Prices versus Quantities Revisited: What Do Policymakers Need to Know to Set Pigouvian Taxes and Subsidies? 
Policymakers designing taxes or subsidies to address externalities face a fundamental question of whether to focus on the size of the externality or on the quantity response to an intervention. Traditional Pigouvian economics suggests that knowing the externality’s magnitude is sufficient, and that the optimal tax equals the harm caused. However, real-world policy discussions often focus heavily on quantity responses rather than externality measurement alone. This disconnect is evident in congestion pricing discussions, which evolved from analyzing traffic harms to predicting traffic reduction, and in housing subsidy decisions, which center on how many units will be built rather than on housing’s social benefits. This paper presents a framework that provides conditions under which a policymaker will prefer to analyze the size of the externality or the quantity response to a tax and applies it to congestion pricing and housing construction subsidies.
Key Findings
- The optimal tax or subsidy deviates from the externality size when taxes create deadweight losses or when distributional consequences matter, making it lower for subsidies and higher for taxes than the externality alone would suggest.
- When implementation costs are low and distributional concerns are negligible, policymakers should focus on externality magnitudes. Conversely, when taxes impose social costs or distributional issues are significant, understanding quantity responses becomes more valuable.
- In the case of London’s congestion pricing, extremely high fixed administrative costs justified the four-decade evolution from the externality-focused 1964 Smeed Report toward quantity-focused analysis, because the pricing system would be acceptable only if it led to significant traffic reduction.
- For Boston’s housing subsidies, the analysis reveals a large ratio of total subsidized units to marginal induced units, indicating high costs per additional unit built.
- The framework demonstrates that housing subsidies become cost-effective primarily when they generate secondary benefits such as neighborhood revitalization or additional tax revenues from neighboring properties, which reduce the distortionary taxation.
Implications
The traditional Pigouvian approach of focusing exclusively on externality measurement is insufficient when policies involve substantial implementation costs, require distortionary taxation for funding, or create significant distributional consequences. Policymakers and economists must invest resources in understanding both the magnitudes of externalities and quantity responses to interventions, particularly in estimating the ratio of total affected units to marginal units induced by policy interventions. For practical policy evaluation, cost-benefit analyses should emphasize how many units of behavioral change each dollar of intervention actually purchases, not merely the value of eliminating the externality. The findings suggest that strengthening public support for welfare-improving Pigouvian policies requires more comprehensive empirical work that documents both price and quantity effects, rather than relying primarily on externality estimates to guide policy design.
Abstract
What information do policymakers need to design Pigouvian taxes or subsidies? Standard logic suggests that it is sufficient to know the size of the externality and unnecessary to know about quantities. Yet this logic is incorrect if interventions have fixed costs, taxes create deadweight losses, or there are distributional concerns. We present a model in which these considerations can make it more valuable for policymakers to learn about equilibrium quantities. We apply the model to congestion pricing, which has high fixed costs, and to a proposed housing subsidy in Boston that features deadweight losses and distributional concerns.