Limit-Pricing and the (Un) Effectiveness of the Carbon Tax

WP: All existing studies on the design of the optimal carbon tax assume that such instrument can generally curb current carbon emissions. Yet this paper shows that the effectiveness of a carbon tax is limited when limit pricing arises on the market for carbon resources. Demand for energy, for fossil fuels in particular, is notoriously very price inelastic, even in the long run. Facing such demand, an extractive cartel may increase its profits with higher prices, as long as those prices do not warrant the profitability of competing substitutes.
Thus the demand for fossil fuels features kinks, each corresponding to the entry price of one substitute. When the entry of a competing substitute may sufficiently deteriorate its market share, the cartel maximizes its profits by inducing the “limit price” that deters the substitute’s production. Limit-pricing equilibria of non-renewable resource markets sharply differ from the conventional Hotelling outcome; for instance, most resource taxes become neutral irrespective of their dynamics. For policies to effectively curb extraction quantities, they must rely on instruments applied on substitutes to fossil fuels.