Thursday, August 18, 2005

War rages over oil prices in Kenya

In the last few weeks, the price of crude oil in nominal terms has hit record high after record high. Yet, this has not led to panic in developed country financial markets about the consequences of for global inflation. However, it has been evident that higher oil prices have greatly affected manufacturing and related sectors and transport sectors. The challenge for the companies in the aforementioned sectors is that competition is fierce, therefore deterring any attempt at passing on the mounting input costs on to consumers. The resultant effect has been tightly squeezed profit margins (economics 101).

My RSS feed brought to my attention the situation in East Africa (namely Kenya) where the public transport is in a bit of a crisis due to higher oil prices. The transport operators have extrapolated on the cost-push inflation, resulting in ridiculous pricing strategies.

The article starts (to cite a few quotes for context):

"The Government and matatu operators [privately run public transport] were yesterday at war over increased fares as high fuel prices continued to hit public travel ",


"…the Government is likely to step in to regulate fares",


"…should the Government intervene, the resultant fares
would be lower than the rates charged by operators of public
transport",

…and the government adds:

"It was unfair, for matatu owners to hike the charges by between 50
and 100 per cent when
[local] fuel prices had only gone up by a marginal 0.8 per cent"
Do the matatu operators have the right strategy?
Adam Smith’s invisible hand theory suggests that self-interests guide the most efficient use of resources in a nation's economy, with public welfare resulting as a by-product. Smith argued that state and personal efforts to promote social good are ineffectual compared to unrestrained market forces. From the above, one could argue that the transport operators should be left alone to run their businesses as they wish, at whatever expense to society, because the "market forces" will determine optimal prices.

On the other hand, does the government have the right approach?
John Maynard Keynes (Keynesian economics) was of the view that government intervention was needed to regulate markets. There are numerous examples that place this view in high standing.

So which of the two economic theories applies best and subsequently, who (out of the government or transport operators) is on the right route?
My stance is that both the government and the transport operators have a reason to squeal. The transport operators are bearing the burden of higher input costs from higher oil prices and the government has a responsibility to protect its citizens from exploitation by unscrupulous businesses.

From the statement "It was unfair, for matatu owners to hike the charges by between 50 and 100 per cent when fuel prices had only gone up by a marginal 0.8 per cent", it is evident that the pricing strategies used by the transport operators in Kenya are not well thought through. It suggests pseudo-economics.
Price increments of the 50%-100% order, highly disproportionate to the rise in input costs, suggest greed and short-termism. Such a strategy only allows for profit taking over the short-term and results – almost inevitably – in government intervention to disciple the market. In addition, transport operators (at times of severe cost constraints), can form tacit pricing collusion, with few incentives for any of the participants to cheat by undercutting because the effective cartel is unregulated or under-regulated and can therefore deliver serious consequences to the operators who want to renege on the tacit arrangement. It is in this very market that the government has to intervene because the symptoms suggest a progression towards market failure. The government’s appropriate action – to target the stimulus of the potential market failure – is indeed to set a price limit high enough to give room for competitive pricing strategies by the operators, but low enough to restrain any excessive pricing.

It is well known that price discrimination can be a handy tool for maximising profits, but only when market demographics have been analysed (resulting in high, middle or low income regions, etc). With such analyses, businesses can charge different prices in different regions for the same goods and services, to capitalise on the higher or lower reservation prices of their consumers, which are primarily dictated by the consumers' incomes. Indiscriminate pricing, the kind applied by the matatu operators, alienates segments of the market and cannot possibly deliver the highest potential profits for a significant business period. Correct price discrimination (pricing to market) doesn't require government intervention.

However, transport operators sometimes add subjective pricing to their costs. This means that prices can change from one customer to another, from one minute to the next and can be ridiculously high without prior warning. In such a market, it is of no long-term benefit to anyone for the market to remain unregulated. The strategies are unsustainable because incomes cannot match the ever-increasing prices. At some vital tipping-point, people may even decide to walk in protest - an outcome envisaged by Adam Smith's invisible hand theory because if people walk, transport fares would have to fall. The market would indeed be sorting itself out. However, it is not in the economy's best interests to have a partly ineffective labour force, so caused by transport problems. The government can't afford to wait until Adam Smith's invisible hand cures the transport sector.

Conclusion:
Will oil prices fall back?
One explanation seems to be that refinery capacity cannot keep pace with demand for the right type of oil being demanded (sweet crude). With the current political climate in oil producing countries, oil prices seem upwardly biased. However, prices could fall as fast as they have risen, but, in the meantime, given the lack of definite timelines for oil price falls, the Kenyan government should definitely intervene in its transport market. A stitch in time saves nine!

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