Some countries tax fossil fuels while others provide subsidies for them.

Explain the economic rationale for both cases and discuss whether fuel prices should be determined by the free market.         [25]

Introduction
Governments impose measures on the market for fuel as a result of market failure. Market failure is defined to be a situation whereby the free market, in the absence of government intervention, fails to allocate resources efficiently, resulting in societal welfare not being maximised. Fuel is an essential factor input and a tax or subsidy on fuel would likely cause significant changes to an economy. The action or inaction by the government would be dependent on the state of the economy – if a certain policy would help improve the economic efficiency of the economy. 

Reasons for the taxation on fuel

Figure 37a: Negative Externalities in Market for Private Transport            

Figure 37b: AD-AS Diagram of an economy

Negative externalities occur in the usage of motor vehicles

Negative externalities are external costs incurred by 3rdparties not directly involved in the production or consumption of a good or service, of which these costs are unaccounted for in the free market.  

Marginal private costs faced by individuals includes cost of petrol and car ownership
Marginal private benefits enjoyed by individuals is increased comfort
Marginal external costs are negative externalities generated from reduced time available for leisure and work because of being stuck in traffic, increased business costs due to longer transport times and costs as well as increased noise pollution and incidences of accidents. The presence of external costs means that there is a divergence between marginal social costs and marginal private costs. 

With reference to figure 37a, which shows the market for private transport,

• Free market output would be at Qm where MPC=MPB, since consumers would only consider their own private costs and benefits when choosing to purchase private transport and not the external costs

• Socially desirable level of output is at Qs where MSC=MSB.

• Since Qm>Qs, overconsumption of private transport occurs and deadweight loss of area ABC is generated

• Due to allocative inefficiency, market failure exists in the market for private transport

A tax on fuel would effectively be a tax on the usage of motor vehicles

Taxes are a market-based solution and increases firm’s cost of production àfirms pass on costs to consumers, increasing prices of fuel àmarginal private cost of consumers increases as fuel is essential for driving. With reference to figure 37a, which shows the effect of a tax on a market with presence of negative externalities

• MPC shifts leftwards from MPC to MPC+Tax, forcing individuals to internalise the external cost

• Quantity of trips consumed would fall from Qm to Q1, bringing the level of output closer to the socially optimal level of output.

Reasons for subsidising fuel

As a policy to address inflation

High fuel prices mean higher cost of living. This is because fuel is a factor input in many final goods and services. Fuel is used to power vehicles as well as produce electricity which powers capital goods such as machines as well as homes of consumers. Fuel subsidies decrease the cost of production of fuelàshort-run aggregate supply increases. With reference to figure 37b,

• SRAS curve shifts rightward from AS0 to AS1

• General price level decreases from P0 to P1

• Real national income increases from Y0 to Y1

Why should pricing of fuel be left to market forces? 
Problems associated with a tax

1.       Taxes imposed should be equivalent to MEC.

2.       Difficulty of quantifying exact costs of congestion and air pollution

3.       Incorrect amount of tax would still lead to an inefficient outcome.

4.       Demand for petrol may be relatively price inelastic (affluence – smaller proportion of incomes) èFall in Demand less than proportionate compared to rise in price.

5.       Raised COP of firms èHigher price consumers pay if firms pass on higher business costs

Problems associated with a subsidy

1.     Subsidies especially on fuel are very costly and are a huge drain on government resources.

2.     To fund such subsidies, taxes in other areas may have to be raised and there could be an opportunity cost in terms of the reduced funding available for the provision of other essential goods. (e.g. a significant portion of Malaysia’s and Indonesia’s budget are used for fuel subsidies).

3.     Subsidies artificially reduce the prices of fuel and could create an increase in quantity demanded for fuel, which may cause the degree of negative externalities to rise.

Conclusion
Governments hence decide the appropriate policies of a tax or subsidy or leaving to market forces per the current state of their economy. There exist merits and demerits of each policy of which would be weighed and considered during their decision-making process.

Comments
The question calls for the discussion of the economic rationale of the policies by the different governments for fuel – reasons for the tax or subsidy of fuel must be explained and supported by with examples. After explaining the merits of each measure, there requires an evaluation. A key problem for students when they attempt this essay is that they fail to see that macroeconomics concepts can be tested in a microeconomics essay. Thus, they would completely ignore the possibility of subsidy being used to tackle inflation.