Externality Control and Endogenous Market Structure Under Uncertainty: The Price vs. Quantity Dilemma

Abstract

In a competitive industry where production entails a negative externality, a welfare-maximizing regulator considers, as control instruments, setting a cap on the industry output or levying an output tax. We embed this scenario within a dynamic setup where market demand is stochastic and market entry is irreversible. We firstly determine the industry equilibrium under each policy and then determine the cap level and the tax rate which maximize welfare in each case. We show that a first-best outcome can be achieved through the tax policy while the cap policy may only qualify as a second-best alternative.

Keywords: Investment, Uncertainty, Caps, Taxes, Competition, Externalities, Welfare