MICROECON - Perfect Competition

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There is free entry into the textile industry. Anybody can enter this industry and have the same U-shaped average cost curve as all of the other firms in the industry.

a) Suppose the government imposes a \$5 tax on every unit of output sold by the industry. After the industry has adjusted to the imposition of the tax, the competitive model would predict the following: the market price would ____ by \$5, there would be ___ firms operating in the industry, and the output level for each firm operating in the industry would ____. If graphed, would the new long-run equilibrium price and quantity at MC = min AVC, below this point or above this point?

b) What if the government imposes a tax on every firm in the industry large enough to raise the minimum average cost by \$5. After the industry has adjusted to the imposition of the tax, the competitive model would predict the following: the market price would ____, there would be _____ firms operating in the industry, and the output level for each firm operating in the industry would _____. If graphed, would the new long-run equilibrium price and quantity at MC = min AVC, below this point or above this point?

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a) increase, more, increase, above the MC = min AVC by an increase of \$5 of the same output (ex: 25 units originally cost \$10—the original long-run equilibrium price and quantity--but it now cost \$15)

b) decrease, fewer, decrease, below the MC = min AVC

• MICROECON - Perfect Competition -

Because all the firms have identical cost structures, all firms would be operating at the minimum of their average cost curve. Further, in long-run equilibrium, Price=MC=ATC. So firms are not making economic profits.

Now then, impose the \$5 per unit tax.

1) Market price INCREASES,
Because P goes up, Q (market goes down). So,
2) the number of firms must DECLINE. Again, since all firms are identical, Because it is a per-unit tax, the average cost curve rises for all firms by \$5. The quantity q at which the AVC and ATC curves are at is minimum will be exactly the same as before. Again, the new equilibrium will be Price=MC=ATC. So,
3) the output level for each firm still operating will be EXACTLY THE SAME AS BEFORE. And 4) to the extent there are zero fixed costs, P=MC=min(AVC). Otherwise, the price will be ABOVE the min(AVC) point.

For part b)
I presume the tax is a per-firm tax; the tax is a fixed cost; it increases total costs but not variable costs. So, the AVC curve remains the same, the TVC curve shifts up an a bit to the right. The minimum point, by definition, is \$5 higher. Again, some firms will drop out, the remaining firms will operate where P=MC=ATC.
So P INCREASES by \$5, there would be a DECREASE in the number of firms, output per firm would be a bit LARGER than before, and the equilibrium price will be ABOVE the min(AVC) point.