Question

Concerning a typical crude oil company in country X,

(a) In response to climate change, the government of Country X would like to reduce crude oil production and consumption by means of taxation. Explain briefly what type of tax (a per unit tax or a lump sum tax) the government should impose. How would this tax affect the oil company's output and profit? What's the disadvantage of the other type of tax?

(b) With appropriate diagrams, explain the impact on (i) crude oil's price and quantity transacted in the market following a breakthrough in crude oil production technology and (ii) price and quantity transacted of gasoline (an end product of crude oil) as a result.

(c) When a barrel of crude oil is refined, a roughly fixed proportion of end products (e.g. gasoline, diesel, residual oil, etc.) will be produced. Explain what may happen to the price of residual oil when the demand for gasoline increases. Do not make any assumptions of residual oil and gasoline being substitutes or complements in consumption. Include demand and supply diagrams for gasoline and residual oil in your answer.

Answer 1

(a) If the country X wants to decrease the production of crude oil, it must increase the taxes imposed on it and should remove the subsidies from it, if any.

By increasing the taxes and removing subsidies, the company producing the crude oil will have to incur high cost of production, due to which it will increase its prices in the market to cover the cost and make appropriate profits, by increasing the price per unit, the demand for the oil will decrease and consumers will shift to another type of oil. The customers may shift to its substitute available, but won't buy the crude oil due to increase in it's price (assuming their income reamins the same) (Ceteris Paribus).

Due to taxes imposed, the cost of production will increase, leading to increase in price, leading to decrease in profits.

Taxes are imposed on a product to reduce its production or market flow, eg- If the government wants to decrease the money flow in the market it will increase the interest rates. Similarily, here the government wants to reduce the production of crude oil, therefore it will impose the taxes.