Working Paper: NBER ID: w17083
Authors: Garth Heutel
Abstract: When consumers exhibit present bias and are time-inconsistent, the standard solution to market failures caused by externalities--Pigouvian pricing--is suboptimal. I investigate policies aimed at externalities for time-inconsistent consumers. Welfare-maximizing policy in this case includes an instrument to correct the externality and an instrument to correct the present bias. Either instrument can be an incentive-based policy or a command-and-control policy. Calibrated to the US automobile market, simulation results from a model with time-inconsistent consumers suggest that the second-best gasoline tax is 18%-30% higher than marginal external damages. These simulations also suggest that social welfare is maximized with a gasoline tax set about equal to marginal external damages and a fuel economy tax that increases the price of an average non-hybrid car by about $750-$2200 relative to the price of an average hybrid car.
Keywords: time inconsistency; Pigouvian pricing; externalities; durable goods; behavioral economics
JEL Codes: D03; Q48; Q58
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Time inconsistency (D15) | Standard Pigouvian pricing does not lead to a socially optimal outcome (D62) |
| Present bias (D15) | Consumers underweight future costs of durable goods (D15) |
| Consumers underweight future costs of durable goods (D15) | Inefficient fuel economy choices and mileage (R41) |
| Standard Pigouvian pricing does not lead to a socially optimal outcome (D62) | Gasoline tax needed to achieve social welfare maximization is 18-30% higher than marginal external damages (D62) |
| First-best outcome (H21) | Achieved through a combination of a Pigouvian tax and a command-and-control mandate (Q58) |
| Incentive-based policies (J33) | Effectively correct for time inconsistency (D15) |
| Policies ignoring time inconsistency (D15) | Substantial deadweight losses (H21) |
| Substantial deadweight losses (H21) | Economy-wide deadweight loss of 144 to 201 billion dollars annually (F69) |
| Policies must consider consumer heterogeneity (D11) | Avoid inefficiencies (D61) |