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AP Economics
Mr. Bernstein
Module 75: Externalities and Public Policy
January 9, 2015
2
AP EconomicsMr. 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
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AP EconomicsMr. 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
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AP EconomicsMr. 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)
MPBMSB
S
Popt
QoptQmkt
Pmkt SubsidyPcons
Price, MSB
Qty, home improvements
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AP EconomicsMr. Bernstein
Positive Externalities: Home Upgrades• Market underproducesvs. socially optimal outcome• Deadweight loss• Policy to eliminate:
Pigouvian subsidy oneach unit of home upgradedemanded pushes Q up
MPBMSB
S
Popt
QoptQmkt
Pmkt SubsidyPcons
Price, MSB
Qty, home improvements
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AP EconomicsMr. 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
Electricity
MPC
D
MSC
Popt
Qopt Qmkt
Pmkt
Tax
Pfirm
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AP EconomicsMr. Bernstein
Negative Externalities: Electricity• Market overproducesvs. socially optimal outcome• Deadweight loss• Policy to eliminate:
Pigouvian tax oneach unit of electricitydemanded pushes Q up
Price, MSC
Electricity
MPC
D
MSC
Popt
Qopt Qmkt
Pmkt
Tax
Pfirm
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AP EconomicsMr. Bernstein
Network Externalities• Value of a product depends on how many others use
product• Example: Facebook
