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Weitzman Theorem Proof

1. The document proves the Weitzman theorem, which compares the expected welfare gain (EWG) of emissions quotas versus taxes. 2. It derives formulas for the EWG under both policies. The EWG under quotas depends on the slope of the marginal benefit curve b and the variance of the marginal cost shock σ^2. The EWG under taxes has the same formula. 3. By comparing the two EWG formulas, it shows that taxes yield higher EWG if the variance σ^2 is greater than twice the slope b, while quotas are better if σ^2 is less than 2b. If σ^2 equals 2b, the EWG is the same under both policies.

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Saurav Dutt
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© Attribution Non-Commercial (BY-NC)
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151 views3 pages

Weitzman Theorem Proof

1. The document proves the Weitzman theorem, which compares the expected welfare gain (EWG) of emissions quotas versus taxes. 2. It derives formulas for the EWG under both policies. The EWG under quotas depends on the slope of the marginal benefit curve b and the variance of the marginal cost shock σ^2. The EWG under taxes has the same formula. 3. By comparing the two EWG formulas, it shows that taxes yield higher EWG if the variance σ^2 is greater than twice the slope b, while quotas are better if σ^2 is less than 2b. If σ^2 equals 2b, the EWG is the same under both policies.

Uploaded by

Saurav Dutt
Copyright
© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
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1

Proof of Weitzman Theorem




Let MB =a-bq -- (1)
MC = u q + + | o where u~(0,
2
o ) -- (2)

Regulator maximises W =E[Net social benefit] = ( ) ( ) | |
}

q
dq u q MC q MB E
0
, --(3)

Procedure: (i) Obtain optimal values of q* and p* substtg these successively into
(3) get EWG
quota
, EWG
tax
( EWG =expected welfare gain)

(ii) Compare the two, EWG
tax
EWG
quota
to measure the expected net
benefit of one policy over another.

Optimal quota: Choose q* to max E ( NSB ) FOC -
( )
* q
NSB E
c
c
=0

E | | MC MB =0 E ( ) | | u q bq a + + * * | o =0 a-bq* = * q | o +
or q* =
|
o
+

b
a

So, EWG
quota
=E
}
+

=
|
o
b
a
q
o
*
| | u q bq a | o dq

=E ( )
( )
*
2
2
q
o
q
b
q a
(

+

|
o =
( )
(
(

|
o
b
a 2
2
1
--(4)

Optimal tax (P*) : derive the firm's reaction function, i.e., the q that is produced by any
P- MC (q,u) =P - firms treat u as certain since they know their MC -
- invert MC - q =h (P,u) q =h (P,u) gives the qty abated (a random
variable) as a function of P -- this is the firm's reaction function, i.e.,
the q produced by any P.


p





O Q

MC
2

To pick optimal tax, set P to maximise NSB

FOC 0 ) ( ) ( ) ( =
c
c
c
c
=
c
c
c
c
=
c
c
P
h
NSB
h
E
P
q
NSB
q
E
NSB
P
E


=E
( ) ( )
( ) ( ) 0 , ,
,
=
c
c
(


P
h
u u p h MC
q
u p h
MB
Note, MB (q) =MB (h (p,u) ) - MB is a function of u because the level of abatement is
uncertain under a tax ( unlike the case w/ quotas ) e.g., set tax = p - you think you'll get
to E on MB but actually you get to F

MC
e



E MC
a




MB
F


Abatement
Now, since MC (q,u ) = P u q = + + | o
Solve for q, q = ( ) ( ) u P h u P ,
1
= o
|

Substitute for q in (5): E ( ) ( ) 0
1
* *
=
(


|
o
|
|
o o
|
u u P u P
b
a

Or, ( )
( )
o
|
|
o =
+
a
b
p
*

|
1
=
c
c
p
h


Optimal tax (P
*
): ( )
b
a
P
+

=
|
o
o
|
*
1
recall E(u) =0 --(6)

So, EWG
tax
=E ( ) ( ) | |
( )
dq u q MC q MB
u P h q
}
=

*,
0
,

Aside : h (P*,u) = ( ) ( )
|
o
|
o
|
u
p u p = *
1
*
1

3
from (6) h ( P*,u) =
| |
o u
b
a


So, EWG
tax
=E ( ) ( ) | |
}
+

b
a
dq u q MC q MB
|
|

o
0
,

=E ( )
}

+


| |
o
| o
u
b
a
dq u q bq a
0


=E ( )
( )
| |
o
|
o
u
b
a
q b
uq q a

+

0
2
2


Skipping a few steps--- Recall E(u
2
)

=
( ) ( )
( )
( ) |
|
o
|
o
|
o
|
o
+
+

+
+

b
b
a
b
a
.
2
.
2
1
2
2
2
2 2 2


=
( )
( ) | |
|
o
|
o
+
(

b
b
a
2
2
.
2
1
2
2 2


same as (4) EWG
quota


So, EWGtax - EWGquota = This is the key result. If
|
>b then


tax better & vice-verse. If b = | EWG
tax
=EWG
quota


Note that E(u
2
) =
2
o affects the magnitude of the difference between EWG under the
two policies ( i.e., it reflects the distance b/w MAC
e
& MAC
t
), but it does not affect the
choice of the policy instrument.


( ) b |
|
o
2
2
2

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