Energy Taxes and Subsidies

7/27/2019 Energy Taxes and Subsidies

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Energy Taxes, susidies andsupport prices

Haripriya GundimedaHS 416

Energy Economics



World wide Gasoline Prices



EVALUATING THE GAINS AND LOSSES

FROM GOVERNMENT POLICIES —

CONSUMER AND PRODUCER SURPLUS

• Review of Consumer and Producer Surplus

Consumer A would pay $10for a good whose market

price is $5 and thereforeenjoys a benefit of $5.

Consumer B enjoys a benefitof $2,

and Consumer C , who valuesthe good at exactly themarket price, enjoys no

benefit.

Consumer surplus, whichmeasures the total benefit toall consumers, is the yellow-shaded area between thedemand curve and themarket price.

Consumer and Producer

Surplus






• Review of Consumer and Producer Surplus

Producer surplus measuresthe total profits of producers,

plus rents to factor inputs.It is the benefit that lower-cost producers enjoy byselling at the market price,shown by the blue-shadedarea between the supplycurve and the market price.

Together, consumer andproducer surplus measurethe welfare benefit of acompetitive market.

Consumer and Producer

Surplus (continued)






• Application of Consumer and Producer Surplus

The price of a good has beenregulated to be no higher thanP max, which is below themarket-clearing price P 0.

The gain to consumers is thedifference between rectangle A and triangle B.

The loss to producers is thesum of rectangle A and triangleC .

Triangles B and C togethermeasure the deadweight lossfrom price controls.

Change in Consumer and Producer

Surplus from Price Controls

Figure 9.2● deadweight loss Net loss of total

(consumer plus producer) surplus.




FROM GOVERNMENT POLICIES — CONSUMER AND PRODUCER

SURPLUS

If demand is sufficientlyinelastic, triangle B can be

larger than rectangle A. In thiscase, consumers suffer a netloss from price controls.

Effect of Price Controls When

Demand Is Inelastic



EVALUATING THE GAINS AND LOSSES FROM GOVERNMENT POLICIES —


Supply: QS = 15.90 + 0.72PG + 0.05P O

Demand: QD = −10.35 − 0.18PG + 0.69P O

The market-clearing priceof natural gas is $6.40

per mcf, and the(hypothetical) maximumallowable price is $3.00.

A shortage of 23.6 − 20.6

= 3.0 Tcf results.

The gain to consumers isrectangle A minus

triangle B,

and the loss to producersis rectangle A plustriangle C .

The deadweight loss isthe sum of triangles B plus C .

Effects of Natural Gas Price

Controls



Types of taxes

• Most governments finance the bulk of their spending through

taxes• A consumption value added tax is placed on sales minus

purchases from other firms

• Energy companies pay corporate taxes,

• Payroll or social security taxes

• Sales taxes and

• Value added taxes just like other companies

• Often necessities are exempt or have lower sales tax rates tomake them less regressive



Types of taxes

• Severance taxes - taxes on producing the resource or severing it from the

earth (applied at the production level).• Governments receive a royalty, if they lease their mineral rights to someone

else to produce

• Other energy taxes are applied as tariffs when energy is traded across borders and

• excise taxes when energy is sold to final consumers, such as the gasoline

tax.• The most heavily taxed energy sources are oil products.

• Two categories of taxes - direct and indirect.

• Direct taxes are on people and institutions. They include personal andcorporate income taxes as well as payroll taxes for social insurance programs such as unemployment compensation, medicare and social

security taxes.• Indirect taxes, are taxes on products and include the special taxes on energy

products. Excise taxes, tariffs, and severance taxes are all taxes on products.



Subsidy on LPG and Kerosene



Electricity Subsidies



THE EFFICIENCY OF A COMPETITIVE MARKET

When price is regulated to beno lower than P 2, only Q3 willbe demanded.

If Q3 is produced, thedeadweight loss is given bytriangles B and C .

At price P 2, producers wouldlike to produce more than Q3.If they do, the deadweight

loss will be even larger.

Welfare Loss When Price is Held

Above Market-Clearing Level



MINIMUM PRICES

Price is regulated to be no lowerthan P min.

Producers would like to supply Q2,

but consumers will buy only Q3.

If producers indeed produce Q2,the amount Q2 − Q3 will go unsoldand the change in producersurplus will be A − C − D. In this

case, producers as a group maybe worse off.

Welfare Loss When Price is Held

Above Market-Clearing Level



PRICE SUPPORTS AND PRODUCTION QUOTAS

To maintain a price P s above the

market-clearing price P 0, thegovernment buys a quantity Qg.

The gain to producers is A + B +D. The loss to consumers is A +B.

The cost to the government is thespeckled rectangle, the area ofwhich is P s(Q2 − Q1).

Price Supports

● price support Price set by government above freemarket level and maintained by governmentalpurchases of excess supply.

Total change in welfare: ΔCS + ΔPS − Cost to Govt. = D − (Q2 − Q1)P s



PRICE SUPPORTS AND PRODUCTION QUOTAS

To maintain a price P s above themarket-clearing price P 0, thegovernment can restrict supply toQ1, either by imposing productionquotas or by giving producers afinancial incentive to reduce output

For an incentive to work, it must beat least as large as B + C + D,which would be the additional profitearned by plant, given the higherprice P s. The cost to thegovernment is therefore at least B +C + D.

Supply Restrictions

ΔWelfare = − A − B + A + B + D − B − C − D = −B − C

• Price Quotas

ΔCS = − A − B

ΔPS = A − C + Payments for not producing (or at least B + C + D)



IMPORT QUOTAS AND TARIFFS

In a free market, the domestic

price equals the world price P w .

A total Qd is consumed, of whichQs is supplied domestically andthe rest imported.

When imports are eliminated,the price is increased to P 0.

The gain to producers istrapezoid A.

The loss to consumers is A + B + C , so the deadweight loss is B + C .

Import Tariff or Quota That

Eliminates Imports

● import quota Limit on the quantity of a

good that can be imported.● tariff Tax on an imported good.



IMPORT QUOTAS AND TARIFFS

When imports are reduced, thedomestic price is increased fromP w to P *.

This can be achieved by aquota, or by a tariff T = P * − P w .

Trapezoid A is again the gain todomestic producers.

The loss to consumers is A + B + C + D.

If a tariff is used, thegovernment gains D, the

revenue from the tariff. The netdomestic loss is B + C .

If a quota is used instead,rectangle D becomes part of theprofits of foreign producers, andthe net domestic loss is B + C +D.

Import Tariff or Quota (General Case)



THE IMPACT OF A TAX OR SUBSIDY

P b is the price (including thetax) paid by buyers. P s is theprice that sellers receive, lessthe tax.

Here the burden of the tax is

split evenly between buyersand sellers.

Buyers lose A + B.

Sellers lose D + C.

T he government earns A + D in revenue.

The deadweight loss is B + C .

Incidence of a Tax

Figure 9.17

● specific tax Tax of a certain amount of money per unit sold.

Market clearing requires four conditions to be satisfied after the tax is in place:QD = QD(P b) (9.1a)

QS = QS(P s) (9.1b)

QD = QS (9.1c)

P b

− P s

= t (9.1d)




If demand is very inelastic relative tosupply, the burden of the tax fallsmostly on buyers.

Impact of a Tax Depends on Elasticities of Supply and Demand

Figure 9.18

If demand is very elastic relative tosupply, it falls mostly on sellers.




A subsidy can be thought ofas a negative tax. Like a tax,

the benefit of a subsidy issplit between buyers andsellers, depending on therelative elasticities of supplyand demand.

Subsidy

Conditions needed for the market to clear with asubsidy: QD = QD(P b) (9.2a)

QS = QS(P s) (9.2b)

Q

D

= Q

S

(9.3c)P s − P b = s (9.4d)

● subsidy Payment reducing the buyer’s price below

the seller’s price; i.e., a negative tax.




Effect of a Rs 1.00-per-litre tax:

Q

D

= 150 – 25 P b (Demand)QS = 60 + 20 P s (Supply)

Q D = QS (Government must receive Rs1.00/litre)

Supply must equal demand)

P b – P s = 1.00150 − 25 P b = 60 + 20 Ps

P b = P s + 1.00

150 − 25 P b = 60 + 20 P s

20 P s+ 25 P s = 150 – 25 – 6045 P s = 65, or P

s = 1.44

Q = 150 – (25)(2.44) = 150 – 61, or Q = 89 bg/yr

Annual revenue from the tax tQ = (1.00)(89) = Rs 89 billion per year

Deadweight loss: (1/2) x (Rs1.00/litre) x (11 billion litres/year =Rs5.5

billion per year




Gasoline demand : QD = 150 25P

Gasoline supply : QS = 60 + 20P

The price of gasoline atthe pump increases from$2.00 per gallon to

$2.44, and the quantitysold falls from 100 to 89bg/yr.

Annual revenue from thetax is (1.00)(89) = $89billion (areas A + D).

The two triangles show

the deadweight loss of$5.5 billion per year.

Impact of Rs1 Gasoline

Tax

Figure 9.20



Modeling Taxes in a Competitive Market

• Let demand and supply for Lignite be given by

• Qd = 18 – 2Pd

• Qs = -6 + Ps

• P is measured in $/s.ton and Q is measured 100,000 tons.

• If we want price in terms of quantity, we can invert to get

• Pd = 9 – 0.5Qd

• Ps = 6 + Qs

• Or solving for the price that makes supply equal to demand 18- 2P = -6 + P − > equilibrium

• P = 8 and Q = 2. In the units designated above that would be$8 per metric ton with a production of 200,000 tons.



02

4

6

8

10

12

14

16

18

20

0 2 4 6 8 10 12 14

Pd

Ps

Supply and demand in an energy industry



Effect of unit tax on the product

• Pd = ps + t• Pd = 9 – 0.5Qd = Ps+1 = 6 + Qs + 1

• At equilibrium Qd = Qs = Qe

• Qe = 1.33

• Pd = 8.33

• Ps = 7.33



0

2

4

6

810

12

14

1618

20

0 2 4 6 8 10 12 14

Pd

PsPs + t

Demand and Supply with Unit Tax on the Producer

Quantity demanded

P

R

IC

E

1.33

7.33

8.33



Who pays what?

• Who pays this tax? We can see that demand pricegoes up from $8 to $8.33.

• So consumers of this energy product pay $0.33 of thetax.

• Supply price falls from $8 to $7.33

• So producers pay $0.67 of the tax.

• Government revenues from the tax equal Q*t =1.33*$1 = $1.33.

• Now suppose that we collect the tax from theconsumer.

• Then the consumer pays the tax and what theconsumer is willing to pay to the supplier is Pd - t.



0

2

4

6

8

1012

14

16

18

20

0 2 4 6 8 10 12 14

Pd

Ps

pd -t

Demand and Supply with Unit Tax energy on consumer



Who absorbs the tax?

• Totally determined by the responsiveness of suppliers and

demanders, we can tell who absorbs the tax by demand andsupply elasticities.

• suppose that the demand and supply elasticities and the tax are

• εd = −0.5.

• ε s = 1

• t = $0.75.

We must be in equilibrium before and after price changes hence

dqd = dqs

Old demand quanty and old supply quantity are the same, so they

cancle

If we start with no tax, old demand price and old supply price are

the same and can also be cancelled



Who absorbs the tax?

• The increase in demand price minus the decrease in supply

price must equal the tax or• dPd – dPs = 0.75

• The solution tells us that with a $0.75 tax per unit,

• supply price falls by 0.25 and

• Demand price goes up by 0.50.

• Thus, the more elastic supplier pays less than the moreinelastic demander.

• In general the larger the elasticity of supply, the larger will bethe change in the demand price.

• Or in other words, the more responsive are suppliers, the morethey can pass the tax on to demanders.

• Similarly the more responsive are demanders, the more theycan pass the tax back to suppliers.



Incidence of a Unit or Volume tax



Dead weight loss from a tax

• Consumer and Producer Surplus Show Deadweight Loss from

a Tax.• In most cases energy taxes decrease quantity consumed,

increase demand price and decrease supply price causing amarket distortion.

• To measure this distortion we consider two measures of socialwelfare –

• consumer surplus

• and

• producer surplus.



Consumer surplus

• Assume there are no externalities in this market.

• Thus, neither the production nor the consumption of thisenergy product causes costs or benefits outside of this market.

• Think of the demand curve as being a marginal benefit curve

• For example, if the demand price is $8.5,

• we sell Qd = 18 - 2*8.5 = 1 unit.

• Then someone must value that first unit by at least $8.5.

• If the price is $8, we can sell Qd = 18 - 2*8 = 2 units.

• Someone must value that second unit by at least $8 and so on.

• At the market price of $8, the person who values that first unit

at $8.5 is getting it at $8 and is getting a surplus of $0.50.• Thus, consumer surplus is the difference between what a

consumer would be willing to pay and what they actually pay.

• In the continuous case, we measure it as the area under thedemand curve and above the price.



Producer Surplus

• On the supply side, suppose that we have a competitive market in whichfirms maximize profits.

• In a competitive market each firm is so small that they take the price asgiven.

• In a competitive market supply equals marginal cost

• Then to see supplier welfare, take the supply curve or the marginal costcurve to be MC =P = 6 + Qs.

• The marginal cost of the first unit MC = 6 + 1 = $7,• MC of the second unit = 6 + 2 = $8 and so on.

• At equilibrium, two units are sold at $8.

• However, the first unit only cost $7 to produce leaving that supplier with asurplus of 1.

• In the continuous case, we measure this producer surplus by the triangle bcd.

• Thus, producer surplus at equilibrium in this market equals ($8 - $6)*2*0.5= $2.

• The sum of producer plus consumer surplus = $3,



Producer and consumer surplus in a competitive market



Deadweight loss from an energy tax



Deadweight losses are smaller than Less Elastic Demand

i f



Design of taxes

• In the inelastic market, quantity demanded stays the same.Government revenue goes up PePtbc.

• Although consumers lose this amount of benefit, there are nodeadweight loses.

• In the alternate market 2, quantity demanded falls.

• Government revenues are only PePtad.

• This amount is smaller than the loss in consumer surplusPePtac. Deadweight losses of acd are incurred.

• Thus, there are no deadweight losses in the case of perfectlyinelastic demand and such losses get larger the more elastic isdemand.

• The implication of the result illustrated by this simpleexample, first worked out by Ramsey (1927), is that

• Commodity taxation rates should be higher for commoditieswith more inelastic demand.



Energy Subsidies• The opposite of an energy tax would be an energy subsidy.

• One way of supporting the industry is to buy up coal and raise its price.

• A simpler way to support the market is to simply pay producers so much per ton of production.

• To see how subsidy payments work, take the coal market example

• Demand: Qd = 66 − 2Pc.

• Supply: Qs = −4.6 + 1Pc.

• Inverse Demand: Pd = 33 − 0.5Qd.• Inverse Supply: Ps = 4.6 + Qs.

• Equilibrium P and Q can be solved from

• 33 − 0.5Q = 4.6 + Q => Qe = 18.93.

• Substituting Qe = 18.93 back into the demand or supply equation yields Pe= $23.53.

• If the government subsidized coal $3 per ton, the supplier would receivewhat the consumer pays plus the subsidy.

• One intuitive way to view the subsidy is to add it to demand Instead ofadding tax to the supply price.



Coal subsidies varied by supplier



Energy subsidies

• To see what happens in the $3 subsidy case, we know that

• Pd + 3 = 33 − 0.5Qd + 3 = Ps = 4.6 + Qs.

• Solving for equilibrium quantity Qd = Qs = 20.93 and atthese quantities Pd = $22.53, Ps= $25.53.

• Who received the subsidy in this case?• Consumer price fell from $23.53 to $22.53.

• So the consumer received $1 or 1/3 of the subsidy.Producer price increased from $23.53 to 25.53 so

producers received $2 or 2/3 of the subsidy.

• Thus, demanders are the more elastic side of the marketand, as with the tax, they receive

• the smaller share of the subsidy.

• The cost of the subsidy to the government is unit subsidytimes coal production = 3*20.93 = $62.8.

Energy Taxes and Subsidies

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