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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- [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.

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