Understanding Externalities and How to Draw Them

Overview

• Externalities occur when the free market doesn't account for external costs or benefits to other people.
• Negative Externality: External costs; example - smoking.
• Positive Externality: External benefits; example - honey production.
• Two types for each externality:
  • Consumption Externality
  • Production Externality

Detailed Explanation

Types of Externalities

1. Negative Consumption Externality

   • Example: Smoking causes others to get sick (external costs on consumption side).
   • Incorrect to depict as a production externality (e.g., pollution from cigarette factories).

2. Positive Production Externality

   • Example: Honey production benefits society by aiding in pollination (external benefits on production side).
   • Incorrect to depict as a consumption externality.

How to Draw the Graphs

• Four types of graphs are necessary:
  • Negative Production Externality
  • Negative Consumption Externality
  • Positive Production Externality
  • Positive Consumption Externality

Rules for Drawing Externality Graphs

• Rule 1:
  • Production externality has two cost curves: Marginal Private Cost (MPC) and Marginal Social Cost (MSC).
  • Consumption externality has two benefit curves: Marginal Private Benefit (MPB) and Marginal Social Benefit (MSB).
• Rule 2:
  • Negative externality results in overproduction.
  • Positive externality results in underproduction.
  • Socially optimal quantity is always at the intersection of MSB and MSC.
• Rule 3:
  • Deadweight loss always points to the socially optimal quantity.
  • For positive externalities, deadweight loss points right (underproduction).
  • For negative externalities, deadweight loss points left (overproduction).

Graphical Representation

• Negative Production Externality:

  • Two cost curves; MPC and MSC.
  • Free market quantity > socially optimal quantity.
  • MSB = MSC at social optimum.

• Negative Consumption Externality:

  • Two benefit curves; MPB and MSB.
  • Free market quantity > socially optimal quantity.
  • MSB = MSC at social optimum.

• Positive Consumption Externality:

  • Two benefit curves; MPB and MSB.
  • Free market quantity < socially optimal quantity.
  • MSB = MSC at social optimum.

• Positive Production Externality:

  • Two cost curves; MPC and MSC.
  • Free market quantity < socially optimal quantity.
  • MSB = MSC at social optimum.

Practice

• Practice with provided graphs to determine type of externality:
  • Negative consumption or positive production externality?
  • Key features to identify:
    • Number of cost or benefit curves.
    • Relative position of free market vs. socially optimal quantity.
    • Direction of deadweight loss.

Additional Resources

• Mention of new study guides and graphing practice in the ultimate review packet.
• Encourage to watch more videos for better understanding.

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Note: This summary provides a comprehensive guide on understanding and drawing externalities, suitable for students preparing for exams or looking to deepen their understanding of economic externalities.