Hello Everyone,

Could you please help me with this question?

1. Gasoline subsidies in Ecuador

For this exercise, read the two financial times article (October 2019) on gasoline subsidies in Ecuador in the problem set page.

This is an excerpt from one of them.

Ecuador is to scrap fuel subsidies to meet targets agreed with the IMF, risking a popular backlash as it tries to keep international investors happy and stay on track in its $4.2bn programme with the Washington-based lender.

(...)

President Lenn Moreno's government shied away from raising VAT rates to keep to Ecuador's IMF targets, which require the country to turn its fiscal deficit into a surplus, reduce its debt pile and shore up foreign reserves.

He said the state would instead eliminate subsidies on diesel and gasoline, saving the state around $1.3bn a year.

The measures will have a massive and immediate impact on fuel prices, which are among the cheapest in Latin America. Local analysts say the price of gasoline will rise by between 25 and 75 percent (...)

"The next few days will determine whether these subsidy cuts are permanent," said Siobhan Morden, head of Latin America Fixed Income Strategy at Amherst Pierpont Securities.

"It's not exactly what we were expecting with the focus shifting from tax hikes to fuel subsidy cuts. But this equates roughly to what was expected from a 3 per cent VAT hike and delivers more efficient fiscal savings."

Part A

(a) Explain why Siobhan Morden claims that cutting the subsidies on gasoline instead of in-creasing the VAT1, delivers more efficient fiscal savings. In particular, compare a scenario 1 with an increase in VAT and no cuts in fuel subsidy and a scenario 2, with no increase in VAT, but the fuel subsidy cuts (we are assuming the same amount of fiscal savings for the two scenarios) and argue whether

i. Scenario 2 is associated with a lower deadweight loss than scenario 1. Explain (maybe with the help of some figures)

ii. Scenario 2 is a Pareto improvement over scenario 1. Explain.

(b) The plan of Ecuador's President triggered weeks of mass protests. Do you think that if Moreno had chosen the scenario 1 (instead of scenario 2) he could have avoided the mass protests? Explain.

Part B

(c) Assume that before the elimination of the subsidies on gasoline, the price paid per one unit of gasoline by the buyers in Ecuador was pb = 5 and that the quantity of gasoline consumed in Ecuador was equal to Q = 100. Assume that the price elasticity of demand of gasoline at pb = 5 is equal to E = 1 .

2

i. If after the elimination of the subsidies on gasoline, the price paid by the buyers in-crease by 50%, what is the decrease in the quantity demanded of gasoline?

ii. Obtain the linear approximation of the demand curve for gasoline and illustrate it graphically.

(d) Now assume that a (different) demand curve for gasoline in Ecuador is given by the func-tion

Thanks,