Energy Policy with Externalities and Internalities

Abstract:     
We analyze how the traditional logic of Pigouvian externality taxes changes if consumers undervalue 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 externalities, 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 Energy Efficiency Policy, including fuel economy standards and subsidies for energy efficient goods. However, this Internality Rationale has surprising features: it does not apply to all classes of behavioral biases, and the socially-optimal response to undervaluation may include energy taxes higher or lower than the externality damages, despite the resulting distortion to utilization. We calibrate our results in a simulation model of the US automobile market, finding that Pigouvian taxes actually increase consumer welfare and that the optimal subsidy for high-fuel economy vehicles could be quite large.

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