Wednesday, May 23, 2012

Notes on Economy — Part II

Role of taxes and subsidies

Taxes and subsidies act as distortion in a price-coordinated economic system. Sowell writes, "These extra tags give focus on one subject and discard all other variables."

In India, electricity is free in the agricultural lands of Punjab. This allow farmers to produce cheaper rice allowing India to export more. Although this generates revenue of the country, but there is a big downside to this. The water-table (amount of water below the soil) decreases rapidly making the land no more cultivatable. Secondly, an artificial price of rice creates a surplus, which leads to starvation.

In Pakistan, indirect taxation on petroleum products help oil companies to prosper. On the other hand, they don't invest in exploration as taxation allow them to grow larger. Similarly, the government gives a cross-subsidy on gas, causing a rapid decline in Pakistan's gas reserves.

In United States, water supply in the state of California are heavily subsidized. A Californian farmer pays less than 1% for the same amount of water consumed in New York. As a result, agricultural outputs consume 4/5 of the water resources to produce just 3% agricultural output.

In a true free market, taxes and subsidies should be applied equally, and there should be no support for any product over other. Unforgettably, taxes and subsidies are used by politicians to meet their political objectives. They play with the dynamics of free market causing deterioration in the standard of living.

For example, in President Musharraf's last year in office, 2007, the government gave a 35 billion rupees subsidy on oil petroleum. This was done to attract voter's attention  towards PML-Q (Gen. Musharraf former party). Although this tactic failed, but economically speaking, it was a disaster for Pakistan's economy. A huge circular debt accumulated, the rupee devalued, and  an immediate removal of subsidy caused public anger towards the new democratic setup back in February 2008.

What is incremental substitution?

Incremental substitution is a pure free market concept. Unlike setting up 'categorical  substitution' — like national priorities, explained below — Incremental substitution means to shift allocation of resources on the basis of their consumption or production. Using the idea of incremental substitution, a free market can chose  product A and product B simultaneously. 

For example, if the price of apples soars, the whole market doesn't shift towards mango. Say, 35% shift towards mango, 40% shift towards watermelon while the 25% still buy apples. This is incremental substitution at work. On ther other hand, if a centrally control economy makes eating mango it's 'national priority', mango consumption will record a 100% increase. This will not only increase mangos' price, but would also diminish apples and oranges in the market. 

Another example, Pakistan considers the army as  its 'national priority'. Prioritizing the army over other institutions and services causes a deterioration in the standard of living. 48% of tax payer's money goes for military development. A large chunk of money goes in repaying debts. Hence, a major part of the public sector development program runs either on aid or foreign loan. Eventually, this causes deterioration in the standard of living.

Another example, if a country makes a 'categorical choice' of banning alcohol, the net result would be the scarcity of alcohol product in the country. Citizens would also be deprived from the benefits of drinking alcohol. 

It should be noted that 'categorical substitution' is based on personally whims of the central planner (i.e. a centralist economy), while incremental substitution runs on the dynamics of demand and supply. No external intervention is possible. 

What is scarcity?

Scarcity means that the amount of natural resources are always smaller compared to human desires. Everyone's desires cannot be fulfilled regardless of any economic system.

Scarcity always causes competition in a society. Competition to make the best alternative use of a resources for the betterment of the society. This is an inherent characteristic of a price-coordinated economy. It's always there. A subjective opinion whether this is good or bad is of no use. 

Completion allows creativity to prosper bringing in more efficient products with the passage of time.

For example, there is an ample prove that the world oil supplies — a scare resource — would end at the turn of this century. Today we observe a number of new renewable energy companies competing for this depleting resource. Many world-renowned universities are offering graduate and doctoral programs in the field of renewable energy. The reason we are experiencing these phenomena today is because of the idea of scarcity. Oil supplies were relatively abundant in the 19th and 20th centruy. Now, due to massive industrialization, things are change making oil a relatively more scare resource. 

Scarcity of resources in measured by their price tags. A large price tag means that the resource is more scare. For example, the price of petrol (95 RON) is US$ 0.21 per litre in UAE, while in Pakistan, it's US$1.41 per litre. Regardless of all the taxes included in Pakistani price tag, petrol is cheaper in UAE compared to Pakistan. This more a resource is scarce, the higher its cost.

Link to Part III

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