Emission Tax or Standard? The Role of Productivity Dispersion

When a society wants to control aggregate emission under a certain target, is it more desirable to impose a tax or a nontradable regulatory standard on emission? We answer this question by focusing on the role of productivity heterogeneity across a continuum of plants. The plants are monopolistically competitive and each plant produces one dirty-good variety whose by-product is emission. The main result is that an emission-intensity standard yields higher welfare than a tax if and only if productivity dispersion and the elasticity of substitution between the varieties of the dirty goods are both small. In the process of obtaining this result, we find that, if no abatement technology is available, then the tax induces higher average productivity, a lower average price, higher output of the dirty goods and higher welfare than the standard does for all feasible values of market power. On the other hand, if an abatement technology is available and productivity is homogeneous, the standard increases the marginal cost of production by less than the tax does, which leads to higher output of the dirty goods and a higher abatement intensity under the standard. This cost advantage of the standard over the tax is overturned when productivity is sufficiently heterogeneous across the plants. Therefore, productivity dispersion and its interaction with abatement choices are important for evaluating market-based versus non market-based environmental policies