Efficiency Inducing Taxation for Polluting Oligopolists

We derive corrective tax rules when firms are oligopolists whose production processes generate emissions that add to a stock of pollution that accumulates over time. In our model, firms play dynamic Cournot games among themselves, and the government designs a tax rule that corrects for both the externality associated with emissions and the market power of oligopolists. We show that there exists a time-independent tax rule that guides the oligopolists to achieve the socially optimum production path. The optimal tax per unit of output is dependent on the current level of pollution stock, and it may be negative (implying a subsidy) when the pollution stock is low. We obtain a rather surprising result: in some cases, the optimal tax rule gives firms a subsidy for an initial time interval even though under laissez-faire their output exceeds the socially optimal output at each point of time. This subsidy, howerver, induces firms to produce less than they would under laissez-faire, because they know that if they produce more then the subsidy will be reduced in the future and/or will soon turn into a tax.
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