A local TV station reports that according to a survey it conducted some 90% of the electricity consumers have said that it is unfair to raise the price of electricity. They don’t say why they say so. The Sinhalese press reflects the same lack of economic literacy. Nobody likes price increases even if it is to recover the true cost of producing the good or service. But how can anybody say it is unfair to recover the cost of producing something? Private firms cannot sell at a price below their cost and will have to wind up rather than continue to function. The public accepts this.
But the public wants a government or a government institution to sell its products or services below their cost because they know they can still carry on if the Treasury will fund the loss. But the Treasury has to collect the money from the public through higher taxation or inflation. If it is a general tax on all commodities like VAT it will tax those who consume electricity as well as the 10% that doesn’t have electricity at all. But it would be unfair to do so. Only those who consume electricity should be called upon to pay for it.
Why subsidize electricity?
Would people be better off if the electricity is subsidized through taxes or inflation? That will depend on the impact of inflation or the incidence of the tax on each person. The taxes are indirect and are payable by all people. So how much will the taxes have to increase per person or household if the electricity is subsidized? The subsidy will have to be divided by the number of household consumers which will have to be weighted by the number of units consumed by each household. In short the tax will be similar to the increase in price contemplated. What if the tax is a general one on all commodities like VAT. It would be unfair for why should those who use less electricity or no electricity at all, be called upon to pay more taxes to fund the electricity consumers, some of whom are affluent and consume more units of electricity than others.
Our people believe in a free lunch and don’t want to pay for anything if the supplier is the government. They therefore don’t like the government to recover the cost of producing any good or service. Politicians like to exercise arbitrary power and enjoy the power to dispense benefits to win the favor of the people. So they propagated the idea of a free lunch. But they fail to realize that they thereby create a ‘false economy’ .
Generally ‘false economy’ is an action that saves money at the beginning but which, over a longer period of time, results in more money being spent or wasted than being saved. There used to be a saying that if you want to make a man poor you should give him a second hand car. Economist Alan Beattie, wrote a book titled "False Economy,". It is a wider concept where through artificial controls, subsidized prices and excessive monetary expansion, a whole false economy is built up which does not reflect economic reality. Our $60 billion dollar economy is just such a false economy bloated by inflation and converted to dollars at an overvalued exchange rate.
Allocation of resources is better through market prices reflecting costs
Economists point out that the allocation of resources according to market prices is fairer and more efficient than any other method of allocation such as allocation by a government bureaucracy. The Communists did away with the market price system and fixed prices purportedly according to the decisions of the Central Planning Commission. But they could not do so efficiently and created a false economy where more guns were produced while bread was rationed to long queues of consumers. They could not equate supply and demand and created shortages on the one hand and unwanted surpluses on the other.
But Socialists still say the allocation of goods and resources through the market price system is unfair because the richer folk have greater market power. But in the case of a widely consumed product, it is the decision of the majority of consumers that has the most impact. Aren’t the prices determined by the majority fairer than what is fixed by some bureaucrat?
Market forces and market prices provide a simpler and more effective method of running an economy. But years of Communist propaganda against the free market economy misled our political leaders. They still think government should fix prices and they ignore the fundamentals of simple economics in doing so. So they fix controlled prices, fix interest rates and exchange rates and provide subsidies to the consumers and producers to win political favor. Local economists justified them on the ‘market failure’ theory. They cited various deviations from hypothetical "perfectly competitive" conditions which may cause market-determined prices to be distorted and outputs to be "inefficient," and in this event they say the government must intervene with taxes, subsidies, and regulations to bring the market into an efficient configuration. But the Economist Robert Higgs points out that market failure theory assumes information about demand, cost, supply that cannot be known except as they are determined in actual markets. So without actual markets how can market failure be diagnosed let alone corrected? This theory also assumes implicitly that the interventionist actions of the government are themselves without costs.
Hidden costs of the electricity subsidy.
It has costs in the form of higher consumption of electricity – higher imports of household electrical appliances, higher imports of oil etc when we don’t earn sufficient foreign exchange to pay for them. Our external account is a huge deficit and has to be funded either by sale of our assets to foreigners (foreign investment in our real or financial assets) or by borrowing from foreigners. So by subsidizing we are providing a false standard of living for our electricity consumers through foreign borrowing. Are they the poor? Should we continue to do so? Should we supplement their real income to enable them to maintain a higher standard of living? Is that fair?
The problem of rationing
Allen Sanderson of the University of Chicago explains the subject of allocating scarce resources to his economics students by talking of the following problem. The first day of introductory economics, he says, there are always more students than seats. Say there are forty extra people and he can only accept ten more into the class. He asks the class: how should the 10 available slots be allocated? Some students say according to seniority because seniors won’t be able to take the class later; some say on the Quality Point Average (a measure of merit in USA) because better students will contribute more to the class and get more out of it; others say on the ‘first come first served’ rule by selecting the first ten people outside his office at 8 am the next day, since that shows the keenness of the students to follow the course. Some other students suggest selection through a lottery because it would be a random selection which is fair. One student says to auction the places to the highest bidder. If you auction the slots then they will go to those who are affluent and who can afford to pay the price. Some will say that it deprives the poor of entry. But economists would argue that if you auction the slots, they will go to the students to whom they are worth the most, Under any other method the slots can be re-sold to others willing to pay, giving windfall gains to those selected. Economists say the auctioning is efficient since those who value it most get the places.
In the case of electricity the supply constraint is the foreign exchange which limits what we can afford to import by way of oil or coal (though not hydro-power which normally supplies only 50% or less). Economists would say the scarce foreign exchange should be allocated on the basis of market prices of the imported goods with no distorting subsidies. Electricity Prices based on cost plus reflect the scarcity value of electricity while the market based exchange rate reflects the scarcity value of foreign exchange. Both are needed for an efficient allocation of resources. If we depart from them, we are creating a false economy.
Why borrow from foreigners to provide a higher income only for electricity consumers?
Since we don’t have enough foreign exchange to satisfy all our demands for imported goods, we borrow from foreigners to fund the difference. So is there a case for giving electricity cheaper and increasing the demand for it unduly and paying for it through foreign borrowing? If all prices reflect costs then it is the people who will decide whether to consume more electricity or more milk foods, chillies or potatoes. This is the core tradeoff of economics: fairness and efficiency.
If electricity is priced below the cost, more electricity will be consumed as people buy more electricity consuming household appliances like refrigerators, washing machines etc. This will increase the welfare of those electricity consumers who can afford to buy such electrical appliances by some amount. Shouldn’t they be willing to pay for that increase in welfare? Should they get a free benefit in welfare?
We are too obsessed with fairness rather than efficiency. By not allowing market clearing prices to function in the economy, we are sacrificing efficiency and creating false unsustainable living standards.