Pigouvian Taxes under Oligopoly with Inter-Firm Externalities

Abstract

Pollution externalities between polluters should be taken into account in the design of optimal Pigouvian tax. When the externalities are substantial and/or the number of polluters is large, the effluent levies on these firms do not necessarily result in a deadweight loss. Rather, the tax can raise outputs and reduce the prices of final products if a marginal decline in a firm's emission leads to a greater aggregate reduction in other firms' marginal production costs than the increase in its own marginal cost. Under this condition, the second-best tax rate exceeds the marginal social cost of pollution.