1

Proof of Weitzman Theorem

Let MB =a-bq -- (1)
MC = u q + + | o where u~(0,
2
o ) -- (2)

Regulator maximises W =E[Net social benefit] = ( ) ( ) | |
}

q
dq u q MC q MB E
0
, --(3)

Procedure: (i) Obtain optimal values of q* and p* substtg these successively into
(3) get EWG
quota
, EWG
tax
( EWG =expected welfare gain)

(ii) Compare the two, EWG
tax
EWG
quota
to measure the expected net
benefit of one policy over another.

Optimal quota: Choose q* to max E ( NSB ) FOC -
( )
* q
NSB E
c
c
=0

E | | MC MB =0 E ( ) | | u q bq a + + * * | o =0 a-bq* = * q | o +
or q* =
|
o
+

b
a

So, EWG
quota
=E
}
+

=
|
o
b
a
q
o
*
| | u q bq a | o dq

=E ( )
( )
*
2
2
q
o
q
b
q a
(

+

|
o =
( )
(
(

|
o
b
a 2
2
1
--(4)

Optimal tax (P*) : derive the firm's reaction function, i.e., the q that is produced by any
P- MC (q,u) =P - firms treat u as certain since they know their MC -
- invert MC - q =h (P,u) q =h (P,u) gives the qty abated (a random
variable) as a function of P -- this is the firm's reaction function, i.e.,
the q produced by any P.


p





O Q

MC
2

To pick optimal tax, set P to maximise NSB

FOC 0 ) ( ) ( ) ( =
c
c
c
c
=
c
c
c
c
=
c
c
P
h
NSB
h
E
P
q
NSB
q
E
NSB
P
E


=E
( ) ( )
( ) ( ) 0 , ,
,
=
c
c
(

P
h
u u p h MC
q
u p h
MB
Note, MB (q) =MB (h (p,u) ) - MB is a function of u because the level of abatement is
uncertain under a tax ( unlike the case w/ quotas ) e.g., set tax = p - you think you'll get
to E on MB but actually you get to F

MC
e



E MC
a




MB
F


Abatement
Now, since MC (q,u ) = P u q = + + | o
Solve for q, q = ( ) ( ) u P h u P ,
1
= o
|

Substitute for q in (5): E ( ) ( ) 0
1
* *
=
(

|
o
|
|
o o
|
u u P u P
b
a

Or, ( )
( )
o
|
|
o =
+
a
b
p
*

|
1
=
c
c
p
h


Optimal tax (P
*
): ( )
b
a
P
+

=
|
o
o
|
*
1
recall E(u) =0 --(6)

So, EWG
tax
=E ( ) ( ) | |
( )
dq u q MC q MB
u P h q
}
=

*,
0
,

Aside : h (P*,u) = ( ) ( )
|
o
|
o
|
u
p u p = *
1
*
1

3
from (6) h ( P*,u) =
| |
o u
b
a

So, EWG
tax
=E ( ) ( ) | |
}
+

b
a
dq u q MC q MB
|
|

o
0
,

=E ( )
}

+

| |
o
| o
u
b
a
dq u q bq a
0


=E ( )
( )
| |
o
|
o
u
b
a
q b
uq q a

+

0
2
2


Skipping a few steps--- Recall E(u
2
)

=
( ) ( )
( )
( ) |
|
o
|
o
|
o
|
o
+
+

+
+

b
b
a
b
a
.
2
.
2
1
2
2
2
2 2 2


=
( )
( ) | |
|
o
|
o
+
(

b
b
a
2
2
.
2
1
2
2 2


same as (4) EWG
quota


So, EWGtax - EWGquota = This is the key result. If
|
>b then


tax better & vice-verse. If b = | EWG
tax
=EWG
quota


Note that E(u
2
) =
2
o affects the magnitude of the difference between EWG under the
two policies ( i.e., it reflects the distance b/w MAC
e
& MAC
t
), but it does not affect the
choice of the policy instrument.


( ) b |
|
o
2
2
2