Price elasticity of gasoline, again

A number of readers seem to be confused by my previous post on who gets the benefit of a gas tax holiday. If inelastic demand means that the consumers are paying a lot of the gas tax, how come when we lower the gas tax, they don't get that money back?

Because the supply curve is kinked, that's why.

gascurve.jpg

Supply is elastic on the downside--companies can take the stuff off the market and store it if they don't like the price, or throttle back their refineries. But there's no way to expand the supply, because Americans can't import gasoline from abroad; each mix must be specially formulated to the air quality regulations of its regulatory region.

Because supply is unresponsive to price on the upside, and prices are already quite high enough for companies to make a profit, the price of oil is currently basically set by consumer demand: they bid the price up to the point where they want to consume the maximum amount that refineries can supply. Oil companies can't sell more gasoline by lowering prices, and they also will not sell any less gasoline, because the current price is the price at which consumers want to consume all the gasoline they produce. Hence, if you lower the tax, the price stays the same, and 18.4 cents goes to the oil companies for every gallon.

Now, one might say that this is good because it will incent them to find more oil. But this is not, in my opinion, a very good argument. First of all, we're also considering mucking around with windfall taxes, which are a much bigger disincentive to invest than any piddling 18.4 cents per gallon. Second of all, oil companies can discover more oil, but they are hard put to increase refinery capacity, because no one wants any refineries near anyone; virtually all of our refineries are decades old, with improvements coming from throughput enhancement rather than new built capacity. The limiting factor on gasoline right now is refinery capacity, not oil supplies. And third of all, they're already making really quite a lot of money. We don't need to give them even more.

Fourth of all, of course, a gas tax is a user fee for roads, which is good, and also encourages people to invest in more fuel efficient cars, which I think is also good. So it's a rare example of a tax that should be much higher, not lower, IMHO.

Why is this getting so much attention? Does it really matter? Well, I don't think that fiddling with the gas tax is going to bring the US economy to its knees. But it offers some interesting lessons about markets and elementary price theory, which many of my readers seem to be interested in. Also, I really like making charts.

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Megan McArdle is a columnist at Bloomberg View and a former senior editor at The Atlantic. Her new book is The Up Side of Down.

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