Question

Consider a perfectly competitive firm currently producing X1 units of a good. Now suppose that
the government levies a tax on economic profits of the firm (for example, 10% of its profits are
taxed). If the firm’s after-tax production level is X2, compare X1 and X2. How much of this tax is
paid by the consumers?

Answer 1

Let's assume that SS is the supply curve of the firm and DD is the demand curve. The output before taxation X1 is determined by the intersection of DD and DD . Price is P1 corresponding to the output level X1.

When a tax is imposed on profits, firm will have less incentive to produce. So, supply curve will shift to left from SS to S1S1. Intersection of S1S1 with DD yeilds the new output X2. New price level is P2

From the graph itself , it's evident that X1 is less than X2 . ( Imposition of tax, leads to a reduction in output equal to X2X1)

We saw that due to the introduction of taxation, price has also increased frm P1 to P2.

Consumer will pay the portion of taxes equal to the increase in price ( P2P1.)