1. a) Assume the long run elasticity of demand for gasoline is -0.25 and start w

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.

Elasticity of demand = % change in gasoline demanded / % change in gasoline Price

-.25 = -50%/% change in gasoline Price

% change in gasoline Price = 50%/-.25 = 200%

Then the new price = 3.1*(1+200%) = $9.3

Hence, price increase up to $9.3 per gallon to reduce the consumption or demand by 50%.

B.

Short run effect will be less as people in short run:

C.

% change in income = (90000 – 45000)/45000 = 100%

Hence, there should be 100% increase in relative tax.

D.

The larger share of income and it is the example of progressive tax.

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