To make sure you understand how to analyze the impact of : -,i you might find it helpful to work through

one or two exampiS :-. : of this chapter.

A Tax on Petrol
The idea of a large tax on petri
-

itn SZ.S, we explain that

,demand is often more price 'elastic in the lonq run than iin the short run because it takes time for people to change their consumption habits and/or because the demand for a good might be linked to the stock of another good that changes
slowly

government revenue and tc re.:,x. Ii, sumption and the cauntry's de".imports, has been discussed r Let's.see how a lts S-per{itre the price and consumption of p'.,:: We will do this analysis r: :-market conditions during thr when petrol was selling for ab:n:::' litre and total consumption was about 100 million litres per _r.s61: use intermediate-run elasticities: elasticities that would applr' :: r about three to six years after a price change. A reasonable number for the intermediate-run elasticity of ;r-=:-0.5 (see Exarnple 2.3 in Chapter 2). We can use this figure, tog=-_:rer Rs 10,and 100 milion litres/year priCe and'quantity numbers, to ca,riL;m demand cltrve for petrol. You can verify that the foliowing den;:*tr
these data: Petrol demand; QD = 150

5P

Petrol is refined from crude oil, some of which is produced dr =c, some imported. The supply curve for petrol will therefore depenc .,n price of oil, on domestic oil supply, and on the cost of refining. I:* beyond the scope of this example, brrt a reasonable number for r,= supply is 0.4. Yo-u should verify that this elasticibp together n ith ti,t i *. million litreslyear price and quantify, gives the following linear s::::,i
Petrol suyply: Qs = 60 + 4P

tlt

For a review of the procedure for calculating linear curves, see 52.6. Given data

{or price and quantity, as well as estimates of demand and supply elasticities, we can use a two-step procedure to solve for quantity demanded and supplied.

You should also verify that these demand and supply curves ir:.:. price of Rs10 and quantity of 100 million litres/year. We can use these linear demand and supply curves to calculai. :rr, a Rs S0-per-litre tax. First, we write the four conditions that must h: -: by equations (8.1a-d):

QD=150-SPa

(Demand)

Q=60+4Pc
QD=Qs

P6-Pr=$

(Supply) (Supply must equal demand (Government must receive R:

-rn'
i
,,

Now combine the first three equations to equate demand and

:,:' =-.

150*sPe=60+4Ps
14fo

Pu

can rewrite the last of the four equations in the above equation:

as P6 =

+ 5 and

s:i

150-s(Ps+5)=6914P.

10Of course, the price

varied across regions and grades of petrol, but we cc-i. : :

286

PARf

2r

producers, Consumers, and Competitive Markets

Before deciding whether a pekol tax is desirabre, it is important to knor.t,hr,w the resulting deadweight ]oss is likeiy to ue. we farge carcurate :--_r from Figure 8.18. cornbining th* t*o smarl triangles into one rarge one, we r:* a that the area

is

""t';;rili

{1

/2) x

{Rs

E/litre)
= Rs 27.5

(11 million lirres/y-ear) million year

This deadweight loss is,about 6 percent of the government revenue resurtrrg from the tax; and must be balanced against any v r additional benefits that the ur might bring.

SUMMARY
1. Simple models of suppty and demand can be used to
programs/ production quotas or incentive programs to limit output, import tariffs and quotas, ani taxes and subsidies. In each case, consumer and prociucer surplus are usecl to evaiuate the gains and losses to consuiers ancl pro_

ing price controls, minimum prices, price support

analyze a wide variety of government policies, includ_

4, Government intervention generally leads to a cle.: weight loss; even if consumer surpius and produ-_, surplus are weighted equally, there wilt be a net l-*from government poiicies thit shifts surplus from c:,.
will be smali, but in other cases_price supports a:: import quotas are examples_it is large. ti,iu a.r. weight loss is a form of econon-lic inlfficiency ti:
group io the oiher. In some cases, this deadweight i.:s.

2.

ducers-. AppJying themethodology to natural gas price controls, airline regulation, price supports for wileat, and.the sugar quota shows that these gains and losses can be quite large.

must be taken into account when policies u." a"r;g.=_ and implemented.

3. When governnrent

that each group ends up paying or receiving depends on the lelative elasticities of supply and demaid. '

imposes a tax or subsidy, price usu_ ally does nor rise or fall by the fuli amount lfin" tu* o. subsidy. Also, the incidence of a tax or subsidy is usually split between producers and consumers. Tire fraction

5. Government intervention in a competitive mari:_ is not always bad. Government_ani the socieh

represents-might have objectives other than econo::_. efficiency There are also sifuations in which governme . intervention can improve economic efficien& Examp-* are externalities and cases of market failure. These stfu., tions, and the way government can respond to them, a:. discussed in Chapters 16 and77.

ou-ESTloNs FoR REVtEw

t.
ceiling usuaily result_in a dladweight loss? ^ _ Suppose 2. the.supply curve for a [ood is compietely inelastic. If the government impJsed a price ceiling below the market-clearing ievel, would Jdeadweighi ioss result? Explain. 3. can a price ceiling make consurners better Ioy off? Under what conditions might it make them worse off? 4. Suppose the government regulates the price of a good to be no lower than some minimum levei. Can such a minimum price make producers as a whole worse off? Explain. 5. How are production limits used in practice to raise
the prices of the following goods or ,"irri."r, (a) taxi rides, (b) drinks in a restaurant or bar, (c) wheat or rice?

whatis mea-nr o, )rrrrn)rrin rr r

rrr,,

*n

o;"r

o;;

5.

7.
8.

a tariff? Why?

.:rtiT-q:_9d.,Is it preferable to use

Suppose the government wants to increase farrr,e :. incomes. Why do price supports or .rcreage_limjtar. , programs cost society more than simpiy giving ia:: ers money? Suppose the government rvants to limit imports

c:

,,

a,_,

import quota .:

9.

The burden of a tax is shared by producers and cc., sumers. Linder what conditions wiil consumers p_:, most of the tax? Under rt hat conditions will prodr-,i-. pay most of it? What determines the share of a subs,:that benefits consumers? Why does a tax create a deaciweight loss? What dett:_ mines the size of this loss?

CHAPTER

The Analysis of Competitive Markets 285

rearrange this equation and solve for Pr:

SPr+4Pr=150-25-64
SIat Pb = Ps
ice

9P, = 65, or P, = 7.22 5, so Po= 12.22. Finally, we can determine the total

am either the demand

s;'year. This represents an ll-percent decline in petrol consumption. illushates these calculations and the effect of the tax. of this tax would be split roughly evenly between consumers . Consumers would pay about Rs2.22 per litre more for pekol, would receive about Rs 2.78 per litre less. It should not be surthat both consumers and producers opposed such a tax, and representing both groups fought the proposal every time it came up. the tax would raise significant revenue for the government. The would be fQ = 5 (89) = Rs 445 million per vear. to consumers and producers, however, will be more than the Rs 445 ta\ revenue. Figure 8.18 shows the deadweight Ioss from this tax as triangles. The two rectangles A and D represent the total tax coll*re government, but the total loss of consumer and producer surplus

or supply curve. Using the demand curve P, = 12.22),we find that Q = 150 * 5 (12.22) = 150 - 6L, or Q = 99

50

60

89

100

150

Quantity (million litres per year)

8.18 lmpact of

Rs

5 PetrolTax

mrue oi petrol at ihe pump increases from Rs I0 per litre toRsl2.22, and the quantityl :ais rrom 100 to 89 miilion litres/year. Annual revenue from the tax is 5 (89) = Rs 445 Jhe two triangles show the deadweight loss of Rs 27.5 million per year. i;
i