Pareto-Optimal Effluent Taxation and Market Structure in the Presence of Uncertain Demand and Detection

Abstract

The analysis of the effect of market structure on optimal effluent taxation under certainty was initiated by Buchanan [I969]. He showed that equal effluent taxes, reflecting marginal damages, imposed on monopolistic and competitive industries alike would result in sub-optimal output by the monopolist. This has provided a caveat to the argument that equal effluent taxes on all firms will lead to Pareto-optimal effluent control when marginal damages are identical across firms. This argument has been further refined by Dnes [I98I], Endres [I978], and Lee [I975], who present models in which the Pareto-optimal tax, or subsidy, is determined as a function of market structure. All these models have been deterministic and conclude that the monopolistic firm should pay a lower tax than competitive firms. The purpose of this paper is to investigate the effects of uncertainty in firm demand and uncertainty of effluent detection on the Pareto-optimal effluent tax. It will be shown that in an uncertain world it is not implausible that optimal taxes for more competitive firms may be less than optimal taxes for less competitive firms. Section II derives the optimal tax in the presence of uncertain demand, while Section III derives the optimal tax when detection is uncertain. Section IV summarizes these results.