A gasoline tax, in contrast, does provide such incentives. Moreover,
cost-effectiveness generally calls for different performance requirements among firms with
differing production capabilities. Regulators generally lack the information required to tailor
the standards to individual firms. On the other hand, this problem could be addressed by
allowing some firms to undercomply, provided that they buy credits from other firms that
go beyond the standard.
As shown in columns 1 and 2 of Table 1, the most cost-effective instruments under the
narrow definition of “cost” are those that directly price the pollution externality: namely,
emissions taxes and tradable emissions permits.Other price instruments are less cost-effective
because they fail to exploit optimally all of the major channels for emissions reductions. Direct
regulatory instruments also fail to engage optimally all of the major pollution reduction
channels and, if nontradable, fail to equate the marginal costs of emissions reductions across
heterogeneous firms.