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Iran is Slashing its Gasoline Subsidies. What Happens Next?

by Michael Levi
December 20, 2010

I took the picture in this post somewhere outside of Tehran in early 2006. The number at the bottom is the price of gasoline – at the time, a massively subsidized 800 rials (about 8 cents) per liter, equivalent to about 30 cents per gallon. As of a few days ago, the price of gasoline was still 1000 rials per liter for the first 60 liters a month. On Saturday night, though, the Iranian president announced that subsidies would be abruptly slashed. Each of the first 60 liters of gasoline per person will now cost 4000 rials (about $1.50 per gallon), and additional gasoline will go for 7000 rials per liter (about $2.70 per gallon).

What’s prompting this price hike, and what will the consequences be? The Iranian government spends tens of billions of dollars each year subsidizing gasoline consumption. That’s money that the financially squeezed government could be spending elsewhere. Press reports have been emphasizing this factor: Iran is also ending subsidies for a host of other basic commodities, and hopes to save as much as $100 billion each year.

I’m surprised, though, not to have seen another angle: Iran is struggling to match gasoline supply with demand. Despite being an oil exporter, Iran imported about forty percent of its gasoline until recently, in order to make up for a shortage of domestic refining capacity. U.S. and European sanctions have, however, prompted many of its suppliers to pull back in the last year. Iran has apparently managed to temporarily bridge the gap by switching some of its petrochemical plants to produce gasoline, but that’s undoubtedly even more costly than paying for imports.

Higher gasoline prices should help ease the strain by curbing demand. How much? This sort of thing is inevitably very difficult to predict, but we can make a crude estimate. A recent paper by three economists at Tehran University and the University of Surrey surveys estimates of elasticities of gasoline demand in Iran. The short-run price elasticity of gasoline demand appears to be somewhere between -0.1 and -0.15. If that’s right, a fourfold increase in gasoline prices should translate into a cut of approximately 10-20% in gasoline consumption. This would make a material contribution to addressing Iran’s sanctions-induced challenge. Indeed as I write this, the Iranian oil ministry is reporting a 16.6% drop in gasoline consumption from Saturday to Sunday – though it’s impossible to know how much of that is driven by the price hike, and how much is the result of other factors.

Setting that aside, there are important caveats, beyond the simple fact that the past studies might not be all that good. Higher gasoline prices normally curb demand in part by shifting it to other products. But because Iran is hiking the prices of a wide range of other products too, that effect might be reduced. Moreover, a fourfold increase in gasoline prices is way outside the range of past experience; it may not be possible for drivers to quickly reduce their gasoline use as much as theory predicts.

Regardless, the big question now is how this all goes over in Iran. Police are bracing for violence. It probably won’t be long until we know how this plays out.

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