Subsidies

For my first post, I thought it would be good to give a layman’s explanation into the economics of subsidies, given the prominence of these in our daily lives as Malaysians. The point of this is to put some economics into everyday arguments over this issue and clarify some of the good and not-so-good arguments on either side.

One of the most frustrating arguments I hear about petrol subsidies is this: Malaysia is an oil exporter, so many other oil-exporting countries subsidise their oil, so Malaysia should do so too.  By this logic, it would not then be a stretch to argue that as one of the largest exporters of gold, South Africa should then subsidise the “consumption” of gold by its people.

The point here is not whether we can afford it or not (although that is of course a key concern), but whether or not we could put the money to better use. There will be two strands to this argument that most microeconomists use, efficiency (can we achieve the same results at a lower cost?) and equity (is our policy the best at addressing differences between the rich and the poor?).

SUBSIDIES ARE HIGHLY INEFFICIENT

For the economists reading this, the term deadweight loss will probably come straight to mind. To illustrate this point, consider the following example. In Scenario 1, we have 2 goods, apples and oranges. Apples are subsidised, from a market price of RM2 to RM1.50 (i.e. a 50 cent subsidy) while oranges are not (priced at RM2). Say you have an income of RM10 – you would aim to purchase the affordable combination of the two goods which gives you the highest level of satisfaction (or utility, in economic terms); in this instance, let us say that is 4 apples and 2 oranges. Here, the subsidy costs the government RM0.50*4 apples = RM2.

In Scenario 2, let us say the government removes the subsidy and gave you RM2 directly instead. Notice that you can still afford what was your favourite combination earlier, i.e. 4 apples and 2 oranges (which costs RM12). Since you can still get your favourite combination under Scenario 1 (i.e. 4 apples, 2 oranges), you cannot be any worse off under Scenario 2. Additionally, given that your income and relative prices have changed here, you can now also choose a different bundle of goods which can leave you better off (i.e. give you a higher level of satisfaction than from purchasing 4 apples, 2 oranges).

Essentially, this method is what economists call revealed preference. What it states is that replacing the subsidies with lump-sum transfers that do not distort relative prices and choices between goods will lead to a greater welfare improvement for a given cost to the government purse*. The only caveat to this efficiency argument is in the case of a positive externality, whereby the consumption/production of the good has positive effects to third parties not directly involved and we may want to encourage more consumption/production but it is hard to justify most subsidies in the country with this argument. An example of this would be education, which has benefits to society beyond what you receive individually. A subsidy on education might thus be justified.

SUBSIDIES ARE RELATIVELY INEQUITABLE

The second strand of my argument is that subsidies are inequitable compared to various alternatives we might have. Consider fuel subsidies. The direct benefit to the average consumer depends on whether or not they have a vehicle, and the extent to which they use it. Clearly then, the richest 5% of the population are likely to benefit far more than the poorest 5% (who are unlikely to have a fuel-powered vehicle) from a fuel subsidy. The common justification used usually applies to subsidies on necessities; this is because as a fraction of their smaller budget, the poor would benefit more from these subsidies than the rich, making it a more equitable subsidy even if in monetary terms this is not as clear.

Nevertheless, I would argue that direct monetary handouts to the poor can be more equitable than the aforementioned subsidies. With direct monetary handouts, we can ensure the overall monetary benefit of the policy benefits the poor disproportionately in both absolute and relative terms. Recent examples would include the one-off RM500 payment to households earning below RM3000. Of course, if these benefits are intended to be continued annually, they should not be removed lump-sum at a boundary like this because it can create incentive problems, e.g. for people earning just above RM3000, there is an incentive to work less in order to go below the RM3000 boundary and obtain the extra RM500.

A better way is likely to have the benefits slowly taper off as someone earns more, which reduces the distortionary effect of people suddenly losing their benefits. Nevertheless, spending money in this way is far more equitable (it is targeted specifically at the poor) than a blanket subsidy that benefits everyone in society.

WHERE DO WE GO FROM HERE?

Given the above arguments, there appears little in defence of subsidies of what economists call private goods such as food and fuel. If we truly want to help the poor, there are far more efficient and equitable ways of doing this. Therefore, in my opinion, the debate should not revolve around whether or not we want subsidies. Rather, it should revolve around what we should do with the money if we remove the subsidies. Should it go towards improving the welfare of the rakyat through direct transfers to the poor, should it go towards financing large-scale projects that should also benefit the rakyat or should it go towards paying down our national debt? To me, there is clear justification for the removal of subsidies, what is subsequently done with the money saved is the far more important issue we should be talking about.

*For those more interested in the technical aspects of subsidies, such as what might happen if producers also get some of the incidence of the subsidy, most intermediate level microeconomics textbooks will give you a comprehensive discussion of the deadweight loss and how to quantify it in a market with several consumers.

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8 thoughts on “Subsidies

  1. Hi Dhruva, it’s a very good read and I agree with you that the money from subsidies can be put to much greater use (and effectiveness) elsewhere. I’d just like to suggest that with the current economic climate, the better policy would be to spend the money on financing large-scale infrastructure rather than giving out lump-sums to the people. The former would help generate jobs and boost economic growth while the latter might not be as effective in helping the economy if consumer confidence is low (people tend to save more). Of course, this is looking from a more macroscopic view of the economy and it probably wouldn’t help reduce inequity much. Just my two cents.

    • Hi Chris, thanks for the reply. The reason I used lump-sum transfers as a comparison is that this is the simplest benchmark economists use. In general, lump-sum transfers are something relatively easy to execute so if a policy does worse than it, then something is seriously wrong with the policy. I’d certainly agree that there is scope for infrastructure projects that could improve the people’s welfare, not just now but also in the future. This is exactly what I mention in the last paragraph, without going into too much detail. To actually determine if a certain large scale project would be the best option could be a whole article on its own. If you’re interested in it, you should have a read on social cost-benefit analysis, which discusses exactly that. In conclusion, I definitely agree with you that there are some large-scale infrastructure projects, executed properly, that could beat lump-sum transfers. My focus on lump-sum transfers was merely to illustrate through comparison that we can do better than the current system with subsidies.

  2. Hey Dhruva, some very good points here and I like the way you make the economics concepts really accessible to all readers. Agree with you that there are better alternatives to certain subsidies. I just have a slight issue with the point that lump-sum payouts may be more efficient than subsidies. The argument you presented with apples and oranges and utility value works in the usual framework of economics where people behave rationally to maximise their expected utility. But in reality, assuming a utility function exists in the first place (which is debatable), people don’t always behave in ways that maximise their expected utility, and in fact we often don’t. This is a popular result in behavioral economics that I’m sure you’ve heard about. If a family were given RM 200 lump sum as opposed to subsidies on apples, they might misuse it on gambling or other purposes for immediate satisfaction (e.g. expensive restaurant meal), which in the bigger picture would achieve a lower utility than if there were subsidies on apples and they led their usual lives (and ate humble apples). Humans have a natural tendency to make poor choices even when we know what’s best for us, much less when our perception of utility can be severely distorted by greed or expectations. So whether or not lump-sum cash achieves greater welfare than subsidies is not immediately clear. IMO giving out cash to the poor serves a government’s political agenda more than anything else. I’m not an economist though so pls correct me if I’m mistaken. 🙂

    • Hi JW, thanks for the feedback. The point you raise is exactly that a friend of mine, Lau Jia Cheng, raised yesterday. I did consider putting it into my original article but decided against it to keep things simple. I must say that you two have a very good case as to why certain subsidies are actually a good idea. Jia Cheng also gave me this article, which I think you might find a good read too; http://www.foreignpolicy.com/articles/2011/04/25/more_than_1_billion_people_are_hungry_in_the_world?

      I think your summary plus this link provides a good explanation of the issue of why people may not always make a decision that appears to be in their best interest, so I’m just going to highlight some of the concerns I’ve always had with this argument. Firstly, having a government-designed subsidy to overcome this myopia suggests that the government does indeed know better. Some may agree with this, but is certainly an issue up for debate. Not everyone would agree that the government knows better what’s best for them, in which case this descends into a philosophical debate. What is for certain is that the poor people who do not intend to “waste” that money would not like the government dictating how they should spend their money

      Secondly, subsidies don’t necessarily overcome this problem if the good in question is tradable. For example, say we use your example and subsidise apples for the poor person. If he/she has truly set their mind on gambling, who’s to stop them from selling the apples to a neighbour or friend at the market price and then using the money to gamble?

      Nevertheless, for a good like education which is non-tradable, I would agree with you that subsidies do make a lot of sense. Education is probably the best example where people only appreciate the benefits after they have received it. Ex-ante, people may sometimes under-estimate the value of education and are myopic. Meanwhile, a subsidy for education cannot be ‘cashed in’ like a subsidy for tradable goods as above. So a subsidy like this would make sense. I should have probably been clearer in my article that my criticism was against things like fuel subsidies and certain types of food subsidies, which is what Malaysians seem to focus on when we discuss subsidies.

      Whether or not giving out lump-sum transfers are a political agenda I’m not sure. Personally, as a person with centre-left political leanings, I think it is at least one way we can reduce the burden of the poor. Although a lot more focus needs to be paid to the cause of the problem itself. Focusing on the symptoms through lump-sum transfers alone will not solve much in the long-run.

  3. Nice cup of teh tarik there bro!
    Here’s a small sip from mine 🙂 (its 4.30am btw, my thoughts are not organised and i should be going to bed!)

    I believe its hard to pinpoint which policies provide the highest efficiency and spread. What is socially beneficial for a nation could be damaging for an individual. I think it’s more of trial and error and to strike the perfect balance.

    About the oil subsidy, I disagree with ur counter argument a tiny bit. The underlying message of ur SA’s gold is that you’re suggesting that Malaysia should not subsidise oil and people should pay a higher price. Well, in that case, it’s valid to say that we should be paying what Britain is paying for rice and palm oil that we produced (and proton too!). We’re not comparing apples with apples here. Malaysia is no where near the largest producing oil country in the world, we’re not even in OPEC. In fact, we only account for 0.82% of the world production. We do import, a lot, of oil. Dig me? 🙂 Do, however, enlighten me why a producer should not pay less for its own good.

    Whether or not we need subsidy for oil, like you’ve said, we shall leave it for another time. (malas lar…)

    So what do we do with the mulah if we remove subsidies?

    Payouts?
    I agree with Chris and JW on the issue of payouts. I’ve never been in favour of handing out free cash due to reasons JW had already mentioned earlier. It is also highly unsustainable! Its easier to reduce subsidy than to reduce the direct debit of one’s account. But lets not dwell on this as it has been tackled earlier d 🙂
    ps. never give a hobo/begger money. same argument! 😀 – personal opinion

    Large scale projects?
    The government won’t even last to see the completion of those projects! XD You’re squeezing people’s current wealth by removing subsidies for future benefits, of which the lower income rakyat couldn’t care less. This could be seen through the uproar when the warisan tower was announced. (though funded pnb) People, especially the poorer ones, like immediate results/benefits (short term) when it comes to spending their tax money.

    Clearing up national debt?
    I don’t think that chunk of money should be coming out from the removal of subsidies if we are not desperate. There a gizillion ways to raise funds to kick ourselves out of debt. Look at the UK with their edu cuts, didn’t/not ending pretty well… (then again, judging from what we’re paying, they are SO HEAVILY subsidised.) So what if when we cut fuel subsidies, inflation rises and aggregate demand falls? Will the reduction of deficit offset this or will it slap us hard back on the face? Many loose ends here… 😦

    Other methods?
    IDK. Right now, at 5 am? All i could think of is… a Gift card! haha… hear me out! It’s the payout idea but a better one? U know one of those that they have in Topman n River Island? Its like Christmas all over again! Ur friend doesn’t know what to get you cuz they don’t know what you really like. Lets narrow it down clothings (symbolising a necessity) So to solve the problem, he gets you a gift card from Topman, worth £20, and you can spend on whatever clothing you like. If you’re a rich kid, you can use it to subsidise nice suits and leather shoes. For a poorer one, go get urself a nice pair of boxers 😀 The trick here is to limit the bundle of goods. Here, the problem of allocation/equity can be solved because you’re giving consumers the power to choose what they really want/need. And by controlling the type of goods that can be used on will remove the argument of misusing the “payout”. The argument of in-sustainability can also be seen lightly as this is slightly different from giving out free cash/not seen as a non-wage income.

    do i even make sense? :S good nite guys! 🙂

    • You are correct that we don’t export that much oil (we may even be a net importer now, I’m not too sure). However, the fact that we do export a significant amount relative to our national budget is what is used by some to justify subsidies. In my personal opinion, being a producer of a good is far from sufficient justification to subsidise that good. I like to break it down into two steps. Step 1: We export the good, in this case oil, and receive the revenue. Step 2: We have this cash at hand, and now want to spend it somewhere. I don’t see any reason on its own why we should channel that money back to subsidising that good we are exporting. Yes, we can afford it, but we could also put the money to other uses which are potentially more beneficial. The benefits of these alternative uses of the money are independent of where we received the money from. My point is that we need further justification than “we are an exporter of ___”. Similarly, if we do choose to subsidise rice, the justification should not be that we are an exporter of it (that is irrelevant to me) but for some other reason. Perhaps as JW points out, we may be able to justify this if we believe if we gave them the money directly to the people, they would not spend enough of it on rice.

      Payouts?
      I said in the reply to Chris, the reason I focused on direct payouts is that it is the easiest to make a comparison to subsidies. I’m not necessarily advocating them (we may have better options), but I do believe in many cases, they are at least an improvement over subsidies (although some may disagree with me on this). If we can do even better by other means, so be it. You are right that it is easier to cut subsidies than reduce lump-sum payments, but I think it is only slightly easier. People can get very emotional when subsidies are removed as well, as was seen in Nigeria in the past few days. So I think they can both be highly unsustainable.

      Large Scale Projects?
      The point of my article was not to get into details of how to spend the money. That would have made my post about 3 times longer. I just listed several options we may have had. You certainly have valid points when talking about the large-scale projects. In many cases, their benefits have not exactly been very clear. However, on the issue of using current funds for future benefits, I disagree with you slightly there. We should also consider the moral implications of using our nation’s oil wealth (which does not just belong to us, but also future generations), to subsidise oil consumption of our generation. Perhaps investing it in viable projects that spreads the benefits over generations may be better. This of course comes down to the question of whether you believe the oil money belongs to those who extract it or all future inhabitants of the country.

      Clearing up national debt?
      I certainly agree with you there are a lot less painful (to the rakyat at least) ways to reduce the debt. I just listed it there as another alternative for people to think about. I do agree with you there are a lot of other holes to be plugged before we can justify using this money there. On the issue of education reforms in the UK, I do strongly support it though. I think I’ll write an article on it in the coming weeks.

      Other Methods?
      In terms of your suggestion, I am not sure how far this can go towards solving the problem of misusing funds. Firstly, we will have to ensure the ‘gift card’ cannot be sold to someone else, or else it is identical to a direct cash handout. Secondly, even if the gift card can’t be sold, the items which the gift card entitles you to should also be non-tradable or else someone intending to misuse the money will just get the good and then sell it on. However, I certainly think there is scope for tinkering and it could work for certain goods. I don’t think the argument of unsustainability is much different though (personal opinion). People would be very much opposed to this being removed as they would if direct cash was removed.

      Thanks for the comment Jesh. It has certainly given me a lot to think about.

  4. Dear Dhruva,

    First of all, I must say that my viewpoint is not of an economist but I will try my best to provide my reasoning on this topic that you have written.

    Give To The Poor
    1. I think subsidy is important for those who are poor and cannot match their income with the rising cost of living in Malaysia. Subsidy as I have learnt in basic economics can be seen as negative taxes (and without going into any economics theoretical debate) and this really does help the poor alleviate the burden.

    2. However, it is also true that providing subsidy to the rich and wealthy is something which is not justified. My basic reasoning is that since they are already wealthy, when equal subsidy is given to a wealthy and to a poor; the utility measure in terms of ‘significance in helping alleviating the cost of living’ for the wealthy is much lower than for the poor (i.e. subsidy given to the wealthy is insignificant).

    3. So the solution here is to take away subsidy from the rich and provide this portion of the subsidy to the poor. However to determine, who is poor and who is rich –> this requires a standardised metric of measurement, and we should think of a way to do this. I admit that this will be a daunting task but if you want a solution for a better subsidy program, this is one of the method (identify the poor and the rich, exclude the rich from subsidy so that we can provide more for the poor).

    The Over-Dependency On Subsidy Argument
    4. Yes I must admit that when we provide subsidy to the poor and they become overly dependent on it, some of them become less motivated to work. And what happens when subsidy is taken away from them? They become angry.

    5. So I think the solution here is to provide subsidy in the form of services such as free healthcare, free education, food-coupon, entrepreneur opportunities INSTEAD of giving them money. My reasoning is that services are prepared for the needy and the ones that do not need these services will indeed find them not useful. But if we give them money, well (1) greed may overcome them and that’s subsidy doesn’t serve its purpose of helping the poor (2) the poor usually do not have good financial management. – so don’t give money but rather provide services.

    Review The Use of Subsidy & Privatise
    6. Take KTMB for example. It siphons a few millions of ringgit from the government every year. It is a loss-making company but yet it continues to invest in new hi-speed commuter trains. Yet, these commuter trains are not used efficiently. Common-sense will tell you that if there is more commuter trains, increase the frequency of trains and apply strict adherence to arrival time. Sadly, this is not happening.

    7. So the government should really review the projects and investments that has already been made. If there is inefficiency, allocate resources to improve efficiency EFFECTIVELY. If no improvement is seen to be happening, government should critically consider terminating the subsidy for projects and privatise state owned firms.(Well if the management team of state owned firms do not want to lose their job, they should either improve or get sacked).

    Financing Large Scale Projects — For Fame or Do We Really Need It?
    8. Since the current Prime Minister has a great vision to bring Malaysia forward to a high income nation, well with large scale projects? Why not! Remember the construction of Putrajaya? Putrajaya started construction in 1990 and became a federal territory 11 years after that in 2001. Petronas Twin Towers completed in 6 years (beginning in 1992).
    My point here is that given that Putrajaya is the largest project ever undertaken by the government of Malaysia, if we take that and the construction of the Twin Towers as a benchmark, any other projects should not take more than 6 years and the development of an entire state should not take up more than 11 years. Well this doesn’t seem to be fair, you might argue? Why not take it as a challenge?

    9. It is true that some economists will argue that the tenure of a government is not long, so it is important to plan strategically what can be done within the tenure period. The tenure period I am referring to here is measured when the government starts taking office until the date of the next election which takes about 5 years time.

    10. So the solution — well the current government administration should know better how to deal with this matter to stay in office in order to fulfil its long term strategic planning and economic goals so that Malaysia can move towards a developed nation status. 🙂

    • Thanks Vince for the comment.

      1. I certainly agree with you that the poor need help to cope with the rise in the cost of living. However, the point of my article is to discuss whether the current subsidy system is best at doing so or if we can come up with a better way to alleviate their burden (perhaps by some form of direct transfers).

      2. I agree with your second point. Which is precisely the reason in my article why I feel blanket subsidies which benefit everyone are not the most equitable way of doing so.

      3. Again, I don’t disagree with your third point in principle. However, it is not so easy for subsidies on goods like petrol to be tailored to how rich a person is. Sometimes, it may be easier to just give poor people the money than try to subsidise petrol for a certain section of the population.

      4. I don’t have much to add to point 4. The one thing I would say is that at least with direct monetary transfers, we can often attach it to some conditions that the person actually tries to seek a job (it is called the jobseekers allowance in the UK). What happens is the benefit is given to those people who demonstrate that they are actively seeking work. This may be slightly harder with subsidies.

      5. I agree that things like education and possibly healthcare should be subsidised. This is because if we give money to someone instead, they very often under-appreciate the benefits of educating their kids or may be somewhat short-sighted. So subsidising education can be justified to prevent this under-consumption of education. For something like food coupons, I don’t see why we shouldn’t instead give the poor the money directly so they can decide what to do with it. Food being a necessity should mean that they will spend enough of the money on food. I don’t think financial management plays a huge role in a person consuming the right amount food. By giving them the money directly, we then don’t need the government deciding/planning how much food each family needs (which may vary from family to family depending on age and other demographic characteristics) or deciding what kind of food should be accessible via the coupons.

      6,7, & 8. I agree with the principles you are getting at. Unfortunately, as to the actual examples (especially the KTMB one) you mention, I don’t have the facts at hand to be able to comment satisfactorily.

      9 & 10. Don’t have much to say really. All I can say is that a problem with all democracies in the world is that a 5 year term is usually not enough for long-term planning. This is why many governments around the world struggle to maintain their long-term plans.

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