This chapter presents a positive theory of externality control that explains the observed frequency of direct regulation as opposed to penalty taxes or charges. In the public-choice theory of policy, the interests of those who are subjected to the control instruments must be taken into account as well as the interests of those affected by the external diseconomies. The chapter emphasizes an elementary efficiency basis for preferring taxes and charges which heretofore has been neglected by economists. Economists of divergent political persuasions agree on the superior efficacy of penalty taxes as instruments for controlling significant external diseconomies which involve the interaction of many parties. There is an important economic basis for favoring the penalty tax over the direct control instrument, one that has been neglected by economists. By assessing a tax per unit of output on all firms in the industry, the government can insure that profit-maximizing decisions lead to a new and lower industry output that is Pareto optimal.
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