1. a) Assume the long run elasticity of demand for gasoline is -0.25 and start w
ID: 1105835 • Letter: 1
Question
1. a) Assume the long run elasticity of demand for gasoline is -0.25 and start with the current California price of gasoline of $3.10 per gallon. How much would we need to increase the price in order to cut gasoline use in half in the long run?
b) Explain in a few sentences why you would expect the short run effect of the tax to be much less.
c) Suppose the income elasticity of demand for gasoline is 0.95. How much more tax (expressed as a percentage of dollars paid, e.g. a payment of $210 is 5% more than a payment of $200) will a household with an income of $90,000 make relative to a household with an income of $45,000?
d) Does your answer to (c) imply that the richer household loses a larger or smaller share of their income to the gasoline tax? Is this progressive or regressive?
Explanation / Answer
a) Thus we need the change in demand to be -50%. The elasticity of demand in this case is -0.25. Thus the price elasticity of demand is given by Ed= percentage change in quantity demanded/percentage change in price. Thus if demand is to be cut in half the price needs to increase by 200%.
b) In the short run demand is generally inelastic particularly for goods like gasoline and so this will mean that demand will take time to respond. Thus the short run effect of the tax will be less than in the long run due to inelastic demand.
c) The change in income in this case is $45000. Thus income rises by 100%. This is the change in income. The change. The change in demand is 95%. The extra tax payable would thus be dependant on the tax rate. This is not given here.
d) The tax rate is not given. Insufficient information.
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