The consumption of petrol generates considerable externalities and petrol is also a heavily taxed product. It is often quoted as an example of a product with an inelastic price elasticity of demand (PED). Studies in different countries have produced varied results. A South African study in 2004 gave a short-run PED of –0.21 and a long-run PED of –0.51. In 2008 an Australian study put the short-run PED between –0.1 and –0.14 and the long-run PED between –0.2 and –0.3. a. i. Compare the price of petrol in the US and China between January 2008 and September 2009. (2 marks) ii. Indicate how does Fig. 1 confirm that it is in China rather than in the US that the price of petrol is set by the government? (2 marks) b. Explain how the consumption of petrol generates externalities. (4 marks) c. i. Justify two points about the PED of petrol on which the studies agree. (4 marks) ii. Explain why the values of the short-run and long-run PEDs for petrol are different. (4 marks) d. Discuss the possible consequences of the Chinese price setting policy between January 2008 and September 2009. (4 marks)

Answer

The consumption of petrol generates considerable externalities and has an inelastic price elasticity of demand (PED). Studies conducted in different countries have produced varied results, but the two most prominent are South African and Australian studies from 2004 and 2008, respectively. Both studies agree that the long-run PED is lower than the short-run PED, and the South African study puts the short-run PED at -0.21 and the long-run PED at -0.51, while the Australian study puts the short-run PED between -0.1 and -0.14 and the long-run PED between -0.2 and -0.3.

US vs China Price of Petrol

The price of petrol in the US and China between the period of January 2008 and September 2009 is compared in figure 1. The graph shows that the price of petrol in China is set by the government, as the price remains constant over the period, whereas in the US, the price fluctuates. This confirms that it is in China rather than in the US that the price of petrol is set by the government.

Externalities of Petrol Consumption

Externalities refer to the positive or negative impacts of an economic activity on a third party, not directly involved in the activity. The consumption of petrol generates considerable externalities due to its environmental effects. The burning of petrol emits carbon dioxide, which is a greenhouse gas, and contributes to climate change. In addition, the burning of petrol releases other toxic pollutants such as nitrogen oxides and sulfur oxides, which can cause respiratory health problems.

Price Elasticity of Demand for Petrol

Two points about the PED of petrol that the South African and Australian studies agree on are that the long-run PED is lower than the short-run PED, and that the PED of petrol is inelastic. The short-run PED is lower than the long-run PED because in the short-run, consumers are more likely to take time to adjust their consumption of the product to the change in price. In the long-run, however, they are more likely to have adjusted their consumption levels and the PED will be lower. The PED of petrol is inelastic because it is an essential product and there are few substitutes for it.

Consequences of Chinese Price Setting Policy

The Chinese price setting policy between January 2008 and September 2009 has had a number of consequences. Firstly, it has resulted in Chinese consumers paying less for petrol than their counterparts in the US. Secondly, it has meant that petrol consumption in China has increased as it has become more affordable. This has resulted in an increase in the amount of carbon dioxide and other pollutants being emitted into the atmosphere, leading to an increase in environmental degradation. Finally, it has meant that Chinese petrol producers have not been able to benefit from the higher prices that petrol was fetching in the US during this period.

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