Permits or Taxes? How to Regulate Cournot Duopoly with Polluting Firms

Abstract

The paper investigates pollution control of firms engaging in imperfect competition. We consider asymmetric Cournot duopoly where firms have linear technologies. Welfare is assumed to be separable in consumers' surplus and social damage which is given by a convex function depending on the aggregate pollution level. After deriving social optimum, we give a complete characterization of the optimal linear tax as well as of the optimal number of permits taking into account the firms' strategic behavior, and then compare the two both policies with respect to welfare. None of them turns out to implement social optimum in general. Also, no policy can be said to be superior, for all parameters. However, for a considerable range of parameters giving out permits yields a higher welfare than taxes. Finally, we consider double taxation of output and pollutants. In this case social optimum can always be achieved, if there are only two firms.