Environmental Policy in General Equilibrium under Market Power and Price Discrimination

TL;DR

This paper develops a general equilibrium model to analyze how environmental policies affect welfare when energy firms with market power engage in price discrimination, revealing complex interactions between distortions and policy effects.

Contribution

It introduces a novel analytical model that incorporates third-degree price discrimination and market power into environmental policy analysis, providing new insights into welfare impacts.

Findings

Output distortion and price discrimination effects often oppose each other.

Certain policies can offset welfare losses from distortions.

Net welfare gains depend on the balance between externality correction and distortions.

Abstract

This study constructs a novel analytical general equilibrium model to compare environmental policies in a setting where oligopolistic energy firms engage in third-degree price discrimination across residential consumers and industrial firms. Closed-form solutions demonstrate the impact on prices and quantities. The resulting welfare change is decomposed across three distortions: output, price discrimination, and externality. This study finds that the output distortion and price discrimination welfare effects generally move in opposite directions under policies such as an emission tax or a two-part instrument. Numerical analysis compares policies and finds scenarios where the output distortion and price discrimination welfare changes fully offset and thus leaves the net welfare gain of the externality correction. In this way, environmental policy can be designed to mitigate output distortion welfare concerns when firms have market power.