Second-best energy policies for heterogeneous firms

This paper investigates second-best issues in the regulation of external co sts of energy use by heterogeneous firms. The efficiency of regulatory ener gy policies depends in general on the policy incentives given for both outp ut reduction and input substitution. The resulting endogeneity of firms' su pply functions appears to lead to complicated policy rules. In contrast to earlier efforts, the analysis considers an arbitrarily large number of non- identical price-taking firms in a joint market; a large variety of possible production functions, including varying levels of economies of scale and p ossibilities for input substitution; and elasticities of market demand whic h may vary from completely elastic to completely inelastic. Two second-best instruments are considered, namely output taxes and energy-efficiency stan dards, and are compared to the benchmark of first-best energy taxes. The un derlying market factors determining the relative efficiency of these second -best instruments, when used optimally, are identified. (C) 1999 Elsevier S cience B.V. All rights reserved. JEL classifications: D62; Q48; D40.