Further Government Cuts in Oil Subsidies Will Help Lower Oil Prices

India and Malaysia announced that they are cutting oil subsidies, which will result in a rise in gasoline and diesel fuel prices in those countries. Indonesia earlier cut fuel subsidies. This will help increase the elasticity of demand and put at least a small amount of downward pressure on oil prices, at least in the short run.

Rapidly growing economies like India account for much of the world’s increase in oil demand. It would be especially helpful if China would decrease their oil subsidies.

Oil subsidies cost the governments a lot of money. India’s state owned oil companies are expected to loose $58 billion for the year through 2009. Malaysia was expecting to spend $14 billion on subsidies.

Oil prices should not be set artificially. Prices that are either to high or too low send the wrong price signals to market driven economies. Prices are high enough now to cause market driven economies to cut demand through better efficiency and through fuel substitution.

It takes time, however, for markets to fully adjust to higher fuel prices. This is indicated by the ‘long term elasticity of demand’. In the short term it is difficult for consumers to change their fuel consumption. For example, you drive your car to work and if gasoline prices rise, you still have to buy gas and drive to work. The short term elasticity of demand is very inelastic. In the long term, you could either buy a more fuel efficient car or even quit you job and find another job closer to home. General Motors announced it is closing 4 truck and SUV plants because of plunging demand for large vehicles and increased demand for small cars. You have more options in the longer term which is why ‘long term elasticity of demand’ for oil is more elastic.

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