social cost is greater than the
value. So in other words, this area right -
8:56 - 9:02here is a deadweight loss. These are the
units for which the social cost is greater -
9:02 - 9:06than the private value, therefore, these
are the units we don't want to produce. -
9:07 - 9:14This is the deadweight loss and this is
the overuse of the antibiotic. -
9:15 - 9:19What conclusions can we make? When there
are external costs, output should be -
9:19 - 9:24reduced to maximize social surplus.
Another way of thinking about this is, for -
9:24 - 9:29determining the efficient level of output.
Who bears the cost is irrelevant. The fact -
9:29 - 9:34that these costs are borne by bystanders
is irrelevant, we want to take into -
9:34 - 9:40account all costs not just the cost of the
suppliers. The problem is, is that when -
9:40 - 9:45other people bear some of the cost of
production, the price is too low. -
9:45 - 9:52Not all of the costs are reflected in the
price. As a result, the price is sending -
9:52 - 9:57the wrong signal. It's incentivizing too
much production. Because the price is too -
9:58 - 10:04low, antibiotic users purchase too many
antibiotics and we get overuse. -
10:04 - 10:09The solution to this or one solution to
this is in what's called a Pigouvian tax. -
10:10 - 10:16A tax on a good with external costs. Let's
take a look at how that works. The idea of -
10:16 - 10:20a Pigouvian tax after the economist
Arthur Pigou, first talked about these -
10:20 - 10:25ideas is pretty simple. The market
equilibrium is down here. The efficient -
10:25 - 10:32equilibrium is here. The problem is that
the suppliers aren't taking into account -
10:32 - 10:36all the costs of their production. They're
not taking into account these external -
10:36 - 10:42costs. So how could we get these suppliers
to take into account all of the costs of -
10:42 - 10:49their production? Well, one way of doing
it is to tax them, a Pigouvian tax equal -
10:50 - 10:56to the external cost makes the private
cost plus the tax, the total private cost, -
10:56 - 10:58equal to the social cost.
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10:58 - 11:03Let's remember how we can analyze a tax.
Remember that one of the ways to analyze a -
11:03 - 11:09tax is to shift the supply curve up by the
amount of the tax. So, if we impose a tax -
11:10 - 11:16on the suppliers equal to the external
cost the supply curve will shift up until -
11:16 - 11:24the private cost plus the tax is equal to
the social cost. In this case, we will now -
11:24 - 11:29have the efficient equilibrium will be the
same as the market equilibrium. The market -
11:29 - 11:36will internalize the externality. All of
the costs, private cost plus the tax equal -
11:36 - 11:41to the external cause will come to be
reflected in the price, and because all of -
11:41 - 11:46the costs are reflected in the price
consumers will buy the efficient quantity -
11:46 - 11:48of the good.
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11:48 - 11:54So, that's one way to handle an external
cost problem. In the next couple of -
11:54 - 11:58lectures, we'll be talking about external
benefits and we'll also illustrate some -
11:58 - 12:01other ways in which externalities can be
handled -
12:01 - 12:07- [male] If you want to test yourself
click Practice Questions. Or, if you're -
12:07 - 12:10ready to move on just click Next Video.
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12:10 - 12:12♪ [music] ♪
- Title:
- An Introduction to Externalities
- Description:
-
What are externalities and what are the different kinds of costs? And what does this have to do with the rise of “superbugs"? This video is an introduction to externalities, including the concepts of private cost, external cost, and social cost. Using the example of antibiotics and viruses, we take a look at how costs are passed along to different members of society beyond the producer and consumer. We’ll use a chart to illustrate how to calculate the effects of a Pigouvian tax, and we provide definitions for the other key terms that will be used throughout this video series.
Microeconomics Course: http://mruniversity.com/courses/principles-economics-microeconomics
Ask a question about the video: http://mruniversity.com/courses/principles-economics-microeconomics/externalities-definition-pigovian-tax#QandA
Next video: http://mruniversity.com/courses/principles-economics-microeconomics/flu-shot-positive-externalities-pigovian-subsidy
- Video Language:
- English
- Team:
- Marginal Revolution University
- Project:
- Micro
- Duration:
- 12:15
Marilia_PM edited English subtitles for An Introduction to Externalities | ||
Cindy Hurlow edited English subtitles for An Introduction to Externalities | ||
Cindy Hurlow edited English subtitles for An Introduction to Externalities | ||
Cindy Hurlow edited English subtitles for An Introduction to Externalities | ||
MRU2 edited English subtitles for An Introduction to Externalities | ||
MRU2 edited English subtitles for An Introduction to Externalities | ||
MRU2 edited English subtitles for An Introduction to Externalities | ||
MRU2 edited English subtitles for An Introduction to Externalities |