This paper shows that the welfare dominance of ad valorem over unit taxes under imperfect competition, extends to the Dixit-Stiglitz framework with differentiated products, entry and love of variety. This contrasts against findings by Anderson et al. (J Public Econ, 2001) made in a similar framework, but under Bertrand competition.Unit tax; Specific tax; Ad valorem tax; Welfare

Philipp J. H. Schröder

English

Research Papers in Economics

Philipp J.H. Schröder
The Comparison Between Ad Valorem
and Unit Taxes under Monopolistic
Competition
Discussion Papers
Berlin, March 2003Opinions expressed in this paper are those of the author and do not necessarily reflect views
of the Institute.
DIW Berlin
German Institute
for Economic Research
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ISSN 1619-4535The Comparison Between Ad Valorem and
Unit Taxes under Monopolistic Competition
Philipp J.H. Schr¨ oder∗
February 2003
Abstract
This paper shows that the welfare dominance of ad valorem over
unit taxes under imperfect competition, extends to the Dixit-Stiglitz
framework with diﬀerentiated products, entry and love of variety.
This contrasts against ﬁndings by Anderson et al. (J Public Econ,
2001) made in a similar framework, but under Bertrand competition.
Key Words: Unit tax; Speciﬁc tax; Ad valorem tax; Welfare
JEL: D43; H21; H22; L13
1 Introduction
Since the writings of Cournot and Wicksell it is well know that the equiv-
alence of unit (speciﬁc) and ad valorem taxes under perfect competition
ceases to exist for settings of monopoly. With the works of Suits and Mus-
grave (1953) and Delipalla and Keen (1992), a consensus that ad valorem
taxes welfare dominate equal yield unit taxes for a wide range of imperfect
competitive settings has been obtained.1
This paper augments the literature by comparing the two tax instruments
under monopolistic competition, i.e. a Dixit and Stiglitz (1977) type setting
that includes the desirability of variety, diﬀerentiated products, economies
∗DIW Berlin, German Institute for Economic Research, K¨ onigin-Luise-Straße 5, 14195
Berlin, Germany, Tel.: +49 30 89789-692 (Fax: -108), E-mail: pschroeder@diw.de. Com-
ments and suggestions from Anthony Atkinson, J¨ urgen Bitzer, Rainald Borck and David
Collie are gratefully acknowledged.
1See also Skeath and Trandel (1994), Myles (1996) and Hamilton (1999). For the policy
relevance of the two tax instruments and a review of the literature see Keen (1998).
1of scale and market entry.2 We ﬁnd that the welfare superiority of an ad
valorem tax to an equal yield unit tax does indeed extend to this case.
The monopolistic competition model of Dixit and Stiglitz (1977), though
widely used in industrial economics and international economics, has found
relatively little application in public ﬁnance.3 Yet the approach has a num-
ber of interesting features. First, it provides a consistent framework where
consumers value variety and where there is entry and product diﬀerentiation.
Second, it is inherently a general equilibrium approach, such that e.g. the
full consequences of redistributing taxes can be studied. Third, since it takes
its starting point in the consumer utility function, there is a natural measure
of welfare.
The ﬁnding of this paper is particularly important in relation to recent
contributions made by Anderson et al. (2001a and 2001b). They have ex-
tended the literature of taxes under imperfect competition to settings with
Bertrand competition and diﬀerentiated products. Anderson et al. (2001b)
establish, inter alia, that the welfare dominance of ad valorem taxes can be
challenged by a unit tax once there is free entry and love of variety. The rea-
son is that the superior ability of the ad valorem tax to extract ﬁrm proﬁts
reduces entry incentives and hence the number of variants and welfare. On
the other hand since a unit tax displays a higher rate of over-shift, ﬁrm proﬁts
are higher and so are entry and welfare. Since the present model features the
central characteristics of Anderson et al. (2001b), i.e. diﬀerentiated prod-
ucts, market entry and love of variety, but not the same mode of competition
(Cournot-Nash), it constitutes a relevant comparison. In particular, Ander-
son et al. (2001b) raise the question whether it is the mode of competition or
the introduction of product diﬀerentiation (love of variety) that produces the
result. The present paper indicates that the mode of competition is decisive.
The following section introduces the model. Section 3 derives the welfare
ranking between the two tax instruments. Section 4 concludes.
2A comprehensive treatment of taxation under monopolistic competition is due to Stern
(1987), who presents results, based on a conjectural-variations model of partial equilibrium
free entry Cournot-oligopoly, thus with homogeneous goods and without love of variety.
3An important exception are Atkinson and Stiglitz (1980, ch.7). Nevertheless, out
of the 707 citations of Dixit and Stiglitz (1977) that are recorded in the Social Sciences
Citation Index only 8 are in the Journal of Public Economics (non of them examining the
two tax instruments). In comparison, the Journal of Industrial Economics and the Journal
of International Economics account for 22 citations each.
22 The Model
Consider a sector (industry) where market conditions are characterised by
monopolistic competition.4 The industry has a large number of potential
variants (ﬁrms), N, which enter symmetrically into demand. The number
of variants actually produced is n < N and is assumed to be large. The
output of ﬁrm i is denoted by xi. All ﬁrms have the same cost structure
li(xi) = (f +βxi) where li is labour – the only factor of production –, where
f is the ﬁxed costs of production and β are marginal costs. The economy
wide wage rate is w. The consumer price is given by the inverse demand
function P(xi). Under an ad valorem tax τ < 1 and a unit tax T (in real
terms t = T
w), ﬁrm i’s proﬁt is
πi = (1 − τ)P(xi)xi − (f + (β + t)xi)w . (1)
Denoting by ci consumption of good i and by L the labour force assumed
to be equal to the number of consumers, market clearing implies xi = Lci.
The model is completed by imposing a simple two-sector Dixit-Stiglitz
utility function. Utility stems from the consumption of an un-taxed ho-
mogeneous good (say labour), and the consumption of diﬀerentiated goods
from the taxed sector described above. In particular, utility identical for all
individuals is assumed to be
U =
 
ˆ l
L
!1−α  
n X
i=1
c
θ
i
!α
, (2)
where 0 < θ < 1 and
ˆ l
L is the per capita consumption of the homogeneous
good at price w. Labour market clearing requires
P
li +ˆ l = L. In this spec-
iﬁcation the elasticity of substitution between goods from the two diﬀerent
sectors is 1 which is less than the elasticity of substitution between products
from within each sector. Further, maximising (2) expenditure shares on ho-
mogeneous and diﬀerentiated products will be (1 − α) and α respectively.
Market clearing requires wL + R = wˆ l +
P
pixi, where R are redistributed
tax receipts. Further denote by s the total expenditure on the homogeneous
good, than we have s = wˆ l = (1 − α)(wL + R), i.e. consumption of the
homogeneous good is aﬀected by taxation in the diﬀerentiated goods sector
via redistributed revenue.
The inverse demand function for the taxed sector is calculated
by maximising utility from the consumption of diﬀerentiated goods
4This section presents a straightforward application of Dixit and Stiglitz (1977) to
public ﬁnance, much in the spirit of Atkinson and Stiglitz (1980, ch.7).
3 
max
 P
cθ
i
α − λ(p1c1 + ··· + pici + ··· + pncn − α(w + R)

. Given the
large number of ﬁrms assumption, ﬁrms do not realise the impact of their
price on overall sales (and on tax revenue). The ﬁrst order conditions are of
the form
P(xi) =
θc
θ−1
i
λξ
, (3)
where ξ = α
 P
cθ
i
1−α assumed to be constant and where ci =
xi
L (from
the market clearing condition). Calculating the price elasticity of demand in
absolute terms yields  = 1
1−θ.
Equilibrium in the taxed sector is characterised by prices, per ﬁrm output
and the number of ﬁrms. Due to symmetry we can restrict our analysis to
one variant (ﬁrm), hence, omitting the subscript i. Setting (3) into (1) and
maximising yields the proﬁt-maximising price
p =
(β + t)w
(1 − τ)θ
, . (4)
Equating the proﬁt-maximising price with the price implied by zero proﬁts,
p0 =
(f+(β+t)x)w
(1−τ)x gives the per ﬁrm output under free entry and exit:
x =
θf
(1 − θ)(β + t)
. (5)
Finally, the number of ﬁrms actually producing in equilibrium can be deduced
via market clearing using the x and p just derived. In particular, pxn =
α(wL + R) must hold. Expressing R in real terms as r = R
w gives
n =
α(L + r)(1 − θ)(1 − τ)
f
. (6)
Thus, while the ad valorem tax aﬀects the number of ﬁrms, the unit
tax aﬀects output per ﬁrm. Further, only the number of ﬁrms reacts to
redistributed tax revenues. Notice also from (4) that the unit tax is over-
shifted with factor 1
θ.
Tax revenue and the resulting number of ﬁrms
The total tax revenue, assuming that taxes are completely redistributed to
consumers in a lump-sum fashion, is given by Γ = τpxn + Txn, where n is
given in (6) when r = Γ
w.5 Then expressing Γ in real terms as γ = Γ
w, total
5All results extend readily to any level (including zero) of redistribution.
4tax revenue becomes
γ = Lα

(β + t)τ + (1 − τ)θt
(β + t)(1 − τα) − tθα(1 − τ)

. (7)
The actual number of ﬁrms is calculated by setting r = γ back into (6).
Denoting by nτ the case of an ad valorem tax (t = 0) and by nt the case of
a unit tax (τ = 0) gives
n
τ =
α
f
(1 − θ)L
1 − τ
1 − τα
, (8)
n
t =
α
f
(1 − θ)L
β + t
β + t − tθα
. (9)
Finally, from (7) the equal yield tax levels can be derived. Deﬁne a
certain tax yield ¯ γ. Given that the respective other tax is zero, the following
ad valorem and unit tax levels result in ¯ γ:
τ¯ γ =
¯ γ
α(L + ¯ γ)
, (10)
t¯ γ =
¯ γβ
αθ(L + ¯ γ) − ¯ γ
. (11)
Since the ad valorem tax has to be strictly less than 1, there exists an upper
limit to the tax yield, in particular, setting τ = 1 in (10) gives ¯ γ∗ = α
1−αL.
3 Results
The tax rates deﬁned in (10) and (11) have to be set into the per ﬁrm
production level (5) and the respective number of ﬁrms derived in (8) and
(9). Further, the expenditure share s on the homogeneous good becomes
now s = (1 − α)(wL + R|τ=τ¯ γ) = (1 − α)(wL + R|t=t¯ γ) = (1 − α)w(L + ¯ γ).
With these ingredients and utility function (2) the utility levels under the
two diﬀerent tax tools can be calculated (see appendix A.1). The utility
diﬀerence, ∆¯ γ = U|τ=τ¯ γ − U|t=t¯ γ, between the two tax tools is:
∆¯ γ =

(1 − α)
L + ¯ γ
L
1−α   
1 − θ
f
(Lα − ¯ γ(1 − α))

fθ
Lβ(1 − θ)
θ!α
−
 
1 − θ
f
α(L + ¯ γ)

f ((L + ¯ γ)αθ − ¯ γ)
L(L + ¯ γ)αβ(1 − θ)
θ!α!
. (12)
5Due to entry, proﬁts are zero and all tax revenue is redistributed to the
population, hence ∆¯ γ is a measure of welfare. From (12) the following result
is derived.
Proposition 1. Given a certain tax level ¯ γ, an ad valorem tax, τ¯ γ, is welfare
superior to the equal yield unit tax, t¯ γ. In particular, ∆¯ γ > 0 ∀ ¯ γ < ¯ γ∗, ¯ γ 6= 0.
Proof is given in appendix A.2. Proposition 1 establishes, that if some
tax revenue is to be raised from a monopolistically competitive industry,
an ad valorem tax is the preferable measure. Thus the welfare superior
performance of ad valorem tax tools that has been established for a wide
class of imperfect competition settings (e.g. Suits and Musgrave (1953) and
Delipalla and Keen (1992)) does extend to a Dixit-Stiglitz-type framework
of monopolistic competition.
This result is obtained, even though ad valorem taxation features fewer
ﬁrms than an equivalent unit taxation. While this distortion skews the model
towards a welfare dominance of unit taxes (love of variety), the lower eﬃ-
ciency of the unit tax (due to the greater over-shift) more than eats up this
advantage, leaving the ad valorem tax as the superior tool. To see this, con-
sider that total sector output is higher under the ad valorem tax than under
the unit tax, i.e. nτxτ > ntxt for τ = τ¯ γ , t = t¯ γ. Furthermore, consider
that the superiority of the ad valorem tax would be challenged if the policy
objective is not a certain tax yield, ¯ γ, but a certain corrective production
volume nx. Now the ability of the unit tax to induce a larger number of
ﬁrms, each producing less output, can dominate the ad valorem tax. Finally,
proposition 1 also applies to ¯ γ < 0, which means that if a subsidy – ﬁnanced
by a lump sum tax on income – is to be given to the diﬀerentiated goods
sector, then an ad valorem subsidy is preferable to a per unit subsidy.
The result of proposition 1 presents a contrast to Anderson et al. (2001b,
proposition 5). They found that in a setting with Bertrand competition, dif-
ferentiated products, entry and love of variety, the dominance of ad valorem
tax tools can be challenged by unit taxes.6 The present Dixit-Stiglitz-type
monopolistic competition model has crucial features in common with Ander-
son et al. (2001b, proposition 5) – apart from the mode of competition – but
does establish that ad valorem taxes are welfare superior.7 This hints at a
6In fact, Anderson et al. (2001a and 2001b) main contributions include to show that
without love of variety most results concerning ﬁrm proﬁts, consumer surplus, tax eﬃciency
and the welfare ranking of the two tax instruments do compare well with the Cournot
competition case presented by for example Delipalla and Keen (1992).
7Notice that while this paper uses the Dixit-Stiglitz approach towards love of variety,
6non-trivial impact from the mode of competition on the welfare ranking of
ad valorem and unit tax instruments.
4 Conclusion
The present paper shows that the welfare-superiority of ad valorem taxes to
equal yield unit taxes, that has been established for a wide range of imperfect
competition settings (e.g. Suits and Musgrave (1953) and Delipalla and
Keen (1992)), also applies to the case of Dixit-Stiglitz-type monopolistic
competition, i.e. a setting which, like the majority of the literature on the
subject to date, features Cournot type competition. This result presents
a contrast to recent ﬁndings by Anderson et al. (2001b) in a setting with
similar features – entry, diﬀerentiated products, love of variety – but with
Bertrand competition.
The question of how the mode of competition aﬀects the eﬃciency of tax
instruments will be of continuing interest for future research. Further issues
that should be examined for the monopolistic competition case presented here
are the optimal combination of tax instruments and the welfare ranking of ad
valorem and unit taxes for objectives other than a revenue target. Finally,
the results of this paper carry implications for the use of ad valorem and unit
tax (tariﬀ) instruments in environmental and international economics.
i.e. directly utilising the convexity of the indiﬀerence surfaces of any well behaved utility
function across potential commodities, Anderson et al. (2001b) rely on a discrete choice
framework for consumer demand. Also, the result in proposition 1 – in contrast to Ander-
son et al. (2001b, proposition 5) – is independent of the taste for variety, θ, the size of the
ﬁxed costs of production, f, the consumer preference for the diﬀerentiated goods sector,
α, and the size of the revenue requirement, ¯ γ.
7A Appendix
A.1 Utility expressions
Ad Valorem tax: The tax rate τ¯ γ given in (10) is plugged into the number
of ﬁrms expression derived in (8). The per ﬁrm output volume is as given
in (5) when t = 0. Utilising market clearing, the fact that c = x
L, and that
s = (1−α)(wL+R|τ=τ¯ γ) = (1−α)w(L+ ¯ γ), these values are set into utility
function (2):
Uτ¯ γ =

(1 − α)
L + ¯ γ
L
1−α  
1 − θ
f
(α(L + ¯ γ) − ¯ γ))

fθ
L(1 − θ)β
θ!α
. (A.1)
Unit tax: The tax rate t¯ γ given in (11) is plugged into the number of ﬁrms
expression derived in (9) and the per ﬁrm output volume in (5). Utilising
market clearing, the fact that c = x
L, and that s = (1 − α)(wL + R|t=t¯ γ) =
(1 − α)w(L + ¯ γ), these values are set into utility function (2):
Ut¯ γ =

(1 − α)
L + ¯ γ
L
1−α



1 − θ
f
α(L + ¯ γ)

 fθ
L(1 − θ)

β +
β¯ γ
(L+¯ γ)αθ−¯ γ



θ


α
. (A.2)
Expression (A.1 ) and (A.2) show the utility portion stemming from the
consumption of the homogeneous and diﬀerentiated goods respectively. The
fact that nτ¯ γ < nt¯ γ and xτ¯ γ > xt¯ γ is veriﬁed by inspection.
A.2 Proof of Proposition 1
Proof. ∆¯ γ > 0 ∀ ¯ γ < ¯ γ∗, ¯ γ 6= 0.
The expression for ∆¯ γ in (12) is
∆¯ γ = (a)
1−α ((b)
α − (d)
α) , (A.3)
where a = (1 − α)
L+¯ γ
L , b = 1−θ
f (Lα − ¯ γ(1 − α))

fθ
Lβ(1−θ)
θ
and d =
1−θ
f α(L + ¯ γ)

f((L+¯ γ)αθ−¯ γ)
L(L+¯ γ)αβ(1−θ)
θ
. Since a > 0, one has to show that b > d.
This inequality can be rewritten as
α(L + ¯ γ) − ¯ γ
α(L + ¯ γ)
>

θα(L + ¯ γ) − ¯ γ
θα(L + ¯ γ)
θ
. (A.4)
Deﬁne the function
q(k) =

kα(L + ¯ γ) − ¯ γ
kα(L + ¯ γ)
k
. (A.5)
8If q(k) is monotone increasing in k, then 1 > θ ⇔ b > d and thus (A.4) and
∆¯ γ > 0 holds.
Monotonicity of q(k): Diﬀerentiating (A.5) with respect to k gives
dq(k)
dk
=
(e)k g
h
, (A.6)
where e = 1 −
¯ γ
k(L+¯ γ)α , h = k(L + ¯ γ)α − ¯ γ and g = ¯ γ + hln(e). Since
¯ γ < α
1−αL = ¯ γ∗ must be fulﬁlled, e,h > 0 holds. Hence it remains to be
shown that g = ¯ γ + (k(L + ¯ γ)α − ¯ γ)ln

1 −
¯ γ
k(L+¯ γ)α

> 0. Rewriting yields
kα(L + ¯ γ)
kα(L + ¯ γ) − ¯ γ
− 1 > ln

kα(L + ¯ γ)
kα(L + ¯ γ) − ¯ γ

, (A.7)
which is always true.
9References
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The Comparison between Ad Valorem and Unit Taxes under Monopolistic Competition

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