Optimal Indirect Regulation of Externalities

To regulate goods that generate externalities upon consumption, textbook analyses typically---and often exclusively---focus on the Pigouvian approach. As first demonstrated by Pigou (1920), a tax on each consumer equal to the marginal external damage that he causes induces him to internalize the true social impact of his consumption and restores market efficiency. However, the Pigouvian approach assumes that the amount of externality that each consumer generates can be measured and directly taxed, which is rarely the case in reality. On one hand, empirical work has shown that the amount of externality that each consumer generates is often heterogeneous: vehicle emissions per mile traveled, for example, differ not only across different vehicle types, but also within vehicles of the same make, model, and model year. On the other hand, prohibitive technological costs preclude the accurate measurement of emissions for individual vehicles.