Pricing instruments in environmental and climate policy when polluters are boundedly rational.

Abstract

The use of pricing instruments in environmental policy has been argued to have certain advantages, notably related to static and dynamic efficiency as well as effectiveness due to economy-wide scope. This paper adopts a broad perspective to provide a complete set of arguments in favour of price-based instruments in environmental policy, illustrated for climate policy. Pricing instruments are still not used to their full potential. The reason is that there is still considerable unfounded scepticism, including by researchers in the social environmental sciences, about their functioning and performance. Different disciplines express distinct and partly inconsistent ideas on the desirability of pricing instruments. An important recent criticism is that traditional economic arguments for pricing instruments are based on rational agents and are inconsistent with findings of behavioural economics. We examine this argument by assessing how instruments behave under various realistic behavioural assumptions in line with bounded rationality and other-regarding behaviour. We find that the case is strengthened for cap-and-trade versus environmental taxation. We also discuss additional instruments to effectively counter environmental and climate challenges under bounded rationality and social interactions.