Prices vs. Quantities: Robust Regulation

TL;DR

This paper explores robust regulation strategies in the presence of consumption externalities, showing that quantity controls are optimal under worst-case welfare, with implications for policy design under uncertainty.

Contribution

It introduces a robust mechanism design framework for regulation with externalities, identifying optimal policies under demand uncertainty and correlational ambiguity.

Findings

Quantity controls are optimal under worst-case welfare.

Uniform taxes or subsidies are optimal when demand correlation is known.

The framework explains the prevalence of non-price policies in regulation.

Abstract

This paper revisits the classic instrument choice problem in a setting with consumption externalities, through the lens of robust mechanism design. A regulator can implement any incentive-compatible policy but is uncertain about how individual demand is correlated with marginal externalities, and evaluates policies by worst-case welfare. The optimal policy is a quantity control: a floor for positive externalities and a ceiling for negative externalities. If the sign of the correlation is known, a uniform tax or subsidy can be optimal. The framework also applies to regulatory uncertainty and costly screening, providing a welfare-based explanation for the prevalence of non-price policies.