A note on environmental taxes and monopoly pricing Joshua Gans

Suppose that consumer utility for a particular item, i, (say, light bulbs) is given by: u(q) − ci q − pi q where q is the amount purchased, pi is the purchase price per unit and ci is the energy cost per unit paid for by the consumer. u(.) is assumed to be concave, increasing and differentiable in q. (Unconstrained)1 consumer demand is then described by a demand function, D( pi + ci ) ≡ arg max q u(q) − ci q − pi q . Note that D(.) is decreasing in pi + ci . Let V ( pi , ci ) ≡ max q u(q) − ci q − pi q . Suppose there are two items available. Item O is competitively supplied at a price of pO with an energy cost of cO . Item N is supplied by a monopolist and has an energy cost of cN < cO but otherwise costs the monopolist nothing to produce. Let pN be the price that satisfies: V ( pN + cN ) = V ( pO + cO ) . If the solution to the monopolist’s problem -max pN pN D( pN + cN ) -- is above pN then the monopolist sets pN = pN . Otherwise, the monopolist sets a price such that the price elasticity of demand is equal to -1; i.e., p N D ′ ( p N + cN ) D( pN + cN ) = −1 . Notice that the Question 1: Is it possible that cN D( pN + cN ) > cO D( pO + cO ) ? There are two cases. First, if pN = pN , then pN + cN = pO + cO and so demand is unchanged. Second, if the monopolist’s price is unconstrained, then pN + cN < pO + cO which means that demand will be higher. So long as cO − cN is high enough, then it is possible that energy consumption rises. This can be demonstrated with a simple linear demand example whereby D( pi + ci ) = 1 − ( pi + ci ) and pO = 0 . Question 2: Can an energy tax (t per unit of energy consumed) ensure that this does not occur? The first thing to note is that pN is independent of the tax rate but pN chosen by the monopolist is decreasing in t. Thus, a tax is more likely to generate the unconstrained pricing case. Nonetheless, the tax can be adjusted to ensure that the unconstrained case never arises (this might occur naturally if emissions were capped and so t adjusted to ensure that emissions did not rise). Question 3: Can putting in an energy tax encourage innovation in more efficient lighting? It is easy to see that the monopolist’s profits are decreasing in t. Thus, the tax will not encourage innovation in more efficient lighting.


That is, if there is only one item in existence.

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