Prices versus quantities in the presence of a second, unpriced, externality

Abstract

AbstractThis paper analyzes whether the presence of a second unregulated externality influences the choice between a price and a quantity instrument to address an externality. The author studies a situation in which two goods jointly generate an externality but only one of them is regulated. The two instruments differ because of the presence of uncertainty regarding the private value of the two goods. To ignore the unregulated good and apply Weitzman's classical result on the comparison of the slopes of marginal benefit and cost could be misleading because of the randomness of the unregulated good's quantity. Beside the relative slope of the marginal damage, the substitutability and the distribution of shocks play a role in the comparison. If there is a “cocktail effect” and the regulated and unregulated goods' quantities are negatively correlated, which occurs if they are substitutes, this reinforces the appeal of a price instrument. Furthermore, if the two goods are weak substitutes with correlated demands, the variance of the quantity of the unregulated good is larger under a quota than a tax, which further reinforces the appeal of the tax instrument.