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Kaplan Exam Kit has the following question and answer. I’m not understanding it, and an explanation would be really appreciated on why exactly the correct answer is A. Thanks a lot, much appreciated.??
A profit-maximising oil producer discovers that the government is to raise an extra 10% levy on his profits. In order to maintain profit maximisation, which policy would you recommend to him?
A) leave price and output the same
B) raise price by 10% and raise output by 10%
C) lower price by 10% and raise output by 10%
D) lower price by 10% and lower output by 10%A
Regardless of the level of taxation, the profit maximisation level remains the same, just 10% less, so leave price and output the same.I was under the impression that the answer would be B, raise price by 10% and raise output by 10%. This is especially due to oil being price inelastic, so a price rise shouldn’t cause too much of a drop in quantity demanded, making overall revenue be higher, increasing profit and thus helping to offset the extra 10% levy on profits the government will introduce.
Profit maximisation occurs when:
MR (marginal revenue) = MC (marginal cost)
MR depends on the demand function linking price and quantity. MC depends on the cost function linking cost and quantity. Neither the cost function nor the demand function are altered by the tax on profits, so the point of profit maximisation is the same – though the government then takes 10% of that maximised profit.
I don’t think B is feasible: if you raise price 10%, demand will go down.
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