Saturday, January 1, 2011

If world leaders (Iran, Bolivia, Venezuela, Cuba, (US?)) would read the chapter in a basic economics textbook on subsidies, they could avoid social unrest and alot of grief.

Bolivian president cancels gasoline price increase

""The government announced Sunday that it was raising gasoline prices by 73 percent, to 92 cents a liter ($3.48 a gallon) for regular gasoline, up from 50 cents ($1.89)....Bolivian President Evo Morales on Friday abruptly canceled a decree that sharply raised fuel prices, reacting to widespread protests and the threat of more to come in the biggest setback of his five years in office... 

Public subsidies are payments by the government to producers and/or consumers of a good or service. The justification for subsidies is the current production of the good/service is less than the socially optimal level of production and/or the current market price is too high. A subsidy to the producer decreases the cost of producing and incentivizes the producer to increase the supply of a good/serviced at a given price (Supply curve shifts RIGHT) which decreases the market price and increases the quantity supplied at that lower price. A subsidy to the consumer decreases the price of a good/service and incentivizes the consumer to increase the demand for a good/service at a given price (Demand curve shifts RIGHT) which Increases the market price (but is off-set with the subsidy) and increases the quantity demanded. This article suggests the subsidy is bestowed on the supply/supplier side, so I will show graphically the effect of the subsidy on supply of gasoline in Bolivia. are payments by the government to producers and/or consumers of a good or service. The justification for subsidies is the current production of the good/service is less than the socially optimal level of production and/or the current market price is too high. A subsidy to the producer decreases the cost of producing and incentivizes the producer to increase the supply of a good/serviced at a given price (Supply curve shifts RIGHT) which decreases the market price and increases the quantity supplied at that lower price. A subsidy to the consumer decreases the price of a good/service and incentivizes the consumer to increase the demand for a good/service at a given price (Demand curve shifts RIGHT) which Increases the market price (but is off-set with the subsidy) and increases the quantity demanded. This article suggests the subsidy is bestowed on the supply/supplier side, so I will show graphically the effect of the subsidy on supply of gasoline in Bolivia.

The first graph shows the apparent market equilibrium price of $3.48 WITHOUT the subsidy, as indicated in the paragraph above. This is shown as Point "A" where Supply* intersects with Demand*. At Point "A" quantity supplied EQUALS quantity demanded.


NOTE: On horizontal axis units are in tens and hundreds. They could be thousands or millions. For simplicity I will just use tens and hundreds
 When the subsidy is granted to the producer the cost of producing decreases. Focus on Supply* curve.  Supply* reflects the quantity supplied (horizontal axis) at every price (vertical axis). With the subsidy, to produce 100 gallons of gasoline it now costs something less than the $3.48 market price, represented by Point "B" in this graph:

What is true at Point "B" is also going to be true ALL ALONG Supply* curve. This is reflected in the following series of graphs:


Points "A", "B", "C", "D", "E" represent different price and quantity supplied combinations that now lie parallel and to the RIGHT of Supply*. If we connect these points and clear the above graphs of all the notations, we will see that we have a new market supply curve, Supply 1:
Notice that ONLY one of these new points on Supply 1, "D", intersects with Demand*.  We have a new market equilibrium price of $1.89 and market quantity 125. Nothing in the market caused Demand to change (shift) ONLY the quantity demanded.  Demanders responded to this increase in Supply, driven by a decrease in the cost of producting, by INCREASING their quantity demanded, moving down and to the right on Demand*, just what the Law of Demand states!
To see this more clearly, assume the market did not recognize what happened and the price stayed "sticky" at $3.48.  In the graph below, we can see at $3.48 the Quantity Demanded is 100 BUT because of the subsidy the Quantity Supplied at $3.48 is 150, shown at Point "F". Quantity Supplied is GREATER than Quantity Demaned! The only why to clear the markets is for the producers and suppliers to move ALONG their respective curves until the reach a new equilibrium at Point "D" where quantity supplied equals quantity demanded at a price of $1.89.

Remember, the price is lower and the market quantity is higher due to the subsidy.  If the subsidy was removed then, absent some other factor affecting cost of producing, Supply 1 would snap back to Supply* and the market price would return to  $3.48.  This is what prompted the Bolivian government to revoke the planned removal of the subsidy.

This is just another reminder of why it is important to study economics and how economic policies can affect politics and society.  As I often say in class, show me a place that has social unrest and I will find you a very basic underlying economic reason for it.
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