Tax or Quota? Regulation on Economies with Externalities of Consumption and Social Comparison

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Abstract
This paper examines the welfare implications and optimal regulation of commodities that generate externalities and induce social comparison. We show that the interaction between these dual market failures is super-additive: the resulting overconsumption and deadweight loss exceed the sum of the distortions generated by each failure independently. When the regulator recognizes and correctly accounts for both mechanisms, Pigouvian taxes and tradable quotas can each implement the first-best allocation. We then consider regulatory unawareness of social comparison: the regulator recognizes the physical externality but omits the positional motive from its perceived model. This unawareness-induced behavioral misperception leaves the first-best aggregate quantity unchanged but causes the regulator to understate the tax required to implement it. Consequently, tradable quotas remain first-best, whereas the misspecified tax induces persistent overconsumption and welfare losses. Our results identify a behavioral rationale for the robustness of quantity-based regulation when a relevant motive for consumption is absent from the regulator's perceived model.

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