Economics, Literature and Scepticism

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I am a PhD student in Economics. I am originally from South Africa and plan to return there after my PhD. I completed my M. Comm in Economics and my MA In Creative Writing (Poetry) at the University of Cape Town, where I worked as a lecturer before starting my PhD.

Wednesday, January 20, 2010

Eskom and Price Elasticity

Posted by Simon Halliday | Wednesday, January 20, 2010 | Category: , , | just read an article in the M&G, 'Cosatu: Tax the wealthy to fund Eskom price hike'.   I shan't discuss the main point of the article, i.e. the proposal by COSATU to tax the wealthy to pay for Eskom's ineptness, sorry, I mean plans for future growth and improvements in infrastructure.  What I thought I'd comment on instead is price elasticity.  The M&G tells us that Eskom plans to increase prices by 35% each year for three years.  A back of the envelope calculation tells us that prices will therefore be about 246% of what they are now (1.35x1.35x1.35=2.46).  That by itself is a bit ungenerous, so let's deflate it a bit for inflation assuming that inflation sits at about 6% for each of the next 3 years (around about the high end of the inflation target).  Therefore, we have a price increase of about 205%-207% (again back of the envelope).  Now, with 'normal inflation' (which I'll assume here is 6% for SA), for prices to double would require about 11 or 12 years, less if inflation was less than that.  So Eskom are proposing prices Now (or in these three years) that people would otherwise face in over a decade (with the benefits of over a decade's growth).  That's quite a hefty weight to bear for anyone, let alone the poor or the rich. What will they people do in response? the response, Eksom must be assuming something about the elasticity of demand for electricity, i.e. the responsiveness of consumers to changes in the price of electricity.   Also, when prices go up people often consume less, because of both income effects and substitution effects.  Because of income effects people have less money overall to pay for stuff when the price of a good goes up (remember all prices are relative not absolute), and therefore they should consume less elecricity if the price of electricity increases.  Also, when the price of elecricity increases people will substitute away from elecricity to consume other good that may perform similar functions, e.g. gas, paraffin, candles, solar panels, cold showers (though that may be for other reasons).  The price elasticity, or consumer responsiveness, effects the extent of these two effect - the income and substitution effects - a good that has elastic demand is normally thought of as a luxury and as prices increase people consume much less of it or stop consuming it, whereas for a good that has inelastic deand people feel that is a necessity and they continue to consume it, though consuming slightly less of it depending on their responsiveness.  Eskom, to pay off whatever they need to improve their infrastructure must be assuming that South Africans' demand for electricity is phenomenally inelastic and that there are very few substitutes, while demand itself may increase (because of economic growth, population growth, or other factors -- see government document for 2008 here). I also don't know, and what I could not find out from the government report linked to above, was a separation of household, commercial, military, and other uses of electricity in South Africa.  That is, to what extent will an increase in tariffs affect households and business differently? Moreover, if an increase in electricity costs happens to crowd out commerce, that is with an increase in electricity costs fewer international businesses elect to open in South Africa but choose instead to open in places where electricity is cheaper or the extent to which business that currently operate in South Africa choose to shut down, to what extent must household bear the brunt of the crowding out? Will households, poor and rich, bear the price increases? Will they bear the increases willingly? Moreover, assuming some class (or income-based) differences in the ownership of capital, if a rich person is taxed both as a household consumer and as an owner of capital, might they not choose to leave the economy entirely, therefore increasing capital flight and the emigration of the taxable wealthy classes? Now, I'm depicting a bit of a nightmare scenario, but I would like to see more intelligent analysis of this topic in our country's newspapers, and, while I favour pro-poor tariffing to improve electricity infrastructure, I also favour in-depth and high quality analysis rather than simple and verging-on-contentless exegeses quoting 'roleplayers' saying 'People will take to the streets.'  It doesn't help educate our populace and it doesn't help us find a better outcome or a workable solution.

Aside: on the COSATU comment, the goverment document I referred to above does say the following, "In order not to adversely affect poor households, the tariff will have to be pro-poor and discourage wasteful consumption." (Intervention to Address Electricity Shortages, 2008, 3)

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