Regulating stock externalities under uncertainty

Abstract

Using a simple analytical model incorporating benefits of a stock, costs of adjusting the stock, and uncertainty in costs, we uncover several important principles governing the choice of price-based policies (e.g., taxes) relative to quantity-based policies (e.g., tradable permits) for controlling stock externalities. As in Weitzman (Rev. Econom. Stud. 41(4) (1974) 477), the relative slopes of the marginal benefits and costs of controlling the externality continue to be critical determinants of the efficiency of prices relative to quantities, with flatter marginal benefits and steeper marginal costs favoring prices. But some important adjustments for dynamic effects are necessary, including correlation of cost shocks across time, discounting, stock decay, and the rate of benefits growth. Applied to the problem of greenhouse gases and climate change, we find that a price-based instrument generates several times the expected net benefits of a quantity instrument.