What is the effect of reduction in per unit tax on market supply of a good?

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detroitted eNotes educator| Certified Educator

The question asks about the effect of a reduction in per unit tax on the market supply of a good. We will assume that this refers to a tax placed on the item at point of sale and assessed by the retailer. The effect of such a tax is to increase the price seen by consumers by the amount of the tax at every point along the supply curve. Therefore a reduction in the tax will in essence shift the market supply curve downward by the amount of the reduction. Given a normal (downward sloping) demand curve, a new equilibrium price and quantity will be established at a higher quantity demanded and a lower price. Note that, assuming competitive markets and an upward sloping (but not vertical) supply curve, the new equilibrium price will not fall by the full amount of the reduction. This is because the increase in quantity demanded will provide suppliers the opportunity to raise prices slightly relative to the previous price minus the reduction. That is, the new equilibrium price will be somewhere between the old price on the one hand and the old price minus the amount by which the tax was reduced on the other. Where it ends up between those two points depends on the relative elasticities of demand and supply at the original equilibrium point. There are longer term effects as well. Namely, the increase in quantity demanded will encourage investment on the supply side in additional productive capacity. This will change the market supply curve in the long run, moving it downward and in the direction of greater quantity supplied at any given price.