The ‘Dharma Sankat’ of Petrol Prices

 The ‘Dharma Sankat’ of Petrol Prices

Co-authored by: Gautam Sodani & Varish Seth

Credit: OfferGrid (Pinterest)

Prime Minister Narendra Modi, on 17th February 2021, said, “India imports more than 85% of its oil requirements and the recent price hike is due to the negligence of previous governments towards reducing India’s import dependence in the energy sector.” He obliquely pointed that this price hike is to curb the domestic demand of petrol and diesel (law of demand), which in turn will reduce our dependence on imports, and as a result we will look at domestic production of alternative sources of energy. 

It is a fascinating ‘economic argument’ and a ‘vital step’ to make India Atmanirbhar in the energy sector, isn’t it? However, the Prime Minister seems to be totally ignorant of another basic economic concept called the ‘price elasticity of demand’ – which essentially renders his entire argument to be inherently flawed.

Petrol and diesel are primary inputs for essential activities like transportation and electricity generation and thus have become our daily needs. This categorizes them as ‘necessity goods’, which tend to have relatively inelastic demand (or steeper demand curve). The Energy Policy 118 (2018), published by ELSEVIER, also highlighted the same – India’s crude oil demand is relatively inelastic. 

In such a case, an increase in the price has minimal effect on curbing the demand for a good. Hence, this will have an insignificant impact on the country’s energy imports. A simple way to see this effect is through typical demand and supply analysis.

                 

As we can see in the above graph, with relatively inelastic demand (D1) and perfectly elastic supply (or horizontal supply curve), a significant hike in prices (from S1 to S2) caused only a small reduction in quantity demanded, with equilibrium shifting from point A to B.

Consequently, this hike in price of a necessity good may lead to either of the following two undesirable outcomes:

1. A reduction in the purchasing power of consumers, as a result of which the demand for relatively elastic goods will fall. Furthermore, the cost of production for industries using petroleum products as raw materials will increase, possibly causing supply shocks. The combined effect of the above two will negatively impact the total output and employment levels in the economy, with the former reducing demand from D1 to D2 and the latter changing supply levels from S1 to S2. Equilibrium quantity shifts from point A to B. However, the price movement will remain uncertain as the net effect (intensity) of both will determine the direction of its course.

2. The other consequence may be that the consumers are forced to save less, keeping demand intact. This will reduce the marginal propensity to save (MPS) in the economy, which in turn will adversely impact investments and hinder growth in the long-run.

Hence, it is clear that fuel price hikes will not do any good to the economy, especially in times of crises such as these when the economy is already struggling with massive unemployment and low levels of investments. This way of reducing import dependence will invite other consequences, ultimately hindering the government’s aim of ‘Atmanirbhar Bharat’ in the long-run.  

With limited oil reserves in the country, it is impossible to achieve self-sufficiency in this sector. The only way to reduce import dependence on oil is to invite investments and make a conducive environment for manufacturing substitutes to oil consuming machines and activities – such as investing and promoting electric/fuel-cell vehicles (instead of internal combustion engine vehicles). Atmanirbharta in the energy sector can only be achieved by channeling the sufficient public spending and other resources into the development and adoption of alternative sources of energy (such as ethanol and hydrogen).

Now, the major question is: Does India need to worry about its oil imports?

There is no denying that India is heavily dependent on imports for its energy needs where crude oil constitutes a huge portion of the country’s imports. However, it is also to note that refined petroleum constitutes a major chunk of India’s exports – more than 25%. This shows that we do not consume all of what we import and the staggering amount of India’s oil imports does not accurately depict the domestic oil demand.

Then what is the real reason behind rising petrol and diesel prices?

One possible reason is poor government finances. With poor GST collections during the lockdown and heavy fiscal expenditure to support the ailing economy, the government may be facing a dearth of funds.

India is already burdened with heavy interest payments as the budgeted interest expenditure for fiscal year 2020-21 stood at around 20% of the overall government expenditure. So, borrowing funds for revenue expenditures of the government does not seem to be viable here. Additionally, with no income tax hike or COVID cess announced in the Budget, heavily taxing petrol and diesel remains a primary way for the government to raise funds to carry on with its budgeted expenditure. Additionally, following the center, various state governments also hiked VAT on petrol and diesel, again due to funds constraint and reduced GST compensation from the center. This added on to the upward pressure on petrol and diesel prices.

However, it can be argued that the timing of implementing such heavy taxation on a necessity good could have been a little later as the economy is currently in a recovering phase from the dreadful impact of the pandemic. The demand has nowhere yet fully recovered and many people are relying on their savings for their current consumption (as evident from consistently rising reserves supply with the RBI) and supply levels are still fluctuating as many businesses were compelled to completely shut down post the onset of the pandemic.

Unfortunately, that ship has already sailed. 

Petrol and diesel prices, for us consumers, is at an all time high and is likely to remain at similar levels for the foreseeable future.