oil pricing policies: short-run general equilibrium effects

Oil pricing policies

This paper identifies some short-run advantages which may be available to an economy with a policy that restricts the rise in domestic oil prices below world parity. This result is obtained by using ORANI, a computable general equilibrium (CGE) model of the Austra- lian economy, to quantify the short-run (two-year) differences between the alternative crude oil pricing policies proposed by the two major political parties at an Australian federal election. The short-run advantages, which are concentrated in export and import competing industries, must be set against the long-run resource allocative be- nefits of parity pricing in deciding what the appropriate oil pricing policy is.

Peter Higgs is a Senior Lecturer, Graduate School of Management, University of Mel- bourne, 200 Leicester Street, Carlton, Vic- toria 3053, Australia.

Comments by Peter Dixon, Brian Parmen- ter, Alan Powell, Russell Rimmer and David Vincent are acknowledged with thanks.

‘ORANI is a multisectoral model of the Australian economy and is fully described in P.B. Dixon, B.R. Parmenter, J. Sutton and D.P. Vincent, ORANI: A Multisectoral Model of the Australian Economy, North- Holland, Amsterdam, 1982. */mport Parity Pricing for Oil, Current Poli- tical Notes No 151, released by the Liberal Party of Australia, Federal Secretariat, January, 1980. 3P.J. Keating, ‘The Labor approach to pet- roleum exploration development and pricing’, Address to the 1980 Australian Pet- roleum Exploration Association Confer- ence, Surfers Paradise, Queensland, 25 March 1980. 40il produced from wells discovered be-

continued on p 286

Short-run general equilibrium effects

Peter J. Higgs

The literature on oil pricing policy has generally concentrated on the long-run issue of resource allocation. From this viewpoint a policy of world parity pricing is usually optimal. This paper uses the ORANI’ model to compare the short-run effects of the alternative oil pricing policies proposed by the Liberal and Labor Parties prior to the 1980 Australian federal election. The Liberal Party* proposed a policy of world parity pricing. That is, the price of all domestic crude oil is adjusted at six-monthly intervals according to a formula based on the price of Saudi Arabian light crude. The Labor Party’s proposal3 distinguished between old and new domestic crude.4 Full import parity pricing was to be applied to new crude but a twofold policy was suggested for the old category: (1) to freeze its price for twelve months, and (2) after the twelve months to then adjust the price at six-monthly intervals by increases in the Australian consumer price index or by percentage increases in the import parity price, whichever was the lesser.

In the long run it may be appropriate to ignore other market distortions and conduct an analysis of oil pricing policy in the context of a first best world.” From this viewpoint a policy of world parity pricing is optimal. This paper, however, compares the short-run effects in a second best context. The results suggest that there are some short-run gains from pricing domestic oil below world parity pricing. Even if the usual long-run conclusions are accepted, the decision on how to price domestic oil requires a cost-benefit analysis encompassing both short- and long-run elements.

For this paper ORANI was used to project the short-run effects on the Australian economy of an increase in the world price of crude oil under three domestic crude oil pricing scenarios which reflect the main elements of the alternative policies described above. The three scenarios are:

1. world parity pricing: the price of domestic crude oil set equal to the world price of crude oil;

2. indexation: the price of domestic crude oil indexed to the consumer price index; and

3. price freeze: the nominal price of domestic crude oil held constant.

0301-4207/90/040285-08 @ 1990 Butterworth-Heinemann Ltd 285


continued from p 285 fore the 14 September 1975, is classified as old oil. It should be noted that at the time this policy was announced no new domestic crude oil was currently being produced and that no significant production of new oil would commence until approximately 1983-l 984 when production from the Fortescue field began. 5For a discussion of these see Industries Assistance Commission, Crude Oil Pric- ing, Australian Government Publishing Service, Canberra, 1976. 6The technical details of the simulations are given in the appendix. 7Peter J. Higgs, ‘Australian mining and the economy: aieneral equilibrium analysis’, Resources Police. Vol 12. No 2, 1986. DD 117-132. - ‘That is, real domestic absorption is assumed to be determined by other arms of government policy (fiscal and monetary for example). Thus because the different oil pricing policies will cause different amounts of tax revenue to be collected, the government is implicitly assumed to take offsetting action to neutralize the effect on real domestic absorption, for example compensatory income tax changes. The differential effects of the domestic crude oil pricing policies do, of course, affect the economy’s gross national product, and this is reflected in the balance of trade projections. %J. Cooper, ‘A tariff experiment on the interfaced ORANI-MACRO system’, lM- PACT Preliminary Working Paper, No IP- 17, mimeo, 1983. Available from Industries Assistance Commission, Canberra, Au- stralia.

An underlying 10% inflation rate was assumed to occur in the world and domestic economies. This assumption is important as it plays a major role in determining the extent of indexation under scenario 2 and of the squeeze on the real price of domestic crude oil which occurs under scenario 3.

In conducting the simulations a 2% increase in the real price of crude oil on world markets was assumed. The model was then shocked with whatever increase in the domestic price of oil products would be implied by this world price increase under each of the three pricing scenarios. The domestic oil products price increases were derived on the basis of the shares of domestic and imported crude oil in the cost of refined oil.h

The results are presented as comparisons between the three scenarios. This is to abstract first from the effects of the 10% underlying inflation rate and second from the effects of the world oil price rise on world commodity prices. Note, it is assumed that oil pricing decisions in overseas countries are made independently of Australia’s oil pricing strategy so that the effects of the world oil price rise on world commodity prices do not vary with the domestic pricing scenario and cancel out in the comparisons.

The macroeconomic environment is the same as that assumed in Higgs.’ Briefly, the nominal exchange rate is the numeraire. Hence, changes in domestic price indices can be interpreted as changes in domestic relative to world prices. The labour market is slack. There are assumed to be no shortages of labour at the going real wage rates. Thus changes in the labour market show up as changes in employment (which is demand determined here). Real domestic absorption is assumed to be independent of the differential effects of domestic oil pricing policies.8 Plant and equipment do not change (from the levels they otherwise would have reached) due to the shock under analysis (ie fixed industry capital stocks). Note that the time period allowed is long enough to allow revisions in all industries’ investment plans, for orders for capital goods to be placed and met and for the new plant and equipment to be installed (but not yet switched on). The length of the standard short run in ORANI has been estimated by Cooper as 7.9 quarters.” In policy work ‘about two years’ is the appropriate level of precision for describ- ing the ORANI short run. Finally, the domestic production of crude oil is exogenous and set at zero change.

Results

Macro projections

Table 1 contains, for some macroeconomic indicators, comparisons of the effects of the assumed 2% increase in real world oil prices under the three domestic pricing scenarios. The two columns show respectively deviations of the ORANI projections generated under the indexation and price freeze scenarios from the projections generated under world parity pricing. Thus the first number in the first column, for example, is to be interpreted as indicating that following a 2% increase in real world oil prices, the index of consumer prices would rise by 0.06% less if the price of domestic crude were indexed to the domestic CPI than it would if world parity pricing were enforced for domestic crude. Similarly the first number in the second column indicates that the rise in the domestic consumer price index would be 0.37% lower if the price of domestic crude were frozen than it would be under world parity pricing.

288 RESOURCES POLICY December 1990

BAll projections are in percentage change form except for balance of trade/GNP where the change in the balance of trade is expressed as a percentage of the GNP. bTo compare the effects of the world oil price increase under the price freeze scenario with the effects under the indexation scenario simply sub- tract column one from column two. CAggregate employment calculated in persons is based on the assumption that hours worked per person is constant.

Oil pricing p0licie.s

Table 1. Macro projections: comparisons of the effects of a 2% real increase in the world price of crude oil under alternative domestic crude oil pricing scenarios.’

Variable

ORANI index of consumer prices

Aggregate employment (persons)

Aggregate exports (foreign currency value)

Aggregate imports (foreign currency value)

Balance of trade/GNP Real gross national product

Comparison9 Effect under indexation minus effect under world parity pricing

-0.06

0.02

0.07

-0.02 0.01 0.01

Effect under price freeze minus effect under world parity pricing

-0.37

0.13

0.42

-0.10 0.07 0.09

In fact the comparisons between the price level projections are the key to understanding the overall result. Since the exchange rate is assumed fixed in the simulations, any shift in the domestic price level can be interpreted as a shift in domestic prices relative to world prices. Such shifts are particularly important for import competing and exporting sectors of the economy. The selling prices of industries in these sectors are heavily influenced by world market conditions which are largely independent of domestic costs. “’ Changes in the domestic price level, and thus in domestic costs, will therefore directly affect the profitability of the trading industries. This is reflected in the aggregate trade comparisons in Table 1. Since the adoption of indexation or a freeze for domestic crude oil prices rather than world parity pricing has the effect of holding down domestic cost levels in the short run when world oil prices rise, exports are projected to be higher and imports to be lower under indexation or freezing of domestic oil prices than under the world parity pricing scenario.

Correspondingly, the indexation and price freeze policy scenarios are projected to have favourable short-run implications, as compared to world parity pricing, for the balance of trade and, with domestic

‘Yn fact a small country assumption is absorption held constant, to increase aggregate employment and GNP.

made in ORANI with respect to import These effects are all larger in the case of the price freeze scenario than prices. Imports and domestic supplies of they are when oil prices are indexed. The reason is that, of the three the same commodity classification are, however, distinguished as separate com-

scenarios considered, freezing the domestic crude oil price has the

modities and modelled as imperfect substi- greatest restraining influence on the domestic price level when world oil tutes for each other. The elasticities of prices increase.” world demand for Australia’s maior export commodities are assumed to -be high, although not infinite. Their exact numerical values are given in op tit, Ref 1, Table 29.5. “Note that the core of the data base for the version of ORANI used here is the ABS 1966-69 input-output tables (Australian Bureau of Statistics, Australian National Accounts, Input-Output Tables, 1968169, Australian Government Publishing Ser- vice, Canberra, 1977). In these data, both the share of oil products in the CPI and the share in industries’ costs are below current values, The implication is that the magni- tudes of our results are likely to be under-

Industry outputprojections

Comparisons of the industry output projections for the three oil pricing policy scenarios are given in Table 2. The interpretation of these results is exactly analogous to that for the macro comparisons. For nearly all industries outputs are projected to be higher under indexation or freezing of domestic oil prices than under world parity pricing.12 When world oil prices rise domestic industries are advantaged in the short run by the adoption of the alternatives to world parity pricing because the rise in domestic costs generated by the world price increase is smaller. The direct effect of oil price changes on industries’ costs is not particularly important in this mechanism. For most industries the share

stated. ‘qhe GNP projections in Table 1 can be

of oil in total costs is small. The main impact is felt via indirect effects,

interpreted as an index of the industry especially the effect on wage rates which are assumed to be indexed to output results. the domestic index of consumer prices. The variations across the

RESOURCES POLICY December 1990 287


Table 2. Industry output projections: comparisons of the effects of a 2% increase in the world price of crude oil under alternative domestic crude oil pricing scenarios.

ORANI number

Export industries’ 1 Pastoral zone 2 Wheat-sheep zone 3 High rainfall zone

11 Fishing 12 Iron 13 Other metallic minerals 14 Coal 18 Meat products 25 Food products, net 30 Prepared fibres 63 Basic iron and steel 64 Other basic metals

Export related industries 4 Northern beef 5 Milk cattle 6 Other farming export 8 Poultry 9 Services to agriculture

49 Chemical fertilizers 69 Ship and boat building 70 Locomotives 76 Agricultural machinery 93 Road transport 94 Railway transport 95 Water transoort

16 Non-metallicminerals net 21 Margarine, oils and fats 24 Confectionery 28 Alcoholic drinks, net 29 Tobacco 31 Manmade fibres, yam 32 Cotton, silk, flax 33 Wool and worsted yarns 34 Textile finishing 35 Textile floor covers 36 Textile products, net 37 Knitting mills 38 Clothing 39 Footwear 40 Sawmill products 41 Plywood, veneers 42 Joinery and wood

products 43 Furniture, mattresses 44 Pulp, paper 45 Fibreboard 46 Paper products, net 47 Newspaper and books 48 Commercial printing 50 Industrial chemicals 52 Pharmaceuticals 53 Soap and detergents 54 Cosmetics, toiletry 55 Chemical products, net 56 Oil and coal products 57 Glass 58 Clay products 62 Non-metal mineral

products 65 Structural metal 66 Sheet metal products 67 Metal products, net 68 Motor vehicles, parts 71 Aircraft building 72 Scientific equipment 73 Electronic equipment 74 Household appliances 75 Electrical machinery 77 Construction equipment 78 Other machinery

Comparisons between projected outputs Effect under indexation Effect under price freeze minus effect under world minus effect under world parity pricing parity pricing

0.03 0.17 0.03 0.16 0.05 0.29 0.12 0.73 0.01 0.06 0.06 0.34 0.12 0.72 0.04 0.26 0.10 0.61 0.06 0.34 0.07 0.45 0.07 0.43

0.04 0.02 0.05 0.01 0.03 0.03 0.06 0.03 0.07 0.02 0.03 0.02

0.01 0.02 0.00 0.01 0.00 0.04 0.04 0.01 0.01 0.01 0.02 0.01 0.01 0.02 0.02 0.01

0.00 -0.01

0.03 0.02 0.01 0.01 0.01 0.04 0.02 0.00 0.00 0.03 0.10 0.02 0.01

0.26 0.10 0.29 0.08 0.20 0.19 0.39 0.16 0.40 0.15 0.19 0.15

0.07 0.11 0.02 0.06 0.01 0.27 0.23 0.04 0.03 0.04 0.15 0.03 0.03 0.13 0.13 0.07

0.02 -0.09

0.18 0.10 0.06 0.07 0.07 0.24 0.10 0.01 0.01 0.17 0.63 0.12 0.07

0.01 0.04 0.02 0.12

-0.00 .o.oi 0.02 0.13 0.03 0.17 0.01 0.08 0.02 0.13 0.01 0.06

-0.01 -0.06 0.02 0.12 0.03 0.20 0.03 0.16

continued on page 289



Table 2 continued. . . i

ORANI number

Import competing industries 79 Leather products 80 Rubber products 81 Plastic products 82 Signs, writing

equipment 83 Other manufacturina

” 96 Air transport Selected industries

supplying investment goods

76 Agricultural machinery 60 Ready mixed concrete 61 Concrete products 88 Buildings, net

Non-trading industries 7 Other farming non-

traded 10 Forestry 15 Crude oil 17 Services to mining 19 Milk products 20 Fruit and vegetable

products 22 Flour and cereal

products 23 Bread, cakes 26 Soft drinks, cordials 27 Beer and malt 51 Paints, varnishes 59 Cement 60 Ready mixed concrete 81 Concrete products 84 Electricity 85 Gas 86 Water, sewerage 87 Residential building 88 Buildings, net 89 Wholesale trade 90 Retail trade 91 Motor vehicle repair 92 Other repairs 97 Communication 98 Banking 99 Finance and life

insurance 100 Other insurance 101 Investment, real estate 102 Other business services

“For full details on Industry classification, see 103 Ownershio of dwellinos P.B. Dixon, B.R. Parmenter, J. Sutton and 104 Public adhinistration- D.P. Vincent, ORANI: A Multisectofal Model of 105 Defence the Australian fconomv. North-Holland, Amster- It-S Health dam, 1982, Section 4i2. Industries 9 to 13 and ‘--

_ _. . 107 Education, libraries

16 to 112 correspond to the 1968-69 official 108 Welfare services input-output classification. See Australian 109 Entertainment _ _ .

Comparisons between projected outputs Effect under indexation Effect under price freeze minus effect under world minus effect under world parity pricing parity pricing

0.02 0.10 0.02 0.10 0.02 0.10

0.02 0.13 0.01 0.05 0.02 0.12

0.07 0.40 -0.01 -0.05 -0.00 -0.03 -0.01 -0.07

0.01 0.03 0.00 0.01 0.00

0.00

0.01 0.00

-0.00 -0.00

0.01 0.00

-0.01 -0.01

0.01 0.00 0.00 0.00

-0.01 0.02 0.00 0.01 0.01 0.01 0.01

0.00 0.01 0.01 0.01 0.00 0.00

0.07 0.17 0.00 0.04 0.01

0.00

0.04 0.00

-0.00 -0.01

0.04 0.01

-0.04 -0.02

0.04 0.01 0.02 0.00

-0.06 0.08 0.00 0.04 0.03 0.04 0.04

0.01 0.03 0.04 0.04 0.00 0.00

0.00 0.00 -0.00 -0.01 -0.00 -0.00

0.00 0.01 0.00 0.02

-0.00 -0.01 0.00 0.00 0.01 0.05

Bureau ot statlstlcs. Ausrfanafl lvanonal 110 Restaurants, hotels Accounts, Input-Output Tables, 1969-69. Au- 111 Personal services stralian Government Publishing Service, Can- 112 Business expenses berra. 1977.

industry output results are explained mainly by variation in the responsiveness of industries to domestic cost changes.

In Table 2 industries have been grouped into categories which roughly reflect their responsiveness to cost changes. The major export industries are on average the most responsive group and hence have most to gain in the short run from oil pricing policies which restrict the rise in domestic oil prices below the rise in world oil prices. These industries sell large shares of their outputs on world markets where demand is



assumed to be highly elastic. Their output prices are therefore largely independent of their costs. A large share of the agricultural sector (industries l-3) is included in this group.

The export related industries are a second group which is projected to experience strong output advantage as a consequence of the price indexation and price freeze policies. Although not exporting directly this group produces commodities that are sold mainly to export industries. A good example is the meat producer, Northern Beef. Beef is not exported on the hoof but only after processing in the meat products industry (industry 18). Note again that the agricultural industries are strongly represented in the export related group.

The major import competing industries also stand to gain from policies which tend to hold down domestic costs. The extent to which an industry competes with imports depends on both the share of imports in the total absorption by the domestic economy of commodities classified to that industry, and the users’ elasticity of substitution between imports and the domestic source.13 Industries in the textiles, clothing and footwear sector and in the metal products sector are good examples of industries which face strong import competition.

The output response of industries primarily supplying investment goods will depend on the way in which the aggregate investment budget (which is assumed fixed in all the simulations) is reallocated among industries under the three domestic crude oil pricing scenarios following the 2% increase in the real world price of crude oil. A selection of the investment suppliers is given in the fourth group in Table 2. Those which supply investment goods to agriculture (agricultural machinery, for example) are projected to gain from the adoption of the alternatives to world parity pricing when oil prices rise. Expansion in the outputs of the agricultural export industries will have led to a reallocation of the investment budget in favour of agriculture. The output of construction related industries, on the other hand, is not intensively used in capital formation in the export sector. Hence the reallocation of investment does not benefit the construction sector.

The final group in Table 2 consists of predominantly non-trading industries. The projections indicate that these industries are not likely to be affected much by the choice of a domestic oil pricing policy. In the absence of international competition their selling prices move closely with their costs.

Conclusion: the short-run results in a welfare context

The long-run resource allocation, first best arguments in favour of world parity pricing are not disputed here. In a world that contained no market distortions, departing from world parity pricing would result unambiguously in a welfare loss. However, in a shorter-run, second best world that contains a myriad of distortions, for example commodity taxes and tariffs, the welfare effects are not so clear.14 The imposition of a distortion in oil pricing may, by offsetting existing market distortions,

j3The relevant substitution elasticities and import shares from the ORANI data base

in fact lead to a welfare gain. For example, in setting up the ORANI

can be found in op tit, Ref 1, Table 45.4. simulations we assumed slack labour markets ie unemployment and 14For a discussion of the theory of second therefore an implicit (monopoly) overpricing of labour. An interpreta- best see R.G. Lipsey and K. Lancaster, ‘The general theory of second best’, Re-

tion of the employment result in Table 1 is that the distortion in the oil

view of Economic Studies, Vol 24, 1956- price partially offsets the effects of the wage distortion. That is, for the 57, pp 1 l-32. purpose of illustration, we could draw Figure 1 in which the real wage



s lab

Figure 1. The domestic labour market. Employment

ISNote that the size of the market distortions caused by the Labor Party’s domestic oil pricing policy would decrease over time. As new oil comes into production and old oil is consumed, the effect on the price of oil products of pricing old oil below world parity will diminish. %ubject to the limitations of using the 1966-69 data base referenced in note 12.

rate appears on the vertical axis and the quantities of labour demanded and supplied are on the horizontal axis. Slob and DIab are the supply and demand curves for labour, assuming optimality in the oil market (that is, world parity pricing). The OA is full employment and OW, is the full employment real wage rate. For some reason the ruling real wage rate (which cannot be cut to give full employment) is at OW2 yielding OD employment, DF unemployment and a welfare loss in the labour market given by the area BCE. From the employer’s viewpoint the effect of the additional market distortion of pricing oil below world parity is to increase the value of the marginal product of labour, that is, to shift upwards the demand curve for labour in Figure 1, and to move towards full employment even at the distorted wage.‘”

While the above analysis is only a partial equilibrium one, it illustrates how the more definitive general equilibrium results obtained from the ORANI model could be interpreted in a second best welfare context.

The results presented in this paper show that a policy of restricting the rise in domestic oil prices when world oil prices rise produces short-run

gains in terms of the domestic price levels, GNP, aggregate employment and the balance of trade as compared with the policy of world parity pricing. Industries which engage in international trade are best placed to take advantage of this relative cost reduction. The results indicate that it is these industries, especially the export sector, which have most at stake, in the short run, in decisions about oil pricing policy.

Thus, in addition to the long-run resource allocation arguments, there are short-run welfare effects to be accounted for. Therefore to resolve the question of how to price domestic oil, requires a cost-benefit analysis, encompassing both short-run and long-run elements. This paper, while.not resolving the question, contributes to the domestic oil pricing debate by analysing and attempting to quantify16 the short-run differences, as opposed to the long-run arguments upon which most of the literature has concentrated.



Appendix

The modelling of the three domestic oil pricing policies and the overriding of ORANI’s 196849 technology, with respect to the effect of a crude oil price rise on the price of domestic oil products, was done via the imposition of a production tax on the domestic oil products industry. The appropriated size of the production tax, or in the ORANI model’s terminology the unit price of ‘other costs’ tickets, for each simulation was determined from the following system of equations:

PI = Sdp:! + &pm2 + (1 - Sd - Sm) cpi

115

(1)

PI = C qPp, pm, pmi i=l

115 + Z 9, pe, Pei + ?pp, oc Oc

i=l (2)

115 cpi = z rlcpi pm, Pmi

i=l

115 + zrl

i=l cpi pe, Pei + rlcpl oc Oc

(3)

Equation (1) says that the percentage change in the price of domestic oil products, pl, equals the sum of the percentage changes in the prices of domestic crude oil, p2, and imported crude oil, pm2, and all other costs, weighted by their shares in the total basic value cost of producing one unit of domestic oil products, Sd, Sm and (1 - Sd - Sm) respectively. All non- crude costs are assumed to be 100% indexed to the ORANI consumer price index, cpi. The shares Sd and Sm were calculated to equal 0.56 and 0.35 respectively, using data, updated to July 1980, from a Broken Hill Prop- rietary Company Limited econometric model of the costs of a typical Austra- lian refinery. In the simulations both p1 and cpi were endogenous variables. Equations (2) and (3) express the re- duced form relationships between these endogenous variables and the non-zero exogenous variables in the ORANI simulations. pmi and pei are respectively the percentage changes in the price of imported and exported commodity i (note that there are 115 commodities modelled in ORANI). oc is the percentage change in other costs

tickets in the domestic oil products industry. The elasticities in Equations (2) and (3) were obtained from the ORANI model.

The three oil pricing scenarios were imposed on the system of equations in the following way. Under world parity pricing p2 was set equal to pm2; under indexation p2 was set equal to cpi; and under the price freeze p2 was set equal to zero. The underlying 10% inflation rate in both the world and domestic economies and the 2% real increase in the world price of oil were imposed via exogenous shocks on the pm,‘s and pets.

The system of equations has three unknowns, namely p,, cpi and oc, the first two being endogenous variables and the later exogenous. By solving for oc the model can be shocked to give the 1980 effects of the three scenarios on the price of domestic oil products. Furthermore, as crude oil is only sold to the oil products industry in the ORANI database, this is equivalent to simulating the short-run effects of the three scenarios on the economy.


oil pricing policies: short-run general equilibrium effects

Documents