Monopoly, asymmetric information, and optimal environmental taxation

Abstract

This paper aims to examine optimal environmental taxation in an incomplete-information two-period model in which a monopolistic firm produces and pollutes. It is assumed that the polluting firm is privately informed about its costs of production, and the policymaker, which can only infer the firm's costs from observing the output produced in the first period, has the chance to set environmental taxes to affect emissions; the emitter of pollution may then choose a non-optimal level of production in such a period in order to manipulate the policymaker's beliefs concerning its costs. If the policymaker values environmental quality sufficiently, the low-cost polluter has an incentive to misrepresent itself as a high-cost firm in order to secure a low environmental tax in the second period. This leads the high-cost polluting firm to produce, in the first period, an output level that is not higher than output which would be optimal if only short-term considerations were taken into account. The optimal environmental tax rate in the first period, when the firm's output is a signal of its cost, is then lower than or equal to what it would be if the firm's output was not a signal of firm's costs. The expected emissions in the former context are also lower than or equal to those in the latter case. By contrast, when the policymaker's valuation of the environment is sufficiently low, the environmental tax is negative (a subsidy per unit of pollutant emitted) in both the signaling and non-signaling contexts and no less in the former context than in the latter.Environmental tax and subsidy policy, monopolistic polluting firm, vertical asymmetric information, signaling and non-signaling