Equilibrium Strategy for Gasoline
Subsidy Policy Removal
by
Muhammad Akimaya, PhD
Carol Dahl, PhD
40th IAEE Conference
Singapore
Background (1)
Oil-rich producing countries implement gasoline
subsidy to distribute welfare.
Good:
Lower transportation costs, high affordability of
energy
Bad:
High cost, inefficiency in gasoline market
2
Background (2)
Further problems:
• Higher opportunity costs because of
significant rise in crude oil price
• Rising domestic gasoline demand
3
Background (3)
4
Background (4)
Solution? Remove the subsidy!
Good:
Welfare gain, fiscal space
Bad:
Strong rejection from the people, violent protests
that may lead to riots
Economic perspective vs. Political perspective
5
Contribution
Complements literature on impacts of a reform
Extends political science literature
Quantitatively models the decision-making process
of the government
Extension on selectorate theory (Bueno de Mesquita
2005)
Extends Harsanyi’s reciprocal power problem
6
Model
1. Selectorate theory (Bueno de Mesquita 2005)
Provides a structure of political power interaction
2. Harsanyi’s (1960) reciprocal power problem
Provides framework
3. Nash bargaining solution (1952)
Provides solution
7
Selectorate Theory
resident
selectorate
winning
coalition
elite
selectorate
leader
8
Harsanyi’s model (1)
2 players:
The government and the people
Game:
To proceed or to abandon
Assumption:
1. Subsidy removal plan comes with price increase
2. The government consists of the leader and winning
coalition
3. The government wants to remove the subsidy
Savings can be used to fund other projects
Each action has an effect on both parties utility level
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Harsanyi’s model (2)
10
Nash Bargaining Solution
Nash Bargaining Solution
Optimal strategy is when both parties are better off
𝑈𝑔𝑜𝑣 = Government’s utility level, status quo
𝑈𝑝𝑜𝑝 = People’s utility level, status quo
𝑈𝑔𝑜𝑣 = Government’s utility level, abandon
𝑈𝑝𝑜𝑝 = People’s utility level, abandon
𝑈𝑔𝑜𝑣 = Government’s utility level, execute
𝑈𝑝𝑜𝑝 = People’s utility level, execute
11
Mathematical Model (1)
Status quo:
𝛼
𝛽
𝛾
𝛿
𝑈𝑔𝑜𝑣 = 𝑓 𝑌𝐺 , 𝑋𝐺 = 𝑌𝐺 𝑋𝐺
𝑓𝑌𝐺 , 𝑓𝑋𝐺 > 0, 𝛼 + 𝛽 = 1
𝑈𝑝𝑜𝑝 = 𝑓 𝑌𝑃 , 𝑋𝑃 = 𝑌𝑃 𝑋𝑃
𝑓𝑌𝑃 , 𝑓𝑋𝑃 > 0, 𝛾 + 𝛿 = 1
X represents political power index
𝑋𝑃 + 𝑋𝐺 = 100
Y represents expenditures
12
Mathematical Model (2)
Abandon:
𝑈𝑔𝑜𝑣 = 𝑓 𝑌𝐺 , 𝑋𝐺 + 𝑥0
𝑈𝑝𝑜𝑝 = 𝑓 𝑌𝑃 , 𝑋𝑃 − 𝑥0
Execute:
𝑈𝑔𝑜𝑣 = 𝑓 𝑌𝐺 + 𝑦, 𝑋𝐺 − 𝑥1 − 𝑡
𝑈𝑝𝑜𝑝 = 𝑓 𝑌𝑃 − 𝑦 ∗ , 𝑋𝑃 + 𝑥1 − 𝑡 ∗
𝑦 ∗ depends on own-price elasticities of gasoline
Dahl (2012) found that Indonesia has own-price elasticities
for gasoline is -0.2
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Mathematical Model (2)
Substituting in,
max 𝑈 =
𝑓 𝑌𝐺 + 𝑦, 𝑋𝐺 − 𝑥1 − 𝑡 − 𝑓 𝑌𝐺 , 𝑋𝐺
𝑓 𝑌𝑃 − 𝑦, 𝑋𝑃 + 𝑥1∗ − 𝑡 ∗ − 𝑓 𝑌𝑃 , 𝑋𝑃
− 𝑓 𝑌𝐺 , 𝑋𝐺 + 𝑥0 − 𝑓 𝑌𝐺 , 𝑋𝐺
∗
− 𝑓 𝑌𝑃 , 𝑋𝑃 − 𝑥0∗ − 𝑓 𝑌𝑃 , 𝑋𝑃
Simplifying further,
max 𝑈 =
𝑌𝐺 + 𝑦
𝑌𝑃 − 𝑦
𝛾
𝛼
𝑋𝐺 − 𝑥1
𝑋𝑃 + 𝑥1
𝛿
𝛽
− 𝑡 − 𝑌𝐺
𝛾
𝛼
𝑋𝐺 + 𝑥0
𝛽
− 𝑡 ∗ − 𝑌𝑃 100 − 𝑋𝐺 − 𝑥0
∗
𝛿
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Policy Options (1)
Common practice:
1. Percentage cut
– Indonesia in 2000, 2002, 2003 (Koran Sindo 2014)
– Malaysia in 2010, 2013 (Bridel et. al 2014)
2. Percentage cut with compensation
– Iran in 2010 (Farzin et. al 2011)
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Policy Options (2)
1. Percentage cut
max 𝑈1 =
𝑝1
𝑌𝐺 + 𝑝1 𝑦
𝛼
𝑌𝑃 + 𝑝1 −𝑦 ∗
𝑋𝐺 − 𝑝1 𝑥2
𝛾
𝛽
𝑋𝑃 + 𝑝1 𝑥2
−
𝛿
𝑌𝐺
−
𝛼
𝑌𝑃
𝑋𝐺 + 𝑥0
𝛾
𝛽
𝑋𝑃 − 𝑥0
∗
𝛿
2. Percentage cut with compensation
max 𝑈1 =
𝑝1
𝑌𝐺 + 𝑝1 𝑦 − 𝑟
𝛼
𝑌𝑃 + 𝑝1 −𝑦 ∗ + 𝑟
𝑋𝐺 − 𝑝1 𝑥2
𝛾
𝛽
𝑋𝑃 + 𝑝1 𝑥2
−
𝛿
𝑌𝐺
−
𝛼
𝑌𝑃
𝑋𝐺 + 𝑥0
𝛾
𝛽
𝑋𝑃 − 𝑥0
∗
𝛿
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Policy Options (3)
FOC to find optimal choice, 𝑝1
1. Percentage cut
𝑝1
= 𝑋𝑃𝑛𝑒𝑤
+ 𝑋𝐺𝑛𝑒𝑤
𝛿−1
𝛽
𝑌𝑃𝑛𝑒𝑤
𝑌𝑃𝑛𝑒𝑤
𝛼
𝛾−1
𝛾 𝑋𝑃𝑛𝑒𝑤 −𝑦 ∗ + 𝛿𝑥2 𝑌𝑃𝑛𝑒𝑤
−𝛽𝑥2 𝛼 𝑦
+
𝑈𝑝𝑜𝑝 − 𝑈𝑝𝑜𝑝
𝑋𝑃𝑛𝑒𝑤 𝑌𝑃𝑛𝑒𝑤
𝑈𝑔𝑜𝑣 − 𝑈𝑔𝑜𝑣
2. Percentage cut with compensation
𝑝1
= 𝑋𝑃𝑛𝑒𝑤
𝛿−1
𝑌𝑃𝑛𝑒𝑤
𝛾−1
𝛾 𝑋𝑃𝑛𝑒𝑤 −𝑦 ∗ + 𝑟 + 𝛿𝑥2 𝑌𝑃𝑛𝑒𝑤
𝑈𝑔𝑜𝑣
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Simulation (1)
Based on Indonesia
Setup for simulation (data)
Parameters
Variable
Value (trillion)
Government Expenditure
𝑌𝐺
Rp 1,435.41
Household Expenditure
𝑌𝑃
Rp 4,496.37
Subsidy Budget
𝑦
Rp 102.82
Government’s power
𝑋𝐺
45*
Note: Based on Badan Pusat Statistik (2016) data for 2012
* Based on electability for 2014 election (Tempo 2014)
18
Simulation (2)
Setup for simulation (assumed)
Symbol
Value
People’s political power*
𝑋𝑃
100-45=55
Government’s preference on expenditure
𝛼
0.5
Government’s preference on political power
𝛽
0.5
People’s preference on expenditure*
𝛾
0.7
People’s preference on political power*
𝛿
0.3
Drop in political support after subsidy cut
𝑥2
4.5
Gain in political support by abandoning the plan
𝑥0
0.45
Parameters
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Simulation (3)
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Simulation (4)
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Simulation (5)
Halve the shift in political power, (𝑥2 = 2.25)
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Simulation (6)
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Simulation (7)
Percentage cut with compensation
Iran did 50% compensation to cover 90% of the gulf price
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Simulation (8)
• Different policy results in different optimal
percentage cut
– 40-80% subsidy cut for percentage cut policy
– elimination of subsidy for 30% compensation rate
• Sensitive to shift in political power
25
Sensitivity Analyses (1)
Income preference of the people, γ
26
Sensitivity Analyses (2)
Expenditure preference of the government, α
27
Conclusion
• Under benchmark scenario, optimal strategy is
to abandon
• Sensitive to preferences of both parties
– Current economic condition
• Sensitive to change in political power
– Who are your winning coalition members?
– Who gets affected by the policy reform?
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Remarks
• Assumption on penalty, t, and inflation
• Applicability of the framework
• Empirical work?
– Government preferences
– Political power index
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Thank you
Q&A
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