Critical Thinking

Abstract price inelastic, therefore, it is not expected

Abstract

In recent years many countries which have subsidies economies are considering subside reforms. In March 2004 oil consumption reached to 80 million barrels per day and made the crisis in the oil market since then fuel subsidiary economies are trying to get rid of fuel subside and increase the price of fuel to the real price. This research has reviewed the studies about price elasticity of demand for gasoline in subside economies and concluded that gasoline demand is price inelastic. By knowing the price elasticity of demand, the government can gauge public response towards a policy change that involved a reduction in the fuel subsidy. Thus the subsidies government should not expect a huge reduction in the demand of gasoline after executing their subsidy reform.  

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Introduction

Recently, most of the government of the subsidized economies have confronted an ample challenge in paying subside for the domestic gasoline consumption and have commenced the subsidy reform. Fuel subsidies irritate gasoline demand, and cause widely problem such as uneconomical gasoline consumption, environmental pollution crisis, the smuggling, gasoline inadequacy and budget shortage. Considerable amount of money could be release by reducing the subsidy of gasoline, which could be used in more crucial public services like welfare and education system.  

Therefore many of these countries have ambitious program to change the fuel subsidy policy and they attempt to raise the gasoline price to adapt with the international prices. Depth knowledge of price elasticity of gasoline helps the government to develop a reasonable policymaking and reduce the probability of inappropriate decisions. The aim of this essay is to investigate and discuss the reaction of the domestic consumer in response to raising price of gasoline in short run and long run. It is postulated that gasoline demand for both short run and long run is tended to be price inelastic, therefore, it is not expected to have a huge reduction in demand for gasoline after increasing its price.

Subsidies governments faced main question “How do the consumers respond to raising the gasoline price?” This question could be answered with the concept of price elasticity of demand as an important factor which should be considered. This essay will investigate the relation between the demand of gasoline and price of it in fuel subsidy economies. This could be crucial as the adjustment the gasoline price from a subsidy price is a risky action for the government. Because this reformation can be broken apart by the differences in the estimation of price elasticity of demand.

 The first section of this paper will present the definition of fuel subsidy, different probable reasons for paying fuel subsidies and the consequences of fuel subsidies. In the following section of the essay, the variety of gasoline prices all around the world including subsidies economics have been shown, also the reason of this variation has been explained. Following it, the consumption of gasoline in subsidies economies have been discussed and the plot of the relation between consumption and price of gasoline has been demonstrated. The last section of the research will outline some of the researches which have been done to estimate the price elasticity of demand for gasoline in fuel subsidize economies, by differentiating subsidize economies it is expected to get more precise estimation of price elasticity of demand. The paper then conclude that, as a result of such investigation, these government should not be disappointed by comparatively small reduction of the gasoline demand in short run.

Fuel Subsidy

Fuel subsidies have been defined in many ways in purpose of explaining different contributions. The Larsen and Shah defined fuel subsidy as: “The difference between domestic fuel prices and their opportunity cost evaluated at end-user prices. When fuels are traded internationally, border prices serve as opportunity cost.” (Shah, 1992) Many developing countries subsidy the fuel prices (concluding natural gas, gasoline and electricity…) and distribute them with lower price than international market. In 2011 International Energy Agency (IEA) announced that 37 countries in the world subsidy oil products which is estimated to be 285$ billion. Table 1 shows countries with rich oil resources and net exporter who provide subsidies for domestic consumption. In the last decade, the amount of the subsidies have been increased enormously. Due to the low price of the gasoline in these countries, demand for it has risen and it also had an effect on the international price of oil. (Nathan Balke, Michael Plante, Mine Yücel, 2014)

Table 1: “Countries with fuel subsidies 2010 (Mohammad Arzaghi, Jay Squalli , 2015)

 

The huge amount of subsidies which is the difference between international and domestic consumer price of gasoline is presented by (Davis, 2014) in Figure 1. Davis declared that “Transport, distribution and retailing cost were incorporated following IMF (2013).” For measuring the total value dollar the author multiplied the subsidy per gallon by road-sector consumption of gasoline and diesel. “By this measure there are 24 countries that subsidize gasoline and 35 countries that subside diesel.” (Davis, 2014)

“Figure1. Dollar Value of Fuel Subsidies in 2012, Top 10 Countries” (Davis, 2014)

 

As figure 1 shows, each year subsidy governments pay billions of dollars for domestic gasoline consumption. The question is that: why do they tend to pay these huge amount of money while the can use this money in developing the infrastructure of the countries? The idea of subsidy in some of these countries has been viewed as sharing the resources among all the habitant of the countries, however this idea is not true about all of the subsidy economics.  (Davis, 2014)

On the other hand, in these countries government leverages the fuel subsidies to moderate the price of fuel as a reaction to the volatility of oil price in international market, and provide fuel in an affordable price to achieve the industrial improvement objectives. (World Bank, 2014)  The fuel subsidies may also arise from some other reasons, like weak institutions, supporting the low income households by the government, motivate production and using other energy resources or even bending some specific interests groups. (Whitley, 2013) “Similarly, interest groups, which are usually highly organized often capitalize on the lack of institutional capacity to press their respective governments for subsidies in return for political support.” (Mohammad Arzaghi, Jay Squalli , 2015)

           While paying subsidies may has some political reasons for the governments, they cause so many problems. As the first impact of paying subsidies and providing low price fuel is the environmental crisis. The fuel subsidies impact on the environment can be divided in two parts: direct impact and indirect impact. As the direct impact, already huge amount of fuel wasted in all around the world and fuel subsidies can strength this amount to a higher level (Pearce, 2003). As the indirect impact, in some articles like (Pearce, 2003) and (Koplow, n.d.) fuel subsidies are considered as an obstacle for investing in new technology for discovering newer and cleaner source of energy. As some other impacts of fuel subsidies Arzaghi (Mohammad Arzaghi, Jay Squalli , 2015) mentioned “the widespread problems such as the budget deficits, the smuggling of the fuel across the borders and fuel shortage”.

            As a result of all these negative impacts of fuel subsidies many of these countries has an ambitious objective to reform their subsidies policies and adapt the fuel prices with the international fuel prices. Many economists believe that such price adjustment is one of the most argumentative matter in the process of subsidy reform. Since such adjustment could involve wide-ranged adaption, a rational understanding of gasoline price elasticity of demand must be considered by theses governments in order to develop the most efficient policy making. (Mohammad Arzaghi, Jay Squalli , 2015). Price elasticity of demand presents a prospect about the behavior of the consumers in reaction to changes in the price of gasoline in the process of subsidy reform, in following sections we will consider some studies which have been done for estimation of price elasticity of demand and investigate some fuel subsidies reform has been done all around the world.

Gasoline Prices

Figure 2 outlines the road-sector gasoline consumption per capita and gasoline for 128 countries from a survey which has been done in November 2012 in the Hass School of business, University of California. Taxes are included in domestic prices and size of the circle is related to the population of the country.  (Davis, 2013)

As we can see in the Figure 1, there is a variation in prices of gasoline worldwide. Average price according to (Davis, 2013) is $5.26 per gallon, the range is between $.09 per gallon in Venezuela to highest amount in Turkey and Norway with $9.00. The most important reason for this variation is that taxes and subside vary extensively all around the world (GTZ, 2009). Taxes for gasoline per gallon in OECD countries vary from an average of 0.49$ in the USA, and the highest tax is in Netherland and Germany with 4$ (Knitttel, Christopher R , 2012). In countries outside the OECD, the variety of gasoline taxes is higher. There are so many countries where the government pay subside for gasoline and diesel, and distributing these products with lower price compare to international market. Majority of them are located in the Middle East (Iran, Saudi Arabia) although some countries in Africa (Algeria, Nigeria), in Asia (Indonesia, Malaysia), and South Africa (Bolivia, Ecuador) subsidize gasoline. (Davis, 2013)

Figure 2: Gasoline Consumption per capita and Price Worldwide (Davis, 2013)

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Gasoline Consumption

In subsidized countries gasoline consumption is higher than other countries in the world, due to the lower price in compare to international market. For instance, Saudi Arabia is the sixth largest oil consumer in the world since fuel consumption in this subsidized country has increased nine fold from 1917 (Gately, Dermot, Nourah Al-yousef and Ahmad M.H.Al-Sheikh , 2012). Another example is Venezuela where gasoline consumption per capita with 40% higher has the first rate among all countries in Latin America (Davis, 2014).

Figure 3 shows the correlation between gasoline consumption per capita and gasoline price in 2014 for subsidized countries listed in Table1. There is an inverse correlation between the two variables: gasoline consumption tend to be higher in the countries with lower gasoline price, relatively it tend to be lower where price is higher. Gasoline consumption differs extensively among countries with nearly identical gasoline price. This variation could be explained by considering some other variables which influence on the demand of gasoline, such as Income per capita or economics and environmental factors.

 Although it should be expected that consumers react to raising the price of gasoline and reduce their gasoline consumption, the evidence from these countries show that usually consumer do not decrease their demand of gasoline as it is expected. So, in order to consider more accurately the relation between price and demand of gasoline, it is suggested to investigate the elasticity of gasoline price and the other variable which could have an influence on the demand of gasoline.

 

 

 

 

 

 

 

        Figure3. Gasoline Consumption and gasoline price, World Bank (Bank, 2014)

Price Elasticity of Demand

In order to estimate the price elasticity of gasoline demand, it should be first considered the demand function of gasoline. Many studies have used the basic microeconomic theory to determine the most important variable which could has an effect on the demand of gasoline. Sterner (Sterner, 2007) in his research presented the following function of demand:

            (1)

In this function the demand of gasoline depends on some variables such as: (p) price of the gasoline, (y) real income, (x) prices and availability of substitutes and complements and some other variables like environmental factors.

            Following the demand function of gasoline, log-linear formulation (2) provides the price elasticity of demand of Gasoline (?) and the income elasticity of demand (?). (Gujarati, 2004) 

    (2)

            Many empirical studies used different methods to estimate the price elasticity of gasoline demand for run long and short run for subsidy economies.  Almost most of them proved that demand of gasoline is inelastic, no matter the long run or short run (Mohammad Arzaghi, Jay Squalli , 2015). Table 2 summarizes the relevant studies which have been done to estimate the price and income elasticity of demand. Although each of studies in table 2 considered different scopes of research for estimation of elasticities, all of them declare that demand and price are both inelastic in short run and long run.                                                                  

Source

Countries

Short Run            

Long Run            

Short Run

Long Run

 (Al-Sahlawi, 1988)

Saudi Arabia

-0.08                            

0.11

(Eltony, n.d.)

GCC

– 0.09                     

 -0.11                     

0.21                    

0.23

(Eltony, M.N., Al-Mutairi, N.H., 1995)

Kuwait

-0.37                      

0.47

(McRae, 1994)

10 Asian Countries          

 

 

 

 

 

Low-Income

-0.03 to 0.38

 

High-Income

-0.12 to -0.49

(Bhattacharyya, S.C., Blake, A, 2009)

MENA

-0.18 to 0.08

-0.49 to -1.06

0.21 to 0.65

0.28 to 2.58

(Pock, 2010)

14 European Countries

-0.04 to -0.19

0.04 to 0.23

(Dahl, 2012)

124 countries

-0.04 to -0.69

0.23 to 2.06

(Burke, P.J., Nishitateno, S., 2013)

132 countries

-0.2 to -0.5

0.95 to 1.10

(Lin, C.-Y.C., Zeng, J. , 2013)

China

-0.19 to – 0.49

1.01 to 1.05

                                                                                               

Table 2 selected previous Price & Income Elasticity of Gasoline (Mohammad Arzaghi, Jay Squalli , 2015)

                                                                                                        Price elasticity                                      Income E

 

Price elasticity of demand for gasoline has also been estimated -0.05 and -0.25 respectively short run and long run by (Mohammad Arzaghi, Jay Squalli , 2015) using biennial panel road sector data for a period of 1998-2010 for 32 subsidy countries. So if governments of subsidy economic decide to raise the price of gasoline for about 10% the demand of gasoline in short run will reduce for about 0.5% in short run and in long run 2.5%.  Thus the governments should not expect a huge reduction in the response to rising gasoline price.

Conclusion

This essay has attempted to answer the question “How do gasoline consumers response to rising its price in the process of subsidy reform?” We declared the concept of the elasticity of demand and reviewed some studies which estimated price elasticity of gasoline for subsidies economies. According to these studies, the price elasticity of demand for gasoline is inelastic in short run and long run in fuel subsidies economies. Because of low price gasoline and highly price inelasticity, subsidies governments have been faced with numerous challenges in the process of subsidy reform. Firstly, on the economic scopes, sharply raising the price may result failure in highly reducing demand in the short run. Secondly, on political scopes, sharply raising the price may stimulate public dissatisfaction and political instability. Thirdly, on the efficiency scope, rising price with any size may fail to change in deadweight loss in the short run. However in long run, it is expected that such reformation may result in improving the welfare benefits. (Plante, 2014)

Countries who pursuing the subsidy reformation knows that adapting the gasoline price at the pump with the international market needs huge adjustment.  They try to raise the gasoline price in the format of different steps, so they are under the pursuer of increasing poverty and economics problems resulting in public dissatisfaction. For instance in 2012, government of Nigeria decided to raise the price of gasoline at the pump from $0.41 to $0.89 per liter, triggering huge demonstration and strikes in Nigeria, Due to public protests, government decided to rationally get back from subsidy reform and reduce the price to $0.61 (Akinbobola, 2012). As another example, in my country Iran, government decided to start the subsidy reform in 2010 with the purpose of aligning gasoline price with the international price, when the gasoline price was $0.10. After quadrupling gasoline price in the first phase of the reformation, the daily gasoline consumption reduced for about 17% (from 64 million to about 53 million1). Thus government should not be disappointed for relatively small reduction of gasoline consumption. It is suggested that these government should be more aggressive to stay on the road map of the subsidy reformation and executing progressively their subsidies reformations. (Mohammad Arzaghi, Jay Squalli , 2015)

It can be concluded that the gasoline consumers will not extensively reduce their consumption in fuel subsidy economies in the short and long run. While governments continue their reformations, they can have some other actions to help controlling the demand, such as improving the public transportation and prohibiting the usage of old cars. On the other hand subsidies could be payed by government to the producer. From this perspective in many developed countries the mass of subsidies are distributing among the producers in order to reinforce the domestic production and to stimulate using new technologies which are named as infant industries. (WorldBank, 2010)

1 Source: PBS, Petroleum Product Usage Plummets Post-Subsidy Paring, December 29, 2010 available at http://tinyurl.com/q3834rj

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