Abstract:
The recent push for environmental regulation has invigorated the discussion
of mechanism design and optimal taxation policy. Recent decades
have also seen growing interest in behavioural economics and empirically
based theory. In this thesis we take a step towards combining the two by
asking how a regulator may correct an externality in situations where they
have a time consistency problem.
Time inconsistency is one of the notable developments of behavioural
economics. It posits that an agent’s decisions do not remain consistent
over time, which causes a utility loss if the agent cannot commit themselves
to a particular course of action and stick to it. The solution to inconsistency
problems is to precommit to a course of action and prevent
future deviations from it. However, finding a mechanism to enable such
precommitment is often problematic.
A regulator who maximises welfare can have a time consistency problem
because welfare will depend on the decisions of firm and households
who may themselves be inconsistent. That inconsistency then propagates
to the regulator’s decision and reduces the level of welfare that the regulator
can reach. Alternatively, the regulator’s time consistency problem can
be caused by non-stationarity in their time preferences. To reach the firstbest
outcome the regulator must not only eliminate the environmental externality:
they must also overcome their own time inconsistency problem.
This thesis draws from the literature on strategic delegation to construct
a taxation game in which the regulator can achieve the first best taxation
regime without the need for external precommitment devices. We
study a dynamic game where the regulator chooses a tax rate and the regulated
monopolist chooses their price. We show that the Markov-perfect
equilibrium price path of this game will replicate the first best plan. Our
results holds for time inconsistency caused by both jump states and quasihyperbolic
discounting.
