Wednesday, December 22, 2010

Want to create a revolution in Iran? It is not very romantic, but taking away subsidies might do it...

LA TIMES: Prices in Iran rise after lifting of subsidies

""The Iranian government's removal of decades-old subsidies for food and energy in an attempt to boost its troubled economy has spurred price increases on everything from fruit and vegetables to gasoline, generated work stoppages and emboldened the political opposition....""
A government can choose to subsidize the production (supply) or consumption (demand) of a good and/or service. From the tone of the article I am going to assume the Iranian government provides the subsidy to the producers/suppliers of goods and/or services. A subsidy is a cash transfer (or tax credit) intended to reduce the cost of producing a good/service for the producer with the goal of reducing the price to the consumer.  To see how this occurs, let's look at it graphically. 

The first graph shows the pre-subsidy market equilibrium for __??___(insert any of the goods/services mentioned in the article).
 

If the government offers the subsidy to the producer this, in effect, decreases their cost of producing. Relative to ANY point on supply curve "S w/o subsidy" the cost of producing  is going to be "P w/o subsidy PLUS the Subsidy".  See graph below.


If we connect our new points, we find our market supply curve has shifted to the RIGHT. Shown below as "S w/Subsidy". At any price the quantity supplied is going to be GREATER than it was relative to "S w/o Subsidy".
Only ONE of these points on "S w/Subsidy" intersects with the existing demand curve (D*)--Point "B". If we connect and re-label our equilibrium points, we see we have a market equilibrium price of "P1 W/Subsidy" and market quantity "Q1".  Illustrated below:
Now, at Point "B" we have  market quantity "Q1".  This implies Quantity Demanded = Quantity Supplied. True enough. But to see the effect of the subsidy, look at what previously suppliers would have had to receive to supply "Q1".  If we take the subsidy away, we see producers would have required "P2" for that quantity supplied. See Point "C" on the graph below:
The subsidy reduced the market price to consumers to "P1 w/subsidy".  When the government rescinded the subsidies, "S w/Subsidy" snapped back to "S w/o Subsidy" very quickly. We returned to the original price and market quantity.

I hope this helps in understanding the current social unrest in Iran. It is important because with all the other problems people have had lately with the ruling regime there, this could be a tipping point for many who were not interested in participating in the protests earlier in the year.  As I am fond of saying, look at the root cause of most wars, revolutions, or other manifestations of social unrest, there is usually an everyday economic problem associated with it...
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