Ka-fu Wong University of Hong Kong

1
Ka-fu WongUniversity of Hong Kong
Long Lines, Lost Profits Chinas Regulated Fuel
Market
2
In a free market, equilibrium price is determined
by its respective supply and demand?
A
Price
Welfare Total surplus Consumer surplus
Producer surplus right triangle ABC right
triangle CBD
Supply
C
B
Demand
D
Quantity
3
Suppose the government wants to regulate the
price of gasoline(Note that both retail and
wholesale prices are regulated.)
By regulating the price below the market
equilibrium, (1) Buyers are encouraged to buy
more (2) Sellers are encouraged to sell less (or
discouraged to sell).
A
Price
Supply
Hence, there will be excess demand (i.e.,
quantity demanded gt quantity supplied).
Consumers will line up for the product. Thus,
consumers wind up paying with waiting time.
C
Price regulation (ceiling)
Demand
(1)
(2)
D
Quantity
Excess demand
4
For the case of China, the regulation not just in
the retail gasoline market but also in the
wholesale market from the refiners to retailers.
Refiners are supposed to supply as much as the
market demands at the regulated price, possibly
with a subsidy from the government.
Consumer surplus right triangle AHE
Welfare CS PS subsidy
A
Price
Producer surplus right triangle DGF
Welfare loss triangle CEF
Subsidy expenditure rectangle EFGH
Supply
Supply with subsidy
F
G
Subsidy to the input price
C
Price regulation (ceiling)
E
H
Demand
D
Quantity
5
Can such price control (with subsidy to input
price) sustained in rising oil prices?
Supply with a higher oil price
A
Price
F
As oil price rises, subsidy required rises from
EFGH to EFGH.
G
Supply
Supply with subsidy
F
G
C
C
Price regulation (ceiling)
E
H
Demand
D
Quantity
6
Oil refinery
Crude oil is separated into fractions by
fractional distillation. The fractionating column
is cooler at the top than at the bottom so the
vapours can condense more easily while moving up
the column. The heavier fractions that emerge
from the bottom of the fractionating column are
often broken up (cracked) to make more useful
products.
7
What is the effect of rising oil prices without a
subsidy (or a comparable increase in subsidy)?
Supply with a higher oil price
A
Price
Supply
As oil price rises, excess demand rises. Longer
line at the gas stations, and hence longer
waiting time, are expected.
C
Price regulation (ceiling)
E
H
Demand
D
Quantity
Excess demand
8
Effect of rising oil price on refinerys
production

MC
The firm will continue to produce as long as P is
higher than AVC although it will be making a loss
if P is lower than AC.
AC
AVC
P
Quantity
9
Effect of rising oil price on refinerys
production
MC
Higher oil prices will shift the cost curves
upward. If P is lower than AVC, the firm will
shutdown. That is, no gasoline will be supplied
to the retail gasoline market.

MC
AC
AC
AVC
AVC
P
Quantity
10
Why would a government choose to subsidize the
supply of gasoline?
To protect the poor and hold back inflation,
governments across Asia, including China, have
either subsidized fuel prices by using their own
budgets, or worse, kept them low by twisting
retailers arms. - Petroleum Economist, China
Fuel shortages prompt rethinking on oil pricing,
October 2005
11
Will you recommend the foreign firms to enter the
Chinas oil market? Exploration and Production?
Refinery? Retail gasoline market?

• Chinas oil industry is regulated. A regulated
  market is a good market for those who know how to
  deal with governments. And, usually a regulated
  market comes with protection from the governments
  as well. That is, monopoly rent may be ensured.
  
• Exploration and Production is good because entry
  is highly regulated and oil produced may be
  exported to the rest of the world and sold at
  world market price. That is, monopoly rent is
  ensured once you enter the EP.
• Retail gasoline market is good because profit is
  guaranteed as there will be a fixed markup from
  the guidance price. Risk-free!! However,
  competition may be keen as the market opens up
  for other participants. Keen competition may
  drive up the cost of running the business
  (including land cost). When variable cost (such
  as labor cost) increases, it may further narrow
  down the profit margin.
• Refinery is the sector that is heavily regulated.
  If the output price is regulated and we fail to
  obtain subsidy from the government, we will lose
  money. The hope is that the output price
  regulation may be relaxed. The move towards a
  free market is likely because it is difficult for
  the government to finance the huge subsidy as oil
  prices rise.

12
The guidance price is revised regularly. Is
there a way to take advantage of the revision?

• If one know that the price is going to revise
  upward tomorrow, one can stock up gasoline on the
  cheap today and sell it on the high tomorrow,
  taking into account the storage cost.
• Thus, the regulation of guidance price and the
  regular revision will invite strategic behavior
  from the participants.

13
Why would the wholesalers willing to supply the
product to the retailers at a regulated price
(much lower than the free market equilibrium)
even if they received no subsidy from the
government?
EP
Cross-subsidy
Retail
Refinery/ wholesale
Cross-subsidy A profitable activity subsidizes a
loss-making activity in a firm.
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End