Background

In an effort to make driving more affordable and to increase local business activity, the New York State legislature is considering eliminating the state tax on gasoline (about $.10/gallon). As an analyst at the Division of the Budget you have been asked to analyze the proposed tax reduction with particular attention to its effect on gasoline statations.

Assignment

Analyze the effect of the tax proposal on a particular gas station (a representative firm), showing the profit maximizing quantity of output and profits. Assume that the firm is initially (before the tax reduction) in long run equilibrium. Show both the short run and long run effects (profit maximizing level of output and the size of profits) of the tax on the same set of diagrams. It will likely be helpful to draw the market diagram as well as the firm diagrams in each case. Explain the market dynamics that lead to the outcomes you observe.