Most people would wonder at the opportunism of the Union government in announcing hikes in petrol and diesel prices after the elections to several state legislatures were over; but they would not dispute the need for such hikes. They would take it for granted that the rise in the international price of oil has got to be passed on to the ultimate consumers.
This, however, is a mistake. It can be shown that not raising the final prices to consumers when international oil prices rise would leave the economy better off than raising prices, not just for the obvious reason that the working people would be spared the distress of inflation but also for a more subtle and profound reason, namely, that while raising prices leads to a contraction of output and employment compared to the original situation, not raising prices leads to an expansion of output and employment compared to the original situation.
This is because the demand for petro-products in the domestic economy is price-inelastic, which means that when their prices rise, the demand for them does not fall proportionately. Consequently, the expenditure on them increases and this happens through a switch of expenditure from some other items; raising petro-product prices therefore causes a reduction in demand for these other items and, as a result, a contraction in output and employment in those sectors and hence in the economy as a whole. In fact, the price-rise and the ensuing recession together reduce the total demand for petro-products to equate it to the reduced supply of such products in the domestic economy. The recession thus becomes part of the modus operandi of the system in situations like this when prices are allowed to increase.
But suppose the petro-product prices are kept unchanged, despite the reduced supply to the domestic economy, and demand is curtailed through a rationing of petro-products. The rationing can be so arranged that its effect falls exclusively on the final consumption of petro-products, and that too of the more affluent sections, and does not curtail their use as inputs for the production of other final goods. Since less petro-products would be used for final consumption, with their prices remaining unchanged, the expenditure on the consumption of petro-products would be reduced; this would leave unspent purchasing power in the hands of consumers which would then increase their demand for other goods, and hence output. The output and employment in the economy as a whole would therefore increase compared to the original situation.
Thus while raising domestic prices of petro-products in response to an international shortage that has raised world oil prices has a recessionary effect on the domestic economy, not raising these prices and resorting instead to a rationing of such products (that affects only their final consumption) has an expansionary effect. This may appear odd at first sight: how can a reduced supply of petro-products give rise to an increase in output and employment in the domestic economy? It follows, however, from the assumption that the effect of reduced crude oil supply falls only on the final consumption of petro-products and not on their use as inputs.
If the government eschews an increase in petro-product prices, then, in view of the rise in world oil prices, the domestic producers and distributors of petro-products may have to be compensated. But this can be done through an increased fiscal deficit. Let us assume that the increased fiscal deficit puts in the hands of the petro-producers and distributors exactly the same amount of money without a price-rise as they would have got with a price-rise. They would use it to pay foreign suppliers exactly the same way they would have otherwise done by raising prices. And instead of the larger fiscal deficit adding to inflation, it would have contributed to a negation of inflation.
The rationing of final consumption by affluent sections of the population alone, however, may not be sufficient to reduce demand to match the reduction in supplies; but the logic of the above argument suggests that in such a case, rationing may be extended (through mutual discussions) to the defence sector, as it had been in 2013, and the fiscal resources saved thereby may be spent by the government in other ways to boost demand, output and employment.
We in India are no strangers to petro-product rationing. Even the odd-even scheme introduced in Delhi some years ago was a form of petro-product rationing, and that too primarily of final consumption. Of course, we should not necessarily repeat that example; but even such repetition over a wider swathe of the country would be preferable to an increase in petro-product prices.
By raising domestic prices because world oil prices have risen, we would be repeating a mistake that all governments had made after the first oil shock in 1973-74. That price-rise had accelerated inflation all over the world and, because of the price-inelasticity of demand for petro-products, reduced demand for other products. And since conventional wisdom demands that 'austerity' should be practised whenever there is inflation (even when the inflation is caused by input-cost-push as it was in 1973-74, where 'austerity' cannot possibly help matters), the fiscal deficit, far from being increased to boost demand, had been restricted in the name of inflation-control. Consequently, the world economy had got into a huge recession in 1975.
That mistake must not be repeated today. The working people of the country must be spared the effects not only of the inflation arising from a price-rise of petro-products but additionally of the recession that would inevitably follow as a result.
Prabhat Patnaik is Professor Emeritus, Centre for Economic Studies, Jawaharlal Nehru University, New Delhi
