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Opinions of Tuesday, 26 April 2005

Columnist: Amegashie, J. Atsu

The economics of subsidies

The removal of subsidies on agriculture, health, education, petroleum products, etc is one of the key policy prescriptions by the World Bank to developing countries. Presumably, this policy is supposed to enhance economic performance in these countries. However, the removal of subsidies can have adverse effects on the poor in these countries and lead to political agitation as evidenced in the recent ?wahala? demonstrations after the NPP government in Ghana removed the subsidy on petrol. But is there a compelling economic argument or basis for the removal of subsidies? Will this policy necessarily improve economic performance? In this article, I shall provide answers to these questions.

Modern neoclassical economics is based on perfectly competitive markets. More than fifty years ago, the Nobel Laureates Kenneth Arrow and the late Gerard Debreu proved the existence of competitive prices under very restrictive conditions. Under certain conditions, a competitive equilibrium not only exists but is also efficient (i.e., maximizes the size of the national pie or maximizes social welfare). In this world, there can be no role for government intervention in the economy. In a competitive equilibrium, the price of each commodity is equal to its cost of production. Suppose the cost per unit of output is constant, where cost is defined to include the minimum return on investment that an entrepreneur requires to remain in business. Since the quantity demanded of the commodity increases as the price falls, an increase in quantity beyond the competitive equilibrium quantity will result in a fall in the price. Given that the price is equal to the cost of production in a competitive equilibrium, any increase in quantity beyond the competitive equilibrium quantity implies that the price will be below the cost of production. This clearly does not make sense. Conversely, any reduction below the competitive equilibrium quantity implies that the price is above the cost of production. But since price is a measure of how society or economic agents value a commodity, the value that society places on an additional quantity exceeds the cost. Therefore, economic welfare increases if quantity is increased when the economy is below the competitive equilibrium quantity. Thus, I have argued that departures from the competitive equilibrium quantity and price reduce social welfare or do not make economic sense. If the market is in a perfectly competitive equilibrium, then a subsidy, by reducing the price of the commodity, increases consumption of the commodity beyond the equilibrium competitive quantity. But since departures from the competitive equilibrium reduce social welfare, the subsidy is not desirable. Herein lies the logic behind the World Bank policy prescription: removal of subsidies. In this world, subsidies are a form of market distortion which leads to a misallocation of resources and a reduction in social welfare.

Given that the conditions required for free markets to operate efficiently are rarely met in the real world, one is inclined to question why the World Bank recommends the removal of subsidies to several developing countries as though this was some religious dogma or mantra. Joseph Stiglitz of Columbia University won his 2001 Nobel prize in economics based on his numerous works which demonstrate market inefficiencies in various contexts. Market imperfections or distortions exist when buyers are uninformed, the number of firms is small, public goods exist, property rights are weak, etc. However, market imperfections do not necessarily lead to market failures or inefficiencies. For example, it can be shown that a market with only two firms which face no capacity constraints could yield an efficient competitive outcome.

If subsidies are distortionary and reduce welfare in perfectly competitive markets, are they necessarily so in markets which are not competitive? Is there a generally accepted economic argument for their removal? The answer is no. Almost fifty years ago, Richard Lipsey and the late Kelvin Lancaster showed that in an economy characterized by many market imperfections, there is no guarantee that the removal of any one such imperfection will improve social welfare. This is the theory of the second best. As the development economist Paul Mosley of Sheffield University, UK observed ?? any ?structural adjustment programme? ? i.e., programme to remove a cluster of such imperfections is therefore not an application of economic principles but rather an improvisation, a gamble based on the premise that if past microeconomic policies have yielded unsatisfactory results, an alteration of those policies may help.? Let me present an illustration of second-best theory. Suppose there is a market imperfection, for example, there is only one firm or very few firms in the market. Typically, the equilibrium quantity in this market will be below the perfectly competitive equilibrium quantity. For example, the equilibrium quantity when the seller is a monopolist is lower relative to the quantity in a perfectly competitive market since monopolies charge higher prices. Therefore, a subsidy, by reducing the price of the commodity, may increase the consumption of the commodity towards the equilibrium (perfectly) competitive quantity, given that output was initially too low. Indeed, an appropriately chosen subsidy will move the economy towards the perfectly competitive equilibrium quantity. This increases social welfare. This benefit must be balanced against the cost of the subsidy, which also includes the cost of financing the subsidy through distortionary taxation. But the main point is that we cannot necessarily conclude that the subsidy will reduce social welfare unless we know the relative magnitudes of the costs and benefits. The theory of the second best suggests that if there are irremovable distortions in some sectors of the economy, then economic performance or social welfare may be higher if free-market pricing principles are deliberately violated in other sectors of the economy.

There is yet another reason why the removal of subsidies may not enhance economic performance. Subsidies may be used by governments to redistribute income from the rich to the poor. For example, subsidies on kerosene in Ghana serve this purpose, since kerosene is typically used by the poor. Indeed, redistribution can enhance economic efficiency in certain situations. Harvard economists Alberto Alesina and Dani Rodrik showed that income inequality had an adverse effect on growth. They argued that in more unequal societies, economic growth is lower because the demand for fiscal redistribution financed by distortionary taxation is higher. Income inequality also fuels social discontent and increases socio-political instability. The uncertainty in the politico-economic environment reduces investment which reduces growth.

My goal is not to argue for or against the removal of subsidies. My main argument is that since there is no compelling theory to support the removal of subsidies, the World Bank and governments in developing countries should implement this policy cautiously and should do so on a case-by-case basis. Indeed, the World Bank does not impose these conditions on the developed nations. Why? Clearly, there is a double standard. The removal of subsidies should not be a one-size-fits-all policy prescription for developing economies because there is nothing in economic theory which unequivocably supports this policy. The public must be educated and informed about the pros and cons of this policy on a case-by-case basis including the alternative uses of tax revenue if the subsidy on a specific commodity is removed. For example, the removal of subsidies on health may have entirely different implications than the removal of subsidies on petrol.

Those who wish to play politics with this piece will only see one side of the story. On the contrary, this piece calls for pragmatism, balance, and common sense. Finally and perhaps, more importantly, the World Bank will not be able to tell us what do if we put our house in order. For the sake of our children, grandchildren, and our own pride, let?s get rid of any canker of corruption, nepotism, incompetence, and apathy in our house. That way, we wouldn?t have to depend on the World Bank.

*J. Atsu Amegashie is an economics professor at the University of Guelph, Canada.

Views expressed by the author(s) do not necessarily reflect those of GhanaHomePage.