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

Saraly Andrade de Sá and Julien Daubanes

April 2015

The conventional analysis of policy-induced changes in resource extraction is inconsistent with the actual way OPEC is exerting its market power. We claim that OPEC is practicing limit pricing, and we extend to non-renewable resources the limit-pricing theory. Facing a very inelastic demand, an extractive cartel seeks to induce the highest price that does not destroy its demand, unlike the conventional Hotelling analysis: the cartel tolerates some ordinary substitutes to its oil but deters high-potential ones. With limit pricing, policy-induced extraction changes do not obey the usual logic. For example, oil taxes have no effect on current oil production. Extraction increases when high-potential substitutes are promoted, and may only be reduced by supporting its ordinary substitutes. The carbon tax not only applies to oil; it also penalizes its ordinary (carbon) substitutes, whose market shares are taken over by the cartel. Thus the carbon tax ambiguously affects current and long-term oil production.

Keywords: OPEC; Demand elasticity; Shale oil; Limit pricing; Carbon tax; Non-renewable resources; Monopoly power; Oil substitutes

JEL classification: Q30; L12; H21