Suppose that the economy of Dreamland produces two kinds of goods, puppies and b
ID: 1249247 • Letter: S
Question
Suppose that the economy of Dreamland produces two kinds of goods, puppies and books (including books about how to raise puppies). Further assume that the market for each good is perfectly competitive and that the price of each good is initially equal to the level of long run average cost in each sector.a. The government of Dreamland is determined to deal with the smelly externality
associated with the production, sale and enjoyment of puppies. If the
government imposes a $50 tax per puppy on the producers of puppies,
what is the affect of the tax on the marginal cost, average variable cost, and
average fixed cost of producing puppies?
b. How would the tax on puppies affect the demand for and price of books in
Dreamland? (Assume that books and puppies are substitutes).
c. The Dreamland Puppy Lovers Association (also known as DPLA or “dee-plah”)
claims that the tax on puppies is economically inefficient because it reduces the
production and sale of puppies below the free market level. Is this argument
right? Why or why not?
d. How does the tax on puppy producers affect the level of employment and wages
for workers in the puppy industry?
e. What is the effect of the puppy tax on the number of puppy farms and booksellers
in Dreamland over the long run?
Explanation / Answer
Assumptions: puppies and books perfectly competitive P=ATC a. The $50 tax will increase the marginal cost by $50 because the tax is made on a per puppy basis. The average variable cost will shift upward by $50 also because average variable cost is variable cost divided by the quantity. AVC=VC/Q The tax increases VC by 50*Q (because it is a tax on every puppy. So, the change in AVC can be represented by: DAVC=50Q/Q, where "D" means "change in." DAVC=50 The average fixed cost does not change because the tax charged per puppy. The fixed costs are those costs that do not change with the number of puppies produced. b. The tax on producers can be represented as a shift in supply to the left. This means a movement up the demand curve to a higher price. Because the price of puppies increases, people are going to buy fewer puppies. If books are substitutes, this means people will buy more books because they are now relatively cheaper. c. This argument is not correct because the puppies create a bad smell, which negatively impacts people. This impact can be quantified in terms of a dollar value and corrected by a tax on puppies. The tax may be two high or two low depending on the amount of the externality, but some tax must exist in order to yield an efficient outcome. d. Because fewer puppies are produced, fewer workers are demanded by the puppy industry. This means that demand shifts left, prices fall and the employment falls. e. In the long run, the number of puppy farms will decrease because the tax causes puppy farms to suffer an economic loss. Remember that we started out with price equals average total cost. Now, the seller charges a higher price but cannot pass on the full cost of the tax to the consumer unless demand is perfectly inelastic. This implies that the price that the sellers get to keep is below average total cost. This is the definition of an economic loss. So, firms will exit in the long run. Alternatively, since the demand for books increases due to substitution away from puppies and toward books, the price of books increases from its previous value. This will cause entry into the market for books. This means, you will have more booksellers in the long run.
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