The economics of environmental federalism identifies two book-end departures from the first-best, which equates marginal costs and benefits in all local jurisdictions. Local governments may respond to local conditions, but ignore inter-jurisdictional spillovers. Alternatively, central governments may internalize spillovers, but impose uniform regulations ignoring local hetero-geneity. We provide a simple model that demonstrates that the choice of policy depends crucial-ly on the shape of marginal abatement costs. If marginal costs are increasing and convex, then abatement cost elasticities will tend to be higher around the local policies. This increases the deadweight loss of those policies relative to the centralized policy, ceteris paribus.
Using a large simulation model, we then empirically explore the tradeoffs between local versus second-best uniform policies for US air pollution. We find that US states acting in their own interest lose about 31.5% of the potential first-best benefits, whereas the second-best uniform policy loses only 0.2% of benefits. The centralized policy outperforms the state policy for two reasons. First, inter-state spillovers are simply more important that inter-state hetero-geneity in this application. Second, welfare losses are especially small under the uniform policy because elasticities are much higher over the relevant range of the cost functions.
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This paper was revised on December 5, 2011
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