Understanding Externalities

Key Concepts

• Externalities: Costs or benefits not reflected in market transactions.
  • Negative Externality: External costs.
  • Positive Externality: External benefits.
• Types of Externalities:
  • Negative Externality: Can occur in consumption or production.
  • Positive Externality: Can occur in consumption or production.

Detailed Explanation

Negative Externalities

• Negative Consumption Externality:
  • Example: Smoking.
  • Impacts: Additional health costs to others.
• Negative Production Externality:
  • Example: Pollution from factories.

Positive Externalities

• Positive Consumption Externality:
  • Example: Education.
  • Impacts: Benefits others who gain from a more educated society.
• Positive Production Externality:
  • Example: Honey production.
  • Impacts: Bees pollinate nearby crops.

How to Draw Externality Graphs

1. Two Curves:

   • Production Externality: Marginal Private Cost (MPC) and Marginal Social Cost (MSC).
   • Consumption Externality: Marginal Private Benefit (MPB) and Marginal Social Benefit (MSB).

2. Production Levels:

   • Negative Externality: Market produces too much.
   • Positive Externality: Market produces too little.

3. Deadweight Loss (DWL):

   • Points to socially optimal quantity.
   • Positive Externalities: DWL points right.
   • Negative Externalities: DWL points left.

Examples of Graphs

• Negative Production Externality:

  • Two cost curves (MPC & MSC), with excess production.
  • Equilibrium at MSC = MSB.

• Negative Consumption Externality:

  • Two benefit curves (MPB & MSB), with excess consumption.
  • Equilibrium at MSB = MSC.

• Positive Consumption Externality:

  • Two benefit curves (MPB & MSB), with underconsumption.
  • Equilibrium at MSB = MSC.

• Positive Production Externality:

  • Two cost curves (MPC & MSC), with underproduction.
  • Equilibrium at MSB = MSC.

Practice and Conclusion

• To master drawing graphs, practice identifying the type of externality and apply the rules.
• Review guides and practice exercises are available to deepen understanding.

Use these notes as a guide to understanding and drawing graphs for various externalities. Remember the key rules and apply them during practice to excel in understanding economic externalities.