Discussion Paper

Indexed Regulation

Jun 20, 2006 | Richard G. Newell, William A. Pizer

Abstract

Seminal work by Weitzman (1974) revealed that prices are preferred to quantities when marginal benefits are relatively flat compared to marginal costs. We extend this comparison to indexed policies, where quantities are proportional to an index, such as output. We find that policy preferences hinge on additional parameters describing the first and second moments of the index and the ex post optimal quantity level. When the ratio of these variables’ coefficients of variation divided by their correlation is less than two, indexed quantities are preferred to fixed quantities. A slightly more complex condition determines when indexed quantities are preferred to prices. Applied to the case of climate change, we find that quantities indexed to GDP are preferred to fixed quantities for about half of the 19 largest emitters, including the United States and China, while (consistent with previous work) prices dominate for all countries.