Limit pricing and the (in)effectiveness of the carbon tax

• We present a theory of limit-pricing monopoly for extractive resources—e.g., oil.
• The demand for the monopolist's resource is inelastic.
• The monopolist seeks to deter competing substitutes.
• With limit pricing, the effect of public policies on resource production is not standard.
• The effectiveness of the carbon tax is limited.

We present a theory of limit-pricing monopoly in non-renewable-resource production. Facing a very inelastic demand, an oil monopoly seeks to induce the highest price that does not destroy its demand, unlike the conventional Hotellian analysis: The monopoly 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, but can be effectively reduced by supporting 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 monopoly. Thus, the carbon tax ambiguously affects current and long-term oil production and carbon emissions.