Applied Analysis of the Carbon Price Mechanism in Australia - Essay Example

CARBON PRICE MECHANISM AND CONSMER CHOICE THEORY CONSUMER CHOICE THEORY: Consumers have limited incomes. With these incomes, they wish to attain maximum satisfaction by consuming maximum goods and services. The consumers have different levels of preferences for different goods and services. However, if a consumer obtains same level of utility and satisfaction by consumption of two goods, he is said to be indifferent. This behavior of consumer is shown by a curve known as Indifference curve and the theory explaining this behavior is known as “Consumer Choice theory”.

The new Carbon Price Mechanism to be announced by Australian government will impact the social well-being of the consumers and will also affect the household budgets. However, the compensations proposed to be made by the government will reduce the adverse effects that these higher prices would have, otherwise, on the energy consumption patterns of the consumers. These effects may be well described with the help of Consumer choice theory. A basic assumption of Consumer choice theory is that the consumer wishes to maximize the utility.

In other words, their decision making is rational. However, it is also assumed that the income available to a consumer to be spent is also limited. Subject to such available budget, the consumer seeks to maximize the total utility gained from consumption of goods and services. 1. EFFECT OF RISING PRICES ON ECONOMIC WELL-BEING OF CONSUMERS: As explained earlier, consumers have limited incomes. With these incomes, they wish to maximize their satisfaction. This satisfaction is gained through consuming goods and services.

However, with limited incomes, there is a limitation on the consumption of goods. Where the consumer has equal preference for two goods, he is said to be indifferent between these two goods. The income of an individual consumer is shown in the diagram below. It is assumed that this income is divided by the consumer for the consumption of two products, one of which is the energy source shown along the X-axis. The economic well-being of the consumer is in that he uses both the goods to his entire satisfaction with his limited income.

To explain the effect of rising prices on economic well-being of households, assume that the consumer has a limited income which is represented by Budget line BC1. This budget line in the graph shows that the consumer can divide his income between the energy source and other goods by such income. The indifference curve IC1 shows different consumption options available to the consumer for consumption generate equal utility to the consumer. But all the points situated on IC1 are located above the budget line except Point A.

so, the consumer will get maximum satisfaction by utilizing X1 units of energy source and Y1 units of good Y. With corresponding increase in the price of energy source, the units which may be consumed by the consumer become less. So, the budget line is rotated inwards. New budget line obtained is BC2. The new indifference curve obtained after rising the price of energy source is IC2 and the new equilibrium point which generates maximum satisfaction for the consumers is B. at this point, the consumer will get maximum satisfaction by consuming X2 units of energy source and Y2 units of product Y.

It is to be noted that due to rise of price of energy source, the consumption of both the products has been reduced. Thus, this will adversely affect the well-being of the consumer as the consumer will have to sacrifice the units of both the goods in order to attain equilibrium for the consumption of both the units. EFFECT OF RISING PRICES ON ENERGY CONSUMPTION PATTERNS OF HOUSEHOLDS: The rising prices will also affect the energy consumption patterns of the households. It will specially affect the consumption patterns if the consumers have an alternative source of energy.

In case of rising prices, the consumer consumption pattern will be tilted towards that alternative source of energy. The budget line is BC1 before the price change and the IC will show the indifference curve. As the price of energy source is raised, the budget line will be shifted to BC2. This budget line shows the shift of the consumers towards alternative energy source. The assumption made in this regard is that the incomes of the consumers remain constant. With the change in price, the consumption pattern of households will change as they will raise the consumption of alternative source of energy from Y1 to Y2.

On the other hand, the consumption of basic energy will be reduced from X1 to X2. EFFECT OF INCREASED GOVERNMENT CASH PAYMENTS ON ENRGY CONSUMPTION PATTERNS, HOUSEHOLD BUDGETS AND ECONOMIC WELL BEING: Increase in payments by government will increase the relative income of the consumers. This will improve the economic well being and budget of the households. It will also improve the consumption capacity of the households. Initially the income of the households is taken as BC1. This show the different combinations of energy source and other goods which he can consume with this limited income.

With the increased government payments, the income of the households will be increased from BC1 to BC2. The indifference curve will also be improved from IC1 to IC2. Now, with this increased income the purchasing power of the household will also be improved. The household can now buy X2 units of energy power and Y2 units of other product. So both the budget and economic well being of the consumers will be increased. The energy consumption pattern of households will also be changed due to increased government payments.

It can be seen that initially the household can consume X1 units of energy source and Y1 units of other product. However, with the increase in price, the consumption of energy source will be reduced to X3. On the other hand, the consumption of alternative source of energy, if any, will be increased to Y3. When the government increases the cash payments to households, the income of the households will be increased and new income line of BC3 will be obtained. The budgets and economic well-being of the households will be improved as well as consumption patterns of the households.

With the increase in income, the consumption pattern is changed as such that the energy source consumption will be increased to X2 and the other goods consumption will be improved to Y2. So, the consumption pattern will be changed considerably due to change in income. References: 1. Intermediate Microeconomics. Chapter 2: Consumer Choice. http://econweb.umd.edu/~trandafi/econ306/Chapter_02_6spp.pdf (accessed August 25, 2011) 2. N. Gregory Mankiw. 2007. Chapter 21: The Theory of Consumer Choice.

http://www.unm.edu/~parkman/M21.pdf (accessed August 25, 2011) 3. 2006. Chapter 5: Consumer Choice Indifference Theory. http://www.oup.com/uk/orc/bin/9780199286416/lipsey_chap05.pdf (accessed August 25, 2011) 4. Basic Economics. Theory of Consumer Choice. http://www.basiceconomics.info/theory-of-consumer-choice.php (accessed August 26, 2011) 5. Consumer Choice. http://en.wikipedia.org/wiki/Consumer_choice (accessed August 26, 2011) 6. John M. Gowdy, Kozo Mayumi. 2001. Analysis. http://homepages.rpi.edu/~gowdyj/mypapers/EcoEcon2000.

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