Question

Consider a market in which firms are price-takers. The inverse demand function is p(Q) = 1 – Q, where p denotes the price of good Q. The production costs are C(Q) = mQ, with 0 < m < 1. The environmental damage caused by output Q is D(Q) = Q 2 .

a) Compute the equilibrium price and output. Also, calculate the socially optimal solution. Explain the differences, using a suitable diagram.

b) What is the aim of an emission tax (Pigouvian tax)? What per-unit charge should be imposed?

c) Technological progress leads to a decline in production costs reflected in a lower cost parameter m. How does this decline affect the optimal tax level and the resultant output? Explain your results, and illustrate them with a diagram.

Answer 1

In practice, a market does not comprise only one type of firm, resulting in two distortions: negative externalities caused by pollution damage and pricing power enjoyed by dominant firms. This paper examines choice of environmental policy instruments (tax-centered, quota-centered, and mixed policy) in markets where multiple dominant firms are price makers and multiple fringe firms are price takers. Environmental policy is not necessarily applied to all firms or facilities. This study focuses on the situation where only dominant firms are objects of environmental policy because this situation best reflects actual policy instruments. Understanding whether abatement costs exceed the environmental damage is essential to determining the best policy. The major finding of the study is that deadweight loss is reduced if dominant firms adopt eco-friendly technology and the regulator increases the ratio of taxed dominant firms to all dominant firms. Additionally, mixed policy is efficient when market distortion as a result of pricing power decreases.