Suppose that the gasoline retailing industry is perfectly competitive, constant-

Question

Suppose that the gasoline retailing industry is perfectly competitive, constant-cost, and in long-run equilibrium. If the government unexpectedly levies a five-cent tax on every gallon sold by gasoline retailers, depict what will happen to the representative firms cost curves. What will the effects of the tax be in the short run on industry output and price? Will the price rise by the full five cents in the short run? In the long run? How would your answers change if the industry was increasing cost?

Explanation / Answer

Marginal Revenue, Marginal Cost, and Profit Maximization • A firm’s profit is the difference between its revenue and its costs: p(q) = R(q) - C(q) where p(q) = profits (not the number 3.14!) R(q) = total revenue C(q) = total economic cost • If the firm is in a competitive market we assume the firm faces a horizontal demand curve. Since the firm is a price-taker, the choice of how to sell q has no effect on the price. In this case R(q) = p × q. It is a straight line. • If the firm can effect the price, we assume the firm faces a downwardsloping demand curve. At higher prices, the firm sell less output. The price it can charge depends negatively on the quantity it sells. In this case R(q) = p(q) × q and the revenue function is curved. ***Output in the Long Run • In the long-run a firm can alter all of its inputs. It can also chooses whether to enter or exit markets. • In the long run can choose whether to incur any fixed cost. If over the long-run a firm cannot cover its fixed cost, the firm will make consistent losses and the firm will want to shut down and exit the market. • In the long run firms will exit the market if the market price is consistently less than their break-even price – their minimum average total cost. • However if the the market price is consistently above the break even point, not only will the firm keep producing and making a profit, but new firms will enter the market. ****Maximizing Profits in the Short-Run • In the short-run we assume the firm’s capital input is fixed and must vary its other inputs (labor and materials) to vary output. • In the short-run, even if the firm is unprofitable because the market price is below its minimum average total cost, the firm may want to stay in business and continue producing. Why? • Total cost includes fixed cost – cost that do not depend on the amount of output produced. In the short run, fixed cost must be paid, regardless of whether the firm produces or not. • Since a fixed cost cannot be changed in short run and must be incurred whether or not the firm produces, it is irrelevant to decision whether to produce or not. *****The Competitive Firm’s Short Run Supply Curve • The firm’s short-run supply curve tells us how its profit-maximizing output decision changes as the market price changes. • As long as the market price is above the shut-down price, the firm’s short-run supply curve corresponds to its marginal cost curve. • Below the shut-down price, the firm suspends output in the short-run. • Anything that shift the firm’s marginal cost curve, shifts the firm’s short-run supply curve – price of an input *****• Whether or not a firm is profitable depends on whether the market price is more or less than the firm’s minimum average cost. • Recall If R(q) > C(q) the firm is profitable If R(q) = C(q) the firm breaks even If R(q) ATC the firm is profitable If p = ATC the firm breaks even If p

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