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

If government levies tax on economic profits of the firm, then overall cost of production of the firm will increase and this will shift the cost curve in the leftward direction. Increase in the costs will reduce the level of output produced by the firm and thus X2 or production level of the firm post taxation will be less than production level of the firm before taxes are imposed.

Since demand curve of the good in case of perfeclty competitive firm is perfeclty elastic because it acts as a price taker, thus, taxes paid by the consumers is equal to zero and the entire burden of taxation is borne by the producers or firm.