Pollution Taxes on Output: Suppose you are one of many firms that refine crude oil into gasoline. Not surprisingly, this process is one that creates pollution. The government therefore announces a new tax of $t on each gallon of gasoline that leaves a refinery (to be paid by the refinery.)
A: For purposes of this exercise, assume that the refinement process of crude oil into gasoline has decreasing returns to scale but entails a recurring fixed cost.
(a) Begin by illustrating the industry in pre-tax equilibrium — showing one firm’s average cost curve as well as the (short run) market supply and demand that supports an industry in long run equilibrium.
(b) What changes for each firm and in the industry in the short run when the tax is introduced?
(c) What changes in the long run?
(d) True or False: While refineries bear some of the burden of this tax in the short run, they will pass all of the tax on to consumers in the long run.
(f) Will refineries change the mix of labor and capital in the long run (assuming they continue operating)?
(g) Here is another quote from a recent TV analysis: “In talking to this refinery’s owner, it seems that there are no plans in place to lay off any workers in response to the pollution tax on refined gasoline. Jobs in the industry therefore appear to be safe for now.” Do you agree?
(e) I recently heard the following comment on one of the TV news shows (regarding a tax similar to the one we are analyzing here): “Regulators are particularly concerned about reports that companies in the industry managed to pass the pollution tax fully onto consumers and view this as a sign that the industry is not competitive but is rather engaged in strategic manipulation of gasoline prices.” What do you make of this TV wisdom?
B: Once again suppose that the production function used by firms in the gasoline refinery industry is f (ℓ, k) = Aℓαkβ with α, β > 0 and α + β < 1, and suppose that each refinery pays a recurring fixed cost F.
(a) If you did not already do so in exercise 14.1, derive the expression for the output level x∗ at which the long run AC curve reaches its lowest point. (This should be a function of A, α, β, w and r.)
(b) How does x∗ change under the per-gallon tax on gasoline leaving the refinery?
(c) Can you use your answer to determine whether the number of gasoline refineries will increase or decrease as a result of the tax?
(d) If you have not already done so in exercise 14.1, determine the long run equilibrium price p∗ before the tax (a function of A, α, β, w and r.) How does this change under the tax?
(e) Can you use your answer to determine who actually pays the tax?
(f) Will the tax result in less pollution? If so, why?