Archive for the 'Oil prices' Category

Sep 29 2010

Price controls in the Chinese Petrol market – or why you may have to wait in line to fill your gas tank!

China rations diesel as record oil hits supplies | Markets | Reuters

In the fall of 2007 I was living in Shanghai, China. At the time, oil prices were hitting record levels world wide, leading to rising petrol prices for drivers in most places.  However, at the time,  I began witnesing an unusual site on my taxi rides into the city of Shanghai: as our taxi passed petrol station after petrol station, I observed dozens of blue trucks (the ubiquitous medium of transporting good from Shanghai’s factories to her ports) spilling out of gas station parking lots into the road, apparently queued, waiting for a spot at the pump. I had never seen such long lines at any of the petrol stations around Shanghai before, and I began to wonder as to the reasons for these crazy long lines!

Well, an article at the time helped solve the riddle of the long lines. As it turns out, there was a simple explanation rooted in the principles of supply and demand that any first semester AP or IB economics student would understand! The Chinese government had been forced to ration petrol (limiting the amount that a driver can buy at one go) due to the shortages resulting from the government’s price controls in the petrol market.

Truck drivers reported long queues at petrol stations along a national highway linking Fujian and Zhejiang provinces, with each truck getting 100 yuan ($13) worth of diesel, or around 20 litres, per visit at a state-run station and 40 litres at a private kiosk…

“What’s wrong with the oil market? Our drivers had to queue the whole night for only a small amount of fill, slowing the traffic by almost one day,” said Gao Meili, who manages a logistics company.

China is a major importer of oil. With an economy growing around 12% in 2007, much of the country’s growth depended on the availability of crude oil at reasonable prices, which China’s oil refining firms turn into diesel and petrol, needed to get Chinese manufactured products from factory to port and from port to overseas consumers.

The problem with the oil market in China, however, was that as “Chinese refiners cannot pass the souring crude costs on to consumers.” Oil is an input needed to make a finished product, diesel. As the price of oil rose in 2007 (it reached a record of $92 per barrel in October of that year), the resource costs to petrol and diesel producers also rose, shifting the supply of petrol and diesel to the left, putting upward pressure on the equilibrium price.   As a first semester AP or IB student knows, resource costs are a determinant of supply, and as oil (the main resource in the production of petrol and diesel) increased in price, the supply of these important commodities invariably decreased.

In a free market, a decrease in supply leads to an increase in price. Herein lies the answer to the riddle of the long lies at petrol stations in Shanghai: the Chinese petrol and diesel market is not a free market. The government plays an active role in controlling prices paid by consumers for the finished product refiners are producing, petrol fuel:

Beijing fears stoking already high inflation and rigidly caps pump fuel rates to shield users from a 50 percent rally in global oil so far this year.

As the costs to petrol and diesel producers rose in 2007, the government in Beijing took the side of consumers and forbade fuel producers from raising the price they charge consumers.  The Chinese government essentially imposed a price ceiling in the market for petrol. A price ceiling is a maximum price set by a government aimed at helping consumers by keeping essential commodities like fuel affordable. As we have learned this week in AP and IB Economics, price controls such as this end up hurting BOTH producers AND consumers, since they only lead to a dis-equilibrium in the market in which the quantity demanded for a product rises while the quantity supplied by firms falls. The shortage of petrol and diesel resulting from the government’s price control are the perfect explanation for the long lines of blue trucks and motor scooters at all the gas stations in Shanghai during October of 2007.

So why, exactly, does the government’s enforcement of a lower than equilibrium price result in such severe shortages that truck drivers are only allowed to pump 20 litres of petrol per visit and made to wait hours each time they need to refill? Below is a supply and demand diagram that illustrates the situation in the Chinese fuel market in 2007:

In the graph above, the supply of petrol has decreased due to the increasing cost of the main resource that goes into petrol, oil. This decrease in supply means petrol has become more scarce, and correspondingly the equilibrium price should rise. However, due to the government’s intervention in the petrol and diesel markets, the price was not allowed to rise and instead remained at the maximum price of Pc.

At the government-mandated maximum price of Pc, the quantity of fuel demanded by drivers far exceeds the quantity supplied by China’s petrol producers. The result is a shortage of petrol equal to Qd-Qs.

The government’s intention for keeping petrol prices low is clear: to make consumers happy and keep the costs of transportation among China’s manufacturers low so as to not risk a slow-down in economic growth in China. However, the net effect of the price controls is a loss of total welfare in the petrol market. Notice the colored areas in the graph above. These represent the effect on welfare (consumer and producer surplus) of the price control.

  • The total areas of the green, orange and grey shapes represent the total amount of consumer and producer surplus in the petrol market assuming there were NO price controls. At a price of Pe, the quantity demanded and the quantity supplied are equal (at Qe) and the consumer surplus and producer surplus are maximized. The market is efficient at a price of Pe. Neither shortages nor surpluses of petrol exist.
  • However, at a price of Pc (the maximum price set by the government), the amount of petrol actually produced and consumed in the market is only Qs. Clearly, those who are able to buy petrol are better off, because they paid a lower price than they would have to without the price ceiling. But notice that there is a huge shortage of fuel now; many people who are willing and able to buy petrol at Pc simply cannot get the quantity they demand, because firms are simply not producing enough!
  • The total consumer surplus changes to the area below the demand curve and above Pc, but only out to Qs. The green area represents the consumer surplus after the price control. It is not at all obvious whether or not consumers are actually better off with the price ceiling.
  • The total producer surplus clearly shrinks to the orange triangle below Pc and above the supply curve. Petrol producers are definitely worse off due to the government’s action.
  • So how is the market as a whole affected? The black triangle represents the net welfare loss of the government’s price control. Notice that with a price of Pe, the black triangle would be added to consumer and producer surplus, but with a disequilibrium in the market at Pc, the black triangle is welfare lost to society.

Price controls by government’s clearly have an intended purpose of helping either consumers (in the case of a maximum price or price ceiling) or producers (in the case of a minimum price or price floor).  But the effect is always predictable from an economist’s perspective. A price set by a government above or below the equilibrium price will always lead to either a shortage or a surplus of the product in question. In addition, there will always be a loss of total welfare resulting from price controls, meaning that society as a whole is worse off than it would be without government intervention.

Discussion Questions:

  1. Why has the supply of petrol decreased?
  2. With a fall in supply of a commodity like petrol, does the demand change, or the quantity demanded? What is the difference?
  3. Define “consumer surplus” and “producer surplus”. Why does a government’s control of prices reduce the total welfare of consumers and producers in a market like petrol?
  4. How would a government subsidy to petrol producers provide a more desirable solution to the high oil prices than the maximum price described in this post? In your notes, sketch a new market diagram for petrol and show the effects on supply, demand, price and quantity of a government subsidy to petrol producers. Does a subsidy create a loss of welfare? Why or why not?

57 responses so far

Sep 29 2009

Letting markets work: the Malaysia fuel subsidy goes bye bye

This article was originally published on June 9, 2008

Asia Sentinel – Malaysia cuts fuel subsidy

One of the recurring themes of this blog is the conflict between good politics and good economics. Most of the time in government, smart economic policy is sacrificed in order to achieve political favor with voters. Whether it’s price ceilings on petrol in China, Zimbabwe’s slashing of food prices, harmful import restrictions to benefit domestic producers, or the proposed suspension of gas taxes in a time when fuel conservation is really what’s needed, politicians often act in economically stupid ways to bolster or hang on to their popularity.

So when a government makes a bold move that is economically sound, it sometimes comes as a surprise, as in the case of the Malaysian government this week. The government in Kuala Lumpur has for years subsidized domestic fuel prices, which at under 2 Malaysian Ringit per liter have been the equivelant of roughly $2.40 US per gallon, far below the average price in the west. Drivers benefited from this subsidy, but were not forced to bear any of the burden of rising oil prices, nor had they any incentive to conserve or switch to more fuel efficient automobiles or alternative forms of transportation. The Malaysian government, on the other hand, has had to allocate more and more of its limited budget towards subsidizing petrol prices.

Well, as of yesterday, all price supports for petrol are cancelled, and the effect will be sweeping in the Malaysian economy:

The government announced Wednesday evening that petrol prices would rise by 78 sen (US24¢) at midnight — a 41 percent jump from RM1.92 per liter to RM2.70. That means those spending RM2,000 per month to fill the tanks of their BMWs will now be paying RM2,820. Regardless of income levels, it is likely most Malaysians will feel the pinch.

The subsidy would have cost the Malaysian government 56 billion ringit (around $17 billion) this year. With the money it will now save by ending the subsidy, the government will begin making public transport cheaper and more convenient for commuters who wish to avoid paying for the more expensive petrol to fuel their personal automobiles:

The government hopes to channel the savings into improving public transportation, as it promised many years and elections ago but with little to show. In Kuala Lumpur, despite having a light rail train service and monorail, public transportation is expensive and inconvenient. Worse, intercity travel is still being serviced by old and slow trains, and accident-prone buses.

Malaysia is not the only country taking measures to end government fuel-price supports:

Indonesia has hiked fuel prices by an average of 29 percent, saving about 34.5 trillion rupiah and kicking off a series of street demonstrations… Similarly, after slashing subsidies, Taiwan will distribute US$659 million to middle and low-income families. The latest to raise oil prices is India, whose government announced Wednesday that gasoline and diesel prices will increase by 10 percent.

As more and more countries allow the market mechanism to work, and in the short-run fuel prices rise with the price of oil, the chances are that the long-run equilibrium price of petrol will actually begin to fall.Price controls and subsidies distort market demand. In Malaysia, where a government subsidy kept the price consumers paid around 2 RM, the quantity demanded exceeded the free market quantity. With the removal of the subsidy, consumers will respond by driving less, reducing overall quantity demanded for petrol. As other Asian nations follow suit, global quantity demanded for petrol will decline, while higher prices incentivize producers to increase output. New prouction facilities will come online, just as drivers begin to find alternative ways to get to work, either through carpooling, public transportation, cycling or walking.

The combined effect of slowing increases in demand (or perhaps even a decline in demand if enough substitution of alternative forms of transportation takes place), and increases in supply as new production facilities come on line will be a stabilization and eventual fall in the price of oil.

The future fall in oil prices is explained in more detail here. Malaysia’s repealing of the fuel subsidy is one example of how markets work to restore equilibrium in a market such as that for oil today, where short-term bubbles always burst. $135 oil is probably not here to stay, if only the market is allowed to works its magic.

Discussion Questions:

  1. Why does a subsidy create disequilibrium in a product market like the petrol market in Malaysia?
  2. Give two examples of how consumers may respond to the 40% increase in petrol prices once the subsidy is removed in Malaysia.
  3. How could making fuel more expensive to consumers in the short-run actually lead to a fall in oil and fuel prices in the long-run?

39 responses so far

Dec 17 2008

The questions no one seems to be asking about the auto industry bailout! | The Economists’ Forum | Will Americans demand the cars that Congress wants the big three to build?

It’s been driving me nuts, this whole bailout debate. My frustrations are definitely appartent to my students, who have had to put up with my occasional rants about the insanity of the whole affair since the issue came to the media forefront over a month ago. Here are some of the issues that just don’t add up from the perspective of a high school economics teacher:

The three companies asking for a bridge-loan supposedly want the money so that hundreds of thousands (some reports say as many as 2.6 million) jobs can be saved. But how could Ford, Chrystler and GM possibly maintain their labor force in a time of a recession when nobody is buying new cars in the first place? In the parlance of AP or IB Economics, automobiles are normal goods, ones for which demand falls as incomes fall. By definition, a recession in the United States means falling incomes. A government loan may allow the Big Three t keep making cars for the time being, but WHY WOULD THEY KEEP MAKING CARS when falling incomes point to falling demand in the immediate future? Making cars that nobody will buy represents a gross misallocation of the nation’s productive resources, not to mention taxpayers’ money. What is required of these industries is precisely what the government loan will prevent them from doing, DOWNSIZING, meaning the shrinking of their labor force as well as the number of plants in operation.

The US recession can not be avoided by allocating the nation’s scarce resources towards a bailout of the auto industry. In fact, it will be worsened because the capacity of any nation to emerge from a cyclical downturn requires the flexibility of the country’s labor force to adapt to the structural changes the country is experiencing in the era of globalization and free trade. America’s future does not reside in labor-intensive manufactured goods, especially in the production of a very expensive durable good for which demand falls drastically during recessions; specifically, automobiles.

The Finanacial Times Economists Forum approaches the issue of long-term falling demand for automobiles from another perspective. One of the conditions of the Big Three accepting a loan from the federal government is the mandate that Detroit will begin producing more fuel efficient automobiles to assure Americans more affordable, more environmentally friendly alternatives to the gas-guzzling SUVs that have dominated the industry for the last two decades. But here’s the problem, gasoline has fallen to a price as low as it was when SUVs were at their peak popularity back in the early 2000s! As any high school economics student knows, gasoline and SUVs are what we call complementary goods, or two goods for which demand and price are inversely related. As gas prices fall to their 2000 levels, demand for SUVs promises to rise once again, while demand for fuel-efficient automobiles will likely decline, creating market pressures for the Big Three to make not more fuel-efficient cars, but more SUVs instead! From the Financial Times:

The basic problem is that Americans like to drive sport-utility vehicles, minivans and small trucks when gasoline costs $1.50 a gallon…

Consumers may have regretted their behaviour when gasoline prices soared above $4 a gallon, but as gas prices descend, there is no reason to believe that left unchecked they will not return to their gas-guzzling ways.

Indeed, there is a distinct possibility that if they really do increase their small car production, in a few years the big three will be back asking for more help, on the grounds that they are losing money by doing exactly what Congress asked.

The only reasonable solution to this dilemma? If Congress DOES begin mandating that Detroit increase its production of fuel-efficient cars and phase out its manufacture of SUVs, any such requirement should be accompanied by a government-set price floor on gasoline. Several months ago, my colleague and fellow blogger Steve Latter blogged about a proposed price floor of $4 per gallon on gasoline. Such a scheme would likely prove nearly impossible to initiate politcally, but may be exactly what’s necessary to add legitimacy to any government requiremens of Detroit to manufacture fuel efficient automobiles. The FT appears to support such a scheme:

Congress should put their mouths where their money is. They should make binding commitments to ensure higher US oil prices and thereby sufficient demand for fuel-efficient cars and trucks in the future.

Discussion Questions:

  1. What message does falling demand in the auto market send from buyers to sellers, and what contradictory message does a subsidy from the government send to auto makers?
  2. If the auto makers receive a low-interest bridge loan (subsidy) from the government, how will this actually undermine the efficient functioning of markets in America?
  3. Why would a price floor on gasoline be needed to accompany a government requirement that the Big Three make more fuel efficient automobiles after receiving a government loan?

13 responses so far

Sep 12 2008

“In-sourcing”: a new trend among US manufacturers?

U.S. companies are rethinking manufacturing in China – Sep. 11, 2008

As the US presidential campaign trudges ever forward, both Obama and McCain have had much to say about “job creation” in the USA. Elaborate plans aimed at retraining workers displaced by globalization, arming them with 21st century skills that will enable them to thrive in our advanced economy, and assure that the hardships imposed by free trade are minimal and all Americans have the skills they need to find employment. These are good goals for America, but even as they preach their job creation plans across the country, right under the candidates’ noses jobs are being created thanks to the invisible hand of the market economy.

Talk of a reverse migration of manufacturing from China to the U.S. has been buzzing across union halls and factory floors, corporate boardrooms and Wall Street.

The cost of shipping outsourced goods from China to U.S. customers has doubled in just two years thanks to high oil prices, and labor costs in China are rising sharply.

“There’s a shortage of technical and managerial talent,” reports Anand Sharma, CEO of TBM Consulting Group. “To attract managers Chinese companies are talking about salary increases of 15% to 30% year-over-year.”

The phenomenon of jobs being “in-sourced” to America after a decade or two of being done by Chinese workers may seem surprising. Certainly, wages are still lower in China than in the US labor market. This is true, however, the demand for highly skilled labor in China is driving wages up higher and higher, due to its relative scarcity in a country where reliable, well-educated factory managers are nearly fully employed by the thousands of foreign and Chinese firms operating plants there. Competition among producers means the only way to attract new managers is to continually offer higher wages. This leads to a form of “wage-spiral inflation” where rising costs lead to higher priced output.

Despite its much smaller work force, the percentage of American workers with the managerial and technical skills needed to run a plant is much higher than in China, and the weak manufacturing sector growth in the US has meant relative wages between the US and China are closer than ever before.

Take into consideration the rising cost of fuel and the fact that China’s economy is producing at or beyond full employment, and it becomes clear why manufacturing certain products in China has become less attractive to American firms. To be sure, not all manufacturing jobs are being “in-sourced” back to the US. As Chinese wages climb and skilled labor becomes more scarce, the giant’s Asian neighbors are beginning to enjoy the re-allocative effects of the “invisible hand”.

…plenty of manufacturers will continue looking for ever cheaper places to produce. In fact, as the cost of doing business in China rises, many companies – including Chinese firms – are shifting their production to less expensive markets, such as Vietnam.

Discussion questions:

  1. What is the “invisible hand” referred to in the post above?
  2. How do higher wages in China benefit Americans? How do they harm Americans?
  3. Some critics of free trade argue that multi-national corporations exploit workers in developing countries. Does the article above illustrate give an example of exploitation? Discuss…

9 responses so far

Jul 14 2008

The opportunity cost of pristine wilderness is…

Bush, Democrats point fingers over energy crisis – Jul. 12, 2008

…apparently just over $4.00 per gallon of gasoline; at least according to the article above:

With gasoline prices above $4 a gallon, Bush and his Republican allies think Americans are more willing to allow drilling offshore and in an Alaska wildlife refuge that environmentalists have fought successfully for decades to protect.

Nearly half the people surveyed by the Pew Research Center in late June said they now consider energy exploration and drilling more important than conservation, compared with a little over a third who felt that way only five months ago. The sharpest shift in attitude came among political liberals.

The travesty of Americans’ attitude in favor of drilling and against conservation is the shortsightedness of it. Regardless of how many millions of acres of wilderness the government opens to drilling, gas and energy prices will only continue to rise over the long-run as emerging market economies like China’s will continually drive demand for energy higher and higher as growth rates remain above 8%.

America, in the mean time, with the largest per capita levels of energy consumption in the world (and some of the lowest gas prices), turns its back on conservation just when it is needed most. The cost to the environment, society and the bounteous wildlife that inhabit the vast tracts of land and sea that Congress is considering opening to exploitation by energy companies will create a permanent scar in one of the most valuable (and simultaneously undervalued) resources, its wilderness.

As my summer vacation approaches its end and I begin to think about another year of teaching Economics in international schools, I find myself reflecting on what’s most important in the world: to me, to my home country, to my fellow Americans, to the kids I teach and the students I will teach 10, 20, 30 years from now. I spend my summers in one of the most beautiful parts of this great country, the Pacific Northwest, whereMy wife Liz, overlooking the Selkirk mountains of Northern Idaho despite over a century of logging, mining, hunting and trapping, beautiful wilderness still remains. Only 2% of America’s original forests remain standing today. Countless species of predator and prey have been wiped out. There are around 300 wolves running wild here in Idaho, and thousands of citizens here are campaigning for a hunting season that will threaten to wipe out that great species once again. Clearcuts dot the landscape, proposed mines threaten watersheds and the wild Bull trout, an endangered species in the lakes and streams of Northern Idaho. Bears are put to death when the stumble into our yards, yet we turn more and more of their habitat into housing tracts every year.

Conservation is on my mind, and the news from Washington saddens me today, as I read that Americans concern themselves less and less with what I consider this country’s greatest resource, its wilderness, when times get the slightest bit difficult economically. As I prepare for another year of teaching Economics, this year at a new school in a new country, one where conservation is of the utmost importance, I will think about ways to incorporate more of an environmental economics perspective into this blog and my own teaching. As I prepare to leave my home in the mountains of Northern Idaho once again, I will cherish what little wilderness remains in this beautiful country, and try to make as little impact as I can on an individual level towards the continued destruction and exploitation of nature that characterizes the path that Americans seem to be choosing in this time of economic hardship.

One response so far

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