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A Hypothetical Question about Free Markets and How Fuel Prices and Taxes Interact

If you believe we live in a free market economy, and you believe supply and demand are the major factors in the price of fuel, you might wonder how including taxes in the price of fuel affects how supply and demand work.

Let’s say, hypothetically, we live in a completely unregulated free market, and the federal government decided not to tax fuel anymore. Would the invisible hand of the market react by automatically raising the price of fuel by the amount of the federal fuel tax (18.4 cents per gallon)?

If you answer this question, please either show your work or tell me where you got your education in economics. I got mine as a business administration major, where I earned As in Macroeconomics and Microeconomics, and I can’t say with authority how the market would react, so I’m looking for informed answers, not mere speculation.

Fell free to speculate, but please don’t expect me to take mere speculation seriously.

I will speculate that if the fuel tax were increased by 50c the pump price would immediately increase to reflect that tax but quickly (within weeks) drop back to near the pre tax increase price.

And BTW, I graduated Magna Cum Lager from the Skool of Hard Knox.

Why do you think it would do that? You must have a reason, and I’m interested in knowing what it is.

I surmize that, if the tax were eliminated, they’d raise the price as you suggest…just because the can !
The greedy s.o.b.s would figure that the market is standing it and surviving as it is so they may as well pocket the profits.
-----------------we get penalized for efficiency---------( procuring taxes from other sources )
And here’s another efficiency market venue issue.
Natural gas prices.
The less we use…the higher the price per unit !
With more efficient appliances, more efficient home building, and more efficient usage practices, we are using much less naturral gas as they all preach to us to do for the sake of the environment and the long term supply.
New Mexico Gas Company is currently petitioning the state for a rate increase…again.
I just paid my gas bill for last month …a bank breaking $29.00.

Yeah, I have a business degree too and got A’s in Economics as well as accounting, finance and management. Not so good at German though so glad we won the war. The price would increase or decrease according to the tax tacked on at least for the immediate term. However, the largest portion of the cost of gas is the price of oil which is set on the world market and artificially supported by OPEC. It is impossible to know what OPEC would do but they have in the past increased or decreased production to stabilize prices. The corner gas station doesn’t control prices anymore with a meager 2 cent profit margin.

My evidence you ask? Minnesota passed a gas tax increase a few years ago and the price was reflected at the pump. The major price changes reflected the world wide cost of a barrel of oil though.

Here’s an article addressing the impact of taxes and other things on the price of gas in different areas of the country:

Now if you want to rephrase the question that the WORLD passes, say, a $1.00/gallon tax, then the price would pop up $1.00. Consumption would drop some, so prices would then drop some fraction of the $1.00 in response. How much? Who knows!

But just a change in the U.S. wouldn’t have near the effect on overall demand (oil price), so like @Bing said the price change would probably stick.

@Whitey Your question does not sound like it’s coming from a person educated in classic economics.

Whether there is a tax on a commodity or not as part of the price does little to determine demand. Demand is determined by affordability and “marginal utility”, which I’m sure you know what that means. Compare butter with margarine, which is a lot cheaper. The relative consumption of those two is reflected by the sellling price, so more margarine than butter is sold. We have no idea who makes more profit.

If the price of gas drops by 50 cents a gallon, there will be a temporary increase in consumption (more affordable), and maybe a slight increase in gas guzzler sales.

The producers might temporarily keep the price at the same level, but fierce competition will quickly drop it to the pre-tax level.

A left wing thinker from the London School of Economics might argue that the public will be “gouged”, but all evidence points towards lower prices. If there was only one oil company, like in Mexico, those prices would probably stay high and the additional profit frittered away with more inefficiencies.

Canada and the USA are currently negotiating a Free Trade agreement with Europe. I’m looking forward to cheaper cheeses from Holland and France as well as cheaper wine from France and Italy! Please keep track of those prices when the agreement takes effect; the US public will not be gouged as Free Market forces result in lower prices for these commodities.

My training and experience is in both engineering and business with a long service in determining market prices for commodites and products my employers sold. Any added profit opportunity due to tax changes is short lived!

The low prices of imported elctronics and appliances is forcing US producers out of the business; Those Koreans and Japanese could have kept prices higher but that did not happen.

My guess – no data to back it up --is the price of gasoline would at first drop roughly to the prior price minus the removed tax. So if the price was $4 per gallon, and the tax was 75 cents, then the price would drop as soon as the tax was removed to $3.25. Soon the difference in the price points would kick in. Maybe some folks would decide they could now go for a Sunday drive, where before they couldn’t. So the price of gasoline would rise above $3.25. I’d speculate the price would stabilize somewhere in-between $3.25 and $4.

Doing the experiment would be tough though, as the price of gasoline isn’t stable for a variety of reasons, geo politics being one of them. And if the loss of tax revenue was made up in another way – like road and bridge tolls – the price of gasoline might not rise above $3.25, b/c folks wouldn’t have any extra money in their pockets.

@GeorgeSanJose Good comment; you point out the concept of “marginal utility” vs “marginal cost”, a prime concept in economics.

In France gas is twice the price as in the USA, so most Fenchmen drive economical cars; they don’t even make 8 cylinder cars in France. However, beer and wine is very cheap; when we were there we consumed lots of it. The high gas tax makes for the expensive fuel cost; they use the same Saudi crude as US refiners. Low gas prices in France would turn the country into a giant parking lot.

Back home I drink more beer than whiskey, and very little champagne. Marginal utility vs marginal cost again.

@Docnick Consider expanding your France example to include Germany. Fuel prices at the pump are as high as they are in France and every German manufacturer has a V8 automobile. Some have V12’s as well. The difference as I can see it is the German economy is much stronger and the people are more affluent plus the German’s export their big motored cars to the US and Middle East. And the beer is both cheap and wonderful.

I agree with @GeorgeSanJose, Losing the 50 cents (state and fed) we pay in gas taxes would decrease the price but demand would push it back up just a bit as people drove more with less fuel efficient vehicle. It would be more profitable overall for the oil companies and the retailer as well. The current profit margin for each is very small but the oil companies make it up in volume and the retailer makes it up in cheap beer sales.

The state and the feds each make more on a gallon of fuel than either the oil companies or the retailers.

I’m an engineer by education but I got A’s in the Econ classes I took. Worked in the for-profit corp world for over 30 years. I got the best Econ education from working at a family owned pharmacy in high school. (What is anything worth? - Whatever anyone is willing to pay for it!)

The whole point is moot because the petroleum market is anything but free…The OPEC consortium still has the power to dictate prices…Any changes in tax rates would appear on the pump the moment the change went into effect. You can rest assured the tax rate will never go down and it’s long overdue a substantial increase…

U.S. based oil companies and refiners are lobbying hard to get the oil export ban lifted…As U.S. production continues to rise and consumption slows, we could go into surplus and OPEC’s price fix would no longer apply here, domestic prices would drop…No No! They would rather export any surplus before letting the price collapse… In Colorado they are flaring natural gas because there is no market for it…The wholesale price does not justify building pipelines to transport it to better markets…

Several years ago in PA, when gas prices were drifting down, one of our governors (do not remember which crook it was, we have had so many) raised the state gas tax and justified it by saying it would not have a big impact on the consumer as they would not see a change in the net price of gas. If the situation were reversed and the tax went away, it would be easy to see the suppliers/distributors raising the street price for the same reason. Nobody leaves money on the table if they can avoid it. MBA Pitt

There is no simple answer to this question. It’s not just supply and demand but also the cost of bringing the product to market. The difference between the selling price and the cost to bring the product to market is where the profit or loss is.

With gasoline, it is a loss, not a profit. Why do oil companies sell gas at a loss you might wonder. A barrel of oil sells for a $100 +/-. Thats 42 gallons of which only about 20 gallons becomes gasoline or other volatile products. The rest becomes plastics, cosmetics, medicines and other high value products which are worth about $2400 on the market. To make money on the other products, they are motivated to process a lot of oil.

Gasoline and the other volatiles are actually hazardous waste, but a useful hazardous waste. Lucky for the oil companies. Now the trick is to sell the hazardous waste at the lowest loss. Taxes are just a part of the cost to bring the product to market and not a major determination in the final price. It is treated as the same as all the other factors.

The oil companies have big computers that take in all these factors and develop curves for the price/sales volume and cost/units delivered. When they overlay these curves, they find the point of most profit, or least loss.

In the end, the cost of the raw materials and the taxes are just factors, the supply and demand for all the other products also factor in and when all the curves for all the products are compared, the oil companies determine the most profitable amount of oil to process each day and the best price (for them) to charge at the pump.

In the end, the tax on gas really has little affect on the final price, but it does have an affect. Its just not linear.

I’ve read “The Wealth of Nations”. Everything else I know about business, I learned from a Waitress. That business degree was a waste of time except to look good on the resume.

@Caddyman. OPEC’s influence on CRUDE oil pricing is diminishing. The world price of crude, the so-called “Brent light”, fluctuates but there is a floor price, largely determined now by the cost of producing those heavier crudes and the cost of deep sea production. That is now about $65 a barrel or so.

If the world price is $105, that means that the Middle East and other countries producing light crude are making a lot of money, which is true.

US shale oil production costs are higher than those in the Middle East, but there is a good margin at the current US price level which is about $10 a barrel less than the world price.

At the refining level the competition is fierce; refining margins are razor thing, causing the closure of many inefficient refineries.

With consumption rising sharply in developing countries, I don’t think we will ever see another “oil glut” driving prices down to $25 a barrel. The spare capacity at this time is 1 million barrels per day with a world consumption of 86 million barrels per day. The Middle East “oil weapon” has been severely blunted by the rise in production all over the world. We have much more flexibility of supply now. Saudi Arabia has tradtionally been the “swing producer”, balancing out overall supply. Those days are fast coming to an end.

It’s important to distinguish between short term price fluctuation and long term trends. Crude oil prices will likely fluctuate $15-$20 a barrel in the short term, but the long term price of internationally traded crude is around $100 a barrel with a gradual increase, and about $10-$15 less than that for West Texas Intermediate, the US benchmark.

When buying a new car expect no long term decrease in gas prices, but a gradual increase, unless the US starts taxing fuels like Europe to reduce CO2 emissions.

Okay, for those of you who think the price would adjust back to the same price, why then is gas more expensive where the state gas tax is higher than other states?

Georgia has raised its gas taxes, but before they did, people who lived near the state border used to go to Georgia to buy their gas. California typically has the highest gas prices in the USA due to its high gas taxes.

If adding or removing the gas tax would have no long term impact on the final price of fuel, then wouldn’t the price of gas in places like Georgia, California, and New York all be the same, in spite of their gas tax rates?

@Caddyman: “The whole point is moot because the petroleum market is anything but free.”

I was afraid someone would come along who doesn’t comprehend the meaning of a hypothetical question.

If your only response is to say “that question isn’t worth asking,” you really aren’t contributing anything to a discussion about a hypothetical question, are you?

I can’t speak for Georgia, but in New York and California, there is a lot more to the equation than the gas tax. California has some very strict environmental laws and other ultra liberal laws that have driven some of the major oil companies out of the state. New York and California also have some very high business taxes that make it difficult for small businesses. Its not just gas that costs a lot in those states.

California also blocks just about every effort to build any industrial infrastructure. There are so many anti-(anything and everything) groups that can tie you up in court to slow you down.

The state gas tax in California is $.375 which is about $.020 higher than where I live now, but the cost per gallon of gas here is about $1.50 less than in California so the tax cannot explain all that difference.

I for one appreciate Doc’s expertise on oil economics. I think people are getting pretty immune to small increases and decreases in gas pump pricing (10-50 cents). I can hardly tell you what I paid for gas yesterday and when I travel I really pay little attention to the price. When Minnesota passed a tax increase, some people howled with anger but six months later, no one hardly knows what the tax is anymore. When it gets up over $4 or so, then people take note for a while. I also am not interested in following Europe into the sea. They have a whole different history and social circumstances that makes them prioritize differently than the US.

@Bing - “I for one appreciate Doc’s expertise on oil economics. I think people are getting pretty immune to small increases and decreases in gas pump pricing (10-50 cents).”

I agree, so that makes me especially dumbfounded at the push for per-mile tracking and fees, instead of increasing the gas tax. Given the choice, I’d MUCH rather see the gas tax go up a dime or two, rather than have the government track my road use. But the excuse given is that “Nobody will go for an increased gas tax.” Of course nobody WANTS to pay more taxes, but if $X billion is needed, why not do it the easy way (gas tax) that as a byproduct directly encourages gas conservation and buying more efficient cars, instead of creating an entirely new and intrusive taxing structure?

@texases Having some experience in government, I am very leery of new proposals that would provide additional monitoring of peoples activities. I suspect that the people behind the scenes who are pushing these proposals either 1) See a huge growth in a program that will improve their career path or status, or 2) Are rubbing their hands with glee at being able to monitor, control, and orient peoples movements. I for one don’t trust them at all. Behind every congressperson is a whole raft of local, state, and federal employees attempting to promote their own programs and world views. I agree. Raise it 50 cents to pay for roads, I don’t care, whatever it takes. I just don’t want some DOT employee to have a record of when and where I drive. It never ends.