Gasoline consumption: incentive effects of taxes vs. standards (Context Rich Problem)

Author: Amy McCormick Diduch, Mary Baldwin College
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This material is replicated on a number of sites as part of the SERC Pedagogic Service Project

Summary

The problem asks students to assess the effectiveness, fairness, and political appeal of two plans to reduce oil imports: increasing CAFE standards or a gasoline tax.

Learning Goals

The activity helps students recognize that a variety of factors (including demand elasticity, the number of people affected, and potentially contrary incentives) affect the probable impact of the tax and gasoline mileage policy choices. Moreover, the activity prompts students to consider how policy decisions affect people at different points in the income distribution.

Context for Use

This brief exercise is appropriate for a Principles of Microeconomics (or potentially an Environmental Policy) course and can be used for in-class small group discussion, on-line discussion or as a homework problem. As an in-class discussion, it will take approximately 10-15 minutes of class time. Students should be familiar with the concepts of externalities and taxes.

Description and Teaching Materials

Your local member of the House of Representatives is working on legislation to reduce U.S. demand for imported oil. She is considering either (1) an increase in Corporate Average Fuel Economy (CAFE) standards, which would require new cars to get better gas mileage, or (2) a 50 cent increase in the federal gasoline tax. Although reducing oil dependence is her main goal, she is also concerned about the policy's impact on low income constituents and whether voters will approve of her choice. Based on these concerns – effectiveness, equity, and political appeal, which of these policies should she support? Write her a letter expressing your opinion (backed by sound economic reasoning).
The problem is also described in the attached file.
Incentive effects of taxes and standards (Microsoft Word 2007 (.docx) 13kB Mar8 12)

Teaching Notes and Tips

The challenge for students in this problem is identifying the many different behavioral incentive effects.
  • Some of the benefits (approximately 10%, according to research) of higher CAFE standards are lost due to increased Vehicle Miles Traveled (VMT). Because of the higher VMT, increased CAFE standards may also increase other highway externalities (such as fatalities and congestion).
  • Once implemented, CAFE standards only affect new cars; thus, the immediate impact on gasoline consumption is very small.
  • The gasoline tax affects drivers of older cars as well as newer cars and can be implemented immediately.
  • However, the short run price elasticity of demand for gasoline is estimated to be fairly inelastic so the initial decline in gasoline consumption will be modest. (In the long run, demand becomes more elastic).
  • Low income consumers spend a higher proportion of their incomes on gasoline, so there are immediate distributional consequences to choosing the tax policy.
  • Political support for increased gasoline taxes appears to be low in most areas.
Instructors can make the problem more complex by adding an increase in oil supply (through exploration and drilling) to the policy options. In this case, the instructor would likely want to add "impact on the environment" to the policy outcomes of interest to the politician. Instructors should indicate to students the level of economic sophistication expected for the letter and whether or not it should include graphs.

Assessment

This problem requires students to apply general microeconomic reasoning as well as specific economics tools (externalities and corrective taxes) in context of a realistic problem.

The purpose of the assessment will determine whether or not you need a rubric. If the problem will be graded, it may be helpful to give the students a rubric such as:

  • Grade=A: All economic reasoning in the answer is correct. All relevant graphs are included. All relevant economic terms are included. May have 1-2 minor mistakes, such as a missing label on a graph.
  • Grade=B: Economic reasoning in the answer is correct, but some relevant economic terms are missing or graphs contain minor mistakes.
  • Grade=C: Contains significant errors in the economic reasoning. Many relevant economic terms are missing or used incorrectly. Graphs contain some significant errors.
  • Grade=D: Very little of the economic reasoning is correct and relevant to the problem. Nearly all relevant economic terms are missing or used incorrectly. Graphs are missing or contain several significant errors.
  • Grade=F: None of the economic content is relevant to the question.

References and Resources

For more details, see Parry, Walls and Harrington, "Automobile Externalities and Policies" Resources for the Future Discussion Paper 06-26, January 2007 (revised) http://www.rff.org/files/sharepoint/WorkImages/Download/RFF-DP-06-26-REV.pdf