In the previous problem, we studied the effects of a cost-saving invention. For this problem, we suppose that there was no such invention, but that a tax is introduced. Suppose that on January 1, 2001, the industry was as described in the previous problem (without the invention of the new kind of plaster). On this day, the government surprised the garden gnome industry by introducing a tax on the production of garden gnomes. For every garden gnome produced, the manufacturer must pay a $1 tax. The announcement came early enough in the day so that there was time for gnome producers to change their orders of gnome molds for 2002. But the gnome molds available to be used in 2001 are those that had been ordered a year previously. Gnome makers had signed contracts promising to pay $1,000 for each gnome mold that they ordered, and they couldn€™t back out of these promises. Thus in the short run, during the year 2001, the number of gnome molds is stuck at 28.
(a) On the graph below, draw the short run industry supply curve for garden gnomes that applies in the year 2001, after the new tax is introduced. On the same graph, show the demand curve for garden gnomes.

(b) In 2001, after the tax is introduced, what is the short run equilibrium total output of garden gnomes, ______. and what is the short run equilibrium price of garden gnomes? ______.
(c) If you have a garden gnome mold, the marginal cost of producing a garden gnome, including the tax, is ______. Therefore all gnome molds (will, will not) ______ be used up to capacity in 2001.
(d) In 2001, what will be the total output of garden gnomes? ______. What will be the price of garden gnomes? ______. What rate of return will Deardwarf€™s cousin Zwerg make on his investment in a garden gnome mold that he ordered a year ago and paid $1,000 for at that time? ______.
(e) Remember that Zwerg€™s neighbor, Munchkin, also has a gnome mold that is to be delivered on January 1, 2001. Knowing about the tax makes Munchkin€™s mold a less attractive investment than it was without the tax, but still Zwerg would buy it if he can get it cheap enough so that he
makes a 10% rate of return on his investment. How much should he be willing to pay for Munchkin€™s new mold? ______.
(f) What do you think will happen to the number of gnome molds ordered for delivery on January 1, 2002? Will it be larger, smaller, or the same as the number ordered the previous year? ______.
(g) The tax on garden gnomes was left in place for many years, and nobody expected any further changes in the tax or in demand or supply conditions. After the passage of sufficient time, the industry reached a new long-run equilibrium. What was the new equilibrium price of gnomes? ______.
(h) In the short run, who would end up paying the tax on garden gnomes, the producers or the consumers? ______. In the long run, did the price of gnomes go up by more, less, or the same amount as the tax per gnome? ______.
(i) Suppose that early in the morning of January 1, 2001, the government had announced that there would be a $1 tax on garden gnomes, but that the tax would not go into effect until January 1, 2002. Would the producers of garden gnomes necessarily be worse off than if there were no tax? Why or why not?
(j) Is it reasonable to suppose that the government could introduce €œsurprise€ taxes without making firms suspicious that there would be similar €œsurprises€ in the future? Suppose that the introduction of the tax in January 2001 makes gnome makers suspicious that there will be more taxes introduced in later years. Will this affect equilibrium prices and supplies? How?

Transcribed Image Text:

Supply Curve 12 Demand Curve 4 8 2 4 62 24 Nmber of gnomies (n thousands)