Pigouvian taxation versus quantity regulation:

Which is better?

In the previous analysis we derived formulas for the expected deadweight loss under quantity regulation and Pigouvian taxation. The natural question is: under uncertainty, which instrument is better? The answer can be found by simply inspecting equations (4.20) and (4.21). The tax will be better if:

which is true if and only if: or:

This has a simple interpretation: Pigouvian taxes have a lower expected deadweight loss if the slope of the marginal social cost curve is less than the slope of the marginal social benefit curve (that is, if the marginal cost curve is relatively flat, compared with the marginal benefit curve).

This result applies more generally. The economic intuition is straightforward and is illustrated in Figure 4.6.4 and Figure 4.6.5 below.

The deadweight loss of a Pigouvian tax under incomplete information

Figure 4.6.3 The deadweight loss of a Pigouvian tax under incomplete information: Social marginal benefits turn out to be less than expected

The expected deadweight loss of quantity regulation falls if the marginal cost curve becomes steeper

Figure 4.6.4 The expected deadweight loss of quantity regulation falls if the marginal cost curve becomes steeper

Figure 4.6.4 is identical to Figure 4.6.2, except we have now made the marginal social cost curve steeper. As the slope increases, the efficient level of production approaches Q, and the welfare loss falls. In the

The expected deadweight loss of Pigouvian taxation rises if the marginal cost curve becomes steeper

Figure 4.6.5 The expected deadweight loss of Pigouvian taxation rises if the marginal cost curve becomes steeper

limit, if the marginal cost curve is vertical, then quantity regulation perfectly mimics the actual marginal social costs of production, and there is no welfare loss.

On the other hand, consider Pigouvian taxation in Figure 4.6.5, which is identical to Figure 4.6.3 above except we have again made the marginal social cost curve steeper. As the slope increases, the efficient level of production moves towards Q and away from Q', the level of production under the tax. The welfare loss rises. In the limit, if the marginal cost curve is vertical, then the welfare loss from Pigouvian taxation increases without bound.

 
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