In contrast to our analysis in Section 5.4.3, Carlton and Loury (1980) suggest that a Pigouvian tax alone will not lead to a long run social optimum for competitive polluting firms. Using their arguments, show that when the damage function is D(E,J), depending on both emissions and the number of firms, an entry tax or subsidy is needed to reach the long run social optimum.

Data from section 5.4.3

Transcribed Image Text:

If firms are subject to an emission tax, it is straightforward to see that the long run social optimum can be achieved by setting the emission tax equal to the Pigouvian level, such that D'(E). Under this policy each identical firm's profit function is -px-C(x,e)-re, and the familiar first-order conditions p=C(x,e) and -C(x,e)=> arise from profit maximization. In the long run, firms enter the market until profits are zero, implying that px-C(x,e)-te=0. (5.53) All of these are equivalent to the social optimum conditions in (5.48) when we substitute p=P(X) and D'(E). The difference between taxes and standards in the long run, identical firm case is therefore one of transfers. In the taxes case an amount related to environmental damages is paid by the firms to the regulator, while in the standards case these rents are kept by the firms. Payment of rents for the environmental damage attenuates the effects