Upside Down Inside Out Economics

Here is a fascination post that I found on the Winter Watch blog. I happen to agree with Aaron that oil subsidies, instead of spurring demand in China, is instead dampening it. I am quoting the text in its entirety and will comment afterwards.

Aaron Krowne wrote:

Detail on my argument about removing subsidies:

The way fuel subsidies work in India and China and probably most other developing countries is that the government mandates a retail price cap. Obviously that alone would be a huge disaster, creating instant shortages, so the governments compensate the fuel sellers with subsidy payments.

Problem is that this system induces lags and inefficiencies: the fuel sellers are out the money to start with, then must go crawling back to the government, which doesn’t really like them anyway, so who knows if the subsidies are really adequate.

The net effect is that they still get shortages, only they are not as bad.

Now, when the price caps are raised and the subsidies lessened, what happens is that the fuel sellers are more motivated to do more business. So they more eagerly go out into the world market and buy crude and gasoline. This bids up the price.

For instance we saw a price spike last November when China raised price
caps.

While raising the caps does necessarily contribute to slowing demand, I
doubt it is much, because these are developing countries. Remember that
shortages are remedied only by higher prices, all other things equal.

Posted on 30-May-08 at 1:54 pm Permalink Quote

Yesterday someone posted photos of Chinese gas stations, and the lines of cars leading up to them. The lines were ridiculously long. People sit in their cars for HOURS. Classical economics teaches us that subsidies artificially boost demand. There are then shortages because the price isn't allowed to rise. Therefore there's no incentive to produce enough product. However, we know there's more than enough oil to go around, what with all those supertankers full of Iranian oil just sitting around.

I believe that Aaron is absolutely correct when he concludes that a lifting of subsidities (at least in China) will increase demand, contrary to what we've been taught to believe.