Question

3. Why would the use of gasoline decline if its price rose as a result of a gasoline tax but the effect of the price rise was compensated by a tax rebate? Give a graphical representation of your answer identifying the income effect, substitution effect. Which of these effects will the rebate represent?

Answer 1

As the price of gasoline increases, the budget line shifts inwards from AB to AC and the optimal bundle shifts from e1 to e2. And Consumption of gasoline goes from X1 to X2 ( Gasoline is represented on X axis). This shift from X1 to X2 is the Substitution Effect. When this increase in price is compensated with a tax rebate, the budget line shifts in such a way that the original bundle at e1 is still affordable at the new budget line represented by A'C'.

At the new budget line A'C', the consumer will only consume at A'e1 part because the part e1C' was still affordable with budget line AB but the consumer didn't choose those bundles. Therefore by revealed preferences, consumer will consume at A'e1 part , at point e3, with X3 being the final Consumption of gasoline.

Since X3 is less than X1, therefore Consumption of gasoline decreases even inspite the rebate. The rebate is being represented by the income effect from X2 to X3.