The irrationality of the public sector in oil rich countries

Behavioral economist have largely focused on the role of irrationalities in the market. An implicit argument is often that the irrational individual is argument for the rational state to play a larger role.

But the state is not made up of divine angels or logical super-computers, it is also constituted of flawed individuals. Politicians and the public they serve in the political system are as prone to irrationalities as much firms and consumers in the market. Sometimes this problem is even larger, because while in the market the individual get's the entire benefit of making rational decisions, as a voter or member of an interest group they get virtually no personal benefit of being rational, causing a collective action problem in public decision making.

I want to illustrate a clear example of public sector irrationality: the price of gasoline in oil rich countries. What is extra interesting is that these countries are mostly non-democracies. Of course even in non-democracies the state is responsive to public opinion, and it seems in this example that the quality of public and state decision making is particularly low in non-democracies.

The price of gasoline in the U.S in 2009 was about $2.7 per gallon ($0.7 per liter). Since taxes on gas are low in the U.S, this is close to the world market price. In contrast, the cost of gasoline in Saudi-Arabia was $0.6 per gallon, in Kuwait $0.87 per gallon, in Venezuela $0.19 per gallon!

This graph illustrates oil reserves per capita, and the price of gas. What you see is that the more oil you have, the cheaper is gas.


Isn't that what economics predicts? Higher supply means lower price?
No! In a integrated world market, there should be no relationship between quantity in any individual point and price.

This is literary a textbook example from economics of oil rich countries ignoring the opportunity cost.

Oil is traded in the world market, so the cost for oil rich countries in giving cheap oil to their citizens is exactly the same (disregarding minor transportation costs) as countries with no oil. While oil prices are kept up by OPEC, the opportunity cost of giving the oil cheap to your population is waiting and selling it expensive to other countries.

Of course part of the reason they subsidize oil instead of taxing could be that they are richer. I did a regression controlling for per capita income: the result is the same. The more oil you produce and the more oil reserves you have, the lower the price of gasoline.

What happens in these countries, such as Iran, is that the public gets angry if gas is expensive "we have so much oil, why should we pay for it?".

The big exception that proves the rule is rational and well-functioning Norway. Norway has as high, or even higher taxes on gas as other countries. Furthermore, unlike most oil rich nations, Norway saves it's revenues from oil and gas, rather than spending most of it.

The artificially low price of gas in Iran is part the reason they need to import refined petrol. Read this excellent report by Atta Tarki if you want a good case illustrating gas subsidies.

Ironically Ahmadinejad is finally reforming its massive and hugely wasteful gas subsidies as part of the military confrontation with the U.S.