Annex I. Efficiency Costs of Price Distortions: Estimating the Deadweight Loss and the Impact on Income (Growth)
The three basic postulates for applied welfare economics are the pillars for assessing efficiency costs and calculating the deadweight loss. The postulates are: 1
a) The demand price for a given unit measures the value of that unit to the demander;
b) The supply price for a given unit measures the value of that unit to the supplier;
c) When evaluating the net benefits or costs of a given action (program, project, or policy), the costs and benefits accruing to each member of the relevant group should be added.
Assume for simplicity a perfectly elastic supply curve –i.e. the marginal cost is zero and the country is a price taker in global markets, at world prices Pw (international benchmark prices). Market equilibrium is reached when consumers buy Qw (Figure 1). Postulate a) indicates that consumers’ valuation for Qw is given by the area below the demand curve (A+B+C); however, from postulate b) we know that for getting Qw individuals pay Pw*Qw is equivalent to area B+C. From postulate c), the net gain for the economy is given by A, which in this case (perfectly elastic supply curve) is equal to the consumer surplus.
If the government decides to sell Q in the domestic market (e.g. energy products) at a price Pd, which is below international prices Pw, then the amount consumed domestically will increase to Qd. The per unit opportunity cost of this policy is given by the price gap Pw – Pd, i.e. the difference between the international price Pw –the price at which the economy could sell in the international market, and the domestic price Pd –the price the government receives for Q given the price policy; the opportunity cost for the government is given by areas B, E, and DW, commonly referred as “implicit subsidy” (or forgone revenue).
However, higher consumption increases consumers’ welfare in an amount given by the increase in the area below the demand curve (areas B and E). The difference between the extra benefits for the consumers and the costs for the government provide the net gain or loss for the economy; in this case, the economy as a whole loses DW, also called deadweight lost or excess burden from the policy of relatively lower domestic prices.2
Arze del Granado, J., D. Coady, and R. Gillingham, 2012, “The Unequal Benefits of Fuel Subsidies: A Review of Evidence for Developing Countries,” World Development, 40(11), pp. 2234–48.
Baig, T., A. Mati, D. Coady, and J. Ntamatungiro, 2007, “Domestic Petroleum Product Prices and Subsidies: Recent Developments and Reform Strategies,” IMF Working Paper, WP/07/71, International Monetary Fund, Washington DC.
BP Statistical Review of World Energy, 2015 (http://www.bp.com/statisticalreview).
Bridel, A., and L. Lontoh, 2014, “Lessons Learned: Malaysia’s 2013 Fuel Subsidy Reform”, The International Institute for Sustainable Development, Winnipeg, Canada.
Charap, J., A. Ribeiro da Silva, and P. Rodriguez, 2013, “Energy Subsidies and Energy Consumption -A Cross Country Analysis,” IMF Working Paper, WP/13/112, International Monetary Fund, Washington DC.
Coady, D., J. Arze del Granado, L. Eyraud, H. Jin, V. Thakoor, A. Tuladhar, and L. Nemeth, 2012, “Automatic Fuel Pricing Mechanisms with Price Smoothing: Design, Implementation, and Fiscal Implications,” International Monetary Fund, Washington DC.
Coady, D, I. Parry, L. Sears, and B. Shang, 2015, “How Large Are Global Energy Subsidies?,” IMF Working Paper, WP/15/105, International Monetary Fund, Washington DC.
Ebeke, C., and C. Ngouana, 2015, “Energy Subsidies and Public Social Spending: Theory and Evidence,” Working Paper, WP/15/01, International Monetary Fund, Washington, DC.
Ghezzi, P, L. Ricci and J. Zuniga, 2011, “Easy Money in Not for All EM: Rising focus on Commodity Prices and EM Inflation,” Barclays Capital, Emerging Market Research.
Harberger, A. C., 1971, “Three basic postulates for applied welfare economics: An Interpretative Essay,” Journal of Economic Literature, September, 9:3, pp. 785–97.
International Monetary Fund, 2011a, Regional Economic Outlook: Middle East and Central Asia, World Economic and Financial Surveys (Washington).
International Monetary Fund, 2015, United Arab Emirates: Selected Issues Country Report, Washington, DC., International Monetary Fund.
Small, K., and K. Van Dender, 2006, “Fuel Efficiency and Motor Vehicle Travel: The Declining Rebound Effect,” Energy Journal, Vol. 28, No. 1, pp. 25–52.
Koplow, D., 2009, “Measuring Energy Subsidies Using the Price Gap Approach: What Does It Leave Out? IISD Trade, Investment and Climate Change Series,” (Winnipeg: International Institute for Sustainable Development.
Leamer, E. E., 1995, “The Heckscher-Ohlin Model in Theory and Practice,” Princeton Studies in International Finance 77, International Finance Section, Department of Economics, Princeton University.
Meltzer, J., N. Hultman, and C. Langley, 2014, “Low-Carbon Energy Transitions in Qatar and the GCC Region,” Brookings Institution, February.
Pedersen, M., 2011, “Propagation of Shocks to Food and Energy Prices: A International Comparison,” mimeo, Central Bank of Chile.
Schott, P. K., 2003, “One Size Fits All? Heckscher-Ohlin Specialization in Global Production,” American Economic Review, 93(3): 686–708.
Prepared by Sergio Rodriguez, Malika Pant, and Juan Carlos Flores. Diana Kargbo-Sical provided editorial assistance.
See Koplow, D. (2009) and IMF (2013a) for a discussion of the price gap approach, including the attributes that the benchmark price should have. In general, when the energy product is traded internationally the benchmark price is given by an export price; when the product is not traded internationally, the appropriate benchmark is the cost-recovery price for the domestic producer, with inputs valued at their opportunity cost, including raw materials, labor, capital, and distribution costs. Using pre-tax prices, however, does not account for the environmental damage caused by high energy consumption. Using a price benchmark that accounted for environmental costs would lead to a larger estimated cost than shown in this paragraph. See Coady et al., 2015, for a comprehensive discussion of this issue.
For instance, for 2011 when the average oil price was $104 per barrel (almost twice the estimated average for 2015 at $52 per barrel) IMF (2013a) reports estimated costs for Emerging and Developing Asia (1 percent of GDP), Central and Eastern Europe and Common Wealth of Independent States, CIS (1.5 percent of GDP), Latin America and the Caribbean (0.5 percent of GDP); estimates for the Middle East and North Africa, which includes the GCC, amounted to 8.5 percent of GDP.
In fact, regressing energy consumption per unit of GDP against the price of gasoline (in natural logarithms) produces an estimated price elasticity of minus 0.5, with confidence interval of (-0.62, -0.28) -in line with other estimates in the literature; note that this estimate imposes income elasticity equal to one. See Charap et al. (2013) for a more comprehensive analysis of energy consumption elasticities, which takes into account other variables such as climate. In particular, they find that having a winter (summer) period that is on average 10 degrees Celsius colder (hotter) will increase energy consumption by 2.9 (2.6) percent.
See Coady et al. (2015) for a discussion and estimation of the costs associated with the environmental damage created by energy consumption. The authors conclude that in many countries domestic energy prices do not reflect the cost of domestic environmental damage, which suggests that unilateral reform of energy prices is mostly in countries’ own interest.
Meltzer, J., Hultman, N., and Langley, C, (2014). “Low-Carbon Energy Transitions in Qatar and the GCC Region,” Brookings Institution, February.
Successful cases are those where countries implemented reforms that led to a permanent and sustained reduction of subsidies; partially successful cases are those that achieved a reduction of subsidies for at least a year, but where subsidies have reemerged or remain a policy issue; unsuccessful cases are those where energy price reforms failed, with price increases or efforts to improve efficiency in the energy sector being rolled back soon after the reform began.
Weights in the CPI reflect both prices and amounts consumed. Low prices of energy products tend to reduce spending and CPI weights. Given the relatively low price elasticity for energy products it is expected that spending on energy products would increase if energy prices were raised.
Monthly inflation is defined as the percent change in prices in one month with respect to the previous month. Domestic inflation shocks were selected as follows: for each CPI sub-index monthly inflation was calculated during the sample period, which varies between 11 and 6 years, depending on data availability for each country. For each sub-index (e.g. Transport) the 10 percent largest monthly price changes were defined as “shocks”. Each shock was compared with monthly headline inflation during the 12 months after and before the price shock occurred. For instance, let’s assume that one of the largest monthly price changes in Transport prices occurred in March 2008. To assess whether the shock to Transport prices in Mach 2008 had an impact on headline inflation, the exercise looks at headline monthly inflation between March 2007 – February 2008 (12 months before the price shock) and between April 2008 – March 2009 (12 months after the price shock). If monthly headline inflation is broadly the same before and after the identified shock to transport prices, then the finding would suggest that the shock to transport prices did not propagate into headline inflation.
Average (2013 -2014) corporate sector return on equity for Bahrain is 8.3 percent; for Kuwait, 3.7 percent; for Oman, 11.9 percent; for Qatar, 14.3 percent; for Saudi Arabia, 7.5 percent; for the UAE, 7.1 percent. See Corporate Vulnerability Utility, IMF.
A more appropriate rate of return to assess the contribution to growth from an energy price reform would be the economic opportunity cost of capital, the weighted average of the return to capital in the private sector and the return on savings, the return of return used to assess public investment projects in several countries.
Harberger, A. C. (1971). “Three Basic Postulates for Applied Welfare Economics: An Interpretative Essay.” Journal of Economic Literature. September, 9:3, pp. 785–97.
Estimation of areas below and above the demand and supply curve is a routine exercise in Cost – Benefit Analysis. Applications of this methodology for assessing efficiency costs in output and input markets, including for labor, capital, and foreign exchange are discussed in Jenkins, G.P., Kuo, C., and Harberger, A.C. (2011) Cost Benefit Analysis for Investment Decisions.
For a discussion on the estimation of efficiency costs arising from price distortions see Hines, J. R. (1999) “Three Sides of Harberger Triangles,” Journal of Economic Perspectives. Volume 13, Number 2, pages 167–188. In particular, note the discussion on general equilibrium considerations:
“Harberger’s papers do not take explicit account of all possible general equilibrium price interactions between markets, relying instead on the assumption that the effects of any unaccounted price changes are unlikely to overturn the qualitative conclusions of his analysis. The general equilibrium work of numerous writers —for example, Shoven and Whalley (1972, 1977), Shoven (1976), Ballard, Shoven and Whalley (1985) and Ballard et al. (1985)—largely supports this assumption.”