First-best Policy Research Articles

Optimal Resilience in Multitier Supply Chains

Abstract Forward-looking investments determine the resilience of firms’ supply chains. Such investments confer externalities on other firms in the production network. We compare the equilibrium and optimal allocations in a general equilibrium model with an arbitrary number of vertical production tiers. Our model features endogenous investments in protective capabilities, endogenous formation of supply links, and sequential bargaining over quantities and payments between firms in successive tiers. We derive policies that implement the first-best allocation, allowing for subsidies to input purchases, network formation, and investments in protective capabilities. The first-best policies depend only on production function parameters of the pertinent tier. When subsidies to transactions are infeasible, the second-best subsidies for resilience depend on production function parameters throughout the network, and subsidies are larger upstream than downstream whenever the bargaining weights of buyers are nonincreasing along the chain.

EXPRESS: Influencing Primary Care Antibiotic Prescription Behavior Using Financial Incentives

Antibiotic resistance is an ongoing public health crisis fueled by overuse and misuse of antibiotics. The goal of this paper is to examine the impact of action-based incentive payments on reducing inappropriate antibiotic prescriptions in primary care, where thirty to fifty percent of antibiotic prescriptions are inappropriate. Various financial incentive programs to reduce the rate of inappropriate antibiotic prescriptions have been implemented and studied empirically. However, there have not been analytical studies to evaluate payment model contract design features and the potential for payment models to impact diagnosis decision making. We develop a stylized physician compensation model to study the interaction between a payer and a provider. The payer offers a payment contract, with a bonus tied to the prescription, to maximize social welfare, considering total costs of providing care and social harm from antibiotic resistance. Given the contract offered and their own opportunity cost associated with factors such as fear of misdiagnosis and time spent explaining to patients why antibiotics are not indicated, the provider chooses whether or not to prescribe antibiotics to patients for whom antibiotics are not clinically indicated. We consider four cases: when diagnostic accuracy relies on symptom presentation vs. additional diagnostic testing and when the opportunity cost of not prescribing antibiotics is public vs. private information of the provider. When there is no information asymmetry, an action-based incentive payment can coordinate care and achieve the first-best policy, decreasing the rate of inappropriate prescribing, even when incentive payments can affect the diagnosis behavior. However, when the diagnosis depends on additional testing, the first-best policy results in fewer inappropriate antibiotic prescriptions, when the test has high specificity. Therefore, when an accurate technical diagnostic is available, a simple to implement action-based incentive payment can be effective in reducing inappropriate antibiotic prescribing. In the realistic setting where the provider’s opportunity cost is private information, an action-based incentive payment cannot eliminate inappropriate antibiotic prescribing. In these settings, the introduction of point of care diagnostics to aid in objective diagnostic criteria will reduce the unintended consequences of the contract.

Penalizing Shirking in Discovering Unsuitability

Abstract We study the optimal penalty scheme for an expert firm and a layman client against shirking in their costly interaction that helps the firm discover the unsuitable transaction, i.e. one that yields a loss for the client. The market solution to the bilateral hidden action problem fails to incentivize sufficient effort and leads to an inefficient outcome, which creates scope for government action. By contrast, private contracts obtain efficiency in an alternative framework with just the firm’s unilateral effort, highlighting the role of the client’s effort in rationalizing legal intervention. Under the unique first-best policy, the firm not only refunds the client but also pays the client’s loss to the government if the firm fails to stop a transaction that ends up being unsuitable. The client receives the refund but submits the firm’s production cost to the government. The optimal punitive penalty is their total contingent loss and is robust to private contracts. The optimal penalty generalizes to a multi-agent team by making each agent internalize all others’ contingent losses.

Tax policy or carbon emission quota: A theory on traditional ICEV transportation regulation

This study investigates the environmental consequences of consumers opting for traditional internal combustion engine vehicles (ICEVs), resulting in heightened pollution. Given the critical importance of addressing environmental degradation and its impact on societal welfare, our research aims to provide insights into effective policymaking strategies. In an ideal scenario, a benevolent planner would equitably distribute wealth, forming the first-best policy. Recognizing the impracticality of this ideal, we propose two viable second-best policies: an income-based tax and the implementation of a carbon emission quota. Theoretical analysis highlights the efficacy of the tax policy in pollution reduction, particularly with the growing number of mid-income electric vehicle consumers. The optimal tax policy adeptly navigates the delicate balance between pollution and income effects. Furthermore, we establish that the optimal pollution quota under the carbon emission policy is lower than in both competitive and first-best scenarios. A numerical comparison of the four equilibrium outcomes underscores these findings. In addition, we advocate for a blockchain-based decentralized carbon emission quota trading platform to digitize and optimize allocation and compliance processes, fostering more efficient and transparent environmental management.

A second-best argument for low optimal tariffs on intermediate inputs

We derive a new formula for the optimal uniform tariff in a small-country, heterogeneous-firm model with roundabout production and a nontraded good. Tariffs are applied on imported intermediate inputs. First-best policy requires that markups on domestic intermediate inputs are offset by subsidies. In a second-best setting where such subsidies are not used, roundabout production and the monopoly distortion in the traded sector create strong incentives to lower the optimal tariff on imported inputs. In a quantitative version of our two-sector small open economy, we find that the optimal tariff is lowered under nearly all parameter values considered, and can be negative.

Tradable performance standards in a dynamic context

Many sectors of the economy that are targets of emissions reduction policy exhibit price-responsive demand, long-lived capital, capacity constraints, and foresighted decision-making. I explore how these features affect the efficiency and dynamics of tradable performance standards (TPS) using analytical and numerical equilibrium models. While I show these dynamic considerations alone do not lead to conflicts with existing theory on the overall efficiency and cost-effectiveness of the TPS relative to a first-best policy, they do affect the transition path and steady state. Most notably, under all but the smallest discount rates, the TPS can lead to a more cost-effective post-transition steady state than the equivalent emissions cap. Given the intergenerational transition that comes with decarbonization, this result suggests some classes of present and future consumers may prefer a TPS to an emissions cap.

Optimal carbon taxation and horizontal equity: A welfare-theoretic approach with application to German household data

We develop a model of optimal taxation and redistribution under an ambitious climate target. We take into account vertical income differences, but also explicitly capture horizontal equity concerns by considering heterogeneous energy efficiencies. By deriving first- and second-best rules for policy instruments including carbon and labor taxes, transfers and energy subsidies, we investigate analytically how vertical and horizontal inequality is considered in the welfare maximizing tax structure. We calibrate the model to German household data and a 30 percent emission reduction goal and show that redistribution of carbon tax revenues via household-specific transfers is the first-best policy. Under plausible assumptions on inequality aversion, transfers to energy-intensive households should be about five times higher than transfers to energy-efficient households. Equal per-capita transfers do not require to observe households’ efficiency type, but increase equity-weighted mitigation costs by around 5 percent compared to the first-best. Mitigation costs increase by less, if the government can implement a uniform clean energy subsidy or household-specific tax-subsidy schemes on energy consumption and labor income that target heterogeneous energy efficiencies. Horizontal equity concerns may therefore constitute a new second-best rationale for clean energy policies or differentiated energy taxes.

Universal basic income: A feasible alternative to move people out of poverty in Mexico?

This paper evaluates the effectiveness of social policy to alleviate poverty in Mexico; where poverty is persistent, social programs are numerous and complex to monitor. Our analysis uses MEXMOD tax-benefit microsimulation. We simulate four scenarios that grant direct money transfers to individuals in multidimensional poverty, elderly people, families with children under 15 years old, and a universal basic income. The more generous and broader the coverage is, the costlier the policies. The first-best policy is the universal basic income, which can eradicate extreme poverty at the cost of 10.61 % of the gross domestic product. The least effective policy transfers only to older people.

Entry, location, and optimal environmental policies

We investigate the problem of choosing environmental regulations to control a multilateral, spatially heterogeneous pollution externality. There are three sources of inefficiency in this problem; the number of firms, their locations and their production/emissions levels. A first-best policy requires three instruments to address each of the sources of inefficiency, but such policies are not practical in most settings. Therefore, we examine the relative performance of second-best policies that optimally control one or two of the sources of inefficiency while leaving the other one or two sources uncontrolled. Because of the complexity of our theoretical model, we conduct numerical simulations to compare the alternative policies. We find that a policy of optimally-chosen individual quotas by themselves perform very poorly, because they encourage excessive entry. Combining individual quotas with an optimal entry restriction performs significantly better. Spatially differentiated taxes alone perform very well, because they partially address both the entry and location sources of inefficiency in addition to limiting pollution. We also argue that the welfare losses associated with even simpler policies like zoning restrictions or homogeneous taxes may not be high enough to justify the additional implementation difficulties associated with theoretically more efficient policies.

Toward Optimal Meat Pricing: Is It Time to Tax Meat Consumption?

Livestock is known to contribute significantly to climate change and to negatively impact global nitrogen cycles and biodiversity. However, there has been little research on economically efficient policies for regulating meat production and consumption. In the absence of first-best policy instruments for the livestock sector, second-best consumption taxes on meat can address multiple environmental externalities simultaneously as well as improve diet-related public health. In this article, we review the empirical evidence on the social costs of meat and examine the rationales for taxing meat consumption in high-income countries. We approach these issues from the perspective of public, behavioral, and welfare economics, focusing in particular on (1) the interaction of multiple environmental externalities of meat production and consumption, (2) “alternative protein” technologies, (3) adverse effects on human health, (4) animal welfare, and (5) distributional effects of meat taxation. We present preliminary estimates of the environmental social costs associated with meat consumption and find that meat is significantly underpriced. We conclude by identifying several directions for future research on optimal meat taxation.

One or two non-fossil technologies in the decarbonized transport sector?

What factors determine whether policymakers should promote one or more technologies in a decarbonized road transport sector, and what policies should governments choose? We investigate these questions theoretically and numerically through a static, partial equilibrium model for the road transport market. We find that one important factor is how close substitutes the two vehicle technologies are. Further, the number of vehicles of one technology depends on the number of vehicles of the other technology, both in the market and in the first-best solution. The first-best policy involves a subsidy of the markup on charging and filling, where the markup is higher the more utility increases with the number of stations. However, as there are several possible market equilibria, additional policies may be needed to avoid an unwanted lock-in.

Policies for Material Circularity: the Case of Lithium

Improper waste management carries social risks and dissipates high-value materials. Moreover, material market prices do not reflect these hidden costs and values. Two important questions are how prices can inform society about their resource use impact and how market-based policies optimize material circularity. This study adds to the literature by analyzing the effect of market-based policies aimed at promoting circular material reuse in a market defied by harmful waste but enhanced by recycling. The findings indicate that a landfill tax is a first-best policy since it targets the external costs of waste disposal, improves welfare, reduces damages, and boosts recycling. If a landfill tax is not feasible, other programs like taxes, subsidies, and a tax-subsidy scheme provide second-best results. Remarkably, recycling subsidies can stimulate higher raw material extraction and generate rebound effects. We also explore other non-market-based strategies to prevent waste and make recycling more cost-competitive and easier to recycle. The numerical results and sensitivity analysis of the lithium market illustrate the model's flexibility and prove why some policies are superior to others for reducing waste and creating value from used materials. Our study results serve as a guide to designing policies for optimal material circularity.

Making the Best of the Second-Best: Welfare Consequences of Time-Varying Electricity Prices

In electricity markets, the price paid by retail customers during periods of peak demand is far below the cost of supply. This leads to overconsumption during peak periods, requiring the construction of excess generation capacity compared to first-best prices that adjust at short time intervals to reflect changing marginal cost. This paper investigates the response of infrequently studied small commercial and industrial establishments to a four-hour increase in retail electricity prices invoked by individual utilities during peak demand periods 15 times per year. This policy intends to reduce electricity consumption when generation costs are highest. I find that the approximately tripled prices reduce establishment peak electricity usage by 13.5%. Using a model of capacity investment decisions, I find that the program delivers 44% of the benefits of the first-best policy of continuously varying prices and suggest two simple improvements in program design that could nearly double these welfare gains.

Open access renewable resources, urban unemployment, and the resolution of dual institutional failures

AbstractThis paper investigates how poverty reduction and natural resource preservation can be simultaneously achieved in a small open dual economy with urban wage rigidity, open access rural resources, and rural-urban migration. An increase in the export tax rate on the rural resource good increases urban unemployment in both the short run and the long run with resource dynamics. Given the institutional failures, the first-best policy is an urban wage subsidy combined with either a rural wage subsidy at alowerrate or, if the urban output price is sufficiently high, a ruraltax. When the institutional failures can be resolved endogenously, an increase in the export tax on the resource good can induce rural institutional change away from open access. However, tariff protection of urban manufacturing hinders such a rural institutional change.

More birds than stones – A framework for second-best energy and climate policy adjustments

A well-known principle in public economics states that at least as many policy instruments as market failures are required to achieve an efficient outcome. In practice, however, regulatory power is often constrained, making implementing the first-best policy portfolio difficult or impossible. We analyze analytically and numerically how available policy instruments should be adjusted vis-à-vis the first-best to account for under-internalized secondary market failures. Consider, for example, the power sector: alongside the external costs of emissions, evidence suggests that consumers undervalue energy efficiency investments, and knowledge spillovers hamper research and development (R&D) and learning-by-doing in low-carbon technologies. By exploring the potential and limits of policy instrument substitution, we provide suggestions for adjusting policies in second-best situations. We calibrate the theoretical model to the European electricity sector and find that, compared with the first-best policy portfolio, relying on carbon dioxide (CO2) pricing alone increases the policy cost of the EU CO2 emissions target by about 30%. Uninternalized R&D spillovers contribute the most to this increase, and are the most difficult to address indirectly, even with subsidies supporting learning-by-doing. By contrast, almost 40% of the additional cost created by the absence of optimal energy efficiency subsidies can be recuperated by a second-best electricity tax.

Investment in environmental innovation with environmental regulation and consumers’ environmental awareness: A dynamic analysis

This paper investigates the effects of environmental regulation and consumers’ environmental awareness on the optimal investment strategies of a monopolist’s environmental innovation. We develop a dynamic optimal control model in which two kinds of environmental innovation are considered (i.e., end-of-pipe and cleaner production technologies innovation), and the installed abatement capacity and green performance of the product are state variables. We explore the monopolist’s optimal investment strategies and find that there exists a complementarity or substitutability relationship between the monopolist’s steady-state investments in end-of-pipe and cleaner production technologies innovation, which depends on the value of consumers’ environmental awareness. Further, we consider the optimal investment strategies from the perspective of social planner. By comparing investment strategies under the monopolist and social planner optimum cases, we show that the monopolist can achieve socially optimal innovation investment levels under a given environmental policy. Finally, we relax the assumption of a given policy and characterize the first-best and second-best policies, respectively, then compare R&D incentives of the two policies by numerical examples. We find that the first-best policy generates higher end-of-pipe and cleaner production technologies innovation incentives than the second-best emission tax policy.

The role of technological innovation in global climate policy

This research builds a dynamic model of the global economy and climate with three endogenous knowledge stocks. We confirm that the contribution of induced R&D in global climate change is shown to be very sensitive to the elasticity of substitution between energy and other factors of production since growth patterns of all types of research depend on whether inputs are gross complements or gross substitutes. The second, the duplication externality. Induced R&D generates a lower abatement cost reduction if we externalize duplication in the business as usual scenario. Third, the initial level of research expenditure. Higher initial levels of energy-related R&D shares would create a market size effect, leading to an increased contribution of induced R&D. Fourth, the inter-firm knowledge spillovers. Firms are not successful in capturing all the benefits they create, as many benefits flow out into other firms free of charge. These benefits are called inter-firm knowledge spillovers. Fifth, first-best and second-best policies. The first-best policy fully internalizes the inter-firm knowledge spillovers, which leads to increases in the levels of all types of research, whereas the second-best policy does not internalize it, which leads to induced changes in research resulting from the carbon tax affecting pre-existing market distortions. Sixth, a research dividend effect and tax burden effect. The tax may induce an increase in research expenditure, which would increase the welfare and consumption levels. Finally, the results demonstrated that induced R&D has a limited role in the abatement cost reduction of carbon emissions overall.

On the design of sustainable cities: Local traffic pollution and urban structure

This paper investigates the impact of local traffic pollution on the formation of residential and business districts. While firms benefit from local production externalities, households commute to their workplaces with private vehicles and exert a local pollution externality on the residents living along the urban transport networks. The spatial location of firms and residents endogenously results from the trade-off between the production and pollution externalities and the commuting costs. The analysis shows that in monocentric cities the benefits associated with a fall in per-vehicle pollution are absorbed by rents paid to absentee landlords. When a city includes business and residential districts as well as a district mixing both agents, a lower per-vehicle pollution enlarges the residential districts and shifts the business districts closer to the geographical center of the city. The paper finally studies the optimal city structure. The first-best policies that fully internalize the externalities still foster business agglomeration.

Is Meat Too Cheap? Towards Optimal Meat Taxation

Livestock is known to play a significant role in climate change and to negatively impact global nitrogen cycles and biodiversity. However, economically efficient policies for regulating meat production and consumption are under-researched. In the absence of first-best policy instruments for the livestock sector, second-best consumption taxes on meat can address multiple environmental externalities simultaneously, while improving diet-related public health. Here, we review the empirical basis for the ‘social costs of meat’ and study rationales for regulatory efforts to tax meat in high-income countries from the perspective of public, behavioural and welfare economics: (i) multiple environmental externalities, (ii) adverse effects on one’s own health, (iii) animal welfare, (iv) learning curves for 'alternative protein technologies', and (v) distributional effects. We conclude that meat is significantly underpriced and provide preliminary estimates of the environmental social costs associated with meat consumption. We identify several directions for future research towards optimal meat taxation.

Optimal Carbon Taxation and Horizontal Equity: A Welfare-Theoretic Approach with Application to German Household Data

We develop a model of optimal carbon taxation and redistribution taking into account horizontal equity concerns by considering heterogeneous energy efficiencies. By deriving first- and secondbest rules for policy instruments including carbon taxes, transfers and energy subsidies, we then investigate analytically how horizontal equity is considered in the social welfare maximizing tax structure. We calibrate the model to German household data and a 30 percent emission reduction goal. Our results show that energy-intensive households should receive more redistributive resources than energy-efficient households if and only if social inequality aversion is sufficiently high. We further find that redistribution of carbon tax revenue via household-specific transfers is the first-best policy. Equal per-capita transfers do not suffer from informational problems, but increase mitigation costs by around 15 percent compared to the first-best for unity inequality aversion. Adding renewable energy subsidies or non-linear energy subsidies, reduces mitigation costs further without relying on observability of households’ energy efficiency