Hey Econ 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 they look like this. These are accurate, but they're not precise.
Your teacher, professor, or maybe the AP test might ask you for some more details, so here we go. Now you already know what an externality 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 costs, 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 can have externalities of consumption or externalities of production. Let's talk about the example that your teacher, professor definitely used 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's additional cost on 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'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 functionality, 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.
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 gonna 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 gonna 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 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 the 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 two benefit curves, and you also know the quantity to the right is the quantity free market.
We're producing too much with a negative externality. The other quantity must be the quantity socially optimal. 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 in their private benefit. They're not recognizing the social benefit is a lot lower because other people are gonna 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 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. But what about a positive production externality? What about honey? Well, remember, we know on the production side, there's always gonna be two cost curves.
So we've got the starting graph looking like this. We know the quantity to the left is gonna be the quantity free market because they're underproducing. That makes the other quantity socially optimal. And if that's a 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. 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 with a marginal social benefit, hits the marginal social cost, the arrow of deadweight loss is gonna point right to that. And if you're underproducing, deadweight loss is gonna 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. Woo, that was a lot. But you're still gonna need to practice. So right now, I'm gonna give you two graphs. You have to figure out what type of externality.
Is it positive or negative? Is it production or consumption? Figure it out.
Here we go. This one is a negative consumption actionality, and this one is a positive production actionality. And how do you know?
Well, you follow the three rules. Number one, consumption actionality will always have two benefit curves, and production actionality will always have two cost curves. Rule two for negative actionality, for both types, the quantity in the free market will always be more than the quantity socially optimal.
And for positive actionality, the quantity in the free market will always be less than quantity socially optimal. And rule three, dead weight 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 or professor might throw at you. Thanks for watching my videos. Until next time.