The Ugly Law of Demand

The Ugly Law of Demand

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When a good friend returned from China after traveling for work, my first question was: what kind of economic problems has such country? The response was very sensible and clear: «Mauri in China they have the same problems of us, only on a larger scale.» Certainly the relationship between large and small countries is not linear, but the market tends, capriciously, to behave similarly either Bolivia or China.

Despite that economics is a social science and therefore make some inferences about human behavior is often a nightmare, it’s surprising how, even with this difficulty, we can find simple and predictable behavior. One this predictable behavior is the famous «Law of Demand», which states very clearly: the lower the price the higher demand.

Strategies to encourage consumption by decreasing the price is part ofour lives: 1) the losing streak of any football team is often accompanied with lower ticket prices; 2) when the quality of a restaurant is usually questionable prices are suspiciously low; finally 3) when years depreciate our assets called «beauty», the value of gifts received is significantly lower (perhaps in this case, the right thing should be replaced by some other beauty asset, for example, good company… ok , leave that for another post).

Why so bored with the Law of Demand? It turns out that part of the problem that Bolivia have now with the «subsidy» to gasoline and diesel prices, may well be explained by this concept.

To start we see that although the Bolivian economy is small, «the business» of gasoline and diesel is very… very attractive. A couple of indicators will help you size it. Every penny in the price of gasoline «moves» around US$ 1.4 million annually, meanwhile, every penny of the national diesel oil means US$ 0.7 million a year. So, dear reader, for example when it is announced that the gasoline price will increase 10 «pennies» Actually, what you should know is that «someone» will receive that year additional US$ 14 million, if that happens with diesel oil other «someone» (or the same) will receive US$ 7 million.

As a corollary, let me tell you that the «Bolivian Christmas ‘gasolinazo’ » in 2010, increased the tax on gasoline at 273 cents and diesel oil at 308… applies here what some year ago my dad told me, «Son, take care of cents, that millions take care of themselves.»

In Bolivia the prices of gasoline and diesel oil are «frozen» for over 5 years, this led to those prices in real terms decrease in each inflationary adjustment. Therefore, thanks to the holy law of demand, a significant increase can be seen in sales.

Please have a look of the following figures, we can see the gasoline and diesel oil demand in Bolivia over the past years. After building these charts, I was impressed with gasoline performance, since 2006 the demand for this product is growing at an annual average of more than 13%… downright remarkable.

Unfortunately the production (supply) didn’t accompany the domestic sales growth. The following figures gasoline and diesel oil sales are contrasted with refined volumes of the same products. I’ll get your attention in two aspects: 1) a few years ago, the domestic production of gasoline demand was greater, however, in recent years (data inside the red circle) the situation is reversed… hence there’s the need to import this product. 2) In the case of diesel oil was observed that while before Bolivia already imported large volumes in recent years the situation worsened; just look how the blue bars (domestic production) decrease and the yellow bars (demand) is constantly rising.

How did we get to this situation? As I mentioned, lower prices of goods generally tend to increase demand, both internally and externally (called smuggling) if to this situation we add the high GDP growth rates and the low purchase prices of imported vehicles (during period 2005 -2009 vehicle fleet increased by over 68%), we have all the ingredients for the current energy problem.

Instead, the news on the supply side are not encouraging, since Bolivian oil production keeps falling from a while back. From the many reason that could explain this situation, I think is important to mention 2:

1. The oil price for producers by refineries is US$/barrel 25-27.

2. Oil producers pay, including production taxes, royalties and nationalization, more than 50% of their gross income… yes, gross income, to the Government.

Such an explosive mixture, low oil prices and high tax burden, causing that the gross margin for oil producers (to cover operating expenses and capital expenses) is approximately US$/barrel 10.

How could I resume today’s Bolivian oil market? Imagine that you and your brother are doctors, you are children’s doctor and your brother is a plastic surgeon. Because there’s a lot of poor children in Bolivia the Government forces you to sell your services at very low prices, however, your brother usually travels with celebrities to operate in Brazil. Clearly your brother revenues are higher than your, but tax policy in Bolivia requires that the two of you pay 50% of their gross revenue to the state… in the end, both are doctors!

What happen in time? Your brother can afford to pay such high taxes plastic surgery business in Brazil are better than ever; but for you the situation is getting worse because too many children (someone starts to bring children from Peru) too low prices and too high taxes.

The analogy is complete, your situation is very similar to oil production situation in Bolivia and your brother’s situation (the lucky surgeon) is quite similar to natural gas exports to Brazil.

Yesterday, when I told my son to take his soup, he replied me: «no daddy, better I’ll do tomorrow», it made me wonder how reasonable is to implement public policies obeying people when these people don’t have all the information.

Mauricio Medinaceli Monroy

La Paz, February 2nd. , 2010

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