Simulation of price control for different grades of gasoline: a case of Indonesia



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Simulation of price control for different grades of gasoline:
A case of Indonesia

by

Muhammad Akimaya



PhD Candidate Mineral and Energy Economics

Division of Economics and Business, Colorado School of Mines

Golden, CO 80401

Email: makimaya@mymail.mines.edu



Abstract

A gasoline subsidy is one of the most prevalent strategies for distributing welfare to the people in oil-producing countries. However well-intentioned, the policy will distort the gasoline market with the resulting inefficiencies. Furthermore, the gasoline subsidy takes a great amount of government’s budget. Arguably, these funds could be spent elsewhere with a greater impact on economic growth. These governments are aware of the cost of such a policy, yet face difficulties in removing the policy because of strong resistance from the public. This paper looks at the unique case of Indonesia that only provides a subsidy for regular gasoline and in turn proposes an alternative policy that introduces a subsidy for premium gasoline at a lower rate to reduce the overall gasoline subsidy cost. There has yet to be any research that simulates price control for gasoline with different grades. The aggregate demand for the gasoline in Indonesia is replicated using a translog cost calibration approach. Simulations based on the calibrated demand are then performed and the results confirm the existence of potential savings that is largely determined by the cross-price elasticities between regular and premium gasoline. The benchmark scenario, based on a study of substitutability between gasoline and ethanol, results in 23.9% reduction in subsidy cost of around 2.1 billion USD. Furthermore, the optimal rate of subsidy for premium gasoline results in a reduction of inefficiency of 10.3% or around 580 million USD.


  1. Introduction


The essence of the gasoline subsidy policy problem is its inefficiency. The policy leads to overconsumption of gasoline since a subsidy drives consumers to purchase a good at a price that is cheaper than the cost of producing it (Harvey and Gayer 2013). In the case of Indonesia, the problem is further aggravated by the fact that the government only provides a subsidy for regular gasoline, the lowest grade gasoline. Indonesia started off in the 1960s with only the national oil company, Pertamina, allowed in the domestic gasoline market and it was subsidized as a way to protect people from the effects of inflation (Beaton and Lonton 2010). In 2001, a new regulation was introduced by the government that opened up the domestic gasoline market to multinational oil companies but only for high-octane gasoline. This was done to combat the 1997 Asian financial crisis. Regular gasoline was left subsidized. Such a scheme violates Ramsey’s tax rule that taxing rival commodities should leave the consumer’s relative choices unaltered (Ramsey 1927). Different tax rates on commodities and factors introduce a distortion between the marginal rate of substitution and the marginal rate of transformation (Stiglitz and Dasgupta 1971). In addition, Ito and Sallee (2014) found that taxation based on different characteristics of automobiles caused distortions in that market. Similarly, the Indonesian subsidy policy distorts both the regular and premium grade gasoline market. Another issue is the unequal benefit of the policy (del Granado et al. 2012). As consumers purchase more regular gasoline, the government’s expenditure on the subsidy increases significantly while income distribution is distorted as high-income consumers that purchase a higher amount of regular gasoline, receive more benefit (Pradiptyo and Sahadewo 2012).

An obvious exit strategy is to eliminate the subsidy. However, the government seems to be reluctant to take this option because of its anticipated impact on the people’s welfare. A lot of studies have been done to analyze the economic impact of phasing out a gasoline subsidy. Adam and Lestari (2008) estimated that an increase in the price of oil correlates negatively with social welfare. Clements et al. (2007) showed that removing the subsidy increases aggregate price levels and reduces real output, while Dartanto (2013) found that there will be an increase of poverty. Arguably, these outcomes might agitate the people and cause a significant drop in the government’s popularity. Furthermore, a well-known economist in Indonesia said that removing the gasoline subsidy is against the constitution of Indonesia (Gie 2011).



The gasoline subsidy takes about 15% of overall government expenditure as shown in Figure 1. It amounts to about 250 trillion rupiahs or around 20 billion USD. The government is aware of the large cost of the policy but it has remained hesitant to act because of the risk of being overthrown by political opposition and strong public resistance. Numerous times the government has tried to cut the subsidy but met with public protests (Quiano 2012, Cochrane 2013).

Figure 1 Gasoline subsidy trend based on planned government expenditures in Indonesia

Source: Badan Pusat Statistik (2014)

Another alternative is to reduce the distortion in the regular gasoline market while leaving the subsidy intact. Using Ramsey’s rule, the government should aim to steer the consumer’s choice back to a non-subsidy pattern. We show this can be achieved by decreasing the price of premium gasoline, which means that the government should also subsidize premium gasoline. However, if the new subsidy on premium gasoline is at the same rate as the current subsidy on regular gasoline, the government’s expenditure will increase significantly. Thus, the rate of the new subsidy has to be lower than the current subsidy but large enough to generate savings for the government.

The contribution of this essay is to analyze this unique policy that could potentially reduce gasoline subsidy expenditures without the political backlash. Arguably, a subsidy reform is difficult to enact because of the effect on purchasing power of the people and the resulting political instability. By implementing a different pricing policy for different grades of gasoline, the issue of inflation and political instability can be avoided.

The rate will depend on the elasticities of demand for gasoline. We predict that the substitutability of gasolines with different grades is what drives the magnitude of the savings. However, we have found no literature on the own and cross-price elasticity for regular and premium gasoline. Nor were our attempts to obtain Indonesian data successful. Therefore, we set up a simulation experiment benchmarked to Indonesian data that uses differential subsidies for regular and premium gasoline. Also, we assume that the market has a perfectly elastic supply and only consumer’s welfare is analyzed. Various simulations using different values of cross-price elasticity are done to determine whether there are cross-price elasticities that generate savings. Also, it has to be noted that the new subsidy will distort the premium gasoline market. There will be a welfare effect on both regular and premium gasoline market. There has yet to be any research similar to this essay.

In the next section, the mathematical model to prove the existence of a potential reduction in gasoline subsidy expenditure is analyzed. In section 3, the data is presented followed by the calibration process in section 4 that follows Rutherford's (2002) method in using a translog unit cost function to calibrate the derived demand function. The necessary parameters for calibration are then presented in section 5. The parameters such as prices and share expenditures are based on Indonesia’s gasoline market, while the elasticities values are based on results or our second essay. Next, the simulations for government spending based on benchmark values of elasticities are discussed further in section 6. Given the high degree of uncertainty in the values of parameters chosen, sensitivity analyses are performed based on substitutes of gasoline studies and presented in section 7. Since the new subsidy policy introduces a new distortion in both markets, the welfare effects on the consumers are analyzed in section 8 and the paper is concluded in section 9.


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