(solution) Transport and elasticities of demand In late 2003 fuel protests began to be heard again as the…

(solution) Transport and elasticities of demand In late 2003 fuel protests began to be heard again as the…

Transport and elasticities of demand In late 2003 fuel protests began to be heard again as the Chancellor raised the tax on petrol by 1.28 pence per litre (6 pence per gallon). Motorists and organisations such as the AA and RAC point to the fact that over 80% of the price paid at the pump now goes to the Treasury in tax, a dramatic rise on the much smaller 44% of the petrol price which went to the Treasury as recently as 1980. Evidence from the developed economies suggests that for every 10% increase in real fuel prices, the demand for fuel will fall by around 6%. This consumer response to higher fuel prices may take several years to fully work through. The demand for car ownership and for travel (and therefore the derived demand for fuel) is also closely related to the level of household income. Again, studies suggest that for every 10% increase in real income the demand for fuel eventually increases by around 12% within two years of the rise in real income. Of course, the demand for fuel does not only depend on its own price and the level of real household income, but also on other factors. For example, whereas the real cost of motoring per kilometre travelled (fuel costs, car purchase, repairs, road tax etc.) has barely changed over the past 20 years (e.g. more efficient engines result in more kilometres per litre of petrol), the real costs of rail and bus per kilometre travelled have risen by more than 30% and 35% respectively over the same 20-year period. Clearly this change in relative costs has given a boost to demand for car ownership and travel, and therefore to the demand for fuel. Many people argue that fuel taxes should rise even higher than they are now, since the private motorist imposes costs on society that he or she does not actually pay for. Extra motorists bring about congestion on our roads and increased journey times, increase the need for more road building with the inevitable loss of countryside, result in more carbon dioxide (CO2) and other toxic gas emissions which damage the ozone layer and lead to global warming. In other words, many believe that the private costs of the motorist do not fully reflect the social costs imposed by the motorist. Higher taxes on fuel will, as we have seen, raise the price of motoring and discourage road travel. For example, it has been estimated that a 10% increase in the price of fuel will lead to an extra 1% of rail passengers on rail services and an extra 0.5% of bus passengers on bus services. Of course, demand for some products may actually decrease as fuel prices rise. With less car usage there may be a decrease in demand for garage-related services and products. The net effect of a rise in fuel prices will depend on the sign and size of all these elasticities, namely own-price, income and cross-elasticities of demand. Questions 1 Can you calculate any own-price, income and cross-elasticities of demand from the information given in the case study? 2 Why do some people believe that fuel taxes and fuel prices are too low? 3 Can you suggest why governments might be wary of making the motorist pay the full private and social costs of any journey?