Externalities and Public Policy AP Economics Mr. Bernstein Module 75: Externalities and Public Policy January 9, 2015

AP Economics Mr. Bernstein Externalities and Public Policy External benefits and costs can cause inefficiencies in the market Deadweight loss occurs when a market does not recognize the externality in equilibrium pricing and supplies too little or too much of a good Some government policies to deal with externalities, such as emissions taxes, tradable emissions permits, and Pigouvian subsidies, are efficient Other government policies, including environmental standards, are not

AP Economics Mr. Bernstein Policies Toward Pollution Auto Emission Standards Limits amount of crud going into the air Tradable Pollution Permits (ie Cap and Trade) Those who can efficiently reduce emissions sell permits to those who are less efficient at reductions An equilibrium permit price is found when there are no more mutually beneficial transactions to be made Same limit on amount of crud going into the air Emissions taxes

AP Economics Mr. Bernstein Positive Externalities: Home Upgrades Improves property values MSB = MPB + MEB (Marginal Private plus External Benefits) Equil: S crosses MPB But society sees External Benefits and would pay Poptimal (MSB=MSC) Price, MSB MPB MSB S Popt Qopt Qmkt Pmkt Subsidy Pcons Qty, home improvements

AP Economics Mr. Bernstein Positive Externalities: Home Upgrades Market underproduces vs. socially optimal outcome Deadweight loss Policy to eliminate: Pigouvian subsidy on each unit of home upgrade demanded pushes Q up Price, MSB MPB MSB S Popt Qopt Qmkt Pmkt Subsidy Pcons Qty, home improvements

AP Economics Mr. Bernstein Negative Externalities: Electricity Electricity creates pollution MSC = MPC + MEC Equil: D crosses MPC But society would actually pay higher MSC at Qmkt! Socially optimal result is where D crosses MSC Price, MSC MPC D MSC Popt Qopt Qmkt Pmkt Tax Pfirm Electricity

AP Economics Mr. Bernstein Negative Externalities: Electricity Market overproduces vs. socially optimal outcome Deadweight loss Policy to eliminate: Pigouvian tax on each unit of electricity demanded pushes Q up Price, MSC MPC D MSC Popt Qopt Qmkt Pmkt Tax Pfirm Electricity

AP Economics Mr. Bernstein Network Externalities Value of a product depends on how many others use product Example: Facebook