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
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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
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AP Economics
Mr. Bernstein
Positive Externalities: Home Upgrades
• Improves property values Price, MSB
• MSB = MPB + MEB
(Marginal Private plus
Popt
External Benefits)
Pmkt
• Equil: S crosses MPB Pcons
• But society sees External
Benefits and would
Qmkt
pay Poptimal (MSB=MSC)
S
Subsidy
MPB
Qopt
MSB
Qty, home
improvements
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AP Economics
Mr. Bernstein
Positive Externalities: Home Upgrades
• Market underproduces Price, MSB
vs. socially optimal outcome
• Deadweight loss
Popt
• Policy to eliminate:
Pmkt
Pigouvian subsidy on Pcons
each unit of home upgrade
demanded pushes Q up
Qmkt
S
Subsidy
MPB
Qopt
MSB
Qty, home
improvements
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AP Economics
Mr. Bernstein
Negative Externalities: Electricity
Electricity creates pollutionPrice, MSC
MSC = MPC + MEC
Equil: D crosses MPC
But society would actually
Popt
pay higher MSC at Qmkt! Pmkt
• Socially optimal result is Pfirm
where D crosses MSC
Q
•
•
•
•
MSC
MPC
Tax
D
opt
Qmkt
Electricity
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AP Economics
Mr. Bernstein
Negative Externalities: Electricity
Price, MSC
• Market overproduces
vs. socially optimal outcome
• Deadweight loss
• Policy to eliminate:
Popt
Pigouvian tax on
Pmkt
Pfirm
each unit of electricity
demanded pushes Q up
Q
MSC
MPC
Tax
D
opt
Qmkt
Electricity
7
AP Economics
Mr. Bernstein
Network Externalities
• Value of a product depends on how many others use
product
• Example: Facebook
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