Question #6: What is the effect on the short-run equilibrium of a specific tax of t

per unit that is collected from all n firms in a market? What is the incidence of
the tax?
Short-run Effects on Cost, Price and Output:
The industry consists of no identical firms before the imposition of the tax. Figure
21.36 shows the initial equilibrium of both firm and industry. The industry supply
curve intersects the demand curve at point E.
average cost curve marginal cost curve
Fig. 21.36 (a) shows the short-run AC curve and the corresponding MC curve for a
typical firm The firm reaches equilibrium at the prevailing market price P0 by
equating its MC with MR. Its equilibrium (profit-maximizing level of) output is Q0.
Fig. 21.36 (b) shows the industry supply curve and the demand curve.

an industry where each firm's costs aren't

impacted by the entry or exit of new firms.
If we assume that the industry under consideration is a constant cost industry,
then the industry supply curve will simply be the horizontal sum of the marginal
cost curves of the firms. Since the industry consists of n0 identical firms, the total
quantity supplied and demanded is n0q0.
Now when the tax is imposed on producers both the MC curve and the AC curve
shift upward exactly by the amount of the tax. It is so because the tax is imposed
on each unit sold. Since the relation between MC and AC remains unchanged a
representative firm reaches its new short-run equilibrium at the same level of
output q0, at which MC = AC.
Here the new cost curves are shown as MC1 and AC1 in Fig. 21.36 (a).
This point may be proved mathematically.
If the total cost of the firm is C (q) before the tax then pre-tax marginal cost is C'(q)
and pre-tax average cost is C (q)/q. In the post- tax situation total cost is C (q) + tq,
where t is a tax.

The post-tax marginal cost is C’ (q) + t and post-tax average cost is C (q)/q + t.

It is well known that a firm maximizes its short-run profit by choosing that level of
output at which price is equal to MC. Now we see that the tax shifts the MC curve
of each firm.

So, when each firm equates its own MC, to price its post-tax level of output will be
less at each price than its pre-tax output at that price. To be more specific, a per
unit tax will shift the industry supply curve vertically upward to S1 as shown in Fig.
21.36(b).

Now the industry reaches equilibrium at point F where the new (post-tax) supply
curve S intersects the demand curve D. This means that the equilibrium price is
higher (P1) but quantity (n0q1) is less than that in the initial situation.
inelastic if demand for a good or service remains unchanged even when the price changes
If the demand curve were completely inelastic price would rise exactly by the
amount of the tax. But in this case where the demand curve is not completely
inelastic, price rises by less than the amount of the tax.
This is because if the new price is equal to the old price plus tax producers would
be eager to supply the same quantity as before the imposition of the tax, but
consumers would be willing to buy less than the original quantity at the higher
price. Thus in Fig. 21.36 the new market price P1 is higher than the old price P0 but
not as high as the tax. This means that producers also pay a portion of the tax.
When price rises from P0 to P1 as a result of the tax the output of each firm falls
from q0 to q1. At this price industry output is n0q1 with each of the n0 firms
contributing q1 to total output. Now the minimum average cost, including the tax,
for the initial level of output (q0), as indicated by point g, is higher than the new
market price P1.
This means that even if firms continue to produce the same old level of output (q0)
they will suffer losses in the short run. Such losses set in motion the forces which
lead to the new long-run equilibrium.