So have you ever been woken up at night by a loud barking dog? Or maybe it's your dog keeping your neighbors up? Maybe you're just wondering what any of this has to do with economics? Well, let's dive into the topic of externalities. And we'll see. So in this unit we're gonna talk about externalities. And basically what I want, how I want you to think about it is we're gonna extend the idea of cost and benefit to the whole society. Before we I've only been thinking of it of the people in the transaction. Right? The buyer and the seller. Now we're gonna think of the benefit to society as a whole and the cost to society as a whole. All right. And this is going to include these ideas of externalities. Okay? So what we're gonna see is that sometimes these market transactions between a buyer and a seller are going to impose some sort of cost or benefit on someone which I call an innocent bystander. Someone who has nothing to do with the transaction. Okay? Um And we're gonna see that this can either be a good a good thing, like a benefit to those outsiders or a bad thing. A cost. All right. So let's talk about both of those. We're gonna start here with the negative externalities. And I'm gonna define a couple of things before we get to our examples. So kind of just stick with me and and and then we'll get there. So first we got a negative externality, right? So it's negative, right? We hear negative externality. We're gonna impose a cost on to these innocent bystanders. Okay? So with the negative externality we impose a cost on those innocent bystanders. So we're gonna start here with what we know already. First we have what's called the private cost. Okay. This private cost is what we're used to. This has been the supply curve that we've seen in previous units and stuff. Right? We we've seen the supply curve. The cost to the seller to produce something creates the supply curve um And compare that to what we're gonna be talking about. Now is this social cost? Right? Remember I'm saying we're gonna extend um the cost and the benefit to society as a whole. Right? And we'll see that autograph. But the idea here is that the social cost right? It's gonna include the private cost. So the cost we're used to from the supply curve but now we're gonna add something to that cost. Which is this external cost? Right? And this is cost to people outside the transaction? All right? So when we're talking about externalities instead of having a supply curve, what we're gonna have is this marginal social cost curve? Okay. And this is kind of like the supply curve plus right? This is kind of like supply curve. Two point Oh where we're gonna have um Not only those private costs but we're gonna have these external costs right? We're gonna be showing that social cost on the curve. So we're gonna use this acronym M. S. C. Marginal social cost. Cool. So let's go ahead and do some some examples of negative externalities to kind of bring this all together. So the first one here is a very common example to help you understand this is we think of a paper production factor. Okay so this factory um it's sitting on a lake, right? And this factory like we're used to they produce paper, right? So their private costs could include things like cutting down the trees and processing them into paper. Right? So kind of just like the standard costs we might be used to in a in a paper production facility. Um But compare that maybe now this this factory right? It's on a lake and it spews chemicals into the lake in the production process, right? It's kind of just like a byproduct of the production is these chemicals right? This pollution it's putting into the lake. And let's say there's a bunch of houses right on the other side of the lake um That now they have to deal with this pollution, right? This cost is being put onto these people who live in these houses. This pollution in their lake um is a cost to these to these residents. So I'm gonna say this external cost is the pollution right to those residents. Um So you'll see that now we're extending it right? Not just the cost to the seller those cutting tree costs but now also the cost to everybody, Right? This pollution. So let's go back to that example from the beginning the dog. Right? So how does this relate to the externalities? We have the idea that you've got private costs for keeping a dog, right? Maybe you gotta feed the dog or something, feeding the dog, you know, getting into bed or whatever. Um But then there's this external cost, right? In this case we've got this loud dog, it doesn't stop barking all night and it's keeping the whole neighborhood out. Right? So we could say that you know the external cost here is your neighbors happiness, right? There's a cost to your neighbors happiness um that you weren't accounting for when you bought the dog yourself, right? You weren't thinking, oh you know how much is this gonna affect my neighbors sleep schedule? Probably not your first. I thought when you got the dog and yet here we see an external cost for a dog. But I could probably make an argument for an external benefit for a dog to right, maybe the whole neighborhood's happier because there's a cute little puppy running around. But in this case it's annoying dog making a lot of noise and it's affecting everybody in a negative way. Right? So that's kind of how you see these external costs were kind of looking beyond just the people inside the transaction, right? It's gonna we're gonna extend it beyond that to the whole society. So let's go ahead and see a positive externality, right? This is gonna be pretty much the opposite of what we just saw, right? So before we with a negative right? We were imposing a cost on to these innocent bystanders. Now a positive externality which I'll just use this plus sign. So sorry I didn't mention it up here, but I'll put a little negative sign when I'm talking about negative externalities later and you know, put it next to things I'm talking about or a little plus sign for the positive ones. So, positive externality, little plus sign. And this is going to create a benefit to the to the bystanders, right? So it's not all bad externalities can be good as well, right? This can put a benefit on to innocent bystanders. So just like before we'll have a couple of definitions and you'll see how similar they are. We've got the private benefit, right? And this is what we're used to when you think about buying something on the market, that demand curve that stands for your private benefit, right? You're thinking about your private benefits when you consider buying something, right? So so maybe you're going to the store to buy a pack of gum, right? And you're thinking you're not thinking about like, oh how is this pack of gum gonna affect everyone else? You're like no, I'm just want a pack of gum. I wanna chew gum and you buy it, right? That's gonna be that private benefit. You're getting. And that's the demand curve that we're used to just like the private cost was the supply curve we're used to. So then you can imagine that this other one is gonna be the social benefit, right? So that social benefit, it's gonna include our demand curve that we're used to plus that external benefit from the externality. Right? So you can see kind of the similarities here. We're gonna have like that demand curve two point. Oh right. Where we're looking at the whole societies benefit, not just your benefit. So it's gonna be kind of like the demand curve plus more benefits. Cool. So, we're gonna see here just like we had the marginal social cost curve. This marginal social benefit curve. Msb um is going to be like that demand curve two point. Oh right. And we're gonna see both of these on the graph, in in just a second. So let's go ahead and do some examples of these positive externalities. First, very common example is vaccinations. Right? So when you go to the doctor and get a vaccine, you have the private benefit of not getting sick. Right? You you went to the doctor because you're not gonna get sick um when you get this vaccine, right, you're you're now vaccinated against the vaccine against the disease, it's not gonna happen to you. But, you know, most, most of times when we get vaccinated, it's usually for some sort of like contagious disease. Like I don't know the measles or something. Right? So the fact that you got vaccinated actually is a benefit to everyone around you, right? Because you're less contagious. So since you can't catch the disease it makes it so it's less likely for everyone else to catch the disease as well. So this external benefit is kind of like having a less contagious population, right? So less people in the population can get sick and pass it on to other people. Right? So there's that x external benefit right? That's beyond you. That's not just you anymore right? You got the benefit of not being sick but the whole society has less of a chance of being sick now. Cool. So see another really common one here is education. I'm gonna scoot out of the way and let's do this one. So private benefit, right? When you went to college you're probably thinking about the private benefits of an education. Your you know your thinking um I'll make more money, right? If I if I get a college education I'll be able to get a higher paying job, something like that. Or maybe you just wanted to be a lot smarter but in this case let's say you did it because you wanted more money right? More more education meant you get a higher salary but there's external benefits to you being smarter too. It's been shown that um education right? When people are more educated we're gonna be more productive. So you can imagine that a country that is full of educated people is gonna have more productivity than a country that is has no education. Right? So we're gonna say we're gonna have a more productive population, right? And you're gonna get external benefits um, from this, right? Or the the society gets external benefits from your education, right? So we're gonna see that in general, a more productive population exists from your education, right? So when you do a service for me, because you're educated, you're gonna do it more efficiently and stuff and I'm gonna get a benefit because you got educated, Right? So something like that. And, and um so that's kind of the idea here with these externalities, right? You can see the negative and the positive externalities and I want to make a quick point before we move on to these graphs, if you look at these external costs and these external benefits that we've discussed so far, they're kind of intangible. Right? They're kind of weird things like an external cost of pollution, right? Like how much does you know, how do we quantify, like the cost of this pollution into the lake affecting the people living on the lake? Right? Like how do we count for what this does to their happiness or a dog barking? How does that affect the neighbors happiness in dollars, right? Or how do we quantify a less contagious population, so you can see that these things are like weird concepts. Um So in practice you can see that it's gonna be kind of difficult to deal with externalities, but when we're dealing with it in theory here, like we're going to do on the graphs, um we can kind of make some conclusions just based on the ideas here. Alright, so let's go ahead and go on to the next video and we'll see these externalities on the graph. Let's do that now.
Externalities on the Graph
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Alright, now, let's see what these externalities look like on the graph. Let's start here with the negative externality and our example of that paper production company. Right? So the company has a factory on a lake and it dumps chemicals into the lake, where on that same lake there's residents that live on the other side of the lake, right? So they're affected by these chemicals, polluting their lake and it affects their quality of life there. Cool. So let's go ahead and see what it looks like on the graph here. We're gonna start with our what we're kind of used to, right? We've got our D one here downward demand. S one upward supply, right? We've got our price access with the price of paper and quantity of paper down there. Right? So we've got kind of what we're used to and we've got here um this quantity of the market, right? So the market here is at an equilibrium, we are going to say it's at equilibrium, but the fact is that this market isn't including all of our costs, right? We've got this cost of pollution. This s one that we see here, this is the private cost right up above. We talked about private cost um being that supply curve that we're used to. So this s one kind of includes uh the things we would expect a paper company too, including their cost, like cutting down the trees and processing them. You know, those types of things are included in this cost curve, but what they didn't include is that cost of pollution, right? They're not including that in their in their cost. When they're figuring out how much how much to charge, right? How much to supply. So what happens is that there's this additional cost, Right? So what do you think happens when there's more costs if you remember from our shifts, right? When we were shifting supply and demand? Well, when we had additional costs, right, those additional costs shifted supply to the left, right? So remember in this chapter, or at least this unit, what we're gonna see is we're gonna be talking about um supply and demand, but we're gonna be extending it to society as a whole. So when we think of supply, we're gonna think of all the cost to society, right? Not just the cost of the supplier, but those external costs too. And the benefits, right? The demand curve is gonna include those private benefits that we're used to in the demand curve, plus these external benefits. Right? So it's gonna be society as a whole, is the picture we're trying to paint. Cool. So, if s one is there right? We've got our private cost but now we've got this additional cost from the externality. Well, we're gonna have to draw our new supply curve which is not really a shift. Okay. I don't want you to think that we're shifting the supply curve to the left. Um What we're doing is showing the true cost right over here, what we've done is essentially shifted to the left. but what we're showing is that we've got an extra cost, right? This curve already existed, it's just that we didn't show the pollution in our original curve, right? So it's not like now the market shifted to this new position. The equilibrium is still where we were right, that we're not at the correct equilibrium because we're not counting for that cost. Um but what we can see by showing this shift, right? So this extra shift represents that extra cost from pollution. And we've got here. S. two, right? And this is gonna be the marginal social cost curve from above, right? So this includes all our costs. And now, remember what I'm saying is it's not that we shifted to this new position because this pollution already existed in the original market. So what we're doing is we're just recognizing that the pollution exists, right? Okay. So the cost of the pollution exists. Now, let's see what that really means in our market. So if I go down here, it shows that the real equilibrium Q. Star right? This is the efficient equilibrium. If we were to account for all costs and all benefits would be right there, and our efficient price would be somewhere over here, Right? But I want to focus on this quantity, that's the important part. And what we'll see is that we're over producing in this case, right? We're overproducing um because we're not accounting for all of our costs, right? So the market, when we don't consider this pollution is going to be producing here at this Q. M. Which I'm calling Qm. Like Q. Market, right? And that P. M. Is that price on the market, Right? But it's an equilibrium that we've reached. But it's a wrong equilibrium because it doesn't account for all our costs. Cool. So in that case of the negative externality, we're producing too much, right? Because we're not accounting for all our costs, we end up over producing, right? And anytime we're not at our efficient equilibrium, um we have we have deadweight loss, right inefficiencies. It's not a good thing, right? We want to be at that efficient equilibrium in this case the negative externality keeps us from it. So let's go ahead and see what happens with a positive externality. Right? Here, you might be thinking positive externalities, that's a good thing, right? Extra productivity in our society and less contagious population, these are all good things. And you're right. But let's see what happens on the graph when we consider these externalities. So just like before we've kind of got our standard situation where we've got D. One here and s one um And we've got our original equilibrium there, right? And remember this isn't gonna be our efficient equilibrium because we're not counting for all our costs and benefits in this case, we're talking about education, right? So we discussed how education creates this extra benefit of a more productive population, right? So there's this external benefit to people outside just you getting the education or the university supplying the education, everyone else is also benefiting, right? So there's this extra benefit in this case. So what do you think is gonna happen? Right, When we had an extra cost, we shifted supply to the left. Right? Now, we have an extra benefit. So this is an extra good thing, right? And we are here, when we talk about benefits, we're gonna move with the demand curve, right? The demand curve is gonna represent our benefits. So here with the one we had our private benefits, right? And that's what we're used to. Right? When we think about college, you know, when you, when you were considering going to college, you were probably sitting there like, man, if I go to college, you know, our whole country will be way more productive. I should go to college because our country will be more productive. You know, that's probably not what's going through your head, right? You're probably thinking about, oh, I go to college, you know, I'll get a higher paying job, I'll be more specialized, right? Not you don't think about these external benefits, but they do exist. So in this case, since we have extra benefits, the demand curve is gonna shift to the right, right? Because this is a good thing. In the other case, we had a bad thing. So we shifted to the left here. it's a good thing and we say we put our benefits on our demand curve. So the demand curve will shift to the right, we're gonna have this new demand curve groups get the color somewhere to the right here. Cool. And remember all these things are quite intangible, right? It's kind of hard to say how much extra benefit we get from this more productive society, right? It's really hard to say. So here it's easy, you know, we can just put an estimate but in real life you can see it could be kind of hard to to deal with this in practice. So let's go ahead and do this. So we've got D. Two now, right, we've shifted to the right and this D. Two is gonna be our marginal social benefit curve. Right? This includes um all of all of our benefits, right? Not only the private benefit you get from going to college but the benefit you put on everyone else because you're smarter. Cool. So let's see what happens here. We've got our original equilibrium which had that Q market, right? And the price on the market. So although this is an equilibrium, this isn't our efficient equilibrium, right? Because we weren't accounting for all costs and benefits. So if we go here um if we go up here, this is our true equilibrium, right? The efficient equilibrium and let's go ahead and look at our quantity here. So our quantity would be somewhere up here. Q. Star, right, are efficient equilibrium and our price something like this. But let's focus on quantity. Again, that's that's the that's the real kicker here. Again, you see that the market by itself um is not gonna produce the efficient quantity, right? We are under the efficient quantity. In this case we're under producing right? When we leave the market to do its own thing, it doesn't count for these extra benefits and it under produces this education, Right? So you'll see that we were thinking, oh this is a positive thing, right? People are smarter, but what ends up happening is we're not providing enough education um as the market wants, right? And that's because we don't consider this extra benefit. So what ends up happening in these cases, you'll see like the government can step in and you know, help the market reach that equilibrium quantity. So we'll see that in other videos. But let's go ahead and make our conclusions here. Cool. So the first thing is that we're gonna see that externalities are gonna cause market failures, right? Positive and negative. Regardless of uh which kind of externality it causes a market failure. And remember that's just an inefficient market, right? Anytime we're inefficient, um we have a market failure. So in the case of a negative externality, we were overproducing, right? We weren't at our equilibrium quantity, We're inefficient anytime we're not at equilibrium. So our overproduction was in the case of a negative externality and we had under production in the case of a positive externality, right? And in both cases were not efficient. And anytime we're not efficient, anytime we have this market failure, we've got a dead weight loss. Right? And when we talk about externalities, we're not gonna be like calculating the deadweight loss as much or anything like that. But I still want to point it out to you on the graph, just so you see where it is, Right? Um It'll help your intuition here too, with dead weight loss. So when we talk about dead weight loss, right? This um we have to look at our equilibrium point and then we've got that bow tie, right, that bowtie of deadweight loss and we gotta pick which side we should be on. So, what what's tricky here is that our equilibrium is actually this point up here, right. The one where our marginal social cost curve um crosses So what are we gonna see? We're seeing that we're overproducing right, We should be producing at this point um that at that quantity, but we're actually up at this quantity. So what we're going to see is that this overproduction causes this dead weight loss up here, right? So a lot of you might have thought that the dead weight loss would have been somewhere around here, or in here. Right, that's wrong because our equilibrium is this point up here. Cool. So we're not gonna calculate or anything. I just kinda wanted to point it out to you. So if that's the case there, where do you think the deadweight loss is gonna be on our positive externality? Well, we're gonna start again at our equilibrium, right? And this is our true equilibrium Q. Star here. Um And this time we're under producing, right? So we want to be at that Q. Star, but we're only trading here at Q Market. So everything here didn't happen right? We're not making these trades even though they're efficient for society. So those that surplus between Q. Market and Q. Star was lost, right? We didn't get it. That's the deadweight loss. Alright, so that's where they are on the graph. Um Don't worry about it too much. I kind of just wanted to point out to you and last year is that why do externalities exist? And the main reason here is because we have property rights that are either not clearly defined or difficult to enforce. Okay, so property rights is kind of like the backbone to this issue. It's pretty easy to explain with that paper production facility. It's true in the case of positive externalities too, but it gets a little more intangible tricky. But let's talk about this negative one. It will make sense. So in this case of this production factory, right? And they're polluting the lake that these people live on. So let's say that in the first scenario, the the company owns the lake, right? The factory that produces the paper owns the lake as well. Well, in this case there's no problem, right? They own the lake, they're allowed to pollute it. So there's not really an externality here. It's the residents fault for choosing to live on this lake that this company owns. Right? So they should have known about that when they bought that that house. Alright? So if the company owns the lake then they're allowed to pollute it, right? There's no externality there. But what if the people own the lake? If the people were to own the lake, right? The people who live on the lake in the lake and now a factory moves in and starts trying to pollute it. Well, the people would say you're not allowed to pollute it. But in this case the factory could maybe say what if we pay you each, you know, $10,000 a month, and we can put pollution in the lake, then maybe people will be like, well, that sounds pretty nice. I guess you could pollute my lake, right? But in that case the property rights are defined, right? So the company is willing to internalize the cost of pollution, Bye bye paying these people, right? In this case, when the company pays the residents to pollute the lake, they're taking the cost of pollution, right? In this case, that private cost is going to include the externality, right? So we're gonna reach this this efficient point because of that extra cost that they're imposing on themselves, right? They want to pollute so they're paying the money to pollute. So those property rights make a big deal there, right? But in most cases, what happens especially with lakes and stuff, Nobody owns it, right? It's one of those things, it's like, hey man, you can't just own a lake man. The lake is mother mother Earth, right? You can't own a lake. So, it's that idea of it's kind of like who owns the lake? Nobody's stopping the factory from polluting the lake because nobody has the property rights there. So, we end up in these cases of these externalities, Right? And that's because it all boils down to these property rights. All right, cool. So that's kind of how we're going to see these externalities, uh, kind of play out here. Why don't we go ahead and do some practice problems related to this? Let's do that. Now,
Which of the following is an example of a positive externality?
Jim hires Dwight to trim the hedges at his house. Jim pays Dwight $100 for the service.
While trimming the hedges, Dwight’s tools emit smoke that Jim’s neighbor, Pam, has to breathe.
Jim’s freshly cut hedges make the neighborhood more beautiful.
Jim’s community manager will pay him if he promises to keep his hedges trimmed on a regular basis.
If the production of a good causes a negative externality, then the social-cost curve will lie ________________ the supply curve, and the socially optimal quantity is _________________ than the equilibrium quantity.
Which of the following is true about externalities?
Positive externalities are efficient, but negative externalities are not efficient
Negative externalities are efficient, but positive externalities are not efficient
Both positive and negative externalities are efficient
Both positive and negative externalities are not efficient