Everything you need to know about EXTERNALITIES- Micro Unit 6

Summary

In this video, the presenter explains how to correctly graph externalities, covering both positive and negative types. The video emphasizes the distinction between externalities of production and consumption, using examples like smoking (negative consumption externality) and honey production (positive production externality). The presenter introduces three key rules: 1) production externalities have two cost curves, while consumption externalities have two benefit curves; 2) negative externalities produce too much, and positive externalities too little; 3) deadweight loss always points to the socially optimal quantity. The video concludes with practice exercises to reinforce the concepts.

Takeaways

• 😀 Externalities occur when the free market doesn't account for the external costs or benefits to others.
• 😀 A negative externality arises when there are additional costs to society, like with smoking (a consumption externality).
• 😀 A positive externality happens when there are benefits to society, like with honey production (a production externality).
• 😀 There are two types of negative externalities (consumption and production) and two types of positive externalities (consumption and production).
• 😀 A production externality always has two cost curves: marginal private cost and marginal social cost.
• 😀 A consumption externality always has two benefit curves: marginal private benefit and marginal social benefit.
• 😀 In a negative externality, the free market produces more than the socially optimal quantity.
• 😀 In a positive externality, the free market produces less than the socially optimal quantity.
• 😀 Deadweight loss always points to the socially optimal quantity on the graph, with the direction depending on the type of externality.
• 😀 Negative externalities' deadweight loss points to the left (overproduction), while positive externalities' deadweight loss points to the right (underproduction).

Q & A

What are externalities in economics?

Externalities refer to the costs or benefits of a market activity that affect third parties who are not directly involved in the transaction. They are either negative or positive, depending on whether they impose costs or provide benefits to others.

What is the difference between a negative and a positive externality?

A negative externality occurs when a market activity imposes an unintended cost on others, like pollution from production. A positive externality happens when a market activity creates an unintended benefit for others, such as beekeeping helping pollinate plants.

How can externalities be categorized in terms of consumption and production?

Externalities can be either consumption externalities, which arise when individuals' consumption of a good affects others, or production externalities, which occur when the production process affects third parties.

Can you give an example of a negative externality of consumption?

An example of a negative externality of consumption is smoking cigarettes. When individuals smoke, others may be exposed to second-hand smoke and become sick, which imposes a cost on society.

How does a positive externality of production work? Can you provide an example?

A positive externality of production occurs when the production of a good generates benefits for others. For example, a beekeeper who produces honey also benefits farmers by pollinating their crops, which helps increase the yield of flowers.

What are the three key rules for drawing graphs of externalities?

The three rules for drawing graphs are: 1) Production externalities involve cost curves, while consumption externalities involve benefit curves. 2) Negative externalities lead to overproduction, while positive externalities lead to underproduction. 3) Deadweight loss always points to the socially optimal quantity, with positive externalities pointing right and negative externalities pointing left.

What is the significance of the socially optimal quantity in externality graphs?

The socially optimal quantity is the quantity of a good or service that maximizes overall welfare in the presence of externalities. In a graph, it is where the marginal social cost (MSC) and marginal social benefit (MSB) curves intersect.

How does deadweight loss relate to externalities, and where does it point?

Deadweight loss represents inefficiency in the market due to externalities. It points to the socially optimal quantity, and for positive externalities, it points to the right (indicating underproduction), while for negative externalities, it points to the left (indicating overproduction).

Why is the graph for a negative consumption externality different from the graph for a positive production externality?

A negative consumption externality graph has two benefit curves (marginal private benefit and marginal social benefit), while a positive production externality graph has two cost curves (marginal private cost and marginal social cost). The shapes of the curves and the points where they intersect differ based on the type of externality.

What are the key characteristics of a graph for a negative production externality?

In a graph for a negative production externality, there are two cost curves: marginal private cost (MPC) and marginal social cost (MSC). The free market quantity is greater than the socially optimal quantity, leading to overproduction, and deadweight loss points to the left.