Tuesday, 19 August 2014

Petrol prices at the border and tax incidence

Petrol prices are one of the more interesting and accessible examples of demand and supply at work. With prices written in bright luminescent letters by the roadside it is a simple task, while driving along, to appreciate the variety of prices on offer. And an interesting economic problem to try and explain that variation in price.
         A recent road trip gave us chance to compare prices in a few European countries. It was pretty obvious that prices were higher in Germany than in Austria or Switzerland and higher in Austria and Switzerland than in Luxembourg. These broad differences primarily reflect differences in tax. What I found interesting, however, was that German prices appeared to be squeezed near the borders with Austria and Luxembourg. Anecdotally, at least, it seemed that prices got lower the closer we got to the border. If true, that would be a very nice example of tax incidence at play.
        Tax incidence is a fantastic economic concept. But it is also very poorly understood by the average politician, headline writer, member of the general public, and economics student. Confusion primarily comes from the need to throw common sense out of the window. So, let us look at the example of petrol prices in Germany to illustrate how tax incidence works. What I want to do is compare a petrol station in the interior of Germany, say in Hannover, with one near the border with Luxembourg, say in Trier.
        The basic difference between Hannover and Trier will be in the price elasticity of demand. In Trier a driver can relatively easily cross into Luxembourg and buy petrol at a cheap rate. That means the average driver in Trier is going to be more price sensitive than the average driver in Hannover. To be more specific suppose that the price of petrol in Luxembourg is €1 per litre. Then the demand curve at the German border (see the right hand figure below) will be flatter above a price of €1 than the demand curve in the Geman interior (left hand figure). One important thing to clarify here is that the demand curves I have drawn show demand for German petrol. Drivers in Trier need petrol just as much as drivers in Hannover it is just that they also have the option to buy Luxembourg petrol. This option flattens demand for German petrol at the border.
 
        

        There is no reason to suppose the supply of petrol is any different at the border and so I have drawn the supply curve the same in both cases. Now, what happens if the German government puts a tax of €0.50 per litre of petrol? Common sense would say that this pushes the price of petrol up by €0.50. And that common sense would be wrong!
        Look first at the left hand figure. A tax of €0.50 pushes up the supply curve by €0.50. The effect of this, however, is to only push up price from €1 per litre to around €1.38 per litre. Why do prices not rise to €1.50? As prices rise drivers demand less petrol because they choose to, say, drive less or drive more economically. If, therefore, the price were to rise by €0.50 there would be excess supply of petrol. In other words petrol companies would be stocking more petrol than drivers want to buy. This is not a good business strategy. And it provides an incentive for those companies to drop prices. At a price of €1.38 demand equals supply.
        Lets looks now at the right hand diagram. Here we see that the €0.50 tax only pushes prices up by around €0.18. Why does the price rise a lot less than in the German interior? As the price rises drivers demand a lot less German petrol because they can hop over the border to Luxembourg. This means that prices have to drop a lot in order for demand to equate with supply. And even with these much lower prices demand for German petrol will be lower at the border than the interior.
         The basic lesson of tax incidence is that demand and supply determine what will happen to prices. In turn, they determine who will pay most for any tax. Hence a crucial difference between economic incidence and legal incidence. For instance, in our simple example it is drivers who primarily pay for the tax in the interior but petrol companies that pay at the border. No amount of government meddling is going to do anything about that. Taxes, therefore, are a really blunt weapon to target prices or company profits. Something that policymakers seem often blissfully unaware of!

 

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