Pigovian taxes that internalize the external damage associated with polluting activities and are now a standard tool in the design of environmental policy. Under perfect competition, the external damage is fully internalized when the optimal tax and the marginal external damage are equal; under monopoly, however, complete internalization imposes an additional social cost by further restricting the already sub-optimal monopolist's output, so the optimal tax will be less than the marginal external damage. In Discussion Paper No. 955, Research Fellow Yannis Katsoulacos and Anastasios Xepapadeas seek to identify optimal environmental policy under oligopoly, which has received little attention despite being probably the most important market structure for the control of externalities in practice. When the number of firms is fixed, the optimal tax falls short of the marginal external damage as for a monopoly and rises with the number of firms. With free entry, however, so the market structure is determined endogenously, full internalization in excess of the marginal external damage may restrict the number of firms to be closer to that associated with the second-best social optimum; the optimal tax may then exceed the marginal external damage. They use comparative statics to relate the likelihood that this will happen to the model's exogenous parameters and show that this probability rises as marginal abatement costs or fixed costs fall.

This `over-internalization' arises because the equilibrium number of firms exceeds that corresponding to the second-best social optimum without taxes. The optimal tax then reduces the resulting distortion and will therefore exceeds the marginal damage. If this is always the case, the optimal tax could be even lower for an oligopoly than for a monopoly. The second-best emission tax need not restrict the number of firms to the second-best social optimum, however, so social welfare may be increased by using a second instrument to reduce the number of firms. Katsoulacos and Xepapadeas derive an optimal policy scheme consisting of a licence fee to reduce the equilibrium number of firms to the second-best social optimum and an optimal tax for an oligopoly with the corresponding fixed number of firms.

Environmental Policy Under Oligopoly with Endogenous Market Structure
Yannis Katsoulacos and Anastasios Xepapadeas

Discussion Paper No. 955, May 1994 (IO)