In the preceding chapter, we focused our attention on a particular policy measure: Pigouvian taxes (or effluent charges) as a means to regulate pollution. In this chapter, we will expand the set of available policy instruments to encompass marketable emission permits. Until fairly recently, most microeconomists would have argued that the two were virtually equivalent – nearly so in practice and surely so in theory. But a series of papers published in the 1970s have forced a major revision in this view. These papers demonstrated that in the presence of uncertainty, the expected value of social welfare can differ markedly under a system of Pigouvian fees from that under a regime of marketable emission permits. These two policy instruments remain equivalent in a setting of perfect certainty. But as we shall see in this chapter, under particular forms of uncertainty, these two approaches to environmental management will yield very different outcomes. Depending on the shapes of the marginal damage and marginal abatement cost functions, the environmental authority will be better advised under some circumstances to use one of them, and under other circumstances to employ the other.

Our objective in this chapter is to describe the logic underlying the choice between these two policy instruments. For this purpose, we shall rely primarily on a series of simple diagrams that depict the basic propositions.

Effluent charges, marketable permits, and direct controls

It is important at the outset to be clear as to the precise character of the alternative policy instruments.