Monday, September 05, 2005

I think Alex is wrong...

On the subject of a decrease in the gas tax, Alex Tabarrok writes:
Ask the man on the street what will happen to the price of gas if the gas tax is lifted and he will reply that the price will fall by the amount of the tax. [...] Does the lifting of the tax change the demand for gasoline? No. Does it change the physical supply? No. [...] Since neither supply nor demand change neither does the price. What does change is that with the tax the government collects the revenues, with the "tax relief" the suppliers of gasoline collect the (former) revenues. Either way, no gain to the consumer.
And his example supporting this claim:
Suppose there is an auction for a pearl. The person with the highest demand is willing to pay $5000 the person with the next highest demand is willing to pay $4999. The winner must pay a tax of $1000 to the government.

With the tax the two bidders bid until the price reaches $4000 at $4000 (note that $3999+$1000 tax= net of $4999) the low bidder drops out and the high bidder wins. Total price to the high bidder is $5000, $4000 to the seller and $1000 to the government.

Now with no tax a price of $4000 leaves two bidders in the ring so the price must rise higher. In fact, the price must now rise to $5000 to get the second bidder to drop out. Final price to the high bidder is $5000 - the seller gets $1000 more in revenues and the government gets nothing.
This example is misleading because it assumes a totally inelastic supply. The seller is going to sell one pearl and only one pearl no matter what the final price is. So in that case, Alex is absolutely correct. But in the gasoline market I don't think that supply is totally inelastic. It's not hard to work out what happens if supply is somewhat elastic (or if it's not) with your usual Ec 1 supply and demand curves. When the tax is eliminated, buyers pay a lower price, sellers pay a higher price, and quantity sold (bought) increases. This is because, sans tax, buyers are willing to pay a higher price to sellers. Because of higher prices, some sellers decide to reenter the market (or current sellers expand their intensive margins) and so quantity increases. This lowers prices a bit. But Alex could be right if in the very short run gas supply is inelastic. And he is certainly right that the effect is not what the man of the street expects, there should be a price decrease but not by the amount of the tax.


Blogger Isaac said...

Ah yes, I read that post and thought something was wrong, but was too lazy to remember what it was.

11:48 PM  
Anonymous Battlepanda said...

By Alex's logic, raising the gasoline tax will also have no effect on the price, merely leading to a decrease in the producer surplus.


4:18 PM  

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