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Efficient bilateral taxation of externalities

In the context of the example of a factory whose smoke emissions affect a near-by laundry, Coase (J Law Econ 3:1–44, 1960) argued for taxing the laundry as well as the factory, while Baumol (Am Econ Rev 62:307–322, 1972) argued for taxing only the factory. Consistent application of marginal cost pricing shows that the efficient tax on laundries is positive when the number of laundries is finite and that the tax approaches zero in the limit as the number of laundries approaches infinity. The efficient tax on factories is bounded away from zero, regardless of the number of factories. Our framework is an application of the Vickrey–Clarke–Groves family of truth-telling mechanisms that require each agent to bear the full social cost of changing the outcome that would have prevailed had she not participated in the decision. Until now, the literature has not fully resolved the discrepancies between Coase’s and Baumol’s arguments, and even contemporary textbooks on environmental economics and public economics do not offer correct and complete analyses.