Fuel Subsidy, External Costs and the Poor
Cameroon fixes the pump price of super petrol at 650 FCFA per litre. The landed cost, including distribution and taxes, is 830 FCFA per litre. Daily consumption is 3.2 million litres. A government study estimates the marginal external cost of petrol use, from congestion, air pollution and road damage, at 120 FCFA per litre. The subsidy is financed by borrowing. The government is considering removing the subsidy and using part of the savings for urban bus services and targeted cash transfers. Fuel importers are few and have strong political connections; many poor households do not own cars but depend on shared taxis and motorbikes whose fares are sensitive to fuel prices. The finance ministry wants to know whether the subsidy can be defended as a pro-poor policy.
1. Calculate the annual cost of the fuel subsidy and the size of the marginal external cost. Explain why the free-market outcome is inefficient.
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Subsidy per litre = 830 − 650 = 180 FCFA. Daily cost = 180 × 3.2m = 576m FCFA. Annual cost = 576m × 365 = 210.24bn FCFA. Marginal external cost = 120 FCFA/litre; daily external cost = 120 × 3.2m = 384m FCFA; annual = 140.16bn FCFA. The private price (650) is below the marginal private cost (830), and far below the marginal social cost (830 + 120 = 950). Consumers treat fuel as cheaper than its true cost, so consumption is too high. The subsidy widens the gap and encourages congestion, pollution and road damage. Efficiency would require price = marginal social cost, or a tax equal to the external cost, plus measures to price road use. The market outcome is inefficient because the external cost is not internalised.
2. Explain why removing the subsidy might reduce welfare for some poor households even though it improves economic efficiency. Propose a policy design that addresses both.
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Removing the subsidy raises the pump price toward 830, and possibly to 950 if the externality is taxed. Poor households may not own cars, but they buy transport, food and kerosene; higher fuel prices raise bus and taxi fares and food distribution costs. The cash saving from the subsidy is also concentrated on richer car owners, so the subsidy is a regressive transfer in absolute terms: a rich household with two cars captures far more benefit than a poor household that uses shared taxis. Removing it without compensation can still hurt the poor through the consumption basket. A phased removal, combined with targeted cash transfers, a temporary bus fare stabilisation fund, and investment in public transport, can protect the poor while keeping the efficiency gain. The transfer should be based on household income or location, not on fuel purchases, to avoid leakage.
3. The government claims that the subsidy protects the poor. Evaluate this claim using the concepts of incidence and targeting.
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The claim is only partly valid. The subsidy lowers the price of fuel, but the benefit accrues mainly to those who buy the most fuel - owners of cars, generators and factories. A poor household that walks or uses one shared taxi gets a small share. The opportunity cost is also high: 210bn FCFA could fund schools, clinics or targeted transfers. However, the subsidy does protect the poor indirectly because transport and food prices are sensitive to fuel. The right test is incidence: who receives the benefit per franc spent? The current design is universal and untargeted, so much of the benefit leaks to the non-poor. A targeted transfer or a lifeline transport subsidy would protect the poor at lower cost. The government should measure the pass-through to taxi fares and food prices before claiming a pro-poor justification.