m his Theory of Public Finance, argues that the pnce effect of a unit tax

Musgrave,
curves
Abstract under monopoly is one half the effect under competition when demand and supply
are linear. It is shown here that this rule applies only for the constant-cost

case. For an increasing supply (marginal cost) schedule, the effect for monopoly is

smaller than under competition, but by a factor less than 2.

A REEXAMINATION OF THE PRICE EFFECTS

OF A UNIT COMMODITY TAX UNDER PERFECT
COMPETITION AND MONOPOLY

ELCHANAN COHN
University of South Carolina

In his treatise, The Theory of Public Finance, Musgrave

( 1959, pp. 291 ff.) develops the algebra for the price effect of
a unit or an ad valorem tax under perfect competition and monopoly.
A similar (simplified) analysis is also provided in Musgrave and
Musgrave (1989, pp. 272 ff.), and in at least one other public finance
textbook (Hyman 1996). Hyman relies on Musgrave’s work when he
concludes that when demand and marginal cost curves are linear, &dquo;the
rise in consumer price under monopoly is precisely one half of the rise
that occurs under perfect competition&dquo; (1996, p. 384, note 8; see also
Bishop 1968; Kudrle 1984). To the best of my knowledge, this
assertion has never been challenged.’1
The analysis performed by Musgrave to prove that the price effect
under monopoly is one half the effect under competitive conditions
appears quite simple. Starting with the competitive structure, let the
inverse demand schedule be given by

AUTHOR’S NOTE: I am grateful to John B. Chilton for extremely helpful comments on earlier
versions of this article. I also thank Robert J. Carlsson, B. F Kiker, and two anonymous referees
for helpful comments. The usual caveats apply.

PUBLIC FINANCE QUARTERLY, Vol. 24 No. 3, July 1996 391-396

m 1996 Sage PubLcations, Inc.
391

Downloaded from pfr.sagepub.com at UNIV ARIZONA LIBRARY on May 30, 2015

392

and the after-tax inverse supply schedule by

where p and s are the demand and supply prices, respectively, x is the
quantity demanded or supplied, andt is the unit tax.
Under pure competition, the equilibrium condition is

Solving (3) for x and substituting in (1), it can be shown that

Now consider the case of monopoly. Let the inverse demand

function be given by (1) above, and the average cost function by

where d, e, andt are as in (2). Musgrave then derives the marginal

revenue function for the monopolist (given by MR a + 2bx) and the =

after-tax marginal cost function (given by MC d + 2ex + t), and sets =

the equilibrium condition as

It is easy to show that, in this case,

Comparing (7) and (4), we observe that the monopoly price effect is
one half the effect on pure competition, as Musgrave argues.
The problem with Musgrave’s reasoning is that he neglects to use
the same marginal cost schedule for the monopoly (i.e., the horizontal
sum of the marginal costs of the plants) that he does for the competitive

industry (i.e., the horizontal sum of the marginal costs of the firms).
Other things being equal, the difference between a monopoly and pure
competition lies on the demand side; in particular, marginal revenue
is less than average revenue. To maintain comparability, Musgrave
should have used the same marginal cost schedule for both the mo-
nopoly and the competitive industries. Using MC = d + ex +t as in (2)

Downloaded from pfr.sagepub.com at UNIV ARIZONA LIBRARY on May 30, 2015

 393

for both the competitive and monopoly structures, the equilibrium

condition for the monopoly should be

Solving (8) for x and substituting in (1), it can be shown that

and it is no longer true that the price effect of a unit tax under monopoly
is always one half the price effect under competition.z The one-half
rule will be correct only when e 0, in which case average and
=

marginal costs are identical.3

Musgrave also provides a more general analysis in which the
assumption of linear supply and demand functions is relaxed. Briefly,
let the competitive demand and supply schedules be given by p p(q) =

and c s(q), respectively. If a unit tax oft dollars is imposed, then it

=

can be shown that

In the monopoly case, if the average cost function is

given by c c(q), =

and the demand function is as above, then, when a tax is imposed, the
price effect is given by

Musgrave points out that the one-half rule does not apply in general,
but that when linear functions are used, the second-order derivatives
vanish, so that (11) changes to

Musgrave contends that a comparison of (12) and (10) yields the

one-half rule. Note, however, that this is true only when s’(q) c’(q), =

which again assumes that the slope of the average cost schedule under
monopoly is equal to the slope of the sum of the marginal cost
schedules under competition-an assumption that can be accepted
only when average costs are constant. This might be based on Mus-
grave’s assertion that in the long run, the supply curve of a competitive

Downloaded from pfr.sagepub.com at UNIV ARIZONA LIBRARY on May 30, 2015

394

industry is equal to the sum of the average-cost schedules of individual

firms (p. 288, fn. 2). If that assertion were accepted, then the one-half
rule would be correct for the long-run case. But, in the short run, even
Musgrave concedes that the &dquo;supply schedule [for the competitive
industry] may be looked upon as the sum of the marginal-cost sched-
ules of individual firms&dquo; (p. 288, fn. 2).
One might also question Musgrave’s assertion concerning the long
run. According to Henderson and Quandt (1980, pp. 142-3), in the
absence of externalities, the long-run supply function of a competitive
industry is the sum of the long-run supply schedules of individual
firms, S&dquo; derived by setting LMC, p and solving for q, S, in the
= =

equations LMC, = f ,(q,), where LMC, is the long-run marginal cost of

the ith firm, and including only the portions of LMC, that lie above the
respective long-run average cost curves (LAC,). If externalities exist,
the derivation of a competitive industry’s long-run supply curve is
more complicated (see Henderson and Quandt, 1980, pp. 143-4).4
The (first-order) long-run equilibrium condition for a multiplant
monopoly is

where LMC, is the long-run marginal cost of the ith plant. Therefore,
we do not have a straightforward comparison of perfect competition
and monopoly in the long run, unless IZMC, is constant at all levels
of output-that is, the case of constant costs-for which the one-half
rule would apply.’ Although constant long-run average costs are likely
to be found in some industries (at least for the relevant range of output),
a generalization to all industries is clearly unwarranted.
In conclusion, it is incorrect to state a general rule that the price
effect of a unit tax under monopoly is one half the price effect under
competition, even when demand and cost schedules are linear. Results
shown here (compare equations [7] and [9]) show that at least in the
short run, the price effect under monopoly may be considerably greater
than Musgrave’s analysis suggests.
It should also be pointed out that a proper comparison of perfect
competition and monopoly requires that demand and cost structures

Downloaded from pfr.sagepub.com at UNIV ARIZONA LIBRARY on May 30, 2015

 395

remain stable when we change from one industry structure to another.66

Such stability is unlikely, especially on the cost side, suggesting that
a comparison of the price effect of commodity taxation between

perfect competition and monopoly should be conducted with extreme

care.

NOTES

1. Numerous articles provide analyses of the price effects of excise taxes, and a few deal
with monopoly (e.g., Behrman 1950; Mixon 1986). Several public finance textbooks provide an
analysis of the effect of unit taxes on price under monopoly but, correctly, do not refer to the
one-half rule. See, for example, Marlow (1995, pp. 444-6) and Rosen (1995, pp. 287-9).
. Alternatively, we could use MC = d + 2ex +t
2 for both the competitive and monopoly
b - 2e) for pure competition and dpldt b
industries and deduce that dp/dt = b/
( 2(
/
b - e) for the
=

monopoly.
3. When the alternative specification of the MC function is as shown in note 2, the one-half
rule would again apply only when e 0. Stiglitz (1988) uses the case of e = 0 to show the one-half
=

rule. He does not point out, however, that this rule is incorrect when e > 0.
4. A generalized treatment of long-run supply for a competitive industry is provided by
Cohen and Cyert (1975, pp. 155-9). The long-run industry supply curve is given by

where Q is industry output and P is market price. Equation (13) is derived by solving the
following system of equations:

, is the output of the ith firm, and LAC, is the

where N is the number of firms in the industry,
q
long-run average cost of the i th firm. The long-run supply function of the ith firm, s,(P, Q, N),
is derived by solving the equation P = i (q Q, N), where LMC, is the "upward-rising portion
LMC
,
of [the firm’s] long-run marginal cost curve which intersects or lies above its long-run average
cost curve" (p. 157), and P = m(Q, N) is the long-run "equilibrium condition [which] determines
one point on the long-run supply function of the industry" (p. 156).
5. We have left out of the discussion the further complication that in the long run, a mulhplant
monopoly would have to select the optimal number of plants.
6. As one referee suggests, "In the present case, greatest clarity in comparison comes from
imagining a monopoly in which all extant or potential output would come from small, identical
operations that would all experience increasing costs and shifting schedules if drawn on the basis
of fixed input prices while the industry expands. These would be analogous to representative
firms under perfect competition." Even in this case, however, there might be some savings to

Downloaded from pfr.sagepub.com at UNIV ARIZONA LIBRARY on May 30, 2015

396

the monopoly (relative to the similar competitive structure), for example, from bulk purchasing
and consolidation of record keeping, employee training, and other personal matters, so that a
valid comparison between the two market structures would require further analysis.

REFERENCES

Behrman, J. N. 1950. Distributive effects of an excise tax on a monopolist. Journal of Political

Economy 58:546-8.
Bishop, Robert L. 1968. The effects of specific and ad valorem taxes. Quarterly Journal of
Economics 82:198-218.
Cohen, Kalman J., and Richard M. Cyert. 1975. Theory of the firm: Resource allocation in a
market economy. 2d ed. Englewood Cliffs, NJ: Prentice-Hall.
Henderson, James M., and Richard E. Quandt. 1980. Microeconomic theory: A mathematical
. 3rd ed. New York: McGraw-Hill.
approach
Hyman, David N. 1996. Public finance: A contemporary application of theory to policy 5th ed.
New York: Dryden.
Kudrle, Robert Thomas. 1984. Excise tax incidence in limit price oligopoly. Public Finance/
Finances Publiques 39:321-45.
Marlow, Michael L. 1995. Public finance: Theory and practice. Orlando, FL: Dryden.
Mixon, J. Wilson, Jr. 1986. On the incidence of excise taxes on a monopolist’s price: A
pedagogical note. Journal ofeconomic Education 17:201-3.
Musgrave, Richard TheA. 1959. theory of public finance: A study in public economy. New York:
McGraw-Hill.
Musgrave, Richard A., and Peggy B. Musgrave. 1989. Public finance in . theory and pratice 5th
ed. New York: McGraw-Hill.
Rosen, Harvey S. 1995. Public finance. 4th ed. Homewood, IL: Irwin.
Stiglitz, Joseph E. 1988. Economics of the public sector. 2nd ed. New York: Norton.

Elchanan Cohn is Professor of Economics at the University of South Carolma and editor
m chief of the Economics of Education Review. His research mterests include education

finance, benefit-cost analysis applied to schooling, efficiency of school operations, and

factors affecting student performance m economics. Recent work has appeared m
Review of Economics and Statistics, Labour Economics, Journal of Human Resources,
and Journal of Econonuc Education.

Downloaded from pfr.sagepub.com at UNIV ARIZONA LIBRARY on May 30, 2015