Answer to Question #262567 in Microeconomics for Ghani

Question

Good X is produced in a competitive market using input A. Explain what would happen to the supply of the good X in each of the following situations:

a) The price of input A decrease.

b) An excise tax of $3 is imposed on good X.

c) An ad valorem tax of 7percent is imposed on good X.

Answer 1

A competitive market is one in which the forces of demand and supply determines the equilibrium price and quantity of a commodity. Price of a good is the main determinant of supply and demand for a good. But factors other than price also affect the supply and demand of commodities. Those factors are responsible for the shift in supply and demand curve.

Change in price of inputs, an improvement in technology, taxes and subsidies are some of the factors which cause a shift in supply curve. Let us examine the effect of each situation on supply of good X.

Good X is produced using input A. Change in price of inputs is a major determinant factor that causes shift in supply curve. When the price of an input decreases, the supply curve of the good shifts to the right. The shift to the right is referred to as an increase in supply. At lesser input prices, the producers would supply more of the commodity at each price. So when the price of input A decreases more of good A is supplied.

b). An excise tax is any duty on manufactured goods that is levied at the time of manufacture. Incidence of excise tax is on producers. When an excise tax is imposed it acts as an increase in production cost. When there is an increase in production cost, there will be a fall in supply and supply curve of the product shifts to the left. The producers would supply less of the commodity at each price. Thus when an excise tax of $3 is imposed, the supply of good X would be decreased corresponding to $3 increase in production cost. 

An ad valorem tax is a percentage tax imposed on a commodity at the time of sales. It is a value based tax. This means at lower prices the tax amount is less and at higher price there will be more tax. Since the effect of this tax is on producers, the supply curve shifts to the left. Upward shift of the supply curve is not parallel but outwards as price increases. This is because of higher tax at higher prices. So when an ad valorem tax of 7% is imposed, the supply of good X decreases with reference to price level.

Technological changes are an other important factor which cause a shift in supply curve. Technology is ever changing and innovations in production sector reduces the cost of production. Technological changes reduce the cost of producing an additional unit of good X. This means with the improvement in technology marginal cost of producing good X has come down. This results in a decrease in total production cost. When there is a fall in production cost, the supply increases and the supply curve shifts to the right. Thus with a Technological change causing less production cost increases the supply of good X.