Optimal policy commitment: investment deterrence versus option value

The consistency and predictability of regulation is thought to be highly important for costly investment decisions. When the government lacks commitment power to maintain a promised policy, and firms are not perfectly competitive, investment levels are typically lower than when the government can commit. However, flexibility in policymaking is beneficial in that it allows for adjustment when conditions change or new information arrives. Shocks to growth or to individuals sectors of the economy, for example, can change the optimal level of taxation. In the environmental context, an important factor for policy decisions is the expected damage caused by a pollutant, which can change over time as new economic conditions and information arrive. What is the optimal frequency and intensity of changes in legislation when both option value and less-than-full commitment power are present? The solution requires balancing the harm of unpredictable legislation with the benefits of option value. This paper considers this tradeoff to derive the optimal policy commitment in the presence of both irreversible investment decisions and informational uncertainty about the damage done by a pollutant. I show that in many, but not all, cases the government will want to commit to lower-than-Pigouvian tax rates in the state of the world where the pollutant is damaging. However, equilibrium investment rates in this ∗I thank Leonid Chindelevitch, Don Fullerton, Julian Reif and Mar Reguant Rido for helpful feedback. 1 partial commitment model are not always larger than when the government lacks the power to commit to a specific tax rate and are not always lower than when the government has full commitment power.