Answer to Question #181661 in Macroeconomics for ahmad Taufiq

Question

As newly appointed “Energy Czar,” your goal is to reduce the total demand for resi- dential

    heating fuel in your state. You must choose one of three legislative proposals designed to

    accomplish this goal:

    (a) a tax that would effectively increase the price of residential heating fuel by $1,

    (b) a subsidy that would effectively reduce the price of natural gas by $3, or

    (c) a tax that would effectively increase the price of electricity (produced by hydroelectric   

         facilities) by $4. To assist you in your decision, an econo- mist in your office has estimated  

         the demand  for residential heating fuel using a linear demand specification. The regression

         results are presented as follows.

Answer 1

Analysis of the estimated values of parameter coefficients indicates that the price of electricity is weakly related to the demand for residential heating fuel. This is because the value of its t-statistic is not greater than 2 which means the price of electricity has no significant effect on the demand for residential heating fuel. Thus the legislative proposal of imposing a tax that raises the price of electricity by $4 becomes inapplicable.

Out of the remaining variables, natural gas and residential heating fuel appear to be positively related, that is, they are close substitutes. A subsidy on natural gas that reduces its price by $3 will reduces the demand for residential heating fuel.

Note that the coefficient of price of natural gas articulates that a $1 fall in the price of electricity will reduces the demand for residential heating fuel by 43.88 units. Hence a subsidy that reduces the price of natural gas by $3 is expected to reduce the demand for residential heating fuel by 131.64 units.

In contrast, a $1 increases in the price of residential fuel itself will reduces its demand by 91.69 units only.

Therefore the most appropriate legislative proposal is the introduction of a subsidy on electricity which reduces its price by $3. This is expected to reduce the demand for residential heating fuel by 131.64 units, which is greater than a tax that decreases the demand for residential heating fuel only by 91.69 units.