Econ 101.01 – Introduction to Economics IHomework IIIDue date: 22 March 2007, ThursdayBilkent UniversitySpring 2007 Part I: (40 points total: 8 points each question) Solving problems from Hubbard andO’BrienFrom the “problems and applications” section answer the following questions from chapter 5:question 15, 23 and 24.From the “problems and applications” section answer the following questions from chapter 9:question 3 and 4.Part II: (60 points) Application of concepts learned in classRead the attached article from The Economist dated October 2, 2006 “Pump priming”. Writean essay that responds to the following question. The essay should be at most 2 pages(excluding graphs, and the usual rules apply: proper margins, at least 1.5 spacing, at least 11fonts, proper grammar and no spelling mistakes and most importantly, proper references.1. Identify two major policies used in Thailand and China, and India and Malaysiaregarding the oil prices.2. Discuss the welfare effects of these policies, both graphically and verbally, using boththe information from the article and Econ 101.3. The article briefly mentions the possible externality effects of the policiesimplemented. Suggest a policy package to the Thai, Chinese, Indian and Malaysiangovernment to totally eliminate the negative welfare effects of the externalities. Indoing so you should include a graph as well as verbal explanations.Pump PrimingThe high price of oil is taking a serious toll on Asia, in more ways than you might think.Inflation is already ticking up, from Mumbai to Manila. Interest rates are beginning to follow.Increased energy costs, the United Nations reckons, will shave a percentage point off theregion’s economic growth this year. The Asian Development Bank has just cut its growthforecasts for next year too. In some cases, the prognosis is truly dire: prices of $50 a barrel, ifsustained throughout next year, will slash four percentage points off Thailand’s growth rate,according to the bank’s projections. Yet many Asian governments, including Thailand’s, aremaking a bad situation worse by subsidising fuel prices.The economies of Asia, like those of most developing countries, are oil-intensive. In otherwords, Asians consume more oil per unit of output than Europeans or even gas-guzzlingAmericans. Thailand and China, for example, use more than twice the rich-country average,while India burns through almost three times as much, according to the International EnergyAgency. So they naturally suffer more when the oil price rises.One reason Asian countries get through so much oil is that many of them subsidise it in oneway or another. Since the beginning of the year, the Thai government has fixed the retail priceof diesel at below market rates, at its own expense. Indonesia has long done the same for alltypes of petrol. In August, the Indian government cut excise and import taxes on oil, to add tothe direct subsidies it already pays on liquefied petroleum gas (LPG) and kerosene. Malaysia,too, keeps petrol prices low through direct subsidies and tax breaks. The government of Chinasets discounted prices, but leaves it to refiners and distributors, which are largely state-owned,to absorb the shortfall.Needless to say, all this costs a fortune. The Indonesian government originally planned tospend 14 trillion rupiah ($1.5 billion) on fuel subsidies this year. But as the oil price has risen,the bill has more than quadrupled, to 63 trillion rupiah. That is almost as much as Indonesia’stotal budget for development. In Malaysia, fuel subsidies and forgone taxes account forroughly half this year’s budget deficit of 20 billion ringgit ($5.3 billion). Rating agencies havebeen muttering about the government’s persistent deficits, yet it left the fuel subsidy intact innext year’s budget too. India, another compulsive borrower, is spending $1.4 billion this yearto subsidise kerosene and LPG alone. The government is also forgoing $540m in tax revenueson various fuels, while state-owned refiners and distributors must also have absorbedconsiderable costs that do not feature on the government’s balance sheet.Taxpayers, of course, will eventually foot all these bills. Meanwhile, growing public debt putsupward pressure on interest rates and reduces the capital available to more productiveborrowers. In the long run, that could cause far more damage than high oil prices.To make matters worse, artificially low prices encourage waste, along with all theconcomitant costs in terms of pollution, traffic congestion and misallocated capital. ThaksinShinawatra, Thailand’s prime minister, claims he is determined to reduce his country’s energybills. To save electricity, he has asked shops to close early and that big buildings shouldswitch off their flood-lights. Yet since January, he has capped the price of diesel–on whichmost Thai vehicles run–at about three-quarters of the market rate. Motorists, naturallyenough, are buying more. Thailand’s oil imports have duly surged in volume, as well as justprice.Higher import bills, in turn, have sent Thailand’s trade balance into the red. That hasdepressed the baht, making imported fuel more expensive still, and feeding the inflation thesubsidies are supposed to curb. Most Asian nations import at least some of their oil; of all thecountries mentioned, only Malaysia is a net exporter. Indeed, Asia as a whole (excluding theMiddle East, but including Central Asia) produces only 11% of the world’s oil, but consumesabout 21%. Oil alone accounts for almost a third of India’s imports, for example. Admittedly,a healthy balance of payments and huge foreign-exchange reserves will allow most Asiancountries to finance expensive oil imports for a long time to come. But there is no sense inincreasing the burden unnecessarily.Furthermore, most oil subsidies do not go to the people in whose name they are paid: thepoor. Cheap petrol, for example, benefits most those who drive the biggest, most inefficientcars, namely the rich. The poorest have no motor vehicles at all. Indonesia effectivelysubsidises its richer neighbours, thanks to a roaring trade in smuggled petrol. Singapore doesnot allow locally registered vehicles to leave the country with less than three-quarters of atank of gas, to prevent them from taking undue advantage of the subsidised stuff across theborder in Malaysia. Even targeted subsidies can end up in the wrong hands. Many countriessubsidise kerosene, since the poor often cook with it. But so do lots of well-to-dorestaurateurs.The biggest beneficiaries of oil subsidies are the politicians who use them as a crude votebuying technique. Mr. Thaksin has declared that diesel subsidies will remain in place untilFebruary, which also happens to be the month by which an election must be held. Theprevious Indian government did not allow any fuel price rises for five months prior toelections in April. The outgoing Indonesian government, too, put off planned price hikes thisyear. How unlucky, then, that a record year for oil prices also happened to be a record year forelections in Asia.Source: The Economist, “Pump Priming”, October 2, 2006, vol.372, Issue 8395, pages 41-42.
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