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.