Date Added: May 2011
When consumers exhibit present bias and are time-inconsistent, the standard solution to market failures caused by externalities - Pigouvian pricing - is suboptimal. The author investigates policies aimed at externalities for time-inconsistent consumers. Welfare-maximizing policy in this case includes an instrument to correct the externality and an instrument to correct the present bias. Either instrument can be an incentive-based policy or a command-and-control policy. Calibrated to the US automobile market, simulation results from a model with time-inconsistent consumers suggest that the second-best gasoline tax is 18% - 30% higher than marginal external damages.