Shifting the Short Run Supply Curve to the Right

In the long run, a perfect competition market is characterized by zero economic profits for individual firms. New entrants join the market until all economic profit is diminished and only normal profits are made. In the long run, taxation will increase the industry's price and decrease quantity. The tax burden will be shifted to consumers, resulting in an increased equilibrium price and a decreased quantity. Ultimately, the number of firms in the industry increases due to economic profits.

Running Head: Budget Incidence of Tax
Budget Incidence of Increase in Tax Resulting from a Need to Raise Government’s Expenditure
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Budget Incidence of Tax 2
Budget Incidence of Increase in Tax Resulting from a Need to Raise Government’s Expenditure
Part a
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).

Budget Incidence of Tax 3
Fig: Production in a competitive market in the short run
Cost &
Price (a) Industry Revenues (b)Single Firm
MC
SS SS1 ATC
P1
P P Super-normal Profit D=AR=MR
DD1 C
DD
Q Q1 Quantity Q Output
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

Budget Incidence of Tax 4
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.
Fig: Tax incidence given a perfect elastic demand curve
Price
S (Tax) S
Pa D
Pb
0 Qb Qa Quantity
The supplier’s revenue is reduced from the reduction in prices after tax imposition; quantity is
also reduced.
Fig: Tax incidence for a firm in perfect competition
Source: Vle.du.ac.in (2017)

Budget Incidence of Tax 5
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.
Part b
Fig: Production in a competitive market in the long run
Cost &
Price (a) Industry Revenues (b)Single Firm
MC
SS ATC
P P D=AR=MR
DD
Q Quantity Q Output

Budget Incidence of Tax 6
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.
Fig: Impacts of per unit tax imposition on the Industry’s quantity in perfect competition market
Source: Vle.du.ac.in (2017)
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

Budget Incidence of Tax 7
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.

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Fig: Impacts of tax imposition on firms with constant cost in the long run
Price
St
S1: Tax shifted short run supply
S: Short run supply
Pt Long run supply (tax shifted)
Pa Tax
P Industry long run supply
Pb
D
Quantity
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.

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References
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competition.
Atkinson, A., & Stiglitz, J. (2015). Lectures on Public Economics. Princeton University Press.
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Gallego, L. (2017). Perfect competition II: Taxes. Policonomics.com. Retrieved 5 September
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Guru, S. (2016). Incidence of Taxation: Meaning, Shifting the Burden of a Tax and other Details.
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Retrieved 5 September 2017, from http://vle.du.ac.in/mod/book/print.php?
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Waugh, W. (2014). Perfect Competition 2 - Lump Sum, Tax & Subsidy.
Econowaugh.blogspot.co.ke. Retrieved 5 September 2017, from
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