In Chapter 4 we derived our results for optimal taxes and payments from a competitive model in which individuals and firms both behave as price-takers. In this framework, prices and our prescribed fees are parameters for individual decision-makers; they take them as given and simply respond so as to maximize utility or profit.

In this chapter, we consider some of the complications that market imperfections introduce into the analysis. More specifically, we will examine the implications of two sources of such imperfections. First, a firm that generates externalities (smoke emissions) may not sell its output in a competitive market. For example, we will consider how a profit-maximizing monopolist will respond to the Pigouvian taxes prescribed in Chapter 4. We will show that an emissions tax rate that is appropriate for the pure competitor will not, in general, induce behavior that is consistent with optimality in the second-best world inhabited by a monopolist.

We then consider a second source of imperfection: the presence of polluters who are not “fee-takers.” There can be situations involving few polluters, the manipulation of whose activity levels can influence the unit tax paid on waste emissions. In such cases, we will see that producers (and perhaps also consumers) of externalities will have an incentive to adjust their behavior so as to influence not only their tax bills, but also the tax rate they pay per unit of pollution. As for the monopolist, this necessitates some modifications in the prescription for an optimal fee.