An Introduction to Externalities

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.

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- [Alex] 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 the price

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 cost, 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 are 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?

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 cost. They don't pay
attention to those costs which are borne

by other people.

When antibiotic users ignore the external
cost

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
cost or external benefits. We'll talk

more about external benefits in a future
talk. In other words, externalities is

just another word for cost 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, 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 of 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 cause 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

- [male] If you want to test yourself
click Practice Questions. Or, if you're

ready to move on just click Next Video.

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