Market equilibrium is defined as the point on a supply and demand graph where supply is equal to demand. In the case being examined in this paper, the equilibrium price is $3.00, because while demand is 6,000 units, supply is also 6,000 units. The three cases to be examined below are: 1) a $1.00 tax is levied on each gallon of gas consumed; 2) a $2.00 tax is levied on each gallon of gas produced; and 3) a $2.00 per gallon subsidy is levied on the production of alternative fuels. The graph reflecting supply and demand curve shifts for each of these scenarios is attached.
Case 1: A $1.00 tax is levied on each gallon of gas consumed
In this case, a tax is being levied on the gas that consumers purchase at their local gas station. The type of tax being levied in this situation is known as an excise tax, because it is being applied to only one good and not all goods in the market. The demand curve for a good automatically shifts downward by the amount of the tax levied. This is why the demand curve in graph no. 1 shifts downward by exactly $1.00, and the price of gasoline goes from P0 to P1. Over time, consumption reduces by the amount of the tax levied. Because of the tax on gasoline, however, demand for this product also falls. In this case, price shifts along the demand curve from Q0 up to Q2. The fact that less is demanded will also reduce the price, though, because suppliers will be producing the same amount and will need to sell the same amount. The best way to sell the same amount of a less demanded product is to reduce the price of it. This can be seen as a shift along the supply curve from E0 to E2 occurs.
In order to determine where exactly this new equilibrium is, we must see where the supply curve intersects with the new demand curve. As it appears, the new quantity of gasoline that will be demanded is about 5,000 units, and the new price for the gasoline demanded will be about $2.50. At P0 there is excess supply, but at P1, there is excess demand. The tax to consumers discourages consumption of gasoline, and as a result, gasoline becomes cheaper. Since the price falls by $0.50, then the price of gasoline to consumers when a $1.00 tax is levied on each gallon of gas consumed is not actually inflated by a full dollar, but by only fifty cents. Therefore, the new equilibrium price does not reflect the entire cost of the tax, because the curve shifts makes up for half of it.
Case 2: A $2.00 tax is levied on each gallon of gas produced
This case involves a tax on each gallon of gas produced instead of consumed. When this is the case, the supply, and not the demand, curve shifts. This is the same excise tax as before, and as a result, the supply curve shifts upward by exactly the amount of the tax, $2.00, from P0 to P1. Since gasoline has now become $5.00 a gallon, demand for it is going to reduce significantly. This will cause a shift in price along the demand curve from Q0 up to Q2, at about 4,000 units. Less people will be demanding gasoline because the price is higher, but because the tax levied is on gasoline produced, suppliers will also produce less of it to begin with. Suppliers realize, though, that in order to avoid ending up in the realm of excess supply, they will have to reduce prices, which is why the price shifts down along the supply curve from $5.00 to $4.00. Areas of excess supply occur anywhere gasoline has a price of more than $4.00. Similarly, areas of excess demand occur anywhere the price of gasoline is below $4.00.
The new point of market equilibrium, therefore, is found at a price of $4.00, with 4,000 units being demanded. Notice that the price only increased by one dollar, though, instead of the amount of the tax, which was two dollars. Because the new point of market equilibrium, E2, is only one dollar higher than before, E0, it does not reflect the entire cost of the tax. The one dollar change is less than the cost of the tax.
Case 3: A $2.00 per gallon subsidy is levied on the production of alternate fuels
In this case, the application being made is that of a subsidy, instead of a tax. Subsidies act like the opposite of a tax, in that they decrease the cost of goods to consumers and in effect increase the demand for those goods. Being examined here is a $2.00 subsidy on each gallon of alternative fuels produced. Because subsidies act in a manner opposite of an excise tax, the supply curve will shift from P0 down precisely $2.00 to P1, or, the amount of the subsidy. This creates supply curve S1, seen in graph no. 3. Because the new fuel is cheaper to produce, suppliers are able to produce more of it given the same inputs as before. This explains the shift along the supply curve from 6,000 units at Q0 to 8,000 units at Q2. With additional supplies, however, comes a dip in price, which explains the shift down along the demand curve from $3.00 to $2.00. This creates a new point of market equilibrium at E2.
Areas of excess demand are those where the price of these alternative fuels is less than $2.00, and areas of excess supply are found where the price of the same good is anything above $3.00. The idea of this subsidy was to lower the price of manufacturing alternative fuels by $2.00 per gallon, however consumers felt much less—only half—of this subsidy, only benefiting by a price drop of $1.00.
Creating a sensible energy policy The results of these taxes and subsidies lead to several obvious conclusions. In order for the US to develop a more sensible energy policy, all three of these policies need to be adopted. If they are, then scenario 1 would reduce demand for gasoline because consumers would want less of a higher priced good, scenario 2 would further reduce demand because the price of gasoline would climb even further as suppliers manufacture less, and scenario 3 would promote the production and consumption of fuels other than gasoline. Each of these effects would serve to decrease US dependence on foreign oil, and increase the country’s consumption of eco-friendly fuels.
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