Saturday, November 19, 2011

Part 2: Deregulation of The Downstream Sector of the Nigerian Oil Industry

Inefficiency and Welfare loss
Nigeria: The welfare of the people needs attention
Building on the first post, it cannot be overemphasized that the demand for PMS and other related product (kerosene, diesel, etc) is very high (inelastic) and the supply of these relatively scarce commodities are low. So we are right to call these few (but foreign based) suppliers monopolists since we assume them to be collectively categorized under the same industry. The monopolist import fuel into Nigeria and sells at the price it fixes by itself. If we look at Diagram A, it becomes clear that the monopolist charging prices at Po results in allocative inefficiency since consumer welfare is loss of the range QoQ1. Another issue is that these foreign based producers will not ensure lowest cost in their production (i.e. it will not produce at its lowest average cost. See Diagram A). It is therefore productively (or technically) inefficient. A monopolistic market mechanism is an imperfect one especially in the Nigerian situation. The affordability range of the common man is improved when prices of petrol come down. And this is where government needs to come in, but should it be through subsidy?
If the data available at PPPRA is correct (sincerely), then there is truly regulation and government involvement; the Diagram B shows the obvious disparity in what is supposed to be the price of petrol to what is obtainable at retail or filling station. What we are supposed to pay is N139.69 but we are currently paying N65 because government has subsidized the actual cost. If the billions of naira subsidy is truly paid as we are being told, the masses are being helped and removal (diversion as some stakeholders claim) of these subsidy will lead to unprecedented hardship for the masses. But applying subsidy itself is not an efficient solution, it comes with problems.
Governmentization Problems
while it is still very difficult for us to verify data,  if governmentization (a word I coined for government + subsidization) is actually applied as we have in other parts of the world (in order to regulate the industry), then it will surely come with certain problems. The first problem is that government lack enough information about the industry and particularly about the production outlay of foreign firms. Paying for subsidy on very poor information of the industry is tantamount to waste of resources and money. Additionally, it may be difficult for government to also quantify these products since they government may not be directly involved in quantity estimation. It may be useful to note also that the time to apply subsidy may have been wrong from the beginning. Subsidy implementation administrative cost may result in overall higher cost. The final and most important problem with subsidy is that most of government involvement in issues like these is politically motivated and the economic rationality may not be fully considered. Although it may look like it benefits the people, maybe an arrangement is been made between the government and a particular foreign oil firm (?)

More Key Issues
If we must always use petrol and related product, we need to demand for lower prices. There must be a way for us to get these products at a cheaper price. If prices must then fall from what we have now, we need to look more into the supply side economics. Governmentization may be a feasible option but it does not look like a sustainable one. Subsidy comes with its own problems as explained above and so may not result in a pareto optimal solution. Since what will result in a continuous price reduction will emanate from reducing production cost and increasing efficiency (allocative and technical), it will be logical for us to think first of revamping Nigeria’s refineries. We can then ensure that those firms that import or sell to Nigeria from abroad establish local refinery in Nigeria. This will not only reduce their overhead costs, it will lead to increasing FDI flows into Nigeria. I have mentioned earlier on this blog that, although it may come with risks, companies that invest in new, unfamiliar or difficult terrain like Nigeria will be quick to reap the revenue because they will build economies of scale, increase in their experience curve and enjoy the ever buoyant domestic demand potentials that Nigeria possess. The result of this is increased infrastructure and competition. We will tie everything together in the economic theory of contestability which I will discuss briefly later.

Seun Oyeniran

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