Question

Problem 1. (13 points) Markets: Perfect Competition.

Assume that a perfectly competitive, constant cost industry is in a long run equilibrium with 35 firms. Each firm is producing 90 units of output which it sells at the price of $39 per unit; out of this amount each firm is paying $5 tax per unit of the output. The government decides to decrease the tax, so the firms will be paying $3 tax per unit.

1. a) Explain what would happen in the short run to the equilibrium price and industry output; number of firms in the industry; output and profit of each firm. Illustrate on diagrams for the market and a particular firm.

2. b) Explain what would happen in the long run to the equilibrium price and industry output; number of firms in the industry; output and profit of each firm. Illustrate on diagrams for the market and a particular firm. Compare to the initial long run equilibrium and to the short run equilibrium found in a).

Your answer to this question should include graphs and explanations in words; please use complete sentences (not dot points). Please note that the numbers are provided for convenience; you should indicate them on graphs, but you are not expected to do any calculations.

Answer 1

a) A reduction in per unit tax shift the MC curve, ATC curve and AVC curve down. The firms in the industry earn zero economic profit in longrun since the longrun price is equal to the ATC. This equality is achieved through the free entry and exit of the firms. In shortrun the industry supply is constant since new firms do not enter into the market or the existing firms do not quit the industry. The fall in lax reduce the ATC and at the prevailing price firms profit increase in shortrun. The output of the firms and industry will remain constant in shortrun. Price Price/cost Јмс Profit $39 $37 - D=ARMR - 3150 Quantity 90 Quantity There are 35 firms in the industry. The industry output is number of firms multiplied by the quantity produced by a firm. The total industry supply is 3150. The longrun equilibrium price is $39 which includes the tax of $5. In shortrun the deduction in tax reduce the average total cost and thus ATC shift to the down. The new cost per unit is $37, but the price it received from the market is $39. Therefore each firm is earning an economic profit of S2 per unit in shortrun. b) In longrun, attracted by this economic profit, new firms will enter into the market and the industry supply curve shift to the right. The entry of new firms will continue till the price falls to $37 where the price is equal to ATC. The positive economic profit changes into zero economic profit in longrun. The industry output expand to the extent of the number of new firms enter into the market.

Si Price/cost Profit ATC KA -D=AR-MR ---- DI= AR1=MR1 \D Quantity 3150 Quantity In longrun the entry of new firms shift the industry supply curve right from Sto Sl. The industry supply increase which lowers the price to S37. The equilibrium of the industry moves from point A to point B. The equilibrium price of the industry decreases and the equilibrium quantity increase. All firms in the industry is earning normal or zero economic profit.