Do You Understand the Basic Economics Behind the Windfall Profits Tax?

The basic economics behind oil and gasoline prices were front and center in the news in the 2008 American election year, and for good reason. The recent rise in prices is a huge economic problem for just about every American, and our dependency on foreign sources of oil is even a national security concern.

The President, the Presidential candidates and Congressional leaders gave presented a host of plans for alleviating our problem, by increasing our supply of oil, cutting our demand, or both.

The goal, I think, should be much cheaper oil.

Let’s see how the proposal to impose a “Windfall Profits Tax” on the major oil companies would help our situation.

To see it’s effect, we first need to understand the demand curve, the supply curve, and their relationship.

The Basic Economics Behind the Law of Supply and Demand
In general, the more something costs, the less we buy. For example, if apples and pears usually are $1.19 per pound each, and we go to the store intending to buy 2 pounds of each, but find that apples are on sale for $0.69 per pound, we might buy more apples (and fewer pears).

Or, if instead we find a higher price, for example pears are $1.89 per pound; we might buy fewer pears (and more apples). Not every individual will respond this way, but by the end of the week, the store sees increased sales (a rise in demand) for items whose price went down and decreased sales (a drop in demand) for items whose price went up.

Some items are affected more by price than others. In basic economics, the technical term for this property is “elasticity.” My replacable apples and pears had elastic demand.

Salt, for instance, is pretty inelastic. If it’s usually $0.39 for a container, I would not buy more if the price dropped to $0.19, or buy less, if the price rose to $0.79.

It has been claimed that gasoline is inelastic in the short run , however, the last year has shown that not to be the case.

People really have changed their driving habits, their vehicle preferences, and their overall demand for gasoline in response to $4.00 per gallon prices in just a few months.

Understanding the Basic Economics of Supply
How does price effect supply? Let’s say you were sitting at home reading articles on the internet (could be worse!), when you hear someone shouting outside, “Ball Point Pens… I’ll buy all your ball point pens for 1¢/each! Bring out all your pens now!”

Wow, it’s a merchant going around with a cart buying ball point pens!

At that price, would you bother to go around the house finding all your pens and taking them out to him?

What about at 25¢/each? At $1/each? At $10/each?

Well, at $10 each, I certainly would find every pen in the house and cash them in!

What about at $100/each?

Think how much supply would be generated! People would be running to the office supply store to buy more pens to sell to the merchant. The guy with the cart would be sitting on a mountain of pens!

But in cases where the item is being produced, producers respond the same way to higher prices. Rising prices are a motivator to grow more, make more, find more, extract more, refine more,… you get the idea.

And lower prices have the opposite effect.

That’s why the Supply Curve slopes up, the other way. When the price goes up, our suppliers are motivated to make more and when it goes down, the opposite.

Now let’s get back to our original question. What would be the effect of putting a “windfall profits” tax on the major oil producing companies?

This proposed tax would be paid by Exxon and the like. Thus it would increase the cost of supplying gasoline.

Therefore, it would shift the entire supply curve upward, by the amount of the tax! Let’s see how that effects our price-quantity equilibrium.

Now trace down to the horizontal axis, showing Quantity. Would the quantity of gasoline being supplied be more or less after the “windfall profits” tax?

Also, trace across to the vertical axis, showing Price. Would the new price of gasoline, after the “windfall profits” tax be more or less?

Basic Economics and The Bottom Line:
Now, if the government should be enacting policies that reduce our problem at the gas pump, how does the “windfall profits” tax proposal fit in?

It would do the opposite! It would raise prices and lower supply. It would put us in even more pain at the pump.

How do I know this? Do I have access to special secrets? Am I a wizard or sorcerer with knowledge of the future? Am I a math or economics genius?

No. I am a math teacher who can read and understand a chart depicting the laws of supply and demand. (I hope I have made the basic economics behind this tax understandable to you, too.)

The effect of a supplier tax on the supply-demand equilibrium is a basic economic topic taught in high school or first semester college courses. You only need to know high school algebra to understand this material.

Why Would a Politician Propose Such a Tax?
Any national politician should know these facts backwards and forwards, or should work with an economics advisor to help him with it.

So here’s the scary part... If a politician tells us the “windfall profits” tax will help us at the pump, what does that mean? Can he or she be so irresponsibly ignorant of basic economics that he or she doesn’t know the effect would be the opposite?

Or, could he or she be so diabolically cynical that he or she knows it would make the situation worse, but pushes for it anyway because the “windfall profits” tax on oil producers idea “plays well” with certain constituents?

I don’t know which is worse.