Optimal Policy Instruments for Externality-Producing Durable Goods under Time Inconsistency

Empirical evidence suggests that individual choices often display behavioral anomalies, like time-inconsistent preferences. For example, a household's preferences at the time of purchase of energy-intensive durable goods like cars and appliances may differ from its preferences later on, "underweighting" future operating costs. The standard solution to market failures caused by externalities—Pigouvian pricing—is suboptimal under time inconsistency. I investigate how public policies aimed at externalities can be optimally designed when consumers exhibit such behavior. An optimal policy includes an instrument to correct the market failure (externality) and an instrument to correct the behavioral anomaly. Either instrument can be an incentive-based policy or a command-and-control policy; behavioral anomalies do not uniquely warrant command-and-control regulations. I calibrate the model to the US automobile market. Preliminary simulation results suggest that, for cars, the second-best gasoline tax is 18%–45% higher than marginal external damages. The optimal price policy includes a gasoline tax set about equal to marginal external damages and a tax related to a car's fuel economy that increases the price of an average non-hybrid car by about $750–$2200 relative to the price of an average hybrid car.