Introduction:
Budget incidence may originate from the changes in government’s expenditure and changes in taxes. Government expenditure may be on salaries to civil servants, transfer payment, purchase of goods and services, debt repayment and services and capital expenditure for development. Government spending and taxation takes place simultaneously. The taxes result in reduced earnings from the private sector and subsequently lowers the disposable income. The end result is that benefits derived from public goods will rise whereas that derived from the private sector will fall. This effect is considered the budget incidence of tax. A per unit tax is tax collected from every unit of output that a firm produces or sells. Irrespective of any kind of tax imposed, the market equilibrium between supply and demand gets disrupted. According to Hyman (2014), an increased tax level for a specific commodity increases the commodity’s price but reduces its demand; this depends on the price elasticity of demand for that product (Guru, 2016).
The industry price in fig (a) is determined by the intersection of demand and supply. Increase in demand to DD1 in the short run raise price to P1, profit rises, and thus attracts new entrants subsequently raising supply to SS1. In fig (b), the single firm is a price taker. The AR = MR for a single firm because all the units are sold at a uniform price. Thus the demand curve for an individual firm is the average revenue. The average total cost for a single firm in a perfect competitive market is lower than the MR in the short run and thus the firm is able to make an economic profit represented by the shaded area in fig (b). According to Waugh (2014), there is no entry of new firms in the short run. Profit is maximized at MR = MC and thus the output that maximizes profit is equal to Q and price is P. The total revenue is equal to PQ; and the cost is CQ. We have seen that the demand curve for the individual firm in a perfect competitive market is horizontal (perfectly elastic at the determined market price. Now, the changes that will result on a representative individual will be affected by the perfect elastic nature of its demand curve.
The marginal cost for the single firm initially was MC and its average cost was AVC. The industry price is P and the quantity produced is q obtained at the point where P = MC. The imposition of per unit tax on output raises the marginal cost curve and the average variable cost from MC to MC1 and AVC to AVC1 respectively; they change is dependent on the amount of tax imposed per unit. Since the AVC is below MR = MC, this firm was initially making a super-normal profit by producing output q. The imposition of tax forced the firm to produce quantity q1 at the AVC1 which is still below MR = MC1. The firm is therefore making super-normal profit although lower than what was raised initially. Since this firm is still making economic profits and there is no entrance in the short run, it will continue its operation to the long run. The impact of per unit tax in a competitive market is to shift the short run supply curve to the right (MC curve) with no influence on price since demand is perfectly elastic.
In the long run, the single firm does not make any economic profit, all firms make an equal normal profit (Gallego, 2017). The super-normal profit enjoyed in the short run as discussed earlier acts as an attraction for new investors to enter the market. The perfect competition market is characterized by zero barriers to entry and thus new firms will freely enter the market (Atkinson & Stiglitz, 2015). The first firms to enter this market will continue enjoying the supernormal profit but not as much as the level enjoyed by the initial fewer firms. Thus the entrants gets a share of the economic profit. This means that, the economic profit for individual firms falls as new entrants join the market. Entry will continue until all the profit is diminished such that firms will only make normal profits (Tresch, 2015). After the profit is diminished, more entry will eat into the firms normal profits and all the firms will begin making losses. In the long run, entry stops at the point where the economic profit diminishes and thus no economic loss or profit is made.
The initial industry’s price is P. Both the demand and supply curve in a perfect competition are elastic in the long run (Kennedy, 2012). The demand curve slopes downwards while the supply curve slopes upwards. At the industrial market price, the quantity produced is equal to Q. Taxing every firm in the industry results in a rising marginal cost for each firm (McEachern, 2013). Thus at the given market price of P, the single firms lower their output level. This will cause the industry’s total output to fall and consequently will result in an increased price for the output since the industrial price is determined by demand and supply. The industry’s supply curve will shift from S to S1 and the price will rise from P to P1; this will be a quantity decrease from Q to Q1. The implication for this is that, the individual firms being faced with the tax imposition can lower their output and sell at a higher new market price; the tax imposition will therefore not make the individual firms to make losses in the long run and thus no firm will be kicked out of the industry. If the number of firms rises in the long run, losses will be made and some firms will be forced out of the industry until the economic losses are eliminated and every remaining individual firm will be making only normal profit.
The long run supply curve for a constant cost industry is perfectly elastic. The supply curve in the short run is however upward sloping (Cahuc, Carcillo, & Zylberberg, 2014). Initially, the per unit tax will result in the price rising on the consumers side; however, the increase will be lower that the tax increase meaning that the suppliers will bear some of the tax burden. In the long run however, some firms will be forced to exit the industry which consequently will lower the industry’s supply level (Abdullah, 2017). The reduced supply will force the whole tax burden to be transferred to the consumers as illustrated below.
Before the per unit tax, the equilibrium price was P with demand D and supply S. after the imposition of per unit tax, the consumers’ price rises to Pa and the price the producers receive falls to Pb. However, the horizontal industry supply curve shifts upward to long run supply (tax shifted) in the long run resulting in firms making losses. The zero barriers to entry and exit facilitates for some firms to exit the market. The shift in the supply curve makes the whole tax burden to be shifted to the consumers.
Therefore we can conclude that the impact of tax imposition on the long run is raising equilibrium price, decreasing quantity. The number of firms increase in the industry because there are economic profits in the long run.
References
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