NPTEL-Economics-Public Economics

Module 3
Lecture 13
Topics
3.25 Price vs. Quantity Approach
3.25.1 Optimal Policy With Uncertainty

3.26 Weitzman: Uncertainty About Benefits

3.27 Recap of Externalities: Problems and Solutions

3.25 PRICE VS QUANTITY APPROACH

Price mechanism (taxes) is identical to quantity mechanism (permits) in above
model.
Weitzman (1974): with uncertainty, the government may not always know how
costly it is for a firm to reduce its pollution levels.
price and quantity no longer equivalent

3.25.1 OPTIMAL POLICY WITH UNCERTAINTY

MB flat, Q regulation:
Example: Global Warning

Figure 13.1 a

1
Indian Institute Of Technology, Kanpur

NPTEL-Economics-Public Economics

First assume that SMB is downward sloping but fairly flat (this could arise for
global warming for example(does not change a lot with pollution reduction)
In addition suppose the governments best guess of the costs is
But it is possible for actual cost to firm
Regulation mandates
Suppose the MC is
, there is a large
MB flat, P regulation (tax):

Figure 13.1 b
If instead the government levied a tax, it would equal MD at
)
Again actual
The result is a much smaller DWL
Or
if
Model with Uncertainty and locally steep Benefits.
MB Steep, Quantity Regulation
Example: Nuclear Leakage

Figure 13.2 a
2
Indian Institute Of Technology, Kanpur

NPTEL-Economics-Public Economics

Assume SMB is downward sloping and fairly steep.

(This for example in case of nuclear leakage).
Suppose governments best guess about
is
But actual is
Regulation mandates
, small

Figure 13.2 b
MB steep, Price Regulation
If instead the government levied a tax it would equal MD at
If

much higher than

in figure 13.2 a.

Figure 13.3 a

3
Indian Institute Of Technology, Kanpur

NPTEL-Economics-Public Economics

Figure 13.3 b
These figures show the implications for choice of quantity regulation versus
corrective taxes.
The key issue is whether the government wants to get the amount of
pollution reduction correct, or to minimize social (same as firm here)
costs.
Quantity regulation assures the desired level of pollution reduction. When
it is important to get the right level (such as with nuclear leakage), this
instrument works well.
However, corrective taxation protects firms against large cost overruns.

3.26 Weitzman: Uncertainty about Benefits

Now suppose that there is uncertainty about the marginal benefits of reducing
pollution but that the costs are known.
For a given p, the government knows the Q that will result exactly since p = C
(Q).
Since the government knows the true c (Q), it can either choose P or Q and the
firm would be minimizing costs (social costs minimized) always. So the society
always minimizes costs.
More generally, uncertainty matters only when it is about the cost/benefit
schedule for the agent who chooses level of pollution reduction.

4
Indian Institute Of Technology, Kanpur

NPTEL-Economics-Public Economics

If consumer chooses level of pollution reduction, then only uncertainty about

marginal benefits matters

3.27 Recap of Externalities: Problems and Solutions

Externality theory
Private-sector solutions
Public-sector solutions
Distinctions between price and quantity approaches to addressing externalities

5
Indian Institute Of Technology, Kanpur