Question

2) Consider the Managing Director (MD) of a firm that produces a differentiated product which faces little competition from a few close substitute products. Recently, the Managing Director has been informed by government officials that a specific (per unit) tax will be levied on the firm’s product in the new financial year that is still 6 months away. The Managing Director during a consultation with you, his economic advisor, states that because the firm produces a product with few close substitutes it is a price-setter and thus will be able to pass on to its customers the full amount of the tax. He asks you to confirm whether his thinking on this matter is correct. Explain what you will tell the Managing Director.

Answer 1

No, the Managing director is incorrect in his assessment.

This is because the good has few close substitutes in the market, which means any increase in price of the good (due to tax) would make consumers switch to its cheaper substitute product in the market, thereby reducing the good's demand and sales to 0.

This occurs due to the elastic nature of the demand for the good (due to close substitutes being present). This means any increase in price would push sales drastically down, leading to losses for the seller.

Hence, raising product prices is not an intelligent decision.