Welfare Effects of the Tax Reforms in Two Vertically Related Oligopolies with Environmental Externality

In two vertically related oligopolies where the upstream industry is polluting, four inefficiencies arise: (i) the suboptimal levels of production in upstream as well as (ii) in downstream, (iii) the input-mix distortion in downstream, and (iv) the environmental damages in upstream. I show analytically that government can always improve welfare through various revenue-neutral tax reforms. The magnitudes of welfare improvement by these tax reforms depend on the relative size of industry profits to environmental damages, the both industries’ input substitutability, the both industries’ market power, and other parameters from demand and cost structures. Among these, the relative size of industry profits to environmental damages is crucial in deciding the direction of taxsubsidy schemes. In general, a tax on the upstream industry should be levied if the size of industry profits is greater than the size of environmental damages. I also show that a specific tax is potentially superior to an ad valorem output tax in terms of welfare even in vertically related oligopolies, since the former can utilize both the upstream firms’ input substitutability and the downstream firms’ input substitutability, while an ad valorem tax on the intermediate good only utilizes the downstream firms’ input substitutability.