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Prices vs. Quantities Revisited: The Case of Climate Change

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  • Pizer, William

    ()
    (Resources for the Future)

Abstract

Uncertainty about compliance costs causes otherwise equivalent price and quantity controls to behave differently. Price controls � in the form of taxes � fix the marginal cost of compliance and lead to uncertain levels of compliance. Meanwhile quantity controls � in the form of tradable permits or quotas � fix the level of compliance but result in uncertain marginal costs. This fundamental difference in the face of cost uncertainty leads to different welfare outcomes for the two policy instruments. Seminal work by Weitzman (1974) clarified this point and derived theoretical conditions under which one policy is preferred to the other. This paper applies this principal to the issue of worldwide greenhouse gas (GHG) control, using a global integrated climate economy model to simulate the consequences of uncertainty and to compare the efficiency of taxes and permits empirically. The results indicate that an optimal tax policy generates gains which are five times higher than the optimal permit policy � a $337 billion dollar gain versus $69 billion at the global level. This result follows from Weitzman’s original intuition that relatively flat marginal benefits/damages favor taxes, a feature that drops out of standard assumptions about the nature of climate damages. A hybrid policy, suggested by Roberts and Spence (1976), is also explored. Such a policy uses an initial distribution of tradeable permits to set a target emission level, but then allows additional permits to be purchased at a fixed "trigger" price. The optimal hybrid policy leads to welfare benefits only slightly higher than the optimal tax policy. Relative to the tax policy, however, the hybrid preserves the ability to flexibly distribute the rents associated with the right to emit. Perhaps more importantly for policy discussions, a sub-optimal hybrid policy, based on a stringent target and high trigger price (e.g., 1990 emissions and a $100/tC trigger), generates much better welfare outcomes than a straight permit system with the same target. Both of these features suggest that a hybrid policy is a more attractive alternative to either a straight tax or permit system.

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Paper provided by Resources For the Future in its series Discussion Papers with number dp-98-02.

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Date of creation: 01 Oct 1997
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Handle: RePEc:rff:dpaper:dp-98-02

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  1. William D. Nordhaus & David Popp, 1996. "What is the Value of Scientific Knowledge? An Application to Global Warming Using the PRICE Model," Cowles Foundation Discussion Papers 1117, Cowles Foundation for Research in Economics, Yale University.
  2. Stavins, Robert N., 1996. "Correlated Uncertainty and Policy Instrument Choice," Journal of Environmental Economics and Management, Elsevier, vol. 30(2), pages 218-232, March.
  3. Lawrence H. Goulder & Ian W. H. Parry & Dallas Burtraw, 1996. "Revenue-Raising vs. Other Approaches to Environmental Protection: The Critical Significance of Pre-Existing Tax Distortions," NBER Working Papers 5641, National Bureau of Economic Research, Inc.
  4. Burtraw, Dallas & Toman, Michael, 1997. "The Benefits of Reduced Air Pollutants in the U.S. from Greenhouse Gas Mitigation Policies," Discussion Papers, Resources For the Future dp-98-01-rev, Resources For the Future.
  5. Roberts, Kevin W S, 1980. "Interpersonal Comparability and Social Choice Theory," Review of Economic Studies, Wiley Blackwell, vol. 47(2), pages 421-39, January.
  6. Pizer, William, 1997. "Optimal Choice of Policy Instrument and Stringency Under Uncertainty: The Case of Climate Change," Discussion Papers, Resources For the Future dp-97-17, Resources For the Future.
  7. William R. Cline, 1992. "Economics of Global Warming, The," Peterson Institute Press: All Books, Peterson Institute for International Economics, number 39, July.
  8. Long, John B, Jr & Plosser, Charles I, 1983. "Real Business Cycles," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 91(1), pages 39-69, February.
  9. Kydland, Finn E & Prescott, Edward C, 1982. "Time to Build and Aggregate Fluctuations," Econometrica, Econometric Society, Econometric Society, vol. 50(6), pages 1345-70, November.
  10. Harsanyi,John C., 1986. "Rational Behaviour and Bargaining Equilibrium in Games and Social Situations," Cambridge Books, Cambridge University Press, number 9780521311830, 9.
  11. Warwick J. McKibbin & Peter J. Wilcoxen, 1997. "A Better Way to Slow Global Climate Change," Economics and Environment Network Working Papers 9702, Australian National University, Economics and Environment Network.
  12. Weitzman, Martin L, 1978. "Optimal Rewards for Economic Regulation," American Economic Review, American Economic Association, vol. 68(4), pages 683-91, September.
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  1. Tax versus max
    by Joshua Gans in Core Economics on 2007-06-05 04:08:49
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