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

1. The sales tax will increase the marginal cost and average cost by $1.

2. The price would remain the same, output and profit would decrease.

3. Entry and exit depend on the end profits.

Step-by-step solution

Step 1. Effect on cost curves of the firm

Implementing a sales tax of $1 on each unit produced will increase the marginal cost by $1. The new marginal cost of the firm would be (MC + $1). The average cost will also increase by the same amount because of the $1 taxation.

Step 2. Effect on firm’s price, output, and profit

The sales tax on each unit produced would increase the total cost of the production. Since the firm is running in a perfectively competitive market, it is a price taker. It cannot influence the price of the product. Thus, the price of the product will remain the same for the firm.

But the increase in total cost will reduce the difference between the total revenue and total cost. Hence, the profit will decrease.

Since the price remains unchanged, an increase of $1 on marginal cost will cause the firm to choose new output whose marginal cost would be equal to price. The new output would be lower than the previous one because of an increase in marginal cost. Thus, the output will decrease.

Step 3. Effect of taxation on entry or exit of firms

The entry and exit depend on the profits of a firm. Taxation decreases the profit level of the firm. If the firm cannot earn a positive or zero economic profit after the taxation, it will leave the market, or else it will stay.