Optimal Environmental Policy with Network Effects: Will Pigovian Taxation Lead to Excess Inertia?

We study a dynamic model with two competing durable goods; one dirty, the other clean. Due to network effects a consumer who adopts the dirty good today will increase the incentive future consumers have to adopt the dirty good. Thus, a consumer who chooses the dirty good, in a sense causes more pollution than just his own. This “externality multiplier effect” may warrant a dirty good tax in excess of the Pigovian tax. If this is not acknowledged, the market may stay with the dirty good even if it is socially beneficial to shift to the clean good.