Limit Pricing and the (In)Effectiveness of the Carbon Tax

Abstract

Demand for oil is very price inelastic. Facing such demand, an extractive cartel induces the highest price that does not destroy its demand, unlike the conventional Hotelling analysis: the cartel tolerates ordinary substitutes but deters high-potential substitution possibilities. Limit-pricing equilibria of non-renewable resource markets sharply differ from usual Hotelling outcomes. Oil taxes have no effect on current extraction; extraction may only be reduced by supporting existing (ordinary) substitutes. Since the carbon tax applies to oil and to its existing carbon substitutes, it induces the cartel to increase its current oil production. The carbon tax further affects ultimately-abandoned oil reserves ambiguously.