Subsidies: Microeconomics point of view

Saturday, August 2, 2008
Author kaawai Category ,

Written by MDYSphere

I agree with you subsidies on the price of petrol is inevitable . You have illustrated at the macro level how subsidies can achieve a desirable level of GDP. Once subsidies are placed into the economy, the multiplier effect will play its part.

When we talk about subsidy we are referring to Fiscal Policy which deals with government spending (Expenditure) and Imposition of Tax. It is an important policy to check and balance the economic activities within an economy.

Government expenditure on subsidies can be looked at as a long-run investment. Obviously, one talk about investment one must consider the concept of Opportunity cost of that investment. Notwithstanding the social obligations of government, perhaps, one way of looking at subsidies as a waste of resources is when the opportunities forgone for such subsidies are not taken seriously. Worst still if subsidies are presumed to stimulate spending during inflationary period. Having that extra money without prior having to produce goods and services for such extra money would only create further inflation as too much money chasing too few goods and services. An example is the subsidies on petrol recently introduced by the government, where cash money is given to motorists.

Another unique example for subsidies is the way Japanese government spent million of yen on subsidising rice. Rice was once so important to Japan’s culture that it was worshipped as a god. Yet the economic problems now facing Japan’s rice farmers make it almost impossible for them to make money. As a result, the Japanese government subsidises the industry and tries to stop imports of foreign rice. Other nations complain these practices breach world trade rules, but it could be very hard for the rice farmers to manage without such subsidies. The US, Australia and China would be popular and cheaper than the home-grown variety. Why then the Japanese government went to the extent in breaking the world trade rules and at the same time, what happen to the law of comparative advantages.

I like to look at the micro economics theory to illustrate why it is important for the government to invest by means of subsidising the price of petrol. We begin by looking at four main reasons that cause the price of crude oil to increase which in turns increase the price of petrol.

Supply and Demand

As incomes rises, economies use more energy for transport, and producing goods and services. Abroad cross section of nearly 180 countries shows that doubling per capita income more than double per capita oil consumption. How much each country contributes to increases in global energy demand depends on its population and rate of income growth.

Micro economics demand and supply theory suggests that there is an inverse relationship between price and quantity. The magnitude change in price and quantity depend on the individual elasticity. Empirical evident suggests that both supply and demand of crude oil tend to be relatively inelastic in short run. What this means is that an increase in demand would shift the demand curve to the right at a given supply curve - a greater percentage increase in price as compare to percentage increase in quantity. However, it unlikely supply will be able to meet demand in the short-run due to the nature of crude oil business. Oil exploration and production require huge investments over long periods. In the long-run supply curve will move to the right and a new equilibrium is reached. At the new equilibrium, the new price will be much higher than the old equilibrium price.

Mismatch between reserves and economic systems

A large part of the world’s oil reserves are outside the easy reach of free market, with their incentives and disciplines. Oil prices are rising not because the world is running out of oil but because the bulk of reserves are in countries where market incentives cannot work fully or in the hands of monopolists who may be exercising their power by restraining investment


The price of crude oil is controlled by an elaborate financial market system as well as by four major Anglo-American oil companies. It has been argued that as much as 60% of today’s crude oil price is pure speculation driven by large trader banks and hedge funds. It has nothing to do with the convenient myths of peak oil. It has to do with control of oil and its price.

Dollar’s Weakening

Oil has long been traded in U.S dollars. It is believed that having a single-currency system lowers transaction costs for commodity that trades globally. The weakening of dollar has a direct impact on demand, supply and price of petrol. A declining dollar makes oil cheaper for consumers this in turn increase demand for petrol. A weakening U.S. currency also reduces the dollar-denominated supply from foreign producers. Together, these two factors exert additional upward pressure on prices. When comes to adjustment in oil consumption and production, a declining dollar takes time to reshape crude oil prices because expectations do not shift quickly. Factors that push up expectations of future prices, however, also put upward pressure on spot prices because markets will adjust until investors are indifferent between holding and selling the marginal barrel of crude oil on the spot market.

Given such factors it is clearly be seen such notion of the invisible hand of Adam Smith by letting the market forces to determine the price equilibrium for patrol is no longer applicable when we referring to petrol production nowadays. Demand and supply situation only play small part in determining the market equilibrium for patrol. On the other hands, even if we agreed that Smith theory is applicable, the price equilibrium will never be reached in the long run. This is true if one looks at Cobweb model which illustrates that given the differences in elasticity of both demand and supply for a product tend be unstable. At this situation where the supply curve is more inelastic than the demand curve for petrol as such the price of petrol will never be stable in the long run. What it implies here is that price of petrol will never be at equilibrium because of mismatch between reserve and economic system, speculators, and the weakening of US dollar. Therefore, when talking about the determination of price of petrol we are no longer talk about the Adam smith notion of invisible hand. The price of petrol and the elasticity of supply and demand are solely determined by the visible hand of the factors mentioned earlier.

We expect the global price of petrol to remain relatively high. Therefore, we need to use other measure to predetermine our local price of petrol. One of the tolls is giving subsidies on the price of petrol. The reason is simple. Subsidies on price of petrol must be treated as a form of investment and the return on investment would be in the form of income collected through tax from businesses. Subsidies reduce the price of petrol and will reduce the cost of production. The reduction on cost will lead to profit for profit maximisation firms and further increase earning for the government. Were profit is there to be captured there will be more investment and more profit that leads to further increase in earning capacity for the government. Obviously, the government needs to find sources on how to finance the subsidies and this problem has been touched by certain politicians.

Subsidies will eventually be self-financing and this is because in the long run the extra earnings by the government will eventually pay for the subsidies invested. The policy of reducing income tax, waive the dividend tax and RPGT has little impact on the burden by the increase in the price of petrol. Money given directly to the population, at times, can do more harm than good to the economy. We must remember lots of money in the pocket does not necessarily imply that money can acquire more goods and services. What matters is the purchasing power of money that we have in the wallet. Therefore, subsidy on the price of petrol is money given indirectly to the population and there is no question of too much money chasing too few goods and services in the economy.

Mirrored from MDYsphere.BlogSpot.Com


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