On commodity taxation in vertically differentiated markets

We examine the impact of commodity taxation on vertically differentiated product markets when entry is allowed. We show that an ad valorem tax may have a dramatic effect on market structure by inducing the entry of a large number of firms in what was previously a natural monopoly. The producers of high quality products reduce market share after an increase in their unit production cost, leaving more room for lower quality products. While within a given market structure aggregate quality decreases monotonically with the tax rate, quality jumps upwards at tax rates that cause a change in market structure.