Everything you need to know about EXTERNALITIES- Micro … — Transcript

Hey guys, students. In this video, I'm going to explain everything you need to know about drawing externalities. If you've seen any of my micro Unit 6 videos, you know when I draw externalities, they either look like this for a negative externality or for a positive externality look like this. These are accurate, but they're not precise. Your teacher or professor or maybe the AP test might ask you for some more details, so here we go.

is it's the idea that the free market doesn't recognize when there's external costs or benefits to other people and when there's cost there's a negative externality and when there's benefits there's a positive externality what you might not know is there's actually two different types of negative externalities and two different types of positive externalities each of them could have externalities of consumption or externalities of production let's talk about the example that your teacher

Now, you already know what an externality is. It's the idea that the free market doesn't recognize when there are external costs or benefits to other people. When there's cost, there's a negative externality, and when there's benefits, there's a positive externality. What you might not know is there's actually two different types of negative externalities and two different types of positive externalities. Each of them could have externalities of consumption or externalities of production. Let's talk about the example that your teacher or professor is definitely using in class: the idea of smoking. When you smoke, other people might get sick, so that's a negative externality. But notice that's on the consumption side. When people consume cigarettes, there are additional costs to other people. It's not on the production side. There's not like a factory that produces cigarettes that's polluting the local waterways and killing fish. So technically, drawing the negative externality from smoking like this is actually incorrect. I'll talk more about that in a second. Let's go talk about positive externalities and the idea of, let's say, honey. When a honey producer takes care of bees, there are benefits to them; they can sell that honey. But there's also external benefits to the rest of society because now bees can go do what bees do. For example, they can help pollinate the flowers from the flower company across the street. So this is a positive externality, but on production, not consumption. It's not people consuming honey; it's the production of honey. So the graph right here that we've been drawing for a positive externality is technically not correct.

more about that in a second let's go talk about positive externalities and the idea of let's say honey when a honey producer takes care of bees there's benefits to them they can sell that honey but there's also external benefits to the rest of society because now bees can go do what bees do for example they can help pollinate the flowers from The Flower Company across the street so this is a positive externality but on production not consumption it's not people consuming honey it's the

Okay, all that said, let's talk about how to draw the correct graphs showing four different things: a negative production externality, a negative consumption externality, a positive production externality, and a positive consumption externality. I have three rules that if you follow, you're going to get the right graph every single time. Rule number one: a production externality always has two cost curves, one a marginal private cost and the other marginal social cost. And this means that a consumption externality always has two benefit curves, a marginal private benefit and a marginal social benefit. Rule two is a negative externality always produces too much, and a positive externality always produces too little. This is going to help you figure out what's going on the graph. If you just look at it, you can see the quantity in the free market is less than the socially optimal quantity. You know what? That must be a positive externality. We're not producing enough. And if the free market quantity is producing more than the socially optimal, you know we're producing too much. That must be a negative externality. Let me show you what I'm talking about on a graph. If you're drawing a negative production externality, that means you have two cost curves, and the quantity to the left must be the socially optimal quantity because the quantity on the right is the free market. We're producing too much, and that makes the rest of the graph super easy to draw. You know the marginal social benefit equals marginal social cost at the quantity socially optimal, and since there are two cost curves and one of them is already the marginal social cost, that means this one must be the marginal private cost. So that's the correct graph for a negative production externality.

always has two cost curves one a marginal private cost and the other marginal social costs and this means that a consumption externality always has two benefit curves a marginal private benefit and a marginal social benefit rule two is a negative externality always produces too much and a positive externality always produces too little this is going to help you figure out what's going on the graph if you just look at it you can see the quantity in the free market is less than

So now let's draw a negative consumption externality. You know there's going to be two benefit curves, and you also know the quantity to the right is the free market quantity. We're producing too much with a negative externality. The other quantity must be the socially optimal quantity, and the socially optimal quantity has to be where the marginal social benefit hits the marginal social cost. So you got those labeled. That means this must be the marginal private benefit. This is the correct graph for a negative externality from smoking cigarettes. It's a consumption externality. The people that smoke cigarettes are only factoring their private benefit; they're not recognizing the social benefit is a lot lower because other people are going to get sick.

market we're producing too much and that makes the rest of the graph super easy to draw you know the marginal social benefit equals a marginal social cost at the quantity socially optimal and since there's two cost curves and one of them is already the marginal social cost that means this one must be the marginal private cost so that's the correct graph for a negative production externality so now let's draw a negative consumption externality you know there's going to be

Now let's go look at the other side and talk about a positive consumption externality. A consumption externality has two benefit curves, and the quantity on the left is going to be the free market because in a positive externality, we're producing too little. We're not producing enough. So the other quantity must be the socially optimal quantity, and since that quantity socially optimal is always where the marginal social benefit hits the marginal social cost, we've got those labeled. The other curve must be the marginal private benefit. So that's it. That's the correct graph for a positive consumption externality.

a consumption externality the people that smoke cigarettes are only factoring their private benefit they're not recognizing the social benefit is a lot lower because other people are going to get sick now let's go look at the other side and talk about a positive consumption externality a consumption externality has two benefit curves and the quantity on the left is going to be the free market because in a positive externality we're producing too little we're not producing enough so the other

But what about a positive production externality? What about honey? Well, remember, we know on the production side there's always going to be two cost curves. We've got the starting graph looking like this. We know the quantity to the left is going to be the free market quantity because they're underproducing. That makes the other quantity socially optimal. And if that's the socially optimal quantity, this must be the marginal social benefit and the marginal social cost, and this must be the marginal private cost. So there we go, four different graphs showing you four different situations: two positive externalities and two negative externalities.

starting graph looking like this this we know the quantity to the left is going to be the quantity free market because they're under producing that makes the other quantity socially optimal and if that's the socially optimal quantity this must be the marginal social benefit in the marginal social cost and this must be the marginal private cost so there we go four different graphs showing you four different situations two positive externalities and two negative externalities but hold up I

But hold up, I said there were three rules, and I've only given you two so far. So what's the third one? Well, that's how to find deadweight loss. Here's the rule: deadweight loss always points to socially optimal. So if you're trying to figure out deadweight loss, put a dot where marginal social benefit hits marginal social cost. The arrow of deadweight loss is going to point right to that. And if you're underproducing, deadweight loss is going to point to the right. Again, for positive externalities, deadweight loss always points to the right, and for negative externalities, it always points to the left. It doesn't matter which graph you're looking at; it's always pointing that direction.

deadweight loss always points to the right and for negative externalities it always points to the left it doesn't matter which graph you're looking at it's always pointing that direction that was a lot but you're still gonna need to practice so right now I'm going to give you two graphs you have to figure out what type type of externality is it positive or negative is it production or consumption figure it out here we go [Music]

That was a lot, but you're still going to need to practice. So right now, I'm going to give you two graphs. You have to figure out what type of externality it is: positive or negative, production or consumption. Figure it out. Here we go.

be less than quantity socially optimal and Rule three deadweight loss always points to socially optimal positive always points right negative always points left hey that was a lot thanks so much for watching this video take a look at the new study guides I just added to the ultimate review packet they're super helpful and they'll include all this new graphing practice stuff that your teacher Professor might throw at you thanks for watching my videos until next time