Suppose gasoline stations operate with identical costs in a perfectly competitive industry. In each of the following cases, explain what happens to an individual gasoline station and what happens to the overall quantity of gasoline sold in the short and long run. Assume that labor is the only variable input in the short run.
a. Last year’s tax returns from gasoline station owners show unusually high income for these owners because of the upward trend in prices this past year. So Congress passes a one-time “profits tax” based on these unusually high incomes last year.
b. Continue with part (a). After the imposition of the “profits tax” from part (a), Congress has to decide what to do with the revenues. The Texas Congressional delegation persuades the government that running a gasoline station is patriotic but difficult work – and that the Congress should put all the revenues from the “profits tax” into a trust fund which will be used to finance annual Christmas gifts in the form of a $10,000 check for all gasoline station owners from now on.
c. Moved by a Hollywood movie on global warming, a teary-eyed senator persuades Congress to impose a $2 per gallon tax on all gasoline sold at the pump.
d. After the industry settles into its new long run equilibrium (following the tax increase from (c)), the Congress decides to help out the gas station owners once more by subsidizing their equipment purchases through a tax credit – thereby lowering the rental rate they have to pay on their equipment. (Assume equipment is fixed in the short run, variable in the long run.)
e. True or False: Since the short run marginal cost curve measures only costs associated with variable inputs (like labor) and not with fixed inputs (like capital), the short run marginal cost curve in the new long run equilibrium (following the policy in part (d)) is the same as the short run marginal cost curve in the old equilibrium (before the policy in part (d)). Explain.
a. This is a sunk “cost” and does not change behavior.
b. Neither of the short run cost curves relevant for firms (i.e. SR MC and AC) are changed — so no change in the short run. In the long run, this is equivalent to a downward shift in the long run AC curve — which means firms earn positive profit until firm entry drives price down to have the marginal firm once again make zero profit. A the lower price, firms will produce less while the industry produces more.
c. This is an increase in the MC in both the short and long run. In the short run, firms produce less, price increases and the industry produces less. (We know firms must produce less since the industry produces less with a short run fixed number of firms as price goes up when the industry supply curve shifts.) In the long run, the AC curve increases by $2 everywhere — implying the lowest point remains at the same output level. Thus, firms produce the same as they did originally but at a price $2 higher. The industry produces less at the higher price — implying that the number of firm falls.
d. In the short run — no change since capital is not variable in the short run. In the long run, price must fall since the long run AC curve has fallen — which implies the industry produces more. Whether each firm in the industry produces more or less depends on whether the lowest point of the AC curve has shifted to the left or to the right.
e. False. Since capital has become cheaper, the firm substitutes away from labor and toward capital — which means there are fewer short run costs in the new LR equilibrium, with the new SR MC curve lower than before.