### Abstract

We consider a general equilibrium model with a production externality (e.g. pollution), where the regulator does not observe firm productivity shocks. We examine quantity (permit) regulation and price (tax) regulation. The quantity of permits issued by the regulator are independent of the productivity shock, since shocks are unobserved. Price regulation implies use of the regulated input is an increasing function of the productivity shock because firms take advantage of a good productivity shock by increasing input use. Thus price regulation generates higher average, but more variable, production. Therefore, we show that in general equilibrium the relative advantage of quantity versus price regulation depends not only on the slopes of marginal benefits and costs, but on general equilibrium effects such as risk aversion. The general equilibrium effects are often more important than the slopes of the marginal benefits and cost curves. In the simplest model, a reasonable risk aversion coefficient implies quantity regulation generates higher welfare regardless of the benefit function.

Original language | English (US) |
---|---|

Pages (from-to) | 36-60 |

Number of pages | 25 |

Journal | Journal of Economic Theory |

Volume | 125 |

Issue number | 1 |

DOIs | |

State | Published - Nov 1 2005 |

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### Keywords

- Asymmetric information
- Choice of instruments
- Pollution control
- Tax regulation
- Tradeable permits

### ASJC Scopus subject areas

- Economics and Econometrics

### Cite this

**Price and quantity regulation in general equilibrium.** / Kelly, David.

Research output: Contribution to journal › Article

*Journal of Economic Theory*, vol. 125, no. 1, pp. 36-60. https://doi.org/10.1016/j.jet.2004.07.006

}

TY - JOUR

T1 - Price and quantity regulation in general equilibrium

AU - Kelly, David

PY - 2005/11/1

Y1 - 2005/11/1

N2 - We consider a general equilibrium model with a production externality (e.g. pollution), where the regulator does not observe firm productivity shocks. We examine quantity (permit) regulation and price (tax) regulation. The quantity of permits issued by the regulator are independent of the productivity shock, since shocks are unobserved. Price regulation implies use of the regulated input is an increasing function of the productivity shock because firms take advantage of a good productivity shock by increasing input use. Thus price regulation generates higher average, but more variable, production. Therefore, we show that in general equilibrium the relative advantage of quantity versus price regulation depends not only on the slopes of marginal benefits and costs, but on general equilibrium effects such as risk aversion. The general equilibrium effects are often more important than the slopes of the marginal benefits and cost curves. In the simplest model, a reasonable risk aversion coefficient implies quantity regulation generates higher welfare regardless of the benefit function.

AB - We consider a general equilibrium model with a production externality (e.g. pollution), where the regulator does not observe firm productivity shocks. We examine quantity (permit) regulation and price (tax) regulation. The quantity of permits issued by the regulator are independent of the productivity shock, since shocks are unobserved. Price regulation implies use of the regulated input is an increasing function of the productivity shock because firms take advantage of a good productivity shock by increasing input use. Thus price regulation generates higher average, but more variable, production. Therefore, we show that in general equilibrium the relative advantage of quantity versus price regulation depends not only on the slopes of marginal benefits and costs, but on general equilibrium effects such as risk aversion. The general equilibrium effects are often more important than the slopes of the marginal benefits and cost curves. In the simplest model, a reasonable risk aversion coefficient implies quantity regulation generates higher welfare regardless of the benefit function.

KW - Asymmetric information

KW - Choice of instruments

KW - Pollution control

KW - Tax regulation

KW - Tradeable permits

UR - http://www.scopus.com/inward/record.url?scp=27844483050&partnerID=8YFLogxK

UR - http://www.scopus.com/inward/citedby.url?scp=27844483050&partnerID=8YFLogxK

U2 - 10.1016/j.jet.2004.07.006

DO - 10.1016/j.jet.2004.07.006

M3 - Article

VL - 125

SP - 36

EP - 60

JO - Journal of Economic Theory

JF - Journal of Economic Theory

SN - 0022-0531

IS - 1

ER -