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

2. 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

3. 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

4. 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

5. 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

6. 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

7. 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

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