Prices or Quantities Can Dominate Banking and Borrowing*

Abstract

The possibility of intertemporal banking and borrowing of tradable permits is often viewed as tilting the various policy debates about optimal pollution control instruments towards favoring such time‐flexible quantities. This paper shows that this view can be misleading, at least for the simplest dynamic extension of the original “prices versus quantities” information structure. The model of this paper allows firms to know and act upon the realization of uncertain future costs two full periods ahead of the regulators. For any given circumstance, the paper shows that either a fixed price or a fixed quantity is superior in expected welfare to time‐flexible banking and borrowing. Furthermore, the standard original formula for the comparative advantage of prices over quantities contains sufficient information to completely characterize the regulatory role of intertemporal banking and borrowing. The logic and implications of these results are analyzed and discussed.