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Monday, September 05, 2005

Gas Tax Economics 201

If any of my (few) readers are knowledgeable about economics, and the economics of gas prices in particular, please chime in.

In support of my earlier post, calling for a temporary suspension of gas taxes, I wanted to explain why I though this would work. I have read a counter-argument that because gasoline is a commodity, it will rise to the pre-tax cut price.

My (admittedly limited) understanding of gas price economics goes like this: There is an international market for oil, price X. Refiners refine the oil into a finished product such as gasoline (or diesel), blend it as necessary, and sell it to retailers at some price, which is X+margin+fuel tax. Retailers get the gasoline, mark it up for retail, and sell it at (x+margin+fuel tax) + retail margin. The core price, X, is set by international demand and market economics, such as speculation. The refined fuel price is set also by refining capacity. The gas pump price is changed mostly by local effects, such as local runs or local competition.

I have heard that the gas station business is a low margin business, and the real money is all made on beer, cigarettes, coffee, and junk food. The primary price mechanism happens at the distributor level.

So my prediction is, that if the federal and state fuel tax applied to the refined product was dropped, the price of gas at the pump would drop by about that amount, unless increased demand caused the refiners to increase the price to the retailers.

6 comments:

Aaron said...

Pretty solid analysis here. You could also look at gasoline manufacturers like Chevron as vertically integrated firms - they do everything in the production process from exploration, extraction, refining and retail. Don't look at the gasoline retailers as the sales entity, but the petro industry as a whole.

Also - speculation is the key. The US dollar isn't doing so hot. Instead of measuring oil in dollars, what if we measured dolars in oil?


The local shocks - look at gas hitting 6 bucks a gallon in the Southern US.

Anonymous said...

I think the analysis is flawed in one respect: it assumes that the international price would remain fixed. The current price pressure is due to a supply issue. So dropping the tax would allow demand to increase, or at least the perception that demand would increase, and the world oil markets would see this as more pressure on supply. The increase pressure on the supply would raise the price.

I suspect dropping the tax would result in a "no net change" or perhaps even in a slight increase in consumer prices. Look what happens when there is just a hint of a supply change.

An alternative that I have heard is to actually increase the tax. This drives demand down and the markets adjust the raw price downward. Then the government can pocket the money and apply it for useful purposes (yeah, right) such as alternative fuel development. Granted there would be a short term hit to price, but the full tax could be phased in slowly.

Steve Ward said...

For a good discussion of the gas tax idea, see the EconoLog blog, located at http://econlog.econlib.org/#000704.

Anonymous said...

There is no international market for refined gasoline. There's not even a national market. The only national/international market is for the basic categories of crude oil.

Gasoline specifications vary region by region, state by state, and city by city...sometimes even block by block. It's an insane crazy-quilt of inconsistent regulations of things like octane, pollution, volatility, and the like.

The primary determinant of price is not crude price or distribution, but refining capacity. Reducing a retail tax will have little impact on price mechanisms at the interim refining stage. Reducing taxes will, in fact, reduce retail costs on close to a 1-for-1 basis. There is nothing in economic theory to suggest that raising taxes lowers NET costs, or vice versa.

The Auto Prophet said...

One minor quibble: I believe there is an international market in refined gasoline, in the sense that there is a market in any commodity. If refining capacity is too low, arrangements can be made to import refined oil products.

Jay said...

If I recall my microeconomics correctly (and God knows it's been a while), the price would fall somewhere in between the current price and the current price minus taxes.

Where exactly it would fall would depend on how elastic the demand for gasoline is, that is, how dependent the quantity demanded is sensitive to price. For instance, the demand for cigarettes is very inelastic (high prices don't reduce Q all that much; the demand curve is steep), so a repeal of cigarette taxes would bring down the price nearly as much as the amount of the taxes.

I don't know how elastic the demand for gasoline is, but seeing how little effect a doubling in price over the past few years has had on activity, I'd have to guess it's pretty inelastic.