Optimal Indirect Regulation of Externalities

When individuals generate different amounts of externality that cannot be directly measured or taxed, how should they be regulated? I study the optimal regulation of externalities via an imperfect proxy good, characterize the optimal policy, and show that it includes quantity surcharges and discounts to exploit the correlation between each individual's consumption behavior and the amount of externality generated. The optimal policy sometimes requires quantity controls, such as a quantity floor or ceiling. I demonstrate how distributional equity concerns can be incorporated into the optimal policy. Finally, I discuss policy implications for several markets