Two weeks ago, Yemen increased gasoline prices from $2.20 to $3.50 per gallon, while increasing diesel prices from $1.70 to $3.40.
And last month, Egypt increased gasoline prices from $.47 to $.83 (premium gasoline went from $1.00 to $1.40), while increasing diesel prices from $.61 to $1.00.
These are significant increases. The reforms in Yemen bring the price of both fuels up to market levels. And although prices in Egypt remain well below market levels, this is an important step toward rolling back subsidies in a country that has some of the largest energy subsidies in the world.
Economists, including myself, always complain about energy subsidies and celebrate in cases like this when subsidies get rolled back. But what is the big deal? What’s wrong with subsidizing gasoline?
As I discuss in the video, the economic cost of fuel subsidies can be summarized by this figure, straight out of Econ 101.
If you are like most people, you tune out whenever anyone says, “deadweight loss”. But this is just economist-speak for waste. When prices are subsidized, gasoline and diesel end up being used in a whole host of low-value ways. People buy fuel-inefficient vehicles and drive them too much. They produce goods and services using inefficient, fuel-intensive technologies. And they consume too many fuel-intensive products.
Subsidizing energy shrinks the economy. The deadweight loss triangle means that it costs the economy more to supply this fuel than the value these consumers get out of consuming. So, with every transaction, economic value is destroyed. This is the opposite of gains from trade. This is losses from inefficient trade.
By my calculations, prior to the reform the deadweight loss from fuel subsidies in Yemen was $40 million per year. Total fuels expenditures in Yemen is $1.2 billion annually, so this is small compared to the size of the market. Worldwide, there are many countries with larger subsidies than Yemen. In fact, Yemen is not even in the top 20.
Egypt, incidentally, with much more generous subsidies and a larger population, was #5 in 2012 in terms of total welfare loss from fuel subsidies, behind only Saudi Arabia, Venezuela, Iran, and Indonesia. When I next redo these calculations, I expect to see Egypt slip back a couple of notches.
The price increases in Yemen and Egypt will also decrease the burden of pollution, traffic congestion, and vehicle accidents. A new IMF report finds that the total cost of externalities from driving exceeds $1.00 per gallon in most countries. By my calculations, removing subsidies in Yemen will decrease fuels consumption by 90 million gallons per year (a 15% decrease). So if external costs are $1.00 per gallon, this is $90 million annually in additional benefits.
Traffic jam near Sana’a, the capital of Yemen.
By the way, you might have noticed that there is a smaller purple triangle to the left of the externalities rectangle. To maximize welfare you really want to increase prices all the way to social cost. This would further decrease consumption, yielding this additional welfare gain. You can think of this as another deadweight loss triangle or, alternatively, think of the entire larger triangle as deadweight loss relative to the full social cost of fuels consumption.
(Yes, this is exactly the same as the discussion in California about including transportation fuels in the cap-and-trade program for carbon dioxide. See here and here. The whole point is to move California fuel prices closer to full social cost.)
There is more work to do in both countries. In Yemen, it will be important to once-and-for-all allow gasoline prices to float at market levels. These reforms have brought prices up to market levels, but if there continues to be price controls, these gains will erode over time with inflation. In Egypt, there is still a long way to go before market prices are reached. The price increases last month went through with relatively little public protest (here), but it remains to be seen whether President Abdel Fattah el-Sisi will be able to push through deeper reforms.
I’m not claiming that subsidy reform is easy. The IMF has some interesting work aimed at trying to better understand the political challenges and potential approaches for facilitating reform (here). But the economic analysis makes it clear that much is at stake. Pricing energy below cost imposes real inefficiencies, and these are enormous markets so the magnitude of the inefficiencies can be very large.
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.