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- [Alex] In previous videos, we've
emphasized that a price is a signal

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wrapped up in an incentive and that prices
coming out of free markets coordinate

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individual actions in just such a way that
the outcome looks as if it were created by

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a benevolent invisible hand. We've shown
how price controls can impede the price

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and what we want to show now is that even
with the free market sometimes the price

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isn't right. In particular, when we have
externalities, external cost, and external

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benefits, which I'll define more in just a
few minutes, then the price isn't right.

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So what we want to do in this video is
show both the causes and the consequences

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of external costs and external benefits.
Let's get going.

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Let's begin with the rise of the super
bugs. These are bacteria which are now

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resistant to our antibiotics. Before the
age of the antibiotic, even a simple skin

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cut or a bruise or scrape could kill
people due to the infection. And people

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who are more seriously injured, for
example, in battle most of them died not

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because of their battle wounds, but
because of infection which took place

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after the wound, because of the wound.

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In the 20th century, the miracle of
antibiotics meant that far, far fewer

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people died from these infections. But
that miracle is now coming to an end, as

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our antibiotics are no longer as effective
as they once were. Why is this happening?

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Part of the problem is that no antibiotic
is always 100% effective. And

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bacteria, like people, are diverse. They
have different strengths and different

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weaknesses.

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The bacteria which are not killed by an
antibiotic which happen to have certain

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characteristics which make them strong
against that antibiotic. Those bacteria

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propagate and survive and become more
dominant. So, the evolutionary process has

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led to resistance.

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We however, are not entirely innocent in
this process. Resistance has been helped

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by the overuse of antibiotics. So why are
antibiotics overused? The fundamental

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reason is that users get all the benefits
but do not bear all of the

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costs of antibiotic use. Each use of an
antibiotic creates a small increase in

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bacterial resistance, at least in a
probabilistic sense. But bacteria don't

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stay in one place or one body, they spread
throughout the environment and indeed

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throughout that world. So an increase that
cost, that increase in bacterial

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resistance is a cost borne by everyone,
not just the user of the antibiotic.

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We can think of using an antibiotic as
creating a little bit of pollution, of

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polluting the environment with more
resistant and stronger bacteria. This is

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true when somebody, for example, uses an
antibiotic when they have a virus which

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the antibiotic doesn't help with rather
than when they have bacteria. That's a

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cost. It's a cost because that use of the
antibiotic then generates more resistance

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and that resistance spreads around the
world. Farmers who use antibiotics not to

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combat disease in their livestock but to
help the livestock grow faster, also

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create more bacterial resistance. But that
resistance is something they don't include

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in their calculus of cost. They don't pay
attention to those costs which are borne

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by other people.

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When antibiotic users ignore the external
cost

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of their choices we get overuse. Since
some costs are ignored by the decision

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makers we get overuse of antibiotics.
Okay, well, with that as an introduction,

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let's define some terms. Private cost:

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this is the cost paid by the consumer or
the producer. External cost:

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this is a cost paid by bystanders, by
people other than the consumer or the

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producer. It's a cost paid by people other
than those who are buying or selling in

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this particular market. The social cost

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is the cost to everyone. The cost when
we take into account consumers, producers

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and bystanders. In other words, it's the
private cost plus the external cost.

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Externalities:

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this is simply another word for external
cost or external benefits. We'll talk

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

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just another word for cost or benefits
that fall on bystanders.

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When there are significant external costs
or external benefits a market will not

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maximize social surplus. Now, remember we
showed earlier that a market maximizes

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consumer surplus plus producer surplus.
That's always true for a free market.

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However, what we've just learned is that
an external cost is a cost that falls on

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bystanders, not on consumers or producers.
So, social surplus which is consumer

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surplus plus producer surplus plus
bystander surplus. That's ultimately

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really what we care about. We care about
not just about consumers and producers, we

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care about everyone including bystanders.
So we want to maximize social surplus.

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However, when there are significant
external costs or benefits, the market is

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not going to maximize social surplus. It's
going to maximize consumer surplus plus

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producer surplus. But that's not
everything. When the

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costs and the benefits to bystanders
are not counted, then we're not going to

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maximize social surplus. In fact, we can
say things a little bit more precisely,

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and we'll do that next with a supply and
demand diagram. Okay, here's our standard

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diagram with the quantity of antibiotics
on the horizontal axis and prices and

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costs on the vertical axis. As usual, the
equilibrium is found where demand

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intersects supply, where quantity demanded
is equal to quantity supplied. Now the key

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point here is that the supply curve is
based on private cost, basically the

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cost of producing the antibiotic. But
there's another cost.

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Every time an antibiotic is produced and
consumed there's a cost of bacterial

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resistance. A cost borne by all of us, by
bystanders. There's an external cost and

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that is not taken into account by the
suppliers. So this external cost doesn't

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go into the price. Nevertheless, what we
really care about is the social cost of

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antibiotic use, not just the cost of
producing the antibiotic but also the cost

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of actually using it, including the
external cost. So, the market equilibrium,

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the market quantity, is found where the
market demand and supply curves intersect.

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But the true efficient equilibrium, the
equilibrium we would like to be at, is

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where the demand curve intersects the
social cost curve. So, the efficient

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quantity is less than the market quantity,
thus we have overuse.

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The market doesn't take into account all
of the costs of antibiotic use so we get

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overuse relative to the efficient
equilibrium. Now we can actually show this

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in another way. Let's look at the value of
the marginal unit,

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the value of the unit, the market unit,
the last unit the market produces. What's

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the private value, what's the value of
this unit? Well, it's given by the height

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of the demand curve. Now, what is the cost
of that marginal unit, of that last unit

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consumed? Well, the private cost is given
by the private supply curve, but the

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social cost is given by the much higher
social cost curve. So notice on that last

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unit, the cost of that last unit is much
larger than the value. That's the sense in

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which we have overuse.

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We don't really want to produce this last
unit because the cost is greater than the

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value. Indeed, if we don't want to produce
this unit, we don't to produce any unit

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where the social cost is greater than the
value. So in other words, this area right

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here is a deadweight loss. These are the
units for which the social cost is greater

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than the private value, therefore, these
are the units we don't want to produce.

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This is the deadweight loss and this is
the overuse of the antibiotic.

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What conclusions can we make? When there
are external costs, output should be

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reduced to maximize social surplus.
Another way of thinking about this is, for

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determining the efficient level of output.
Who bears the cost is irrelevant. The fact

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that these costs are borne by bystanders
is irrelevant, we want to take into

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account all costs not just the cost of the
suppliers. The problem is, is that when

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other people bear some of the cost of
production, the price is too low.

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Not all of the costs are reflected in the
price. As a result, the price is sending

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the wrong signal. It's incentivizing too
much production. Because the price is too

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low, antibiotic users purchase too many
antibiotics and we get overuse.

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The solution to this or one solution to
this is in what's called a Pigouvian tax.

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A tax on a good with external costs. Let's
take a look at how that works. The idea of

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a Pigouvian tax after the economist
Arthur Pigou, first talked about these

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ideas is pretty simple. The market
equilibrium is down here. The efficient

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equilibrium is here. The problem is that
the suppliers aren't taking into account

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all the costs of their production. They're
not taking into account these external

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costs. So how could we get these suppliers
to take into account all of the costs of

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their production? Well, one way of doing
it is to tax them, a Pigouvian tax equal

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to the external cost makes the private
cost plus the tax, the total private cost,

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equal to the social cost.

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Let's remember how we can analyze a tax.
Remember that one of the ways to analyze a

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tax is to shift the supply curve up by the
amount of the tax. So, if we impose a tax

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on the suppliers equal to the external
cost the supply curve will shift up until

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the private cost plus the tax is equal to
the social cost. In this case, we will now

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have the efficient equilibrium will be the
same as the market equilibrium. The market

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will internalize the externality. All of
the costs, private cost plus the tax equal

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to the external cost will come to be
reflected in the price, and because all of

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the costs are reflected in the price
consumers will buy the efficient quantity

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of the good.

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So, that's one way to handle an external
cost problem. In the next couple of

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lectures, we'll be talking about external
benefits and we'll also illustrate some

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other ways in which externalities can be
handled

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

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ready to move on just click Next Video.

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♪ [music] ♪