Prices vs Quantities under Severe Uncertainty *

Abstract

The consensus among economists in favour of carbon taxes over emissions permits is based on a groundbreaking result due to Weitzman (1974). It assumes, however, a probability distribution over abatement costs and damages. As many have argued, current climate uncertainties are far more severe, and do not justify any such distribution. This paper reconsiders the tax-permit comparison in the presence of severe or Knightian uncertainty, drawing on the workhorse maxmin-EU model from the literature on decision under ambiguity (Gilboa and Schmeidler, 1989). Our results show that optimally set permits are strictly more efficient than optimal taxes when uncertainty concerning the slope of marginal abatement costs is severe. They suggest that, given the uncertainty reported in the latest IPCC report, permit policies should be preferred.

Keywords: Carbon taxes, emissions permits, severe uncertainty, ambiguity, uncertainty vs. risk, robust policy analysis. JEL codes: Q5, D62, D81

JEL Classification: Q5, D62, D81