Efficiency-Inducing Policy for Polluting Oligopolists

This paper characterizes an efficiency-inducing policy for a polluting oligopoly when pollution abatement is technologically feasible and when environmental damage depends on the pollution stock. Using a dynamic policy game between the regulator and the oligopolists, we show that a tax–subsidy scheme can implement the efficient outcome as a regulated market equilibrium. The scheme consists of a tax on production and a subsidy that can either be on abatement efforts or on abatement costs. Both schemes prescribe a different tax rule, but both implement the efficient outcome. If firms act strategically, taking into account the evolution of the pollution stock when they decide on abatement and production, the subsidy reflects the divergence between the social and private valuation of the pollution stock associated with the abatement decision. Consequently, the tax has to correct the two market failures associated with production: the market power of the firms and the negative externality caused by pollution. Using an LQ (differential) policy game, we show that the tax increases with the pollution stock for both schemes, and that the application of a subsidy on abatement costs leads to a laxer tax rule. Interestingly, it also yields a lower fiscal deficit at the steady state. Thus, from a fiscal perspective, the policy recommendation is the application of a subsidy on abatement costs.