What is the long-run welfare effect of a profit tax (the government collects a s

Question

What is the long-run welfare effect of a profit tax (the government collects a specified percentage of a firm's profit) assessed on each competitive firm in a market? Assume the market is in long-run equilibrium before the profit tax. Also assume the profit tax is on economic profit The tax on economic profit will ( A, decrease surplus by increasing the market price. ( B. not affect surplus by leaving the market quantity unchanged. ° C. decrease surplus by decreasing firm profit. O D. increase surplus by decreasing the market quantity. O E. decrease surplus by driving firms out of business.

Explanation / Answer

The effects of a profit tax are the same as those of a lump-sum tax. The profit tax, taxes on the economic profits, reduces the profits and will not affect the marginal cost (MC). In the long-run, exit of firms will be inevitable if the pre-tax period if the firms were earning only normal profits. The supply curve in the market would shift leftward and a new equilibrium would be reached. The price would be at a higher level, a lower quantity produced, and a smaller number of firms.

E. Decrease surplus by driving firms out of business.

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