No Such Thing as a Free Lunch: Principles of Economics (Part 18)

Economics is a choice between alternatives all the time. Those are the trade-offs.

Paul Samuelson

Demand and Supply Applications and Elasticity

(Part C)

by

Charles Lamson

Supply and Demand Analysis: An Oil Import Fee

The basic logic of supply and demand is a powerful tool of analysis. As an extended example of the power of this logic, we will consider a proposal to impose a tax on imported oil. The idea of raising the federal gasoline tax is hotly debated, with many arguing strongly for such a tax. Many economists, however, believe that a fee on imported crude oil, which is used to produce gasoline, would have better effects on the economy than would a gasoline tax.

Consider the facts. Between 1985 and 1989, the United States increased its dependence on oil imports dramatically. In 1989, total U.S. demand for crude oil was 13.6 million barrels per day. Of that amount, only 7.7 million barrels per day (57 percent) were supplied buy U.S. producers, with the remaining 5.9 million barrels per day (43 percent) imported. The price of oil on world markets that year averaged about $18. This heavy dependence on foreign oil left the United States vulnerable to the price shock that followed the Iraq invasion of Kuwait in August 1990. In the months following the invasion, the price of crude oil on world markets shot up to $40 per barrel.

Even before the invasion, many economists and some politicians had recommended a stiff oil import fee (or tax) that would, it was argued, reduce the U.S. dependence on foreign oil by (1) reducing overall consumption and (2) providing an incentive for increased domestic production. An added bonus would be improved air quality from the reduction in driving.

The difference between the total quantity demanded (13.6 million barrels per day) and domestic production (7.7 million barrels per day) is total imports (5.9 million barrels per day).

Now suppose that the government levies a tax of 33 1/3 percent on imported oil. Because the import price is $18, a tax of $6 (or .3333 * $18) per barrel means that importers of oil in the United States will pay a total of $24 per barrel ($18 + $6). This new higher price means that U.S. producers could also charge up to $24 for a barrel of crude. Note, however, that the tax is paid only on imported oil. Thus the entire $24 paid for domestic crude goes to domestic producers.

Figure 5(b) shows the result of the tax. First, because of higher price the quantity demanded drops to 12.2 million barrels per day. This is a movement along the demand curve from point B to point D. At the same time, the quantity supplied by domestic producers increased to 9.0 million barrels per day this is a movement along the supply curve from point A to point C. With an increase in domestic quantity supplied and a decrease in domestic quantity demanded, imports decrease to 3.2 million barrels per day (12.2 -9.0).

The tax also generates revenues for the federal government. The total tax revenue collected is equal to the tax per barrel ($6) times the number of imported barrels. When the quantity imported is 3.2 million barrels per day, total revenue is $6 * 3.2 million, or 19.2 million dollars per day (about 7 billion dollars per year).

What does all this mean? In the final analysis, an oil import fee would (1) increase domestic production and (2) reduce overall consumption. This would in turn help with the problem of air pollution and simultaneously reduce U.S. dependence on foreign oil. 

*MAIN SOURCE: CASE & FAIR, 2004, PRINCIPLES OF ECONOMICS, 7TH ED., PP. 78-80*

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