Abstract
Fuel subsidies distort end-use prices below cost, resulting in overconsumption and huge environmental cost. On the other hand, the mark-up over cost due to the exercise of market power results in the social loss of consumer surplus. We open a new line of inquiry into the potential for a market-based solution from these two countervailing forces: can the two offsetting distortions conceivably achieve a second- best optimum? Relying on dynamic panel techniques and gasoline market data for 68 developing countries, we uncover an excessive second-best subsidy offset to market power mark-up on the order of 4.5. Our results indicate that the potential for policy failure strongly exceeds the potential for market failure in our model, and gasoline prices across our sample may not be aligned with vigorous anti-climate change policy.
Highlights
Fuel subsidies are often employed by developing countries1 as instruments to alleviate poverty and promote social welfare
We rigorously examine the possible endogeneity of fuel subsidies using the Hausman specification test, which requires the identification of an exogenous variable that influences gasoline price subsidies but does not directly influence retail gasoline prices
We find the coefficient on Endownt to be positive and statistically significant at the 1% level, indicating that oil-endowed countries are more likely to intervene in domestic gasoline markets via subsidies
Summary
Fuel subsidies are often employed by developing countries as instruments to alleviate poverty and promote social welfare. We are careful in this paper not to use the term welfare optimum to identify the second-best outcome that arises from the countervailing forces of market power and subsidy because we have not explicitly included estimates of the social cost of carbon.. We are careful in this paper not to use the term welfare optimum to identify the second-best outcome that arises from the countervailing forces of market power and subsidy because we have not explicitly included estimates of the social cost of carbon.2 These would be needed if the aim was to pin down the welfare optimal outcome. A major consensus in the fuel subsidy literature is that they distort prices and lead to socially inefficient levels of consumption (e.g. Davis 2014; Coady et al 2017) They constitute a drain on government budgets, often resulting in scale imbalances. The overconsumption arising from fuel subsidies indicate misallocation of scarce resources. fossil fuel subsidies encourage the “lock-in” for fossil-based technologies by limit the adoption of more efficient (low-carbon) technologies since they lower the opportunity cost of fossil fuels below consumers’ willingness to pay.
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