Information Costs of Externality Control Instruments

Abstract: Externality problems usually cannot find their solution in markets. Hence, Pareto optimality generally requires control of externality-producing behavior. Several legal instruments offer such control, most prominently quantity regulation and Pigouvian taxes. The economic and legal literatures reveal various differences between quantity and price controls that affect the social choice between these regulatory instruments. One of these differences is based on information costs: the design of corrective taxes requires a smaller amount of informational resources than does regulation, and Pigouvian taxes are deemed to be socially superior on this account. The present paper proves this argument wrong (in a static model), and explains why an identical information set is required for the design of both regulatory instruments. The paper argues further that if individuals' information costs in compliance are also accounted for, quantity regulation may prove less costly to implement, and hence socially superior to corrective taxes.

Keywords: externality, Pigouvian tax, quantity regulation, information, alleviation

JEL classification: H2, H3, Q5