Efficient Bilateral Taxation of Externalities

In the context of the example of a factory whose smoke emissions affect a near-by laundry, Coase (1960) argued for taxing the laundry as well as the factory, while Baumol (1972) argued for taxing only the factory. The literature on bilateral taxation during the past 40 years has not fully resolved the discrepancies between Coase's and Baumol's arguments, and even contemporary textbooks on environmental economics and public economics do not offer correct and complete analyses. An application of marginal cost pricing shows that the efficient tax on laundries is positive when the number of laundries is finite and that the tax approaches zero in the limit as the number of laundries approaches infinity. The efficient tax on factories is positive, regardless of the number of factories. The role of consistent application of marginal cost pricing has not yet become part of the common wisdom of economists, which makes our contribution relevant today