Can I play with elasticity?

The government’s latest gimmick to keep petrol prices unrealistically low is to impose a special additional levy on income tax and corporate tax in order to finance the deficit. Basically a scheme to rob peter and pay paul. Make the higher-income guys pay for the excess oil consumption by the lower income guys.

It might sound robin hood-esque and pro aam aadmi and all that – which might prove useful in an election year. It might be seen as a pro-poor move, a move that can curb headline inflation figures (actually I think there should be a component for taxes also when it comes to inflation – after all – a third of everyone’s income goes in that). And while still maintaining the targets mandated by the FRBM act of 2003.

However, my fundamental issue with this method is that there is absolutely no signal sent out to people that oil is a precious commodity, and that it should be consumed carefully. By this act of keeping prices constant, there is no signal to the common man that petroleum is actually getting more and more expensive, and one should try to conserve it. There is no way that the common man is feeling the government’s enormous burden of subsidizing petroleum products.

There have been a number of studies in the US (ok i’m too lazy to provide links now) which have shown that with increasing gasoline prices in the last one year, consumption has fallen. Which indicates that demand for petroleum products is elastic. How are petroleum products elastic? If petrol costs more, you might drive less and use more public transport. You might use the cooking gas more economically, and only when absolutely necessary. You might try and cut down unnecessary trips. You might use your bike instead of using your car. You might buy a more fuel-efficient bike.

So here is the deal. Let the current retail price of petrol (i’m using petrol as an example. you can have the same argument for gas and diesel and all that)? be Rs. 50 (random number) and the ideal price (one where there is no subsidies) is Rs. 70. Let the average daily consumption of petrol be one million litres (this is a very random number; i have no clue about the actual figures). The average daily burden for the government and oil marketing firms now is Rs. (70-50) * 1 million = Rs. 20 million. Now, this is proving to be a big pain for the government.

Suppose there is a non-zero level of subsidy that the government is willing to bear. Suppose it is Rs. 10 million per day. Now, you might quickly think that the price of petrol has to be raised to Rs. 60 per litre for the subsidy to reach a tolerable level. However, you don’t need to go so far. All because of the elasticity.

What the government should now start doing is to gradually increase the prices. Very gradually. Say by Re. 1 per litre per month. This is not big enough to cause any political issues, but will send out a message to the people that petroleum is indeed more expensive. After some 3-4 months, you will know how the market is responding to this – in terms of elasticity. And soon you might discover that you can bear the subsidy for a price much lower than Rs. 60.

The moral of the story is that all it takes for a virtuous cycle of elasticity to kick in is a small movement in prices of oil products. However, given the kind of brains that the current UPA has shown so far, it’s unlikely that they’ll see this logic. Hopefully the additional tax that they want to impose will work against them next elections.

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