# Economics Model Essay 4

### This question will be discussed in economics tuition in the third week of term 2.

The production of petrol should be left to market forces. In spite of this, some governments subsidise petrol while others impose a tax on it. Discuss. [25]

### Introduction

The demand for a good is the quantity of the good that consumers are able and willing to buy at each price over a period of time, ceteris paribus. The supply of a good is the quantity of the good that firms are able and willing to sell at each price over a period of time, ceteris paribus. The question on why some governments subsidise petrol while others impose a tax on it can be discussed with reference to the concepts of the market forces of demand and supply, allocative efficiency, negative externalities, tax revenue, market dominance and affordability.

### Market Forces of Demand and Supply

The market forces of demand and supply determine the allocation of resources in a market economy. An equilibrium is a state where there is no tendency to change. If consumers demand more of a good, the quantity demanded will exceed the quantity supplied at the initial price, assuming the market is in equilibrium. The resultant shortage will push up the price. This is because when firms do not produce enough to sell, they can raise price without losing sales. Therefore, they will do so to increase their profits. A rise in the price of the good will incentivise firms to increase the production due to the higher profitability and consumers to decrease the consumption due to the higher relative price and the lower real income. Therefore, the quantity supplied will rise and the quantity demanded will fall. The price will continue rising until the quantity demanded is equal to the quantity supplied, at which point the shortage is eliminated and a new equilibrium is established. At the new equilibrium, the output level will be higher than that at the initial equilibrium. Therefore, a larger amount of resources will be allocated to the market.

In the above diagram, given the demand (D0) and the supply (S0), the price and the quantity are P0 and Q0. When the demand increases from D0 to D1, although the quantity demanded rises at the same price (P0), the quantity supplied remains at Q0 and this results in a shortage. As the price rises, the quantity demanded falls and the quantity supplied rises and this process continues until the price rises to P1 where the quantity demanded and the quantity supplied are equal at Q1. Similarly, if firms supply more of a good, the quantity supplied will exceed the quantity demanded at the initial price, assuming the market is in equilibrium. The resultant surplus will push down the price. This is because when firms cannot sell all the output that they produce, their stocks will build up. Therefore, they will lower price to reduce their stocks. A fall in the price of the good will incentivise firms to decrease the production due to the lower profitability and consumers to increase the consumption due to the lower relative price and the higher real income. Therefore, the quantity supplied will fall and the quantity demanded will rise. The price will continue falling until the quantity demanded is equal to the quantity supplied, at which point the surplus is eliminated and a new equilibrium is established. At the new equilibrium, the output level will be higher than that at the initial equilibrium. Therefore, a larger amount of resources will be allocated to the market.

In the above diagram, given the demand (D0) and the supply (S0), the price and the quantity are P0 and Q0. When the supply increases from S0 to S1, although the quantity supplied rises at the same price (P0), the quantity demanded remains at Q0 and this results in a surplus. As the price falls, the quantity demanded rises and the quantity supplied falls and this process continues until the price falls to P1 where the quantity demanded and the quantity supplied are equal at Q1.

### Market Forces and Allocative Efficiency

In the absence of externalities, the market forces of demand and supply will allocate resources efficiently, assuming no market dominance, information failure, public goods and immobility of factors of production. Allocative efficiency is achieved when it is impossible to change the allocation of resources in the economy in a way that will increase the welfare of society. This occurs when marginal social benefit (MSB) is equal to marginal social cost (MSC) where MSB is the sum of marginal private benefit (MPB) and marginal external benefit (MEB) and MSC is the sum of marginal private cost (MPC) and marginal external cost (MEC). External costs and benefits, or externalities, are costs and benefits of consumption or production experienced by society other than the producers or the consumers. Consumers consider only private costs and benefits. This means that demand is MPB. Similarly, firms do not take into account external costs and benefits. It follows that supply is MPC. Therefore, when demand is equal to supply, MPB will be equal to MPC. In the absence of externalities, and given the above assumptions, MSB will be equal to MSC which will lead to allocative efficiency.

In the above diagram, due to the absence of external benefits, the MSB is equal to the MPB, and due to the absence of external costs, the MSC is equal to the MPC. As a result, the equilibrium output level (QE) where MPB is equal to MPC is equal to the allocatively efficient output level (QAE) where MSB is equal to MSC.

### Objective of Tax: Correct Market Failure (Negative Externalities)

Governments may impose a tax on petrol to correct the problem of over-consumption due to negative externalities. The consumption of petrol produces negative externalities. For example, it leads to air pollution in the form of carbon emissions and this leads to a divergence between the MSC and the MPC resulting in over-consumption. A tax on petrol will lead to a rise in the cost of production and hence a fall in the supply. When this happens, the price will rise which will lead to a fall in the quantity demanded. In this way, a tax on petrol induces consumers to internalise the external costs. For example, the Singapore government imposes a tax on petrol partly to reduce the consumption.

In the above diagram, due to external costs, the MSC is higher than the MPC. Therefore, QE is higher than QAE. A tax on petrol will lead to a rise in the MPC. If the MPC after tax is MPC’, the new equilibrium output level (QE’) will be equal to QAE.

### Objective of Tax: Increase Tax Revenue

Governments may impose a tax on petrol to raise tax revenue. The demand for petrol is price inelastic due to the high degree of necessity and lack of close substitutes. A tax on petrol will lead to a rise in the cost of production and hence a fall in the supply. When this happens, the rise in the price is likely to lead to a small fall in the quantity demanded and this is likely to result in a large increase in tax revenue. For example, the Japanese government imposes a tax on petrol partly to raise tax revenue.

In the above diagram, a tax on petrol leads to a decrease in the supply (S) from S0 to S1. Due to the inelastic demand which gives rise to the relatively steep demand curve (D0), the decrease in the quantity demanded (Q) from Q0 to Q1 is small.

### Limitations of Tax

Imposing a tax on petrol to correct the problem of over-consumption due to negative externalities or to raise tax revenue has its limitations. First, for a tax on petrol to correct the market failure, it must be equal to the marginal external cost, assuming no other causes of the market failure. However, it is difficult to precisely measure the marginal external cost of petrol consumption. Therefore, a tax on petrol may not be equal to the marginal external cost and hence may not correct the market failure. Second, a tax on petrol expressed as a percentage of income is higher for low income individuals than for high income individuals. Therefore, a tax on petrol is regressive and hence worsens income inequity.

### Objective of Subsidy: Correct Market Failure (Market Dominance)

Governments may subsidise petrol to correct the problem of under-production due to market dominance. Market dominance occurs when the firm or firms in a market have substantial market power which leads to under-production. An example of a firm with substantial market power is Microsoft Corporation in the market for PC operating systems. Market dominance occurs due to high barriers to entry in monopolistic and oligopolistic markets. To maximise profit, a firm with substantial market power restricts output and charges a price higher than its marginal cost resulting in under-production. In the case of monopoly, the demand for the good is likely to be price inelastic due to lack of close substitutes and hence the difference between the price and the marginal cost, which is a measure of the extent of allocative inefficiency, is likely to be large.

In the above diagram, the allocatively efficient output level where MSB is equal to MSC, or price (P) is equal to marginal cost (MC), is QAE. However, if the firm increases output beyond Q0 where MC is equal to MR, the increase in total cost will be greater than the increase in total revenue as MC will be higher than MR. If this happens, profit will fall. Therefore, the firm restricts the output level to Q0 which is lower than QAE and charges a price (P0) higher than the marginal cost (MC0). The less price elastic the demand and hence the steeper the demand curve is, the larger will be the difference between the price and the marginal cost. A per-unit subsidy will lead to a fall in MC. If the MC curve after subsidy is MC’, the profit-maximising output level (Q1) will be equal to QAE and the price (P1) will be equal to the MC (MC1).

### Objective of Subsidy: Increase Affordability

Governments may subsidise petrol to increase the affordability. Petrol may have a high degree of necessity to the mass of the population in a country where many people own private motor vehicles. In such a country, a high price of petrol is likely to lead to hardship for the people especially if many owners of private motor vehicles are poor households. A subsidy on petrol will lead to a fall in the cost of production and hence a rise in the supply. When this happens, the price will fall which will lead to an increase in the affordability. For example, the Malaysian government subsidises petrol to increase the affordability.

### Limitations of Subsidy

Subsidising petrol to correct the problem of under-production due to market dominance or to increase the affordability has its limitations. First, to make more profit, the monopoly may provide false information about its cost structure to the government by overstating its marginal cost. If this happens, the use of subsidy in a monopolistic market will not achieve allocative efficiency. Second, subsidising petrol puts a strain on the government budget which may compel the government to decrease expenditure on other important areas such as education and infrastructure to avoid a budget deficit and this may result in adverse consequences for the economy in the long run.

### Evaluation

In the final analysis, the main purpose of a tax on petrol is likely to correct the problem of over-consumption rather than to raise tax revenue. A tax on petrol is typically imposed in a developed economy such as Singapore. In such an economy, due to the affluence of the people, a high premium in placed on a clean environment and hence a tax on petrol is likely to substantially increase the welfare of the people. The main purpose of a subsidy on petrol is likely to increase the affordability rather than to correct the problem of under-production. A subsidy on petrol is typically given in a developing economy such as Malaysia. In such an economy, many poor households own private motor vehicles due to a poor public transport system and hence a subsidy on petrol is likely to substantially reduce the hardship of the people. Apart from tax and subsidy, the government can also use other measures such as regulation and direct provision to deal with the problems arising from resource allocation in the petrol market. However, like tax and subsidy, they are also subject to limitations, despite their strengths. To overcome this problem, the government should adopt a policy mix. The use of a policy mix allows the strengths of some measures to compensate for the limitations of other measures. This will eliminate their limitations and improve on their strengths resulting in greater effectiveness. Therefore, the use of a policy mix to deal with the problems arising from resource allocation in the petrol market is likely to be more effective than the use of any single policy.

The question will be discussed in greater detail in economics tuition by the Principal Economics Tutor.

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