Externalities, internalities, and the targeting of energy policy

Externalities, internalities, and the targeting of energy policy / Hunt Allcott, Sendhil Mullainathan & Dmitry Taubinsky. NBER, April 2012, 63 p. (Working Paper No. 17977)


We show how the traditional logic of Pigouvian externality taxes changes if consumers under-value energy costs when buying energy-using durables such as cars and air conditioners. First, with undervaluation, there is an “Internality Dividend” from externality taxes: aside from reducing the provision of public bads, they also reduce allocative inefficiencies caused by consumers’ underinvestment in energy efficient durables. Second, although Pigouvian taxes are clearly the preferred policy mechanism when externalities are the only market failure, undervaluation provides an “Internality Rationale” for alternative policies such as product subsidies that reduce the relative price of energy efficient durables. However, when some consumers misoptimize and others do not, a crucial quantity for policy analysis is the average marginal internality: the extent to which a policy preferentially targets misoptimizing consumers. As an example of the importance of the average marginal internality, we carry out a randomized field experiment to provide rebates for energy efficient lightbulbs and illustrate how the welfare effects of the rebate depend significantly on whether consumers that undervalue energy costs are more or less elastic. (©  Allcott,  Mullainathan & Taubinsky)

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