In the realistic case of imperfect information, however, externality fees
have certain advantages over standards. For example, suppose the regulator is
in a good position to estimate the benefits from cleanup but is in the dark
about the industry’s cost of cleanup. In this case, if the regulator overestimates
cleanup costs, the standard will be too lax; if it underestimates these costs, the
standard will be too stringent.
Pollution fees, though also subject to error, allow more flexibility. Suppose
the regulator mistakenly sets too low a tax; let’s say that T MB* in
Figure 11.2. Since firms clean up only to the point where the marginal cost of
doing so equals the tax (MC T), the result will be relatively little cleanup. The
regulator will see that additional cleanup affords a marginal benefit above mar-
ginal cost: MB T MC. Thus, it can adjust the tax upward until, by trial and
error, the resulting level of cleanup satisfies MB* T MC*, thereby achiev-
ing the social optimum.
The advantage of fees over standards is even more pronounced when we
recognize the enormity of regulating the myriad sources of pollution. Could a
regulatory body, no matter how well informed, be expected to know the mar-
ginal benefits and costs associated with each pollution source and set optimal
standards? Clearly, such individual standards would be subject to considerable
error. In contrast, the value of the tax approach is that all generators of a given
externality would be charged the same fee. This uniform fee is set to reflect the
estimated externality cost. Whatever their differing costs of abatement, each
firm cleans up pollution to the point where its marginal cost equals the tax:
T MC 1 MC 2 ... MCn. (Firms for which cleanup is cheap undertake
greater pollution abatement.) Marginal costs are equated across all firms,
ensuring that the total amount of pollution is eliminated at least cost. The fee
system achieves full efficiency when the tax matches MB*.
Regulators have used externality fees in a variety of areas. London, for
example, has imposed a congestion fee for driving in the central city. Analysts
credit this fee (about $20 per day for driving downtown) with reducing traffic,
shortening wait times, and more than doubling average speed in the city.^9
Another regulatory response to an externality, such as pollution, is the
introduction of transferable emissions permits.The regulator sets the num-
ber of permits to allow the discharge of a fixed total quantity of pollution.
However, these permits can be bought and sold freely among firms. One would
expect a ready market for these permits to emerge. Which firms would end up
obtaining and using the permits? Those with the highest cleanup costs. This is
exactly the efficient solution the regulator is seeking. A certain amount of pol-
lution is permitted; the rest is cleaned up at least cost.
The trading of pollution permits implies that the required amount of pol-
lution will be cleaned up at least total cost. Nonetheless, the regulator still faces
the problem of determining the allowable total amount of pollution (presumably460 Chapter 11 Regulation, Public Goods, and Benefit-Cost Analysis(^9) See “Lessons from London’s Congestion Charge,” The Economist, February 22, 2007, p. 51.
c11RegulationPublicGoodsandBenefitCostAnalysis.qxd 9/29/11 1:34 PM Page 460