Question

We have learned in class that tax distorts market equilibrium price, reduces the quantity purchased/produced, and induces deadweight loss. Although tax revenue is indispensable for any country’s financial sovereignty, governments sometimes cut taxes as a stimulus for economy growth. In 2009, when financial crisis hit Europe, household spending was greatly dampened because people were concerned about their income perspectives. To revitalize the economy, many European governments decided to intervene by providing economic stimulus packages. Among these measures, the French government delivered a policy cutting the value‐added tax (VAT) for food items in the country’s restaurants from 19.6% to 5.5%, although the VAT for alcohol would remain at 19.6%. Restaurant trade groups welcomed this policy change. They agreed to create more jobs using the increased revenue and pledged to cut prices of many menu items by 11.8%. Nonetheless, restaurants were not obligated to cut prices. Despite skepticism, for a time, the policy seemed to be working. At least some of the restaurants passed the VAT cut through to diners, which encouraged people to spend more and dine out more often. However, three years into the tenure of this policy, the French government was considering raising the VAT again. This was largely motivated by “a damning report to France's National Assembly on the tax‐lowering measure found restaurants largely failed to honour their part of the bargain.” Starting from January 2014, the VAT in French restaurants has been raised to 10%. The French story is not an independent case. Recently in UK, more than 40 pubs and restaurants launched a campaign to cut prices by 7.5% on Wednesdays. This was a lobbying effort from the restaurants hoping to convince the government that cutting VAT would lead to reduction of prices and spur consumer spending. 1) As a restaurant manager, how would you decide on how much you are going to cut the prices and which items’ prices to cut? 2) What kind of restaurants would cut their prices deep and what kind of restaurants are not likely to pass any benefit to consumers? Please elaborate with graphs and examples. what about the type of firm? If it is a competitive firm or a monopoly? Also if the costs, such as MC, AVC etc are involved? thank you.

Answer 1

1) As a restaurant manager, I may cut the price till the normal profit I earn, i.e., the total revenue(TR) must be equal to the total cost (TC) of production. But I will select the price(P) which is greater than the average variable cost (AVC) of production; i.e. P>AVC in short run. TC in short run =Variable cost(VC)+ Fixed cost(FC)    Average total cost(ATC) in short run=AVC.+Average fixed cost(AFC) Average variable cost is cost per unit of output. To sustain in the market in short run, price must be greater than the AVC of production. If the price is less than the AVC, I have to shut down the production.

I will cut the prices mainly on the items whose price elasticity of demand is elastic, these items are expensive and luxurious to some people.The foods that are expensive, reducing price will massively change its consumption. The foods that are necessary and people eat routinely, like staple food, reducing prices won't change their consumption.Even if I reduce the prices of this kind of items, people won't consume more as they take them in required amounts whatever be the price.The price elasticity of this kind of foods is inelastic.

2) The restaurants that are luxurious, make expensive dishes and drinks and in price competition with other restaurants, would cut their prices deep.These are the competitive firms.

Restaurants that have monopoly presence in the market, are not likely to cut the prices. The demand for their products won't diminish even if they don't change the prices. The monopoly firm's price of the good will always be above the marginal cost (MC) of production at equilibrium, that gives the firm an economic profit.