Bud Owen operates Bud’s Package Store in a small town. Bud sells packs of cigarettes for off-premises consumption.

Bud Owen operates Bud’s Package Store in a small town. Bud sells packs of cigarettes for off-premises consumption. Bud has very limited store space and has decided to limit his product line to one brand of cigarette. Bud’s is the only cigarette retailer physically located with the town limits. He faces considerable competition,however, from sellers located outside of town.

Bud regards the market as highly competitive and considers the current \$2.50 per pack selling price to be beyond his control. Bud’s total and marginal cost functions are:

TC = 2000 + 0.0005Q2 MC = 0.001Q, Where Q refers to packs per week.

Included in the fixed cost figure is a \$750 per week salary for Bud, which he considers to be his opportunity cost.

(a) Calculate the profit maximizing output for Bud. What is his profit? Is this an economic profit or an accounting profit?

(b) The town council has voted to impose a tax on Bud of \$0.50 per pack sold in town, hoping to discourage cigarette consumption. What impact will the tax have on Bud’s cost curves? Should Bud continue to operate? What impact will the tax have on Bud’s out-of-town competitors?

(c) Suppose the State Government now doubles the licence fee for all cigarette retailers in the state. This is an increase in fixed costs. What will be the effect on the number of firms, the size of firms and economic profits when the market returns to long-run equilibrium? Illustrate your answer with diagrams for the firm and the industry.

(d) If the long-run supply curve in a perfectly competitive industry is upward sloping, what does this imply about input markets for the industry ? Explain