Indonesia has been in the news this week for taking an important step in the right direction with energy pricing. Prior to last week, Indonesia had some of the lowest gasoline and diesel prices in the world. In the data I examined for my blog post last month (here), only a handful of countries had lower prices in 2012.
Last Friday at midnight the Indonesian government moved to reduce these subsidies. Gasoline prices increased from $1.78 to $2.50 per gallon, while diesel prices increased from $1.78 to $2.12. Prices remain well below market prices, but, particularly for gasoline, this is a real increase.
And for the moment, the streets of Jakarta are calm (Bloomberg, 2013). Tens of thousands took to the streets in protest when the reforms were first announced (NYT, 2013). But the public seems to have accepted the higher prices. This acceptance reflects, in part, that the government simultaneously agreed to substantially increase funding for a cash transfer program for low-income households.
The public may also have grown to understand how dire the situation had become from a fiscal perspective. By my estimates based on World Bank data, gasoline and diesel subsidies cost the Indonesian government $18 billion in 2012. This is 2% of GDP, and 11% of total government spending. Only Saudi Arabia and Iran spent more on subsidies in 2012.
Part of this is a pure transfer. Taxpayers pay more; fuel consumers pay less. But fuel subsidies also create economic inefficiency because they lead to overconsumption. Car and motorcycle ownership in Indonesia has soared over the last decade fueled by cheap gasoline and diesel. Some of this would have occurred even without the subsidies. But not all of it. Every gallon of gasoline sold for which the buyer’s willingness to pay is less than its economic cost represents a welfare loss. See the shaded region below.
The size of this inefficiency depends on the private cost of fuels. Gasoline and diesel are both widely traded, so spot prices in international markets provide a good measure of opportunity cost. In calculating the size of the subsidy I used prices from New York Harbor, where this week the price of regular gasoline is $2.66 per gallon, and the price of diesel is $2.86 per gallon (EIA, 2013). I then added an extra $.75 per gallon to reflect international transport, distribution, and retailing costs (IMF, 2013).
The size of the deadweight loss triangle depends, in addition, on the elasticity of demand for fuels. The more elastic is demand, the larger the deadweight loss. If the elasticity is -0.4, then fuels consumption in Indonesia is about 28% higher than it would be if priced at the private marginal cost, even before accounting for negative externalities. The resulting deadweight loss from underpricing was $2.5 billion in 2012.
Fuel subsidies also increase traffic congestion, accidents, and air pollution. These externalities mean that the social cost of driving exceeds the private cost. If these externalities are worth, for example, $2.10 per gallon (Parry, Walls, and Harrington 2007), then the deadweight loss from underpricing in Indonesia more than triples to $9.0 billion in 2012.
This $2.10 comes from a study of the United States. I am not aware of any similar estimates for Indonesia. One could come up with a list of arguments why the right number for Indonesia is larger or smaller, but I need to leave that discussion for a future blog post. It is worth highlighting, however, that even if the cost of the externalities is only $1.00 per gallon, the deadweight loss triangle is still very large, $5.3 billion.
These are crude, back-of-the-envelope calculations. But you get the idea. Fuel subsidies are a bad idea. They impose large economic inefficiencies and inhibit governments’ abilities to address other fiscal objectives. In addition, recent studies show that fuel subsidies are not particularly effective at redistribution. Particularly in low and middle-income countries, studies show that only a small part of the benefits of fuel subsidies go to low-income households (Sterner, 2011).
Increasing prices is extremely difficult politically, and the Indonesian government deserves credit for effectively managing these reforms. Government credibility was essential. If Indonesians had not believed the government’s commitment to fund transfer programs, the reforms likely would not have worked. Indonesia still has more work to do, but this is an important step in the right direction.
Lucas Davis is the Jeffrey A. Jacobs Distinguished Professor in Business and Technology at the Haas School of Business at the University of California, Berkeley. He is Faculty Director of the Energy Institute at Haas, a coeditor at the American Economic Journal: Economic Policy, and a Faculty Research Fellow at the National Bureau of Economic Research. He received a BA from Amherst College and a PhD in Economics from the University of Wisconsin. Prior to joining Haas in 2009, he was an assistant professor of Economics at the University of Michigan. His research focuses on energy and environmental markets, and in particular, on electricity and natural gas regulation, pricing in competitive and non-competitive markets, and the economic and business impacts of environmental policy.