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Prices vs Quantities in a Second-best Setting

  • Philippe Quirion


    (CIRED - Centre International de Recherche sur l'Environnement et le Développement - CNRS - CIRAD - Centre de coopération internationale en recherche agronomique pour le développement - EHESS - École des hautes études en sciences sociales - Ecole Nationale du Génie Rural des Eaux et Forêts - École des Ponts ParisTech (ENPC))

The choice between taxes and tradable permits has been independently analysed by two distinct research traditions. The first proceeds from Weitzman's partial equilibrium stochastic model and concludes that a tax should be preferred if the marginal abatement cost curve is steeper than the marginal environmental benefit curve. The second utilises deterministic general equilibrium models with pre-existing distortionary taxes. It concludes that non-revenue-raising instruments (e.g., grandfathered tradable permits) are costlier than revenue-raising ones (e.g., a tax on every unit of pollution or auctioned permits). To build a bridge between these two traditions, we introduce in Weitzman's model a positive cost of public funds due to pre-existing distortionary taxes. The tax admits a greater comparative advantage over the permits, as compared to Weitzman's classical result. Then, we assume that the regulated industry blocks any proposal that poses it too high an expected burden. This may require a transfer to firms, in the form of freely-allocated permits or lump-sum tax rebate. It turns out that if this acceptability constraint is binding, then the comparative advantage of taxes over permits is still reinforced. Quantitatively, even if the marginal benefit function is 50% more steeply sloped than the marginal cost function, the price instrument should be preferred.We also compare the expected net benefit of these two instruments to a contingent instrument which leads to the ex post optimum. The superiority of the contingent instrument over the quantity one is higher than in first-best.

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Paper provided by HAL in its series Post-Print with number halshs-00009890.

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Date of creation: 2005
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Publication status: Published in Environmental and Resource Economics, Springer, 2005, 29 (3), pp.337-360. <10.1007/s10640-004-5265-y>
Handle: RePEc:hal:journl:halshs-00009890
DOI: 10.1007/s10640-004-5265-y
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