1. 1 Ka-fu Wong University of Hong Kong Long Lines, Lost Profits: China’s Regulated Fuel Market

2. 2 In a free market, equilibrium price is determined by its respective supply and demand? Supply Demand Price Quantity A B C D Welfare = Total surplus = Consumer surplus + Producer surplus = right triangle ABC + right triangle CBD

3. 3 Suppose the government wants to regulate the price of gasoline (Note that both retail and wholesale prices are regulated.) Supply Demand Price Quantity A C D 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). Price regulation (ceiling) Excess demand Hence, there will be excess demand (i.e., quantity demanded > quantity supplied). Consumers will line up for the product. Thus, consumers wind up paying with waiting time. (1)(2)

4. 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. Supply Demand Price Quantity A E D Consumer surplus = right triangle AHE Price regulation (ceiling) Supply with subsidy Subsidy to the input price F C G H Producer surplus = right triangle DGF Subsidy expenditure = rectangle EFGH Welfare = CS + PS – subsidy Welfare loss = triangle CEF

5. 5 Can such price control (with subsidy to input price) sustained in rising oil prices? Supply Demand Price Quantity A E D Price regulation (ceiling) Supply with subsidyF C G H As oil price rises, subsidy required rises from EFGH to EF’G’H. Supply with a higher oil price F’ C’ G’

6. 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. 7 What is the effect of rising oil prices without a subsidy (or a comparable increase in subsidy)? Supply Demand Price Quantity A E D Price regulation (ceiling) C H As oil price rises, excess demand rises. Longer line at the gas stations, and hence longer waiting time, are expected. Supply with a higher oil price Excess demand

8. 8 Effect of rising oil price on refinery’s production $ Quantity P* MC AC AVC 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.

9. 9 Effect of rising oil price on refinery’s production $ Quantity P* MC AC AVC 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’ AVC’

10. 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. 11 Will you recommend the foreign firms to enter the China’s oil market? Exploration and Production? Refinery? Retail gasoline market? China’s 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 E&P. 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. 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. 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? E&P Retail Refinery/ wholesale Cross-subsidy Cross-subsidy: A profitable activity subsidizes a loss-making activity in a firm.

14. 14 End