♪ [music] ♪ - [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. - [Narrator]
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