Question

A sales tax of \(\$ 1\) per unit of output is placed on a particular firm whose product sells for \(\$ 5\) in a competitive industry with many firms. a. How will this tax affect the cost curves for the firm? b. What will happen to the firm's price, output, and profit? c. Will there be entry or exit in the industry?

Short answer

The imposed sales tax will shift the firm's cost curves upwards by \$1, increasing the output price and possibly decreasing the quantity. The firm's profit might remain unchanged, depending on the demand elasticity. The tax might lead to some firms exiting the industry in the short run, but in the long run, new entries might occur if the price increase is sufficient to compensate for the higher cost.

Step-by-step solution

Understanding the effect of sales tax on cost curves

A sales tax of \$1 per unit of output increases the firm's costs by exactly that amount for each unit produced. This will shift the firm's marginal and average cost curves upwards by \$1. In a graph, this will be demonstrated as an upward shift of the cost curves.

Analyzing effect of cost increase on price and output

Considering that the firm operates in a competitive market, all firms will experience the same increase in cost. Therefore, the price in the market will increase by the same amount as the tax, i.e., by \$1. The output might decrease slightly due to the increase in cost and the subsequent increase in price.

Estimating changes in profit

The increase in cost due to the tax and the increase in price might mean that the firm's profit remains relatively unchanged. However, this will depend on the elasticity of demand. If the demand for the product is elastic, the increase in price could lead to a significant decrease in quantity demanded and thus a drop in profits.

Considering industry entry or exit

In the short run, the tax could lead to exit of some firms if the increased cost and price results in losses for these firms. However, in the long run, as the firms adjust their production to accommodate the tax, the industry could see new entries if the increased price can compensate for the tax-induced rise in cost.