Optimal pollution tax under imperfect competition and international trade: the small country case

This work depicts the possibility of setting up an optimal pollution tax under non-competitive markets and international trade in a small country. The model employed describes a situation of partial equilibrium characterized by imperfect competition among domestic producers, where the domestic good is a substitute for an imported polluting commodity. In this framework, we also bring in the possibility that the domestic firms can introduce innovation offsets via their investment in R&D. From the results, the optimal pollution tax under domestic distortions can be expressed as a function of a ‘domestic production effect’ and a ‘pollution effect’. Furthermore, when the firms execute R&D expenditures, the optimal policy adds an ‘innovation effect’, which captures the change in welfare coming from a decrease in total costs and can lead our results to a win–win situation.