On the taxation of polluting products in a differentiated industry

This paper studies the provision of environmental quality in an imperfectly competitive market. It uses a vertical differentiation model in which the free entry equilibrium results in an under-provision of quality. The following main results are obtained. First, a commodity tax may have a significant impact on the market structure: in this setting it tends to increase the number of active firms. Second, through its impact on market structure, a commodity tax may be welfare-improving, even though quality creates a positive externality. Third, a commodity tax may bring about an equilibrium that is arbitrarily close to a Pareto-efficient allocation.