Prices versus Quantities with Strategic Communication between Government and Polluting Industry

Abstract

We compare the performance of emission taxes and quotas when there are opportunities for communication between the government and a polluting industry. We consider a competitive industry that communicates its private information about production costs strategically to the government before the latter sets the tax rate or the quota level. We show that while the communication is completely uninformative under taxes, it can be informative under quotas. This is because quotas can create "windfall profits" for the industry via an output price increase, thereby closely aligning the interests of the government and the industry. We also show that by committing to refund a portion of tax revenues or to auction off a portion of total quotas, the government can improve the informativeness of communication under each policy. Overall, our results suggest that when emission restrictions have a price-raising effect, the possibility of government-industry communication modifies the Weitzman (1974) result in favor of emission quotas.

Keywords: Emission Tax, Emission Quota, Asymmetric Information, Cheap Talk, Windfall Profit

JEL Classification: D72, D83, Q58