What are the economic implications of government subsidies on fuel costs?

By Albert Phung AAA
A:

In order to make the price of oil more affordable to its citizens, governments sometimes provide subsidies, which can allow the price of oil to remain fixed below free floating market rates. For example, in May 2008, Venezuela was heavily subsidizing oil, allowing its citizens to only pay $0.05 per liter, whereas most Western countries pay costs in excess of $1 per liter (or $3.80 per gallon). However, if oil prices increase, countries that heavily subsidize oil prices may suffer, because the cost of the subsidies will start consuming ever-larger amounts their budgets. This could lead to money being taken away from other areas of public funding, such as social programs and infrastructure.

Similarly, this effect will be magnified by the fact that the demand for oil in these countries will tend to remain stable, or even grow, because the lack of change in fuel costs fails to provide any incentive for citizens to reduce their consumption. Eventually, the government will have no choice but to slowly remove the subsidy in order slowly lessen the public's demand for fuel, although doing so is likely to result in some civil unrest.

On a global scale, many of the countries that use subsidies are emerging countries, which need the cheap fuel to power their fledgling industries. However, if these subsidies are still in place over the long term, the price of fuel will grow even higher as the hunger for subsidized fuel grows in emerging countries, regardless on how much demand for fuel drops in Western countries.

For related reading, check out Why You Can't Influence Gas Prices and Getting A Grip On The Cost Of Gas.

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