What Are Negative Externalities?

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- [Tyler] Let's travel back
to June 1924.

President Coolidge's son,
Calvin Jr.

is outside the White House
playing lawn tennis.

While playing,

he develops a blister
on his right foot.

A week later,

Calvin Jr. is dead.

A simple staph infection
developed from a blister

leading to sepsis.

Even though Calvin Jr.
was the president's son,

there was no medicine to save him.

Deaths from infection
were common at the time.

Even small wounds could become
a life or death ordeal.

Just four years later,

penicillin was discovered --

a breakthrough that could
have saved Calvin Jr.'s life.

This first antibiotic
revolutionized medicine.

Once fatal, bacterial infections
became easily curable.

But today, that miracle
is under threat from superbugs --

bacteria resistant to antibiotics.

How did superbugs happen?

And what does this have to do
with economics?

In the market for antibiotics,

we have buyers

-- represented
by the demand curve --

and sellers -- represented
by the supply curve.

A trade happens
when the buyer values the good

more than the market price

and the seller values
the market price

more than the good.

The buyer and the seller transact,

and both benefit.

All the buyers on this part
of the demand curve

value the antibiotics
more than the price,

and they buy them.

All the sellers on this part
of the supply curve

can produce antibiotics for profit

and sell them.

When we say a market maximizes
the gains from trade,

we're referring to every trade
being mutually beneficial.

Consumer and producer surplus
are maximized.

This is why economists
like markets.

But now we have a problem:

those pesky superbugs.

We have to introduce
a new entity into our analysis:

the bystanders.

Bystanders
are neither buying nor selling,

but nonetheless, they're affected

by the purchase
and use of antibiotics.

The economic concept
of externalities

describes the effect
of market trade on bystanders.

When bystanders bear a cost,

it's called a negative externality.

When bystanders receive a benefit,

that's called
a positive externality.

Either way,

buyers and sellers do not
typically consider externalities

on other people,

and that means
the market equilibrium

will maximize the sum
of producer and consumer surplus

but not bystander surplus.

And that's not good.

The use of antibiotics
has a negative externality problem.

Why is that?

No antibiotic is 100% effective.

The antibiotic kills some bacteria,

but some stronger bacteria survive,

flourish, and reproduce,

eventually rendering
the antibiotic ineffective.

We then develop a new antibiotic,

and the story repeats.

Play this evolutionary process out,

and you end up with superbugs

that are resistant
to many of our antibiotics.

The fundamental problem

is that antibiotic users reap
all the benefits of antibiotic use

without bearing all of the costs.

Each use of an antibiotic
creates a small increase

in bacterial resistance.

We all suffer the consequences

of the resulting
less effective antibiotics

every time that someone uses them.

Now, let's deploy supply and demand

to better visualize
this externality problem.

Here's our standard diagram

with the quantity of antibiotics

on the horizontal axis.

On the vertical axis,

we're showing both prices and costs

so that we can illustrate both
the price charged for antibiotics

and the costs to bystanders.

As usual, the equilibrium is found

where demand intersects supply.

Now, the key point

is that the supply curve is based

on what we'll call
the "private cost" --

the cost of producing
the antibiotic

paid by the supplier.

But we know there's another cost.

Every time an antibiotic
is produced and consumed,

there's a cost of increased
bacterial resistance.

We'll call that
the "external cost."

Negative externality
is just another way of saying

there's an external cost
on bystanders.

Suppliers do not typically consider

the external costs
of their production to bystanders,

so bystander costs
are not reflected in the price.

We can add the external cost

to the private supply curve

to make a new curve:

the social cost curve.

The social cost
is the cost to everyone,

including bystanders.

The vertical distance here
is the external cost --

the cost to bystanders.

Now, let's evaluate
both quantities.

The market equilibrium shows
the quantity the market produces --

the quantity that maximizes
producer and consumer surplus.

But we want to maximize
social surplus,

which is the total
net value created,

namely the sum of consumer surplus,

producer surplus,
and bystander surplus.

Since we have large external costs,

we don't want to produce

at the market equilibrium.

We want to produce here,

where the social cost curve
intersects the demand curve --

that's where social surplus
is maximized.

You can see that
the market equilibrium quantity

is higher than
the socially efficient quantity.

This difference represents
the overuse of antibiotics.

We can show this in another way.

Let's look at the value

of the last unit
the market produces.

What's the value of that last unit?

The private value is given

by the height
of the demand curve --

that's what consumers
are willing to pay.

What's the cost of that last unit?

The private cost is given

by the private supply curve,

but the social cost is given

by the higher social cost curve.

We don't want
to produce this last unit

because the social cost
is greater than the value.

If we don't want
to produce that last unit,

then we don't want
to produce any of the units

where the social cost is going
to be greater than the value.

In other words,

this area is a deadweight loss.

The social cost of these units

is greater than their value.

Producing these units means

society is worse off as a result.

And this represents
the loss to society

from the overuse of antibiotics.

So what conclusions can we draw?

If every deployment
of an antibiotic

had a high-value use

-- say, if it saved a life --

then the rise of superbugs
would be unfortunate,

but not necessarily something

we could or should do
something about.

But in fact, antibiotics
are often deployed

in low-value uses.

For instance,

sometimes people take antibiotics

when they don't even need them.

The market price does not include
the external costs,

namely the costs
of bacterial resistance

on bystanders.

It's incentivizing consumption

where the social cost
exceeds the value.

The market price
of antibiotics is too low.

We would like to discourage
these low-value uses

with a higher price.

Many people assume
with a negative externality

that the optimal quantity is zero,

but that's almost never the case.

We still want the people

who highly value
the good to buy it --

in this example, for instance,

someone with a dangerous infection.

We just don't want
to produce and sell goods

whose value is less
than the social cost.

Remember that a free market
maximizes consumer surplus

plus producer surplus,

but it does not take into account

the costs or benefits
to bystanders.

Ultimately, what we care about

is the total social surplus --

costs and benefits to consumers,

producers, and also to bystanders.

When external costs are large,

the market will not maximize
social surplus.

Externalities,

whether negative or positive,

are useful tools
for analyzing markets

and leading us
toward a variety of solutions

to account for them.

We'll discuss those
in other videos.

- [Narrator] If you're a teacher,
you should check out

our Externalities
and Public Goods Unit Plan

that incorporates this video.

If you're a learner,
make sure this video sticks

by answering
a few quick practice questions.

Or, if you're ready
for more microeconomics,

click for the next video.

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