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