An Introduction to Externalities

Summary

This video discusses how externalities, such as the overuse of antibiotics leading to antibiotic resistance, can cause market prices to misrepresent true social costs. It explains the concept of private and social costs, and how external costs can lead to overuse of goods. The video suggests a Pigouvian tax as a potential solution to correct the market failure by aligning private costs with social costs.

Takeaways

• 📊 Prices in free markets signal and coordinate actions, but they can be distorted when externalities are present.
• 🦠 The rise of antibiotic-resistant superbugs is partly due to the overuse of antibiotics, leading to external costs borne by everyone.
• 🌍 Bacterial resistance spreads globally, making it a shared problem, not just affecting the individual using the antibiotics.
• 💊 Overuse of antibiotics happens because users gain all the benefits but do not bear all the costs, creating a type of pollution through bacterial resistance.
• 🚜 Farmers contribute to bacterial resistance by using antibiotics for livestock growth, without considering the broader external costs.
• 📉 Private cost refers to costs borne by consumers or producers, while external costs are borne by bystanders, creating a social cost.
• ⚖️ Social cost includes both private and external costs, and the market fails to maximize social surplus when external costs are ignored.
• ❌ When external costs are not accounted for, markets overproduce, resulting in a deadweight loss where social costs outweigh private benefits.
• 💡 A Pigouvian tax can correct the overuse of antibiotics by internalizing external costs, aligning private costs with social costs.
• 🔧 When the external costs are incorporated into the price, market equilibrium can reflect the efficient level of output, reducing overuse.

Q & A

What is the main idea of the video?

The video discusses how prices in a free market sometimes fail to accurately reflect the true cost of goods due to externalities, specifically using the overuse of antibiotics and the rise of antibiotic-resistant bacteria as an example.

What is an external cost?

An external cost is a cost that is borne by a party not directly involved in the transaction, such as the cost of antibiotic resistance to society when an individual uses antibiotics.

How does the overuse of antibiotics contribute to the rise of superbugs?

The overuse of antibiotics contributes to the rise of superbugs because each use increases bacterial resistance, which spreads throughout the environment, leading to the proliferation of antibiotic-resistant bacteria.

What is the difference between private cost and social cost?

Private cost is the cost paid by the consumer or producer, while social cost includes the private cost plus any external costs, which are costs borne by others not directly involved in the transaction.

Why do farmers contribute to antibiotic resistance?

Farmers contribute to antibiotic resistance by using antibiotics not only to combat disease in livestock but also to help them grow faster. They often do not account for the external costs of increased resistance in their cost calculations.

What is meant by the term 'efficient equilibrium' in the context of the video?

The term 'efficient equilibrium' refers to the point where the quantity of a good produced and consumed is such that the social cost equals the value derived from its use, maximizing social surplus.

How does the supply curve reflect the cost of producing antibiotics?

The supply curve reflects the private cost of producing antibiotics, which is the cost borne by the suppliers, but it does not include the external cost of bacterial resistance that affects society at large.

What is a Pigouvian tax and how does it relate to external costs?

A Pigouvian tax is a tax imposed on a good that generates external costs. It is designed to make the private cost (including the tax) equal to the social cost, thus internalizing the externality and correcting the market failure.

What is the role of the demand curve in determining the efficient quantity of antibiotics?

The demand curve represents the value that consumers place on each unit of antibiotics. At the efficient quantity, the value of the last unit (as indicated by the demand curve) is equal to the social cost of producing that unit.

What is deadweight loss in the context of antibiotic use?

Deadweight loss refers to the inefficiency caused by producing units of a good (in this case, antibiotics) where the social cost exceeds the value to society. This overproduction leads to a net loss in social welfare.

How does the video suggest we can reduce the overuse of antibiotics?

The video suggests that imposing a Pigouvian tax on antibiotics, equal to the external cost of resistance, can align the private cost with the social cost, leading to a reduction in overuse and reaching the efficient equilibrium.

Outlines

00:00

💊 Antibiotic Resistance and Externalities

In this paragraph, Prof. Alex Tabarrok discusses the concept of prices as signals and incentives in free markets, and how they can sometimes fail to reflect the true cost of goods, such as antibiotics. He introduces the issue of antibiotic resistance, explaining how the overuse of antibiotics has led to the rise of 'superbugs'—bacteria resistant to antibiotics. The problem is exacerbated by the fact that users of antibiotics reap the benefits but do not bear the full costs, as the cost of increased bacterial resistance is spread across society. This leads to an overuse of antibiotics, creating a negative externality.

05:05

📈 Market Failure and Social Surplus

This section delves into the consequences of external costs on market efficiency. Prof. Tabarrok explains that when there are significant external costs or benefits, the market does not maximize social surplus. He contrasts the market's focus on consumer and producer surplus with the broader concept of social surplus, which includes the well-being of bystanders affected by externalities. Using a supply and demand diagram, he illustrates how the market equilibrium for antibiotics is determined without considering the external cost of bacterial resistance. The result is an overuse of antibiotics, as the market quantity exceeds the efficient quantity where social costs equal social benefits.

10:07

💼 Pigouvian Tax as a Solution

In the final paragraph, Prof. Tabarrok proposes a solution to the problem of external costs: the Pigouvian tax. Named after economist Arthur Pigou, this tax is levied on goods that generate external costs, such as antibiotics. The tax is designed to make producers internalize the external costs by adding the tax to the private cost, thus aligning the private cost with the social cost. By shifting the supply curve upward by the amount of the tax, the market equilibrium aligns with the efficient equilibrium, leading to a reduction in output to the socially optimal level. This approach ensures that all costs, including those borne by society, are reflected in the price, guiding consumers towards the efficient quantity of the good.

Keywords

💡Externalities

Externalities refer to the unintended costs or benefits that affect bystanders, who are not directly involved in the transaction or activity. In the video, Prof. Tabarrok discusses how the overuse of antibiotics leads to bacterial resistance, which is an external cost borne by society, not just the users of the antibiotics. This concept highlights how private decisions can have broader social impacts.

💡Private Cost

Private cost is the cost paid by the consumer or producer directly involved in a transaction. In the context of antibiotic use, the private cost includes the price of the antibiotic and its effects on the individual user. However, the video emphasizes that this does not account for the broader societal costs of increased bacterial resistance.

💡External Cost

External cost is a cost that is not borne by the individual or firm making the decision but by others, often society at large. The video explains that when antibiotics are overused, the development of resistant bacteria is an external cost, as it affects people beyond the immediate user, contributing to a global health problem.

💡Social Cost

Social cost includes both the private cost and any external costs. In the video, Prof. Tabarrok argues that when making decisions about antibiotic use, society should consider the social cost— the total cost to both the individual user and the broader society due to increased bacterial resistance.

💡Antibiotic Resistance

Antibiotic resistance refers to the ability of bacteria to survive and propagate even when exposed to antibiotics, making treatments less effective. The video uses this as a key example of how private decisions, such as overusing antibiotics, can lead to external costs that harm society by making previously curable infections more dangerous.

💡Overuse

Overuse, in this context, refers to the excessive consumption of antibiotics beyond what is socially optimal. The video explains that because users only consider their private costs and benefits, they tend to overuse antibiotics, leading to greater antibiotic resistance, which is a societal problem not accounted for in individual decisions.

💡Pigouvian Tax

A Pigouvian tax is a tax imposed on goods or activities that generate negative externalities, intended to correct the market outcome by aligning private costs with social costs. The video introduces this concept as a potential solution to the problem of antibiotic overuse, suggesting that a tax could help reduce consumption to the socially optimal level.

💡Market Equilibrium

Market equilibrium is the point where the quantity demanded by consumers equals the quantity supplied by producers at a given price. In the video, Prof. Tabarrok explains that the market equilibrium for antibiotics does not account for the external costs of bacterial resistance, leading to overuse compared to the socially optimal equilibrium.

💡Deadweight Loss

Deadweight loss refers to the loss of social surplus that occurs when the market fails to allocate resources efficiently. In the video, the overuse of antibiotics creates a deadweight loss because the social cost of using antibiotics exceeds the private value, meaning that too many antibiotics are being consumed compared to the efficient level.

💡Invisible Hand

The invisible hand is a metaphor introduced by economist Adam Smith, describing how individuals' self-interested actions in a free market can lead to outcomes that benefit society. The video contrasts this idea with the concept of externalities, showing that in cases of significant external costs, the invisible hand fails to maximize social surplus.

Highlights

A price is a signal wrapped up in an incentive that coordinates individual actions.

Price controls can impede the coordination of individual actions.

External costs and benefits can cause the price to be incorrect.

The rise of antibiotic-resistant bacteria is a consequence of external costs.

Antibiotics were a 20th-century miracle that significantly reduced infection-related deaths.

Antibiotic resistance is partly due to the evolutionary process and overuse of antibiotics.

Users of antibiotics bear none of the costs of increased bacterial resistance.

Antibiotic use can be compared to environmental pollution with resistant bacteria.

Farmers' use of antibiotics to promote livestock growth contributes to resistance.

Ignoring external costs leads to overuse of antibiotics.

Private cost is the cost paid by the consumer or producer.

External cost is a cost paid by people other than the consumer or producer.

Social cost includes the costs to consumers, producers, and bystanders.

Externalities refer to costs or benefits that fall on bystanders.

Significant external costs or benefits prevent a market from maximizing social surplus.

Market equilibrium does not account for all costs of antibiotic use.

The efficient quantity of antibiotics is less than the market quantity due to overuse.

The value of the marginal unit of antibiotics is less than its cost, indicating overuse.

A deadweight loss occurs when social cost is greater than private value for certain units.

When external costs exist, output should be reduced to maximize social surplus.

A Pigouvian tax can correct the market failure by making suppliers account for external costs.

A Pigouvian tax equal to the external cost aligns the private cost with the social cost.

Imposing a tax on suppliers can lead to an efficient market equilibrium.

Transcripts

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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.

- [Narrator] If you want to test yourself

click “Practice Questions.”

Or, if you're ready to move on just click “Next Video.”

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