CHAPTER • Individual and Market Demand 123 Let’s begin by focusing on the effect of the program over a period of five years The relevant price elasticity of demand is about -0.5.1 Suppose that a low-income consumer uses about 1200 gallons of gasoline per year, that gasoline costs $1 per gallon, and that our consumer’s annual income is $9000 Figure 4.9 shows the effect of the gasoline tax (The graph has intentionally been drawn not to scale so that the effects we are discussing can be seen more clearly.) The original budget line is AB, and the consumer maximizes utility (on indifference curve U2) by consuming the market basket at C, buying 1200 gallons of gasoline and spending $7800 on other goods If the tax is 50 cents per gallon, price will increase by 50 percent, shifting the new budget line to AD.2 (Recall that when price changes and income stays fixed, the budget line rotates around a pivot point on the unchanged axis.) With a price elasticity of -0.5, consumption will decline 25 percent, from 1200 to 900 gallons, as shown by the utility-maximizing point E on indifference curve U1 (for every 1-percent increase in the price of gasoline, quantity demanded drops by 1/2 percent) The rebate program, however, partially counters this effect Suppose that because the tax revenue After Gasoline Tax Plus Rebate F A Expenditures on other goods ($) H After Gasoline Tax C E U2 U1 900 913.5 1200 Original Budget Line D J B Gasoline consumption (gallons per year) F IGURE 4.9 EFFECT OF A GASOLINE TAX WITH A REBATE A gasoline tax is imposed when the consumer is initially buying 1200 gallons of gasoline at point C After the tax takes effect, the budget line shifts from AB to AD and the consumer maximizes his preferences by choosing E, with a gasoline consumption of 900 gallons However, when the proceeds of the tax are rebated to the consumer, his consumption increases somewhat, to 913.5 gallons at H Despite the rebate program, the consumer’s gasoline consumption has fallen, as has his level of satisfaction We saw in Chapter that the price elasticity of demand for gasoline varies substantially from the short run to the long run To simplify the example, we have assumed that the entire tax is paid by consumers in the form of a higher price A broader analysis of tax shifting is presented in Chapter