Stock Externality Regulation Under Uncertainty

Discussion papers are research materials circulated by their authors for purposes of information and discussion. They have not undergone formal peer review or the editorial treatment accorded RFF books and other publications. Abstract Uncertainty about costs causes otherwise equivalent price and quantity controls to result in different quantity responses and costs. Weitzman (1974) found that the efficiency of price relative to quantity controls in a regulated market depends critically on both the existence of cost uncertainty and the relative slopes of marginal benefits and costs. We explore how uncertainty could influence the choice of policies to regulate flows when benefits are associated with the stock, rather than the flow. For example, in controlling emissions of greenhouse gases, the stock of greenhouse gases is associated with global climate change. Other environmental and natural resource examples include policies that address ozone-depleting substances, land use change, species preservation, hazardous waste disposal, natural resource conservation, and groundwater pollution. Potential non-environmental examples include research and development, educational attainment, and monetary policy. Using a simple analytical model that incorporates costs and benefits, stock decay, time discounting, and uncertainty, we uncover five important principles governing the choice of price-based policies (e.g., taxes) relative to quantity-based policies (e.g., tradeable permits) for controlling stock externalities. First, the slower a stock decays (or the longer the stock persists), the more likely it is that quantity controls are preferred to price controls because deviations in flows under a price policy persist over long periods of time. Second, low discount rates give greater weight to these future deviations and thus reinforce the policy divergence over time, thereby favoring quantity controls. Third, in a multi-period analysis results hinge on correlation across periods. In particular, positive correlation among cost shocks across time tend to decrease the net benefits of using prices, thereby favoring quantities. Fourth, controlling for the aforementioned effects, 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. Fifth, and finally, we find that the assumption of a globally quadratic benefit function almost guarantees that price controls will be more efficient than quantity-based policies for controlling stock externalities. In the case of climate change, these results suggest that the current focus on quantity-based policies, to the exclusion of policies that include price-like elements, may be inappropriate.