In the last chapter we introduced the output market to our analysis and used it to extend several of the results we derived in Chapter 3. Throughout we maintained the assumption that all markets were competitive, which allowed us to show that the optimal level of pollution was still characterized by the marginal abatement cost equals marginal damage condition. In this chapter we consider how optimal policy might be different under non-competitive market structures. As we will see, our analysis is complicated by the presence of both market power and pollution-related distortions, and these will cause some of our familiar results to no longer hold. Indeed, the presence of multiple distortions means the regulator's objective is typically to locate a second-best optimal emission tax rate that reflects the relative strength of the two market distortions. The material we present in this chapter will therefore be more technical than what was used in Chapter 5.

What is our motivation for including a chapter on non-competitive markets? Although competitive markets provide a useful starting point for studying environmental policy, non-competitive industries are the primary sources of many regulated pollutants. For example, in both the United States and parts of Europe electric utilities and petroleum refineries tend(ed) to exercise monopoly power at the regional level, pulp and paper production has concentrated in recent decades, and automobile manufacturing is done by a relatively small number of firms in any given country. These examples suggest that non-competitive industries are more than a theoretical curiosity for environmental policy. In response, an enormous literature has arisen that considers the role of market power in all its guises. Researchers have examined output market structures such as monopoly, oligopoly, and monopolistic competition. Homogeneous versus differentiated products, quantity versus price competition, and market power in factor markets have also been considered. In this chapter we limit attention to monopoly and oligopoly output market structures, since these provide useful vehicles for demonstrating the main techniques and conclusions from this larger literature.

The early literature on environmental policy and market power provides additional motivation for studying non-competitive output markets. Papers by Buchanan and Stubblebine (1962) and Buchanan (1969) challenged the Pigouvian point of view outright, by noting that a monopolist distorts the market by producing too little output.