There was an excellent article by a SMH economist writer on how it works in the print edition of the SMH today which I have found online and repeated the relevant bits below. She explains it much better than i could and used carbon instead of coffee as well........
Story follows
Economics students learn pretty early on that there are two important ways that changes in prices influence consumption. First, a price increase on a certain good has an ''income effect''. By reducing a consumer's real income, it makes them feel poorer and prompts them to consume less of that good.
It is true the government intends to shield low- and middle-income households from this income effect by compensating them with tax cuts or cash payments for the full impact of any price increases on energy or food.
But there is a second way that higher prices influence consumption. Economists call it the ''substitution effect''. A higher price for carbon-intense products, such as electricity, encourages consumers to switch to consuming less carbon-intense goods and services.
For households this may mean simply consuming less electricity, by unplugging that second fridge or not heating the pool year-round, meaning they have more money for other things, such as ice from the servo to cool their drinks or a bicycle for exercise instead of swimming in winter.
Raising the price on a particular good gives households the signal to reduce their consumption of that good. And here's the happy news for those households: because the government has decided to assume no change in household energy consumption in response to higher prices, paying people for their current consumption levels, households that reduce their energy use after a carbon price is introduced will end up financially ahead of where they would be with no carbon price.
Treasury noted this effect in a confidential executive minute to Treasurer Wayne Swan on October 11, released under freedom of information laws last Friday. ''A feasible assistance package assists people with the higher prices of goods and services they currently consume, even though the higher prices will encourage them to switch to cheaper or less carbon-emitting products. Therefore, some overcompensation should be expected.''
For all the bleating about rising cost-of-living pressures, the fact is low- and middle-income households will be no worse off with a price on carbon and to the extent they change their behaviour to reduce their consumption, they will be better off.
The government is, in effect, laying a $100 note on the ground - all households have to do to pick it up is switch to consuming less carbon-intense sources of energy or use less energy. What would you do?
One caveat to this is that it can be relatively hard for households to reduce their energy use. In fact, most of the reduction in emissions coming from a carbon price are likely to come from businesses responding to price signals by switching to less carbon-intensive inputs, such as moving from coal-fired electricity to LNG. By lowering their costs of production they can can boost their profits. But exposing households to higher prices on carbon-intense products should also help at the margin.
If the former prime minister Kevin Rudd's simple admission this week that he made a mistake delaying the push for a price on carbon proves anything, it is that simple statements on this complex issue are hard to come by. The whole carbon pricing debate involves mastering some complex economic jargon. It is one of the reasons advocates have found it so hard to prosecute their case, and why opponents have found it so easy to sow seeds of doubt. But you've made it this far, so I reckon you can take it.
At heart, putting a price on carbon is about pricing an ''externality''. An externality is any benefit or cost incurred by a third party and which is not priced in the production process. When it comes to pollution, it is hard to calculate the cost to the environment. But make no mistake, there are costs associated with carbon pollution and climate change, such as the impact of more severe weather events.
High-income households and carbon-intense businesses are finally being told to wear some of that cost. But for most households, the carbon price will be pain free and, if they are clever, there might even be a $100 note or two in it for them.
