Thursday, August 26, 2010

Why do regulations come into existence?

Over the course of an average day, our life is touched by literally thousands of regulations. They are at work from utility services, telecom services, oil and petrol, to public transport,banking, housing and other government services. Ever wondered why these regulations exist at the first place??? What is the economics behind these Regulations?

What is free in free market??
Economics explains lot of real life scenarios such as public welfare and regulations which are entwined with complex set of cause and effect phenomenas. Few such interesting concepts which explains why regulations are in existence are 'Free Market Failures and Externalities'. You will appreciate their true meaning and contribution in explaining the esoteric workings of an economic system when you see them at work in real life.

These seemingly arcane terms, work on the fundamental premises of ecomomics i.e. forces of demand/supply and efficient allocation of resources. A free market is a market where there is no intervention of a controlling authority (Government) and market is left to the forces of demand and supply. The prices of the services or products exchanged in such markets are agreed solely by mutual consent of buyers and sellers in the market. In such a market the allocation of products i.e. who gets what, is decided by purely the purchasing power of consumers and forces of supply/demand. Adam Smith, one of the influential economist of 19th century, coined the term 'invisible hand' to describe the self regulating structure of market due to invisible forces of
- Self interest i.e. doing what maximizes my profit or doing what is good for 'me';
- competition between the market participants and;
- demand and supply

Now, free market premise is based on ideal conditions in the market such as markets are perfectly competitive and no market power exists with any player eg. Monopoly, market participants are perfectly informed about choices and interchangeability exists between goods and services. The necessary components for the functioning of an idealized free market include the complete absence of artificial price pressures from any form of government intervention(other than protection from coercion and theft, and no government-granted monopolies which eventually makes it "pareto efficient'(Named after italian economist). So we see the cause and effect chain as:

Free Market - causes - Competitive forces, prices decided by market forces with no government intervention (idealized conditions)- leads to - efficient allocation of resources- leads to - Pareto Efficient market

Why Markets Fail?
In reality, we dont see a idealized scenario of a free market at work. What we see is a deviation from the equillibrium where there are lot of other factors influencing the market forces and competition which leads to an inefficient allocation of goods and services to producers and consumers. Economists have identified following scenarios when a market can fail(i.e. where individual self intretest leads to inefficient the resource allocation). Now this is the exact reason why government steps in to ensure that allocation happenes in a way that ensures equitable distribution of benefits to all participants and therefore economic and social welfare can be maximized. Market Failure eventually lead to inefficient and hence said to be 'Pareto inefficient'. Economists have defined following causes of market failures:

- Externalities: When consumers and producers come together in the market, the products/services are exchanged in return for money or the price of the goods/services. However, there could be costs/benefits associated with this transaction which is not transmitted through prices but through any other means and borne by the thrid parties not involved in this transaction.A live Eg. is Posco, steel maker,is alleged to have violated the forest act while acquiring land for a steel project near Paradip and where as Vedanta, mining company, is battling criticism from environmental groups over plans to extract bauxite in Niyamgiri hills in the state's Kalahandi district. Both firms are engaged in capacity enhancement activities which is linked to profit maximization. however, these actions have negative externalities in terms of social cost(effect on tribes and wild life in orissa) being greater then the private cost of the firms.

- Monopolies or market dominance: these occur due to imperfect competition in the market. It can happen due to various reasons. A firm gains a monopoly over market resource, Government gives exclusive right to one firm to produce or provide services or cost of production (gained from economies or scale or strategic investments)makes a single produce more efficient then others in the market.An example is BSNL as it was given exclusive rights to sell telecom service to users and entry barriers were high till the time the market was opened to private players.

- Information Asymmetry: This happenes when both buyers and sellers will have different information about the product’s attribute or one party has more or better information about the product than the other.A classic example is Financial services and Financial intermediaries.Imagine for a moment that Banks do not exist and people have no other options to search for the right lender who can lend the fund to them. Similerly lenders search for the right investors. That would be a difficult scenario. So the primary reason why people give/deposite their money to Banks/financial intermidiaries instead of lending or investing the money directly is because of the risk that is present from the information asymmetry between the provider of funds and the receiver of those funds.A seller knows more about the sale item than the buyer.Likewise, a borrower knows more about his financial condition and his future prospects than the lender.

How Government intervenes to correct Market Failure?
In a market failure scenario, an economic rationale behind government intervention is:

1) Ensuring equitable distribution of economic benefits/income/wealth to the participants as a whole.
2) Correcting the losses suffered by market failure thereby making market efficient.

A government achieves this by several means such as taxes, subsidies, bailouts, public policies etc. One of the means is Regulations also called Command and Control technique.However, government regulation does not necessarily ensure equity and efficiency and may result in what is called Regulatoy Failure which could be a negative externality of regulations.

Market Inefficiency- causes -Market Failures - Government intervenes by means of Regulations, subsidies, taxes etc - which may (or may not) lead to - efficient allocation of resources and equitable distribution of income and wealth- leads to - Pareto Efficient market

Thursday, August 19, 2010

Targeting Below The 'Line'...

Food is one of the basic necessities of human being without which all other amenities would hold little meaning. And to a poor, it could mean the vary existence of his life. In a rapidly growing indian economy and a nation of  more than one billion people with per capita income crossing 40,000, more than half of the population live below the elusive poverty line (BPL).  Well that sounds alarmingly menacing isn't it? In such a scenario food security becomes one of the major developemental objectives for government.

How does one measure poverty in India?
If we go by the definition set by  Planning Commission of India, poverty line is drawn with an intake of 2400 calories in rural areas and 2100 calories in urban areas. That means, if a person is unable to get that much of calories he is considered to be BPL. However, many descrepanies have been observed in the measuring methodologies adopted by various agencies and no body has been able to nail down the exact number. The meauring methods and parameters differ from countries to countries. This vary reason has led to disparities in defining the real distribution of poor population in states of India.

How does food get to the poor?
A poor man in India has two options.Either food should be made available to him at an affordable prices by the government or Government should find ways and means to raise the income level of the poor so that they are capable enough to buy food for themselves. While employment generation programmes attempt the first solution, the PDS is the mechanism for the second option.In terms of both coverage and public expenditure the most important safety net is Public Distribution System (PDS) of central government. With a network of more than 4.62 lakh fair price shops (FPS) distributing commodities worth more than Rs 30,000 crore annually to about 160 million families, the PDS in India is perhaps the largest distribution network of its kind in the world. The FPS provide rice, wheat, sugar, edible oil, soft cake and kerosene oil at subsidized prices.With PDS, government achieves two objectives ensure food security for the needy and price stability of food.

Targeted Public Distribution System(TPDS)
The Public Distribution System in India was modified into the targeted public distribution system (TPDS) in 1997, as part of the larger reforms under the new economic policy of the 1990s. The TPDS divided the population of the country into those below the poverty line (BPL) and above the poverty line (APL); with PDS foodgrains being given to those in these two categories at differential prices. this price differential is acheived by giving greater subsidies to the poorest of poor compared to those BPL in normal sense. In 2002, another category was introduced to reach out to the ‘poorest of the poor’ through the Antyodaya Anna Yojana (AAY) which provides foodgrains at about half the BPL prices. In PDS-

· The central government, based on the population of the state and its share of below and above poverty line households, allocates state wise quota of food grains. It also decides the Central Issue Prices (CIP) for the food grains
· The state government then determines off-take, the public delivery, and the list of commodities provided. The state government is allow to add to the CIP the transactions cost of keeping the stock and district wise allocation of food grains.
·  thenBlock/ Taluk wise allocation of food grains is determined by District Administration. Location of Fair price shops are also decided at this level.
· Food grains are stored in godowns at various levels
· And finally, distribution of Food grains to the Fair Price Shops and sold to beneficiary, the poor.
But is making food grains available by TPDS, a sufficient condition to ensure food security to the poor? Given central government's poor record of public welfare schemes implementation. has TPDS managed to achieve its slated objectives?

Lacuna in TPDS

1) The very first reason being the divergent views on measurement of the poverty and number of people below poverty line. The earlier 1993 Expert Group on Poverty Estimation even explicitly specified in its report that these poverty lines should not be used for the purpose of targeting public programmes. However, in practice the exercise of setting a poverty line and estimating poverty on the basis of this has very much been linked to determining allocations for public programmes;

2) The decision that a particular household will qualify as BPL household and would be eligible for a BPL ration card is arrived at by two different processes. Firstly, the numbers of BPL households are determined based on the Planning Commission estimates of poverty superimposed on the number of households from census data. Secondly, an independent exercise of identification is conducted based on a household census using criteria determined by the Ministry of Rural Development (MoRD), with the restriction that the number of poor to be identified by this process should be within the number estimated by the Planning Commission.

3)The next immediate fallout of the above two factors is problems of imperfect targeting. That is the system is likely to include people that should be excluded and exclude household that should be included.

4) The reports of the Supreme Court appointed Wadhwa Committee point out a number of issues that make the PDS a corrupt and inefficient system. Among the issues these reports raise include corruption because of the presence of middle-men at all stages such as private storage agents, transporters, millers and so on, who are in a nexus with the politicians and bureaucracy resulting in the leakage of foodgrains meant for the PDS into the open market even before it reaches the village fair price shop (FPS).

5) Wadhwa committe report also identified following deficiencies in the system:
 · Multiple ration cards being issued under a single name
· Faulty system of issue of ration cards and record keeping
· Pilferage - PDS foodgrains find way to market and all the lot don’t reach the eligible/needy person
· No bio-matric identification for the users
· No central monitoring system to track the carriage trucks
· The delivery mechanism has no RFID (Radio Frequency Identification Device)

In addition to above glaring gaps, there are even instances where the wheat and rice provided were unfit even for cattle consumption !, but the poor are forced by these weevil ridden grains.

There have been recent reports of around 61,000 tonnes of foodgrain rotting in granaries of Food Corporation of India (FCI), the government body responsible for TPDS. Officials admit that for 65 million tonnes of food buffer stocks the total warehousing capacity in the country is only 40 MT, a deficit of 25 MT. Investment of 10,000-15,000 crore is required for additional storage capacity. 

Can Technology be a solution?
Wadhwa committee suggested major revamping of the system by leveraging technologies such as RFID and biomatric finger prints. Also, with the commencement of UID project, the databases of beneficieries could be maintained enabling digital record keeping. Use of smart card based technologies and presence of Point of Sales solutions to the Fair price Shops could make the system more efficient and could pave way for the setting successful e-governance example.

Allocations for public programmes must be delinked from the poverty line, which in spite of any number of revisions cannot avoid an element of uncertanity. How can a system be efficient of the vary foundation it is built on (measure of poverty) has the element of arbitrariness, a moving target!! Given the fact that we have the highest malnutrition rates in the world, there cannot be an alternative to provision of universal services especially in relation to food along with education, health, employment and social security.The proposed National Food Security Act should be seen as an opportunity for pressing for universalisation of PDS (along with administrative reforms) to make the system more effective. We must not allow an Act to remain an entitlement for only a few (as is being proposed), especially because as long as PDS remains targeted even the few who are entitled to it are unlikely to get any benefits.

JUSTICE WADHWA COMMITTEE Report on Public Distribution System (PDS)
Planning Commision Report on five year plan

Monday, August 16, 2010

Oil Economics - Indian Perspective

Oil has been one of the most significant and vital industrial resource to any economy. When first and second waves of industrialization (pre and post WW I and II) happened across US and Europe during the beginning of 19th century, Oil played a very crucial role in fuelling the growth of world economies. India rely on primarily crude oil (32%), coal(52%), natural gas(10%), hydro(5%) and nuclear energy (1%) sources for its energy needs. There is no denying to this fact that as India ushers into a new age of growing competitive markets, there would be ever increasing reliance on scarce resources.  However, if we have to understand the extent of this dependence, we first have to familiarize ourselves with the structure and economics of India Oil industry structure.

Structure of Indian Oil Industry
Oil industry exists at two different levels. "Upstream” players are involved in the site exploration and production of the primary component that gives all varieties of petroleum products i.e. crude oil. The major state-owned players in the upstream sector are Oil and Natural Gas Corporation Ltd. (ONGC), and Oil India Ltd. (OIL); the major private sector players are Reliance, Cairn Energy, Hindustan Oil Exploration Company Ltd. (HOEC), and Premier Oil. Upstream players perform following activities:
->Exploration for hydrocarbons.
->Production of crude oil and natural gas.
->Transportation of crude oil to downstream players refineries

"Downstream" players are involved primarily in operations such as refining, pipeline transportation, fuel marketing and R&D. These companies directly interface with the retail customers. The players include Hidustan petroleum (HPCL), Bharat Pentroleum(BPCL), Mangalore refinery and petroleum limited(MPCL), reliance Industries, Essar oil etc. These companies maintain a retail distribution network across the nation deploying retail outlets, bulk consumer pumps, LPG distributorships and plants, aviation fuel stations etc.

India is a net importer of crude oil. What that means is, more than 50% of its petroleum needs are fulfilled by sourcing and import of crude and petroleum products. This import is fully controlled through the government-owned Indian Oil Corporation and controlled by the empowered standing committee of the Centre.

Petroleum prices in India are affected by three broad factors:
-> International price of crude oil and petroleum products in terms of dollars - as the downstream players import crude oil from international markets;
-> Rupee - dollar parity - rupee/doller fluctuations significatly impacting the prices;
-> Inflation within India

How are petroleum products priced?

In India there are four highly consumed (> 60%)petroleum products are petrol, diesel, kerosene and LPG.  The country operates under an Administered Pricing Mechanism for petroleum products. Under the APM, product prices are directly administered by the GoI, based on an opaque and complex “cost of operating capital plus” formula.This system is based on the retention price concept under which the oil refineries, oil marketing companies and the pipelines are compensated for operating costs and are assured a return of 12% post-tax on networth. Under this concept, a fixed level of profitability for the oil companies is ensured subject to their achieving their specified capacity utilisation. Upstream companies, namely ONGC,oil and GAIL, were also under retention price concept and were assured a fixed return.

The administered pricing policy of petroleum products ensures that products used by the vulnerable sections of the society, like kerosene, or products used as feedstocks for production of fertilizer, like naphtha, may be sold at subsidized prices.

In simple terms, what that means is government controls the prices of crude oil and basket of derived products under APM which provide a cushion to the consumers against the oil shocks in the global market.

How increase in international oil prices trickle down to consumer petroleum products?
The downstream players import more than 80% of the crude oil from the global markets. Any increase in crude oil prices globally would affect the petroleum prices. The downstream companies(OMC/refineries) deal with two kind of prices. One is crude oil price which refiners pay to purchase the crude oil (either from domestic or foreign producers). While 'refinery gate price' is the price at which the refiners “sell” the petroleum products to the next stage of the industry. So its easy to understand that as more than 80% of the crude oil requirements are met through imports, the prices of the petroleum end products are bound to get hit by international crude oil prices.

There are other important prices at various stages of the product journey to the end cosumer:
-> Pre-tax prices- This price can be arrived at by adding marketing, storage and transportation costs to the refinery gate price of the relevant petroleum product.

-> Retail prices - Adding excise duty (a form of tax levied by the Central Government) and sales tax (levied by State Governments) to the pre-tax price gives the final retail price of petroleum products, the price, for instance, that you or any of us pay at the petrol pump.

So,  Retail price = crude oil price+ refinery gate price(refining cost+profit)+ pre-tax price(marketing and storage cost+profit)+ distribution cost+ dealers profit+ excise duty+sales tax

Why does Government provide cushion?
Refining of crude oil is a process industry where crude oil constitutes around 90% of the total cost. Since value added is relatively small, determination of individual product-wise prices becomes problematic. The oil marketing companies (OMCs) currently source their products from the refineries on import parity basis which then becomes their cost price which is the refinery gate price. The difference between the cost price and the realized price(i.e centrally determined sales price) called the 'under-recoveries' of the OMCs. This is the indicative measure of the subsidization of prices by GoI. In simple terms, OMCs are selling the products at prices much lower than their free market prices in a price control regime by government through subsidization.

Other sensitive products such as kerosene and domestic LPG are provided to the below poverty line consumer through Public Distribution System (PDS) on the ground that these were fuels of mass consumption largely consumed by “economically weaker sections of society”. The subsidy on these two products was to be continued on a flat rate basis financed from the budget and was to be phased out in three to five years.

When crude price increase is not passed through to consumers, the cost will have to be borne by oil marketing companies (OMCs). Since private OMCs would get out of a business if they made losses, it would be left to public sector OMCs to supply petroleum products at prices below their costs. If the OMCs are asked to bear the losses, they would go bankrupt. This would seriously compromise our energy security.

Under-recoveries of OMCs were at Rs 46,000 crore in 2009-10 !! But how does that contribute to the overall government budget deficit??