This paper considers the implications of firm and product entry for optimal
taxation. The market entry of a new differentiated product has two opposing
effects on welfare: consumer surplus increases, while the profits of incumbent firms
decrease. Under monopolistic competition à la Dixit-Stiglitz (1977), the two effects
offset each other. However, under Cournot competition with strategic interactions,
entry has an additional negative effect on markups and profits. In equilibrium, the
number of firms can be above or below the optimum, depending on the substitution
elasticity across goods. The optimal tax policy mix involves subsidising labour,
taxing entry and balancing the government budget with lump sum taxes. Policy
can replicate the First Best outcome only if all those three instruments are available.
With a restricted set of instruments, the labour tax appears to be more effective
than the entry tax.
Keywords: product diversity, entry, market structure, optimal taxation.