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Cap and trade policies in the presence of monopoly and distortionary taxation

  • Fullerton, Don
  • Metcalf, Gilbert E.

We extend a simple analytical general equilibrium model of environmental policy with pre-existing labor tax distortions to include pre-existing monopoly power as well. We solve for the endogenous net wage rate, labor supply, and monopoly profits as functions of exogenous parameters and the environmental policy shock. We use plausible parameter values to calculate the interactions of the three simultaneous market failures: pollution, taxes, and monopoly. We confirm prior results that the extent of profits taxation affects whether environmental policy can improve welfare at all, even with uncorrected pollution. This result still holds with monopoly power. However, the existence of monopoly has two offsetting effects on welfare. First, the environmental policy reduces monopoly profits, and the negative effect on income increases labor supply in a way that partially offsets the pre-existing labor supply distortion. Second, environmental policy raises prices further, so interaction with the pre-existing monopoly distortion further exacerbates the labor supply distortion. Thus monopoly power means that the income effect of capturing the scarcity rents from the emissions restriction is less important, but the price effect of higher output prices on the real net wage is more important. This second effect is larger, for reasonable parameter values, so the existence of monopoly reduces the welfare gain (or increases the loss) from environmental restrictions.

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Article provided by Elsevier in its journal Resource and Energy Economics.

Volume (Year): 24 (2002)
Issue (Month): 4 (November)
Pages: 327-347

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Handle: RePEc:eee:resene:v:24:y:2002:i:4:p:327-347
Contact details of provider: Web page: http://www.elsevier.com/locate/inca/505569

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