Question

The U.S. government is considering reducing the amount of carbon dioxide that firms are allowed to produce by issuing a limited number of tradable allowances for carbon dioxide \(\left(\mathrm{CO}_{2}\right)\) emissions. In an April 25 , 2007, report, the U.S. Congressional Budget Office (CBO) argues that "most of the cost of meeting a cap on \(\mathrm{CO}_{2}\) emissions would be borne by consumers, who would face persistently higher prices for products such as electricity and gasoline \(\ldots\) poorer households would bear a larger burden relative to their income than wealthier households would." What assumption about one of the elasticities you learned about in this chapter has to be true for poorer households to be disproportionately affected?

Short answer

Answer: A reduction in tradable CO2 emission allowances disproportionately affects poorer households because they spend a higher percentage of their income on necessities like electricity and gasoline, which have inelastic demand. This means that when production costs rise due to the emissions cap, suppliers pass on the cost to consumers in the form of higher prices, forcing poorer households to bear a larger burden relative to their income compared to wealthier households.

Step-by-step solution

Identifying the Elasticity

To explain how poorer households bear a larger burden due to cap on CO2 emissions, we need to consider the concept of price elasticity of demand. Price elasticity of demand measures the responsiveness of the quantity demanded for a good to a change in its price. If the demand for a product like electricity and gasoline is inelastic, it means that a change in price will not have a significant impact on the quantity demanded. In this situation, consumers are more likely to bear the burden of the higher price as they cannot reduce their consumption significantly.

Inelastic Demand for Necessities

Products like electricity and gasoline are considered necessities for most households, meaning that their consumption cannot be significantly reduced, even when the prices increase. Necessities usually have a low price elasticity of demand. Hence, when production costs rise due to the enforcement of CO2 emissions cap, suppliers pass on the cost to consumers in the form of higher prices, since they know that demand is less sensitive to price changes.

Impact on Poorer Households

Typically, poorer households spend a higher percentage of their income on necessities like electricity and gasoline compared to wealthier households. Because their demand for necessities is inelastic, they still need to purchase these products despite the higher prices. Therefore, when prices increase due to CO2 emissions cap, poorer households end up bearing a larger burden relative to their income than wealthier households.

Conclusion

In this context, the crucial elasticity involved is price elasticity of demand. For poorer households to be disproportionately affected by the reduction in tradable CO2 emission allowances, it is assumed that the demand for the products influenced by these allowances, such as electricity and gasoline, has a low price elasticity of demand (inelastic demand). This assumption implies that the quantity demanded does not change significantly with an increase in price, making consumers bear the burden of those higher prices and thus disproportionately affecting poorer households who spend a higher percentage of their income on these necessities.

Key concepts

Inelastic Demand

Inelastic demand refers to a situation where the quantity demanded of a product doesn't change significantly when there's a change in its price. This is a crucial concept in understanding how price changes affect consumer behavior and spending patterns.

When demand is inelastic, even when prices rise, consumers will continue to purchase similar amounts of the product because:

• The product is essential to everyday life.
• No readily available substitutes exist.
• The product forms a small but necessary portion of overall expenditure.

In the context of carbon dioxide emissions and related policies, inelastic demand explains why consumers, particularly poorer households, are likely to absorb higher costs. Since essentials like electricity and gasoline are difficult to substitute or reduce consumption, individuals remain tied to purchasing similar quantities despite rising costs.

Carbon Dioxide Emissions

Carbon dioxide (CO₂) emissions are a significant concern for environmental policies and economic impacts. The introduction of tradable allowances by governments is aimed at controlling the amount of carbon emitted by firms.

The proposed system works by limiting total emissions through issuing a set number of allowances that can be traded among firms. This encourages companies to reduce emissions by making it economically viable to do so.

• Firms with low emissions sell excess allowances.
• Firms with high emissions buy more allowances to meet requirements.

Ultimately, the goal is to incentivize firms to innovate and reduce their carbon footprint over time. However, the cost implications are often passed onto consumers, leading to higher prices for products like electricity and gasoline. The policy impacts can be uneven, hitting those most reliant on such services harder—typically poorer households—due to inelastic demand for these necessities.

Income Inequality

Income inequality refers to the unequal distribution of wealth and income across different populations. When it comes to economic policies, such inequality often means that the financial burden of policy changes falls disproportionately on lower-income households.

Poorer households typically allocate a larger portion of their income towards basic necessities such as electricity and gasoline. As such, any increase in prices due to policies aimed at reducing carbon emissions disproportionately affects these households. Since their demand for these essential goods is inelastic, they cannot easily reduce consumption to offset higher costs.

• Higher energy bills take a more significant portion of smaller incomes.
• This exacerbates the financial strain on already economically vulnerable groups.

Addressing income inequality in the context of environmental policies requires careful consideration of how costs are distributed and alleviating the load on lower-income families.

Necessities vs. Luxuries

Understanding the difference between necessities and luxuries is key to grasping the concept of price elasticity of demand. Necessities are essential goods that people must consume regardless of price changes, like food, electricity, and gasoline. Luxuries, on the other hand, are non-essential goods that consumers can choose to forego if prices become too high.

Necessities typically exhibit inelastic demand; a consumer's purchase habits remain stable even when prices increase. This is because:

• They are essential to facilitate daily life and activities.
• Lack affordable alternatives or substitutes during price hikes.
• Ensure minimum living standards or quality of life.

Luxuries, however, have a more elastic demand because consumers can easily adjust or eliminate their purchases. The differing elasticities mean that price changes affect necessities and luxuries differently, with consumers bearing a more substantial financial impact from price hikes in necessities due to inelastic demand.