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Taxation and Market Power

Photo: iStock/p51d

It is much easier for a monopolist to pass an increase in taxes onto consumers than it is for a firm exposed to competition. Do you agree? If yes, you are in good company with many people. But you are not in line with standard textbook economics.

Kai A. Konrad, Florian Morath and Wieland Müller wondered about the discrepancy between the predictions made by standard theory and public opinion on the impact of market power on the burden of a tax. They conducted laboratory experiments to analyse the incidence and welfare effects of sales tax increases in monopoly and Bertrand markets. The economists showed that – contrary to public opinion but in line with economic theory – firms with no market power are able to shift a high share of the tax burden to consumers. Intuitively speaking, with Bertrand competition, firms without market power charge prices equal to marginal costs and earn zero profits. Hence, firms cannot bear an additional tax. Either they shift it to the buyers, or they must exit the market.

In contrast, monopolists have already made use of their market power before the tax increase. They bear a large share of the burden of a tax increase: The monopolist’s profit can serve as a buffer that enables it to absorb the additional costs. The empirical outcome of the analysis of Konrad, Morath and Müller is close to the textbook prediction as long as the monopolists are dealing with automated demand that emulates consumers behaving in line with textbook economics. For monopolists who offer their goods to real players, things are changing. Some players do not buy at prices they consider too high, even if the price is lower than the monetary value of the goods. The observed monopoly prices are significantly below the monopoly price predicted by standard theory. Therefore, monopolists who face real buyers can shift some of the burden of a tax increase to the consumer. However, the increase is less than half the size of the tax-induced increase in the monopolist’s cost.

Konrad, K.A., Morath, F., and Müller, W., 2014. Taxation and market power. Canadian Journal of Economics, 47(1), pp. 174-202.

Februar, 2014