0:00:02.425,0:00:04.628
♪ [music] ♪

0:00:09.596,0:00:13.855
- [Alex] In previous videos, we've[br]emphasized that a price is a signal

0:00:14.000,0:00:19.180
wrapped up in an incentive and that prices[br]coming out of free markets coordinate

0:00:19.300,0:00:25.748
individual actions in just such a way that[br]the outcome looks as if it were created by

0:00:25.748,0:00:31.640
a benevolent invisible hand. We've shown[br]how price controls can impede the price

0:00:31.820,0:00:36.950
and what we want to show now is that even[br]with the free market sometimes the price

0:00:37.130,0:00:42.660
isn't right. In particular, when we have[br]externalities, external cost, and external

0:00:42.840,0:00:48.490
benefits, which I'll define more in just a[br]few minutes, then the price isn't right.

0:00:48.670,0:00:53.160
So what we want to do in this video is[br]show both the causes and the consequences

0:00:53.340,0:00:57.838
of external costs and external benefits.[br]Let's get going.

0:01:01.240,0:01:05.650
Let's begin with the rise of the super[br]bugs. These are bacteria which are now

0:01:05.830,0:01:12.500
resistant to our antibiotics. Before the[br]age of the antibiotic, even a simple skin

0:01:12.680,0:01:17.870
cut or a bruise or scrape could kill[br]people due to the infection. And people

0:01:18.050,0:01:23.020
who are more seriously injured, for[br]example, in battle most of them died not

0:01:23.200,0:01:27.440
because of their battle wounds, but[br]because of infection which took place

0:01:27.620,0:01:30.130
after the wound, because of the wound.

0:01:30.310,0:01:35.750
In the 20th century, the miracle of[br]antibiotics meant that far, far fewer

0:01:35.930,0:01:41.810
people died from these infections. But[br]that miracle is now coming to an end, as

0:01:41.990,0:01:48.940
our antibiotics are no longer as effective[br]as they once were. Why is this happening?

0:01:49.120,0:01:54.680
Part of the problem is that no antibiotic[br]is always 100% effective. And

0:01:54.860,0:01:59.100
bacteria, like people, are diverse. They[br]have different strengths and different

0:01:59.280,0:02:00.503
weaknesses.

0:02:00.530,0:02:05.420
The bacteria which are not killed by an[br]antibiotic which happen to have certain

0:02:05.600,0:02:10.669
characteristics which make them strong[br]against that antibiotic. Those bacteria

0:02:10.850,0:02:17.070
propagate and survive and become more[br]dominant. So, the evolutionary process has

0:02:17.250,0:02:19.910
led to resistance.

0:02:20.090,0:02:25.600
We however, are not entirely innocent in[br]this process. Resistance has been helped

0:02:25.780,0:02:33.100
by the overuse of antibiotics. So why are[br]antibiotics overused? The fundamental

0:02:33.280,0:02:37.410
reason is that users get all the benefits[br]but do not bear all of the

0:02:37.590,0:02:43.550
costs of antibiotic use. Each use of an[br]antibiotic creates a small increase in

0:02:43.730,0:02:48.400
bacterial resistance, at least in a[br]probabilistic sense. But bacteria don't

0:02:48.580,0:02:53.210
stay in one place or one body, they spread[br]throughout the environment and indeed

0:02:53.390,0:02:58.030
throughout that world. So an increase that[br]cost, that increase in bacterial

0:02:58.210,0:03:04.850
resistance is a cost borne by everyone,[br]not just the user of the antibiotic.

0:03:05.030,0:03:09.640
We can think of using an antibiotic as[br]creating a little bit of pollution, of

0:03:09.820,0:03:14.900
polluting the environment with more[br]resistant and stronger bacteria. This is

0:03:15.080,0:03:19.560
true when somebody, for example, uses an[br]antibiotic when they have a virus which

0:03:19.740,0:03:24.090
the antibiotic doesn't help with rather[br]than when they have bacteria. That's a

0:03:24.270,0:03:30.520
cost. It's a cost because that use of the[br]antibiotic then generates more resistance

0:03:30.700,0:03:36.060
and that resistance spreads around the[br]world. Farmers who use antibiotics not to

0:03:36.240,0:03:42.180
combat disease in their livestock but to[br]help the livestock grow faster, also

0:03:42.360,0:03:48.810
create more bacterial resistance. But that[br]resistance is something they don't include

0:03:48.990,0:03:53.640
in their calculus of cost. They don't pay[br]attention to those costs which are borne

0:03:53.820,0:03:55.770
by other people.

0:03:55.950,0:04:00.550
When antibiotic users ignore the external[br]cost

0:04:00.840,0:04:06.450
of their choices we get overuse. Since[br]some costs are ignored by the decision

0:04:06.630,0:04:12.490
makers we get overuse of antibiotics.[br]Okay, well, with that as an introduction,

0:04:12.670,0:04:15.220
let's define some terms. Private cost:

0:04:15.400,0:04:20.600
this is the cost paid by the consumer or[br]the producer. External cost:

0:04:20.779,0:04:26.150
this is a cost paid by bystanders, by[br]people other than the consumer or the

0:04:26.330,0:04:32.010
producer. It's a cost paid by people other[br]than those who are buying or selling in

0:04:32.190,0:04:35.260
this particular market. The social cost

0:04:35.440,0:04:40.830
is the cost to everyone. The cost when[br]we take into account consumers, producers

0:04:41.010,0:04:48.140
and bystanders. In other words, it's the[br]private cost plus the external cost.

0:04:48.320,0:04:49.260
Externalities:

0:04:49.440,0:04:54.360
this is simply another word for external[br]cost or external benefits. We'll talk

0:04:54.540,0:04:59.090
more about external benefits in a future[br]talk. In other words, externalities is

0:04:59.270,0:05:04.980
just another word for cost or benefits[br]that fall on bystanders.

0:05:05.160,0:05:10.230
When there are significant external costs[br]or external benefits a market will not

0:05:10.410,0:05:15.260
maximize social surplus. Now, remember we[br]showed earlier that a market maximizes

0:05:15.440,0:05:21.140
consumer surplus plus producer surplus.[br]That's always true for a free market.

0:05:21.320,0:05:26.540
However, what we've just learned is that[br]an external cost is a cost that falls on

0:05:26.720,0:05:33.240
bystanders, not on consumers or producers.[br]So, social surplus which is consumer

0:05:33.420,0:05:38.340
surplus plus producer surplus plus[br]bystander surplus. That's ultimately

0:05:38.520,0:05:42.330
really what we care about. We care about[br]not just about consumers and producers, we

0:05:42.510,0:05:49.390
care about everyone including bystanders.[br]So we want to maximize social surplus.

0:05:49.570,0:05:53.590
However, when there are significant[br]external costs or benefits, the market is

0:05:53.770,0:05:58.460
not going to maximize social surplus. It's[br]going to maximize consumer surplus plus

0:05:58.640,0:06:01.750
producer surplus. But that's not[br]everything. When the

0:06:02.000,0:06:08.290
costs and the benefits to bystanders[br]are not counted, then we're not going to

0:06:08.470,0:06:13.480
maximize social surplus. In fact, we can[br]say things a little bit more precisely,

0:06:13.660,0:06:18.330
and we'll do that next with a supply and[br]demand diagram. Okay, here's our standard

0:06:18.510,0:06:22.290
diagram with the quantity of antibiotics[br]on the horizontal axis and prices and

0:06:22.470,0:06:27.040
costs on the vertical axis. As usual, the[br]equilibrium is found where demand

0:06:27.220,0:06:32.200
intersects supply, where quantity demanded[br]is equal to quantity supplied. Now the key

0:06:32.380,0:06:37.500
point here is that the supply curve is[br]based on private cost, basically the

0:06:37.680,0:06:42.260
cost of producing the antibiotic. But[br]there's another cost.

0:06:42.440,0:06:48.720
Every time an antibiotic is produced and[br]consumed there's a cost of bacterial

0:06:48.900,0:06:55.150
resistance. A cost borne by all of us, by[br]bystanders. There's an external cost and

0:06:55.330,0:07:01.600
that is not taken into account by the[br]suppliers. So this external cost doesn't

0:07:01.780,0:07:07.760
go into the price. Nevertheless, what we[br]really care about is the social cost of

0:07:07.940,0:07:12.960
antibiotic use, not just the cost of[br]producing the antibiotic but also the cost

0:07:13.140,0:07:18.860
of actually using it, including the[br]external cost. So, the market equilibrium,

0:07:19.040,0:07:23.910
the market quantity, is found where the[br]market demand and supply curves intersect.

0:07:24.090,0:07:29.630
But the true efficient equilibrium, the[br]equilibrium we would like to be at, is

0:07:29.810,0:07:34.830
where the demand curve intersects the[br]social cost curve. So, the efficient

0:07:35.010,0:07:41.900
quantity is less than the market quantity,[br]thus we have overuse.

0:07:42.080,0:07:48.770
The market doesn't take into account all[br]of the costs of antibiotic use so we get

0:07:48.950,0:07:54.590
overuse relative to the efficient[br]equilibrium. Now we can actually show this

0:07:54.770,0:08:00.250
in another way. Let's look at the value of[br]the marginal unit,

0:08:00.500,0:08:05.180
the value of the unit, the market unit,[br]the last unit the market produces. What's

0:08:05.360,0:08:09.740
the private value, what's the value of[br]this unit? Well, it's given by the height

0:08:09.920,0:08:15.810
of the demand curve. Now, what is the cost[br]of that marginal unit, of that last unit

0:08:15.990,0:08:21.280
consumed? Well, the private cost is given[br]by the private supply curve, but the

0:08:21.460,0:08:29.000
social cost is given by the much higher[br]social cost curve. So notice on that last

0:08:29.180,0:08:36.000
unit, the cost of that last unit is much[br]larger than the value. That's the sense in

0:08:36.179,0:08:37.860
which we have overuse.

0:08:38.039,0:08:43.559
We don't really want to produce this last[br]unit because the cost is greater than the

0:08:43.740,0:08:49.270
value. Indeed, if we don't want to produce[br]this unit, we don't to produce any unit

0:08:49.450,0:08:55.360
where the social cost is greater than the[br]value. So in other words, this area right

0:08:55.540,0:09:02.200
here is a deadweight loss. These are the[br]units for which the social cost is greater

0:09:02.380,0:09:06.440
than the private value, therefore, these[br]are the units we don't want to produce.

0:09:06.620,0:09:14.380
This is the deadweight loss and this is[br]the overuse of the antibiotic.

0:09:14.560,0:09:18.610
What conclusions can we make? When there[br]are external costs, output should be

0:09:18.790,0:09:24.120
reduced to maximize social surplus.[br]Another way of thinking about this is, for

0:09:24.300,0:09:29.190
determining the efficient level of output.[br]Who bears the cost is irrelevant. The fact

0:09:29.370,0:09:33.790
that these costs are borne by bystanders[br]is irrelevant, we want to take into

0:09:33.970,0:09:39.950
account all costs not just the cost of the[br]suppliers. The problem is, is that when

0:09:40.130,0:09:45.260
other people bear some of the cost of[br]production, the price is too low.

0:09:45.440,0:09:52.030
Not all of the costs are reflected in the[br]price. As a result, the price is sending

0:09:52.210,0:09:57.480
the wrong signal. It's incentivizing too[br]much production. Because the price is too

0:09:57.660,0:10:04.060
low, antibiotic users purchase too many[br]antibiotics and we get overuse.

0:10:04.240,0:10:09.370
The solution to this or one solution to[br]this is in what's called a Pigouvian tax.

0:10:09.550,0:10:16.030
A tax on a good with external costs. Let's[br]take a look at how that works. The idea of

0:10:16.210,0:10:19.630
a Pigouvian tax after the economist[br]Arthur Pigou, first talked about these

0:10:19.810,0:10:25.110
ideas is pretty simple. The market[br]equilibrium is down here. The efficient

0:10:25.290,0:10:31.900
equilibrium is here. The problem is that[br]the suppliers aren't taking into account

0:10:32.080,0:10:36.190
all the costs of their production. They're[br]not taking into account these external

0:10:36.370,0:10:42.030
costs. So how could we get these suppliers[br]to take into account all of the costs of

0:10:42.210,0:10:49.390
their production? Well, one way of doing[br]it is to tax them, a Pigouvian tax equal

0:10:49.570,0:10:55.530
to the external cost makes the private[br]cost plus the tax, the total private cost,

0:10:55.710,0:10:58.050
equal to the social cost.

0:10:58.230,0:11:02.520
Let's remember how we can analyze a tax.[br]Remember that one of the ways to analyze a

0:11:02.700,0:11:09.460
tax is to shift the supply curve up by the[br]amount of the tax. So, if we impose a tax

0:11:09.640,0:11:16.150
on the suppliers equal to the external[br]cost the supply curve will shift up until

0:11:16.330,0:11:23.800
the private cost plus the tax is equal to[br]the social cost. In this case, we will now

0:11:23.980,0:11:29.290
have the efficient equilibrium will be the[br]same as the market equilibrium. The market

0:11:29.470,0:11:35.900
will internalize the externality. All of[br]the costs, private cost plus the tax equal

0:11:36.080,0:11:40.940
to the external cause will come to be[br]reflected in the price, and because all of

0:11:41.120,0:11:45.980
the costs are reflected in the price[br]consumers will buy the efficient quantity

0:11:46.160,0:11:47.570
of the good.

0:11:47.750,0:11:53.720
So, that's one way to handle an external[br]cost problem. In the next couple of

0:11:53.900,0:11:57.540
lectures, we'll be talking about external[br]benefits and we'll also illustrate some

0:11:57.720,0:12:00.700
other ways in which externalities can be[br]handled

0:12:00.880,0:12:06.890
- [male] If you want to test yourself[br]click Practice Questions. Or, if you're

0:12:07.070,0:12:09.614
ready to move on just click Next Video.

0:12:09.614,0:12:11.756
♪ [music] ♪