Question

Explain the effects of a tax on producers on the equilibrium price and quantity in a competitive market. Comment on the effect on surpluses and the gains from trade.

Answer 1

Producers in the perfect competition are called firms. Tax on these firms will discourage the producers to produce more and therefore the supply curve will shift upward. The tax, indeed, result in a welfare loss and the period of analysis would decide the impact on consumer and producer surplus.

The equilibrium price, due to tax, will increase and the quantity would fall.

In the Short run, firms in order to keep their revenue high due to tax, keep the prices of goods at a higher rate. The incidence of the tax depends upon elasticity of supply. If the supply curve is less elastic, then producers have to bear most of the burden of the tax. In this case , larger amount of producer surplus would be lost.

In the long run, the supply curve becomes perfectly elastic and the demand curve still remains downward sloping curve. So, the entire burden of the tax will shift to consumers and the producer surplus would be zero since the supply curve is horizontal.

The net effect would depend upon the elasticities of demand and supply. Higher the elasticity, more will be deadweight loss and higher will be loss to consumer and producer surplus.