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Mexican Chutes and Ladders
Subject Taxes and subsidies
Topic Equilibrium
Key Words Government, subsidies, budget deficit, prices, sales taxes, inflation, monetary policy
News Story

The Mexican government had planned massive cuts in electricity subsidies to residential customers in an attempt to reduce the budget deficit. Electricity prices, already among the world's highest, would have risen by up to 300 percent. However, there were demonstrations in the northern states that use a lot of air-conditioning; and the opposition party urged customers not to pay their new bills. As a result, the government reduced the planned cut in subsidy by 20 percent, and only the wealthiest 25 percent of households will see an increase in prices.

The government also failed to convince Congress of the merits of a new 15 percent sales tax on food and medicine. Nevertheless, Congress did approve a patchwork set of sales taxes on cellular telephone service, flat computer screens, restaurant meals, and certain luxury goods.

The subsidy reductions and tax hikes are expected to increase inflation above the target 4.5 percent. Restrictive monetary policy may be necessary.

(Updated April 1, 2002)

Questions
1. Draw a supply and demand diagram of the Mexican market for electricity. Mark the initial equilibrium price and quantity.
a) In which curve is the subsidy embodied? Explain why.
b) Show the effect of reducing the subsidy on the equilibrium price and quantity of electricity.
2. Now draw a supply and demand diagram of the market for restaurant meals. Show the initial equilibrium.
a) Which curve would a tax influence? Why?
b) Show the effect of an increase in the tax on restaurant meals on the equilibrium price and quantity.
3. Why was the rate of inflation endangered?
Source Sara Silver, "Mexico Reneges On Plans To Cut Electricity Subsidy," Financial Times, February 7, 2002.

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