Optimal Indirect Regulation of Externalities

Abstract

In many markets ranging from gasoline to alcohol and vaccines, individuals generate different amounts of externalities that cannot be directly taxed. I study how such externalities should be optimally regulated. I characterize the optimal policy and show that it generally requires quantity surcharges and discounts. I evaluate the gain from using the optimal indirect policy rather than a uniform tax and show that it can be significant. I apply my results to gasoline taxes to demonstrate their policy implications. Finally, I incorporate distributional concerns and show how "non-market" solutions such as quantity floors and ceilings might be required.

Keywords: regulation, externalities, mechanism design, imperfect pricing, Pigouvian tax

JEL Classification: D47, D62, D63, D82, H23