Washington, D.C. (rightcommentary.com): I am an economist by training, and a policy analyst by choice, so thus it is obvious that I’m ill-qualified to appraise the gas tax debate. As an economist, I understand in great detail how to calculate equilibrium conditions - most importantly what factors determine prices. As a policy analyst, I’m used to figuring out what policies maximize constituent benefits given costs and scarce resources.

Given all of this - I must be ill-equipped to understand the gas tax holiday, and the criticisms leveled against Sen. Obama, for opposing removing (either temporarily or permanently) the federal tax imposed on gasoline.

This week, economic analysts seem to have reached a consensus that the US economy is headed for recession and oil just hit an all-time high of almost $120 a barrel. Gas prices have gotten high enough that people are, for one of the first times in recent history, actually beginning to drive slightly less. No doubt that the high prices at the pump are putting pressure on Americans, to the point where many are altering their driving behavior or even perhaps thinking about living somewhere that allows them to drive less.

Thus, it seems like a no-brainer to reduce the price of gasoline by eliminating, temporarily, the 18 cent per gallon tax that the US government collects as part of the price of gasoline. Reduce the tax - the price goes down whatever the reduction in the tax was? Right? Drop the tax from 18 to 0 cents… and the price of gasoline should fall 18 cents… to approximately an average of $3.43 nationwide.

Unfortunately - it’s bollocks. I’m not against the idea because of the allegations it will undermine the “global warming” debacle (unlikely). I’m not against it because of arguments that say it will encourage waste (it won’t). I’m not against it because of the arguments that its impact on the highway projects would be severe (those projects could be funded through the GFR mechanisms).

I’m against it because it just won’t work. The problem is, the laws of supply and demand are immutable and not subject to politician whimsy. Dropping the tax will not drop the price.

The law of supply and demand isn’t really a “law” in the normal sense. Instead, the “law” captures the idea of a equilibrium between suppliers and consumers. The law states that more is always supplied at a lower price, and less is supplied at a higher price; more is always demanded at a lower price, and less is demanded at a higher price. Thus, the price of a good is determined by where the demand function and the supply function intercept. The intersection between quantity and price is the equilibrium point that makes the market “efficient”. It’s considered “efficient” because at the equilibrium price - the amount supplied and the amount demanded represents the maximum capacity for both sides to bargain.

In this case, the supply curve - the amount of gasoline available over the three month period - is essentially fixed. Thus, the drop in price is not a result of a change in “supply.” When Congress removes the 18 cent gas tax - what will happen? There are two possibilities:

• One: The price of gas remains constant - with larger profits being given to the retailers of gasoline. Many retailers charge what the market will bear and make only a few cents per gallon. Elimination of the gasoline tax could result in price staying the same as before, with larger profits going to retailers. Some variant of this option could be the refiners keep more money or somewhere else down the line. Bottom line of this scenario is - that retailers know where the equilibrium price point is because they know what supply is (fixed) and they know that demand is insatiable. They also know the price will be bid up (as I’ll demonstrate her in a moment) and that either they can wait for that to happen or just start charging as they did before.
• Two: The price could drop by some amount - perhaps in a perfect world - it would drop by the full amount of the tax.

Let’s for a moment consider option two - that the price of gas falls. If it does fall - it would only be until consumers can adapt to the new price, demanding more and more gasoline. Since supplies are fixed, the price of gas would necessarily rise back to the original equilibrium point. And that’s the problem with equilibrium points - they kinda like to stay in equilibrium. The graph below demonstrates what would likely happen:

Inititally, the price will fall to (D0, P0). As you can see, this price is lower than the original start point. But since demand is at D1 and not D0, the price MUST rise back to D1, P1 and not D0, P0. Put perhaps more simply, since supply is fixed, lowering the tax will not affect the price - because demand will necessarily drive it back up to the maximum level of efficiency of profits given the supply - namely - the original equilibrium point.

In other words… it’s just political pandering… it just won’t work.