How fuel subsidies drag down a nation

Many emerging economies employ fuel subsidies that keep domestic fuel prices far below the world price. As a result, these countries consume far more fuel than they would otherwise, says Robert H. Frank, an economist at the Johnson School of Management at Cornell University.

By one estimate, countries with fuel subsidies accounted for virtually the entire increase in worldwide oil consumption last year.

Without this artificial demand stimulus, world oil prices would have been significantly lower.

Earlier this summer, for example, world oil prices fell by $4 a barrel on news that reduced subsidies would increase Chinese domestic fuel prices by about 17 per cent.

Governments might want to reconsider their policy in the light of overwhelming economic evidence that the subsidies create net losses even for their ostensible beneficiaries, says Frank.

The problem is that when the price of a good is below its cost, people use it wastefully. In the case of a gallon of gasoline, the cost to a country is the value of every additional sacrifice that its use entails. That includes not just the price of buying the gallon in the world market – say, $4 – but also external costs, like dirtier air and increased congestion. The external costs are often hard to measure but are nonetheless substantial, says Frank:

With reasonable estimates factored in for them, the true cost of using a gallon is clearly greater than $4.

By contrast, the price of gasoline to users is simply the amount they pay at the pump.

With a $2-a-gallon subsidy in effect, gasoline bought in the world market at $4 would sell for $2, or more than $2 less than its true economic cost.

Source: Robert H. Frank, How Fuel Subsidies Drag Down a Nation,

For text: http://www.nytimes.com/2008/08/17/business/economy/17view.html

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FMF Policy Bulletin/ 26 August 2008