Mahoshada

The apparent continuing problems with the market position of the Lanka Indian Oil Corporation (LIOC) reveals a fundamental flaw in the government’s approach to pricing fuel and in creating a competitive and efficient economic environment. And as is usually the case, it is consumers that must bear the burden of these economically unsound policies.

It was reported this week that LIOC is now urging the government to have the CPC raise the prices it charges for fuel sold through its retail outlets so that they would equal the prices that the LIOC’s is charging.

Ordinarily, if one company is able to charge a lower price for its products, it would be to the consumers’ benefit. Competition among firms is to be welcomed because it helps to ensure that consumers are able to get the goods and services they buy at the best prices possible. However, in this case the market for retail fuel consists of only two players with one of them being the government itself. And any financial losses that the government-owned CPC incurs must inevitably be borne by the people of this country.

Recall that a crisis was averted several weeks ago when the government agreed to amend its policies of holding fixed fuel prices, which were leading to enormous financial losses for both the state-owned CPC and privately owned LIOC. Forced to absorb large losses and with what the company argued was the government’s refusal to honour its agreement to compensate them for selling its products below their costs, the LIOC was reportedly on the verge of bankruptcy.

The government amendment to the fuel price formula allowed the LIOC to increase its prices all types of fuel by Rs 5 per litre while the CPC responded by raising its prices by only Rs 3 a litre for petrol and Rs 2 for kerosene and other types of fuel. The two rupee price differential has been enough to cause a significant shift in business away from LIOC to the CPC. Before the crisis, when both companies charged equal prices fixed by the government, the LIOC had 22 percent of the market. Their market share has reportedly fallen by half, to 11 percent and this is once again putting considerable financial pressure on the company.

The Need for Effective Competition
A free market typically benefits the consumer only when there is sufficient competition to force competitors to keep their prices at the minimum levels consistent with making a profit. When there is only one firm selling a good – a monopoly – consumers inevitably pay higher prices. Monopolists are also usually less productive, operating with higher costs and providing inferior quality service. This was certainly the case until several years ago, when the government decided that would introduce greater competition by allowing private companies into the retail market for fuel.

The plan under the previous government was to sell one-third of the state owned petrol facilities to two private firms, leaving one-third with the CPC. Then market forces were to be gradually introduced and allow the three players in the market to compete freely for consumers’ business. The LIOC became the first new player, but after the change in government, a third player was never brought in. The result has been one large player, the CPC with about two-thirds of the outlets and the LIOC with about one-third.

One might argue whether three roughly equal sized firms in the retail fuel market would provide a sufficient degree of competition to ensure that prices would be kept as low as they should be. There is always a danger when there are only a few firms – what economists call an oligopoly – that they will conspire amongst themselves to fix prices at levels higher than they would be otherwise. That is why it was agreed that after several years, any new firms wishing to compete in the market would be free to do so. The best assurance that there will be effective levels of competition in any market is for the government to guarantee that any new entrants to a market are free to do so. Even the threat of new competitors is often sufficient to maintain the required level of market discipline.

By changing direction and abandoning the reforms being introduced into the retail fuel market, the government has in many ways created an even worse outcome than was the case before. Not only do consumers fail to realize the full benefits from a competitive retail fuel market, the country’s reputation as a reasonable location for foreign investors to do business has been seriously damaged. The LIOC, a subsidiary of one of the world’s largest oil companies, made a major investment in Sri Lanka with the government’s assurances that they would be able to operate in a competitive market. Nothing was being handed to them on a platter. To succeed they would have to work to win consumers’ business.

It is worth noting that consumers did see some immediate although limited benefits with even the very modest increase in competition. Almost immediately after the LIOC began to operate, conditions in many petrol sheds were improved substantially. Long run down outlets were cleaned up and painted and new services were offered, such as small markets, ATMs, etc. Even the state-owned outlets were compelled to clean up their act if they wanted to retain their customers.

A Level Playing Field?
The LIOC is now arguing that it is unfair for the CPC to be under-cutting their prices at the taxpayers’ expense. And they have a point. There is nothing even approximating a competitive retail market for fuel today. With the government continuing to effectively control prices in ways that will make it impossible for the LIOC to be able to compete or perhaps even to financially survive, there is the prospect that sooner or later the LIOC will give up and the market will revert back to a state-run monopoly.

Should the government agree and raise the CPC prices? The LIOC’s proposal that the CPC match its price increases would at least permit them to compete on the basis of the quality of their services instead of retail prices. It would in this sense be a more level playing field.

However, a situation where the two firms, the CPC and LIOC, negotiate fuel prices on which they both agree is also not an attractive alternative. These two firms constitute an oligopoly and there is little reason to believe that consumers’ interests would be well served. Left to their own devices, it is to be expected that as is usually the case when there is too little competition at work, prices would end up being higher than they should be.

The only economically sensible solution would be for the government to introduce a more competitive market. They should resurrect the idea of inviting a third player into the market, selling them the one-third of the total number of outlets as planned earlier. This should be done on the basis that additional new entrants would be able to invest and compete as well.

And the government should get out of the business of fixing retail prices. Let the CPC, LIOC and a new third player pay market prices for fuel, plus the high taxes being levied by the Treasury on fuel imports. They would be then free to compete against each other in terms of the prices that they charge consumers. This would not only put an end to the enormous losses being incurred by the CPC and the government, it would also ensure that consumers would be far more likely to pay reasonable prices and have more reliable supplies available.

The High Cost of Distorted Fuel Prices
The CPC says that even at these recently increased prices, they are losing approximately Rs 1.5 billion every month on their fuel sales. According to their figures, they lose on average Rs 6 for every litre of petrol that they sell. However, petrol accounts for only a limited amount of their sales. Diesel fuel constitutes a much large share of their business. The CPC says that it loses about Rs 7 per litre of diesel sold. In total, the government through the CPC estimates that it is losing Rs 10 million every month through its petrol sales and Rs 910 million through its diesel sales. (Most of the rest is due to losses associated with kerosene sales.)

By keeping retail prices below the full cost plus taxes, consumers are led to believe that the prices that they pay are really lower than they are in fact. And because of this, they tend to use more fuel than they would if they had to pay the actual price. The difference is made up largely through taxes that are hidden in the other goods that they buy. If they saw the full price when they purchased fuel, they would conserve more.

Consumers are not really being benefited by the government’s policies of keeping fuel prices artificially low – they just think that they are. And consumers are not benefiting from the government’s continued dominant role in the retail fuel market. For the sake of consumers and the country’s economy, a policy that brought about genuine competition in this market, as in most other markets, would be the sensible solution.