Emission Tax or Standard: The Roles of Productivity Dispersion and Abatement

We compare the welfare effects of different emission-reduction policies in a general equilibrium model with heterogeneous plants. We found that an emission standard could outperform an emission tax or a tradable permit. We characterize the equilibrium conditions for this result to hold. We understand that an emission tax (or Pigouvian tax, Pigou 1954) can maximize social welfare under two conditions: (1) complete information and (2) we consider only the pollution market. The welfare effects of different policies with incomplete information are thoroughly analyzed in the literature (Weitzman 1974, among others). This literature uses a partial-equilibrium analysis. We analyze the welfare effects of different policies when the plants’ responses to policies affect the efficiency of two markets simultaneously: the goods market and the pollution market. A tax policy changes the market behavior of plants in the goods market when the purpose is only to interfere with the pollution market, increasing the gap between the plant-preferred level of output and the society-preferred level of output in the goods market if plants have some market power in the goods market. A standard-policy directly reduces the emissions and causes less goods-market distortion. We show that when some advanced abatement technology is available, the standard policy could achieve higher welfare than the tax policy.