Optimal tax rules are analyzed in an oligopolistic economy with free entry. The initial market allocation has two types of distortion: price is set above marginal cost by the oligopolistic behavior, and the advantage of increasing returns to scale is left to be unexploited by excessive entry of oligopolists. With production subsidy accompanied by a self-financing lump-sum franchise tax on oligopolistic firms, Pareto efficient allocation could be restored. Without a lump-sum tax on oligopolists, however, the second-best optimum requires taxing intermediate inputs used in the oligopolistic industry. The optimal intermediate goods taxation follows the production-side Ramsey rule to encourage the use of intermediate inputs elastic to output level, and vice versa.
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