Question

Diagram and explain.

Suppose that a $10,000 lump sum is imposed on each firm in a perfectly competitive industry. (At the end of the year a fixed $10,000 tax must be paid to the government by each firm).

a. Describe what happens in the short run 1. to the typical firm's costs: variable cost, fixed cost, total cost marginal cost. 2. to the typical firm's output 3. to the market: equilibrium price and output.

b. Diagram and fully explain both the typical firm and the market outcome in the Long Run. 1. How much will the market price rise? 2. What will happen to the typical firm's output? 3. Who (consumers, producers, or both) will ultimately bear the burden of the tax?

Answer 1

1).

Consider the given problem here the market demand and supply curve are D1 and S1 respectively, the equilibrium is E1 where demand is equal to supply. At the equilibrium the market price and quantity are P1 and Q1 respectively. The firm’s average variable cost, average total cost and the marginal cost are AVC1, ATC1 and MC1 respectively. If the price is P1 then at the optimum P=MC, => the profit maximizing output choice is q1.

Now, as the lumpsum tax is imposed the new ATC is ATC2, but the marginal cost will not change implied the profit maximizing output will not change. So, the profit maximizing output is q1 and the market price and quantity are also remains at P1 and Q1 respectively.

2).

Now, in the LR all the existing firms in an industry earn a normal profit that at the equilibrium price is equal to minimum of LRATC. So, in the LR the equilibrium price is P1 and the market quantity is Q1, where all the firms are getting normal profit. All after the imposition of the lump sum tax the LRATC is increases to LRATC2, => the old equilibrium price is P1, all the firms will incur losses, => few firms will exist the industry. Now, as the few firms exists the industry the market supply starts shifting to the left until the new LR will be established. The new LR price is P2 and the market quantity is Q2 < Q1.

Here as the lumpsum tax is imposed the LRATC will shift upward, but the consumers and the producer both will share the burden of the tax.