What Are Negative Externalities?

Let's travel back to June
nineteen twenty four.

President Coolidge's son, Calvin junior,

is outside the White
House playing lawn tennis.

While playing, he develops
a blister on his right foot.

A week later, Calvin junior is dead.

A simple staph infection developed
from a blister leading to sepsis.

Even though Calvin junior
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 Junior'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.

Now, why is that?

Well, no antibiotic is a
hundred percent 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?

Well, the private value is given
by the height of the demand curve.

That's what consumers are willing to pay.
Now what's the cost of that last unit?

Well, 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.

Now, 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.

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.