Question

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

Other goods Consumer consumes Q1 units of gasoline and this initial choice is shown by point A. Now price of gasoline has increased because a tax is imposed on its consumption. This tilts the budget line inwards from red one to green one. The new choice is at B where gasoline quantity is reduced to Q2. This is the substitution effect A tax rebate is provided to the consumer which is equal to her likely consumption expenditure on gasoline at the taxed price. Budget line shifts out from green to blue. U1 U2 However, the income effect is not strong enough, though it increases the consumption of gasoline to Q3 and consumer reaches at C, but consumption of gasoline is still lower at Q3 than what it was before tax at Q1. Q2 Q3 Gasoline