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Environmental Taxes in Monopolistic Competition

Taxes can change product selection bias in markets where set-up or fixed costs play an important role. We demonstrate that the Pigouvian correction for externalities will introduce products in the socially optimal order but too few firms survive. Allowing for firm specific taxes we find the optimal tax which is strictly less than the Pigouvian tax rate. The optimal tax leaves the monopolistically-competitive industry with too few firms.