You are hired as an economic consultant by the Federal Treasury to analyse the impact of a fee or a tax in a market, taking account of different potential market structures. In your answer you should use appropriate models (and diagrams) studied in class.
Consider the financial services market. Assume for now that the market is competitive with many buyers and sellers, that financial services are a homogeneous good and that market demand and short-run market supply are linear and respectively downward and upward-sloping. At the current market equilibrium supply is more inelastic than demand. Assume also that the financial services industry is a constant-cost industry in the long run. To fund extra regulatory functions, the Federal government introduces a per-unit tax (called a financial services government fee) for every unit of financial services traded in the market.
a. What is the impact of the new financial services government fee in this industry in the short run? What is the economic incidence of the fee? In other words, analyse and explain who bears the burden of the new fee. (4 marks)
b. The Treasury is interested in the impact of the fee in the financial services market in the long run. Analyse the impact and economic incidence of this fee in the long run in this competitive industry. Compare your answer to the short-run case discussed in part (a). (3 marks)
c. Now assume that the financial services industry is instead a monopoly, serviced by just one firm. The monopolist faces the same market demand curve for financial services as in parts a-b, and incurs marginal costs as in the competitive market above (but without new firms entering/exiting the industry). Analyse the impact of the fee levied on the monopoly market outcome and the economic incidence of the fee in the long run. (4 marks)
d. Thinking more broadly, if as an economic consultant you observe a price rise in a market in the long run that is smaller than the per-unit tax levied, what can you imply about the structure of that market? Explain briefly. (2 marks)
Economic consultant to the Federal Treasury.
The case of taxation and design of an optimal tax system has been extensively researched, in the public finance context. There is some research done on this subject have been conducted within the framework of a competitive market, or a homogenous good (Ginsburgh & Throsby, 2006 ). This indicates that most of the studies carried out are of the oligopoly market structure. An oligopoly market structure is where products are differentiated both horizontally and vertically, and the effect of taxation may be complex since the tax system may affect not only prices but also the profile and quality of the products that each firm sells (Robert E. Hall, 2009).
When the new tax is imposed, it changes the market equilibrium, not only based on prices but also the equilibrium of distribution of goods and services that are sold in the industry. A uniform increase in tax rate while reducing overall sales in the market and overall sales of a particular firm, may increase the sales of a particular model (Robert E. Hall, 2009). This will occur due to a shift in the demand curve caused by the increased tax. This extra tax imposed by the government on the industry is transferred to the consumers of the goods and services at an increased price. Although the brands offered are fixed in the short run, the consumer’s views and taste on the products are likely to shift due to the tax increase (Greg, 2012). In the short run, the firm would experience a slight reduction in consumer purchase, which will reduce their price. This will not add any more new customers, but instead lead to market diversion from other competitors.
The main problem here is that there would be a reduction in demand for the products due to the vertical movement in the products nature. However, at times this demand effect is mitigated by the market power and the increased tax would reduce the quality of goods that the industry provides (Ginsburgh & Throsby, 2006 ). This shows that there is a demand shift when there is a change in tax. It is, therefore, evident that the demand effect resulting from the tax change would likely encourage firms to reduce the quality of the products they sell and offer more products of inferior quality. Therefore, the increased tax would lead to a shift in the distribution of sales to lower quality products. Furthermore, the firms can opt to differentiate their products either horizontally or vertically so as to adjust the introduced tax system (Ginsburgh & Throsby, 2006 ).
In the short run, with the introduction of the unit tax rate, which in turn leads to an increased tax, affects the overall sales in the market and finally it entirely changes the entire market structure from the production stage (Ginsburgh & Throsby, 2006 ). Also, firms are forced to reduce the quality of products they produce to enhance their sales.
When a tax system is introduced to a monopoly, this means that the price the firm would receive should be different from the price of the consumer. There will be no change in demand as consumers would not change their view on the value of the product just because there is an extra tax imposed (Robert E. Hall, 2009). The consumers would still demand the same amount of product, at the same price as before meaning their demand function remains constant. However, the price the supplier gets would be less as the vendor pay the specific tax per unit, to the government. The tax is intended to drive a wedge between the amount paid by the consumer, and the price received by the supplier. There is expected to be a shift in marginal revenue, but the minimal cost remains constant. This addition of tax would be better for the government, but worse for the firm as the government would be making profits as the firm’s marginal revenue decreases. (Robert E. Hall, 2009)
This is a market structure in a very competitive market due to product’s homogenous nature, and they face stiff competition from the rival firms in the industry. A firm would opt to have a lower price than that of tax levied so as to stand a competitive advantage against its rivals. The firms here try to adjust to the increased taxes so as to avoid a shift in the distribution of sales (Ginsburgh & Throsby, 2006 ). In other cases, the prices are lower than the tax levied which may attribute to the quality of products the firm decides to produce. A firm might resolve to provide goods of lower quality so as to mitigate the effect of the price per unit. Firms in this type of market structure would try to differentiate their products as a result of the tax effect. Firms can consider either selling horizontally or vertically differentiated goods so as to compete on prices (Greg, 2012).
Ginsburgh, V. A., & Throsby, D. ( 2006 ). Handbook of the Economics of Art and Culture, Volume 1. Boston: Elsevier.
Greg, I. (2012). The Little Book of Economics: How the Economy Works in the Real World. Boston: John Wiley & Sons.
Robert E. Hall, M. L. (2009). Economics: Principles and Applications. New York.