Energy policy with externalities and internalities

Hunt Allcott, Sendhil Mullainathan, Dmitry Taubinsky

    Research output: Contribution to journalArticlepeer-review


    We analyze optimal policy when consumers of energy-using durables undervalue energy costs relative to their private optima. First, there is an Internality Dividend from Externality Taxes: aside from reducing externalities, they also offset distortions from underinvestment in energy efficiency. Discrete choice simulations of the auto market suggest that the Internality Dividend could more than double the social welfare gains from a carbon tax at marginal damages. Second, we develop the Internality Targeting Principle: the optimal combination of multiple instruments depends on the average internality of the consumers marginal to each instrument. Because consumers who undervalue energy costs are mechanically less responsive to energy taxes, the optimal policy will tend to involve an energy tax below marginal damages coupled with a larger subsidy for energy efficient products. Third, although the exact optimal policy depends on joint distributions of unobservables which would be difficult to estimate, we develop formulas to closely approximate optimal policy and welfare effects based on reduced form "sufficient statistics" that can be estimated by using field experiments or quasi-experimental variation in product prices and energy costs.

    Original languageEnglish (US)
    Pages (from-to)72-88
    Number of pages17
    JournalJournal of Public Economics
    StatePublished - Apr 2014


    • Energy efficiency
    • Energy-using durables
    • Implied discount rates
    • Inattention
    • Internality taxes
    • Optimal taxation
    • Pigouvian taxes
    • Present bias

    ASJC Scopus subject areas

    • Finance
    • Economics and Econometrics


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