Taxes and Market Power: A Principal Components Approach

Abstract: Suppliers of differentiated goods make simultaneous pricing decisions, which are strategically linked. Because of market power, the equilibrium is inefficient. We study how a policymaker should target a budget-balanced tax-and-subsidy policy to increase welfare. A key tool is a certain basis for the goods space, determined by the network of interactions among suppliers. It consists of eigenbundles -- orthogonal in the sense that a tax on any eigenbundle passes through only to its own price -- with pass-through coefficients determined by associated eigenvalues. Our basis permits a simple characterization of optimal interventions. A planner maximizing consumer surplus should tax eigenbundles with low pass-through and subsidize ones with high pass-through. The Pigouvian leverage of the system -- the gain in consumer surplus achievable by an optimal tax scheme -- depends only on the dispersion of the eigenvalues of the matrix of strategic interactions. We interpret these results in terms of the network structure of the market.