"Fuel Subsidies Drag Down a Nation"

Why lump-sum transfers are better than fuel subsidies:

How Fuel Subsidies Drag Down a Nation, by Robert H. Frank, Ecponomic View, NY Times: ...[M]any emerging economies employ subsidies that keep domestic fuel prices far below the world price. As a result, these countries consume far more fuel than they would otherwise.

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. ...

It would surely be unrealistic to expect other governments to abandon subsidies just so Americans who drive S.U.V.’s and live in big houses could benefit from lower world energy prices. But those 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. ...

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 ... 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 ... substantial. 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...

Consider how this difference might affect a trucker’s decision about whether to accept a hauling job. ... Suppose the job... requires 1,000 gallons of fuel, available at the subsidized price of $2 a gallon, for a total fuel outlay of $2,000. If the cost of the trucker’s time and equipment are, say, $1,000 for the trip, his narrow interests dictate accepting the job if the shipper is willing to pay at least $3,000. Suppose the shipper is willing to pay that amount but not more.

The problem is that if the trucker accepts the job at that price, the country as a whole will be worse off by more than $2,000. Although the $3,000 fee would cover his own costs, the government would end up paying $2,000 in additional subsidies for the 1,000 gallons consumed. On top of that, the trip would generate additional pollution and congestion costs. So the fact that the subsidy encouraged him to accept the job means that its net effect is equivalent to throwing more than $2,000 onto a bonfire.

Waste is always bad. ... Subsidy proponents cite the firestorm of political protest that would erupt if fuel were to sell at the international market price. That fuel subsidies are wasteful, however, implies that there must be less costly ways to keep the peace.

Consider again our trucker... Instead of paying $2,000 to subsidize his fuel, the government could give him a tax cut of, say, $1,000, and use the remaining $1,000 to help pay for public services. Because the trucker’s earnings from the hauling job were only enough to cover his costs at the subsidized fuel price, he would be $1,000 better off with the tax cut alone than with the fuel subsidy. The additional support for public services would augment this benefit. In short, a tax cut is always a better way to keep political protest at bay because ... it does not encourage shipments whose costs exceed their benefits.

If a United States president urged developing economies to eliminate fuel subsidies because they result in higher energy prices for Americans, the conversation would probably end very quickly. But this conversation might be reframed.

A good place to start would be to heed the same advice we’d like others to follow. Emerging economies are not the only ones in which prices at the pump substantially understate the true social cost of fuel. ... Adopting some variant of a tax on carbon ... would help eliminate this discrepancy.

That would set the stage for our next president to explain to other leaders why eliminating fuel subsidies would make the overall economic pie larger. Because the resulting efficiency gains can be redistributed so that everyone gets a bigger slice than before, the idea should be fairly easy to sell.

Comments

[Aaron]

Why should we care if other nations subsidize their citizens oil consumption? Lord know they screw them at every other turn. If subsidizing consumption is how they want to spend their money, then let it be.

[Bruce Wilder]

Why do so many countries do it? Why subsidize fuel, and not other goods?

Robert H. Frank is not one of my favorite economists, and this condescending arrogance, apparently, is his stock-in-trade. "Waste is always bad" is the lecture. Glad you could clear that up for us, Professor.

When economists are not assuming markets are performing perfectly, they are assuming that governments and politicians are as dumb as rocks. (I'm sure politicians everywhere will appreciate the tip that tax cuts are a good way to keep protest at bay.)

Somehow, I suspect Frank is missing something essential here. It certainly wouldn't be the first time the economic naturalist mistook a post for a tree, and assumed a forest. He couldn't be bothered to think that anything so common might be motivated by something more than rank stupidity -- he, after all, is sure he understands, and can explain the matter plainly enough that a first-grader can understand.

[Lorenzo]

China recently had reduced gasoline subsidies, or so they say. It would be interesting to see how much consumption has decreased in that country and what affect that has had on the price of gas in the U.S..

[ilsm]

The US taxpayer is the largest source of oil based "fuel subsidy".

Remove the US from the Persian Gulf and end the one payer insecurity subsidy.

Let the buyer see the price of dependence on the sheiks.

[save_the_rustbelt]

"Because the resulting efficiency gains can be redistributed so that everyone gets a bigger slice than before, the idea should be fairly easy to sell."

Yeah, sure, that will happen. Everyone? Not a chance.

[ken melvin]

Frank's a real big picture kinda of guy, just what the country needs.

[anne]

China selectively reduced fuel subsidies, keeping subsidies for the agricultural sector as have been the case for years. The use of fuel subsidies in China has evidently been most successful for years, and could well be studied to understand the success which would seem to be a model for developing countries to use.

The easing of international growth, including Chinese growth in recent months, from the fastest period of international growth since 1945, has been responsible for the easing of commodity prices.

[anne]

Imagine my surprise....

http://www.nytimes.com/2008/08/17/washington/17pelosi.html?hp=&pagewanted=print

August 17, 2008

House to Rethink Drilling, Pelosi Says
By CARL HULSE

WASHINGTON — Dropping her opposition to a vote on coastal oil exploration, Speaker Nancy Pelosi said Saturday that the House would consider expanded offshore drilling as part of broad energy legislation when Congress returns next month.

says...

Am I missing something? If the way you measure the results is GDP, doesn't his whole analysis fall apart?

- Exchange the $2000 subsidy for the $1000 credit. The trucker stays home, GDP goes down.
- Add in the external costs (pollution, etc.) Also add a payment for someone to clean up the pollution. GDP goes up.

I don't see where he is proposing a measure of the social benefits that would make the analysis work.

In which case, he's also not shown in any way that there's something wring with subsidies.

[Julio]

That was me.

[Bruce Wilder]

[ ]:"I don't see where he is proposing a measure of the social benefits that would make the analysis work.

"In which case, he's also not shown in any way that there's something wring with subsidies."

Well, duh.

I wouldn't say that fuel subsidies are generally a good thing, but Frank's analysis of fuel subsidies is total crap.

If the trucker doesn't take the shipment, the underlying transaction doesn't take place. So, the widgets in the shipment are not produced at the point of origin, and the widgets are not sold at the destination. If widgets are not produced, economies of scale in widget production are not realized, and the average cost of widgets rises; if widgets are not sold, the widget store must close and people do not have the widgets available to produce other things.

Transportation is a network transaction, and has (potentially) a multiplier effect across the whole system of production and distrbution. It is why governments are so often keen to build railroads, highways, bridges. If you build a bridge to nowhere, nowhere becomes somewhere, as the costs of all transactions with other places fall. As the costs of transactions fall, the potential for investing in more productive, higher-scale specialization increases.

As anne wrote, China has used fuel subsidies extensively, as part of their development strategy. I wouldn't assume that they did it stupidly, because they lack the kind of "real big picture kinda of guy" that Frank is, to tell them it would drag them down.

I'd like to know the rationales and results of "successful" fuel subsidy programs, the context in which they make some sense, and when it makes sense to phase them out, and what the political problems are, when the appropriate time for phase-out comes. I'd like to know why a developing country would find fuel subsidies appealing, even though a developed country might not.

I'd like an economist, who is not an ignorant, arrogant jerk.

[Ashish]

The reason why many poor nations subsidize fuel (or fertilizer) is because they do not have a mechanism to make lump sum transfers. Social security type payments needs an extensive corruption-free banking system which most poor nations lack. So they subsidize commodities at the national level.

Most gasoline-diesel cross subsidies and fertilizer subsides were eliminated through GATT (and later WTO). So now only rich nations have social security and agricultural subsidies through the direct payment method.

It is quite unfortunate that economists and leaders of rich nations continue to go after the few remaining subsidies in poorer nations. And as in the past, they seem to be unconcerned about the plight of the poor. For example, I haven't seen any article linking the elimination of input subsidies exclusively in poorer nations to the surge in farmer suicides in India.

[reason]

Nitpicking
The problem is that when the price of a good is below its cost, people use it wastefully.

The words even more seem to be missing here. It is still not explained why people are wasteful with resources in the first place (or what wasteful means). After all as long as the marginal cost is above zero there is an incentive to avoid waste.