Producers treat a lump-sum tax as a fixed cost, seeing as the amount of tax remains the same and does not vary with the production. The imposition of a tax does not cause an increase in the variable cost; rather, it causes the fixed cost to increase. Marginal cost measures the change in the total cost due to each additional unit of output produced. Since the variable cost does not change, the marginal cost also remains the same. The equilibrium output and the price will remain the same because there is no change in the marginal cost.
The total cost, however, does increase because it includes both fixed costs and variable costs. An increase in the total cost will cause the average total cost to increase as well. As the average total cost (ATC) rises in the short run, the firms will incur losses as the price remains the same initially. However, despite the losses, the firms can continue operating in the short run, seeing as they cannot leave the market.
If a firm incurs losses in the long term, then it will exit from the market. If multiple firms leave the market, the supply of the product will decline. This decrease in the supply will cause the supply curve to shift to the left. As the supply curve shifts to the left, the price level will increase. This process of decrease in the supply will continue until the price level is equal to the average total cost and all the firms operating in the market are earning normal profits.
Effect of lump-sum tax in monopoly
As in a perfectly competitive market, a lump-sum tax is also treated as a fixed cost in a monopoly market. The imposition of a lump-sum tax does not cause the variable cost to increase. As the variable cost remains the same, so does the marginal cost. Since there is no change in the marginal cost curve, the equilibrium price and the output level remain the same.
The imposition of the lump-sum tax, however, will cause the total cost to increase, as it includes both fixed costs and variable costs. An increase in the total cost will cause the total cost curve to move upwards by the amount of the tax. As the total cost increases, the difference between the total cost and the total revenue, which is the profit of the firm, decreases. The welfare cost of monopoly, which is the loss of social welfare due to underproduction in monopoly, remains the same even after the imposition of the lump-sum tax.
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