Friday, June 1, 2012

The petrol-diesel story and market distortions

What happens when the price of two products, though not perfect substitutes, change in opposing directions? Say, the price of Product A increases sharply, while that of its near-substitute, Product B, remains relatively stagnant. Econ 101 teaches us that people substitute away from Product A to Product B.

The relative prices of petrol and diesel in India have been following similar trajectories. Last month the government had increased petrol prices by Rs 7.50 a litre and also vowed to keep diesel prices unchanged. As the graphic below shows, petrol prices have been rising sharply in relation to diesel...

... with the result that the diesel premium has been rising sharply, especially since 2009-10. At over Rs 42 today, this differential is a recipe for market imbalances. 

The increases in petrol prices have not been matched by increases in diesel prices, creating several distortions in the market. Apart from the inevitable incentives for black marketing, such large differentials will encourage people to shift usage from petrol to diesel in a significant manner - the dieselisation of car market. This is already evident in the faster growth of diesel vehicles and the increasing trend among manufacturers towards diesel models across the four-wheeler segments. For more on the incentive distortions and inefficiencies, see this presentation by the CSE on diesel use.

And while cheaper diesel prices does contribute to keeping public transport and food product costs low and thereby cushion the poor, it also has perverse distributional consequences. Most of the petrol users are those with two-wheelers and small cars, whereas, apart from commercial vehicles, diesel users are mostly the larger SUV users. This therefore constitutes a subsidy transfer from the less well-off to the richest. 

Consider these figures. From 2000 to 2011, the share of diesel cars have gallopped from just 4% market share to over 40% of the all car sales. The CSE presentation also reports that 40% of the total fuel used by cars in 2011 was diesel. In 2010-11, diesel cars were 34% higher than pervious year. While 87% of petrol cars are below 1200 cc, more than 40% of the diesel cars are above 1500 cc. Over the 2009-10 to 2010-11 period, the diesel variants of cars with engines above 2100 cc (or SUVs) rose 41%.

Further, there are much more diesel models in the large and heavier classes of cars. 

The policy takeaways are simple. This trend of diesel personal car sales have to be reversed. The simplest way to manage this is to reduce the petro-diesel price differential. However, given the strong political overtones associated with this, this may not happen anytime soon. The second best alternative is therefore to heavily tax diesel passenger car sales, and therefore incentivize people away from it. Another approach would be to considerably tighten diesel car emission norms, which in turn would sharply increase the prices of these car models.

Update 1 (9/6/2012)

Even as the government contemplates hiking the excise duty on diesel cars to deter the well-off from exploiting the subsidised fuel, a CRISIL report argues that such hikes are not likely to affect the demand for diesel vehicles in the long term.

The report also claims that hiking petrol prices alone would not make any difference to the petroleum subsidy burden of the government since diesel subsidy makes up 60% of all petroleum subsidies. In 2011-12, petroleum subsidies shot up by almost 80 per cent to Rs 68,000 Cr as crude oil prices rose and the rupee weakened. Under-recoveries on diesel are at an all-time high of Rs 14 per litre at current diesel prices. 


KP said...

Dear Gulzar,

How do we evaluate the cascading effect of every increase in either diesel or petrol prices in the economy ??

in a notoriously inefficient economy - the translation of costs to the street is again disproportionately directed at the common man ( the middle class and the poor)

Passing on increases at the pump / retail has turned out to be a windfall for all kinds of industries and services where there is minimal threat of substitution - example : auto fares / most commodities where the increase is passed - and is an opportunity for disproportional transfer of charges.

Since you do look at the behavioral aspects of the economy -I wonder what is the best way to ensure that such market based pricing is not another opportunity to skim people off once again.

The diesel subsidy for cars is an obvious absurdity and the only people who don't get that appears to be the government - but I wonder why the government hesitates to touch diesel ? the cascading effects on prices are much greater ??? - What perentage of diesesl subsidy is directed at Industry ???

The addiction of the government to oil is again a source of inefficiency - with the government absorbing all kinds of losses - effectively subsidising industry through inefficient methods of privatising the commons / inefficient extraction of value - the easiest source of revenue appears to be the various taxes on oil.

Why is government reduction of 'dependence on oil' - or government efficiency - never on the table ??

In an economy that is so completely inefficient - where increases quickly cascade but reductions almost never - I think we need to force a much larger transparency across the system before we expect people to lump the inefficiencies in both decision making and execution.

I like to take the example of overcharging of auto's - the racket that results in the poor being fleeced everytime there is an increase, even if most autos run on gas and the effective cost per KM is low - points to a complete breakdown of our administrative mechanism, the controls exist only in theory - though we would'nt like to see it as such.

I don't see public transport being anywhere close to providing a solution ( an alternative / choice / public option)) to the problem inspite of all the JNNURM spending on infrastructure.

The ability of the system to even introduce a price increase fairly, is increasingly being questioned - and that may be the cause of the backlash - as people question the legitimacy of the system to inflict such high costs.

regards, KP.

gulzar said...

Thanks KP.

I completely agree that it is very difficult to isolate the relative impacts of oil price hikes on different categories of consumers. however, at the margins, it affects the poor much more than the non-poor.

as to the point on why govt hesitates to touch diesel, i am inclined to believe that it suits everyone. a belief that diesel price increases will affect food prices makes it a more political product than petrol. the kirith parikh committee found that 10% of diesel was used by industry and 12% in agriculture. both business and farmers are powerful interest groups who will obviously lobby to keep diesel prices low. in contrast, petrol suffers from Mancur Olson's collective action problem. further, in case of petrol, both state and central governments benefit from higher petrol prices by way of higher attendant taxes.

about your point on prices being an unsatisfactory means to allocate resources in an inefficient economy, my counter question is whether there are any other more satisfactory means available. i have held the view that in such circumstances, instead of tinkering with prices, a more effective approach (to cushion the poor) would be to work from the supply side (say, with good public transport facilities or stronger PDS system) or provide direct cash transfers (to reimburse people on the higher cost of certain services).