Setting the Price of Oil in a Distorted Economy
The international price of oil increased dramatically in 1974 and again in 1979. Many developing countries responded to these price shocks by keeping the domestic price of oil products below import parity levels and borrowing abroad to finance the increased oil import cost. In extreme cases the domestic price of sensitive fuels such as kerosene was frozen, so that, for example, by 1981 the price of kerosene in Egypt was 15% of its border price. (World Bank, 1983, Table 12, p. 109; see also Julius, 1981). In many cases this was not a sustainable strategy, and, with some prompting from international agencies such as the I.M.F. and the World Bank, these countries were persuaded that the domestic prices of oil products should be increased. Economists were asked to advise on the 'correct' domestic price of oil, and frequently argued that it should be raised to the international price level. This would be sound advice in an undistorted and competitive economy, but few developing countries satisfy that description, and in many cases whilst the Government was prepared to change the price of oil, it was not willing to alter the whole structure of taxation and trade protection. What, then, is the optimal price of oil (or, equivalently, tax on imported oil) in a distorted economy in which no other tax or tariff can be altered ? This is a fairly standard second-best problem in the choice of policy, which is readily answered given certain conventional assumptions. Suppose that it is possible to discriminate between the price of oil facing producers and consumers, so that we can separate the efficiency and equity aspects of the pricing problem, and, rather less plausibly, that domestic industry is production efficient, (though not trade efficient, as it faces a distorted set of prices). Finally, suppose that any revenue collected from the oil tariff can be redistributed to consumers in a non-distortionary way. Then it is well known (e.g. Green, 1962) that the solution is to set the tariff on oil (which is equivalent to setting the domestic price of oil given the world price) at an ad valorem rate which is a weighted average of other ad valorem distortions in the economy. If these weights were all non-negative, then the tariff on oil would have to lie