Think Globally, Cap Locally, and Trade Widely: Efficient Decentralized Policy Making in the Presence of Spillovers

Abstract

This paper shows that when decentralized governments atomistically compete in caps or mandates to address externalities or public goods that impose spillovers on others they may be able to achieve an efficient allocation. Competition in quantity instruments eliminates distortions that arise when spillover generating factors cross borders. If governments also allow free trade in virtual permits and on average consider the external benefits their policy choices impose on others, then efficiency can be restored. This occurs because an explicit price link between virtual and real markets induces governments to arbitrage away terms of trade distortions. This result is robust to any number and permutation of public goods, bads, and/or externalities, and thus specifies the precise conditions by which competition among decentralized governments to set the size of virtual markets can restore Pareto efficiency, even when markets are incomplete and spillovers cross government borders.