Question

Suppose that the government places a tax on heating oil in order to conserve oil. However, for poor families, the government rebates enough income to ensure that poor consumers are able to achieve the same level of utility after the rebate that they had before the tax was imposed. That is, the poor are no worse off after the tax and rebate than they were to begin with. Will the tax and rebate policy completely eliminate the conservation of oil by the poor? Illustrate and explain using an indifference curve diagram

Answer 1

The indifference curve diagram below depicts what happens to the consumption of oil before tax, after tax and after tax with rebate:

The consumer starts out at point A consuming Q_A litres of oil and has a utility level of U₂. After the tax, which rotates the budget line downward as shown by the dashed budget constraint, the consumer moves to point B which is on a lower indifference curve U₁, and consumption falls to Q_B. Finally, after the rebate which shifts the budget line outward, the consumer moves to point C and consumption increases to Q_C .

Overall, the consumption of heating oil has fallen, as intended, and the consumer is worse off because the level of utility attainable at point C is below the level U₂ at point A. Even though the money comes back to consumers in the form of a rebate, the reason consumption falls from A to C is because the income elasticity of demand for heating oil is relatively low so that the substitution effect dominates the income effect.

No, the tax and rebate policy will not completely eliminate the conservation of oil by the poor. In this example, a low-income household would be made worse off by the tax and rebate proposal (because indifference curve U₂ is no longer attainable), but it's still possible for some low-income individuals, those who consume less oil than the value of the lump-sum rebate, to benefit. Due to the domination of substitution effect over the income effect, the overall consumption of heating oil has fallen and led to conservation of heating oil as intended by the government.