1

The Impact of the Changes in the Domestic Fuel Price Policy in Indonesia
on Consumer Welfare
Academic Adviser: Professor CHEN Kuang-hui
Presented by: ROCKY Gunung Hasudungan
Student ID: 086i407i
Master Thesis Resume

Oil plays an important role in the world. People use it in many aspects of daily life,
from cars, trains, and planes; to industry; to the farms that supply our food at the
supermarket. Some countries need more stock of oil in the winter season, and some people
in developing countries use it for cooking and also lighting. Thus, a change in supply and
demand, reflected on the price, has great influence on peoples life.
The price of oil is not always determined by a market mechanism. A government can
intervene in that price. Some regions, such as Europe and Japan, impose high taxes on
gasoline; others, such as Saudi Arabia and Venezuela, highly subsidize it. Recently, 12% of
world population has enjoyed fuel subsidies that are given by 24 oil rich countries. Like in
many oil producer countries, the Indonesian government has implemented fuel subsidies
and set official prices started in 1967. At present, Indonesian fuel subsidies are applied to
five regulated oil products: gasoline, kerosene, automotive diesel oil, industrial fuel oil, and
heavy fuel oil.
In mid-2005, when the crude oil price in international market reached around US$ 60
per barrel (three times the end-2001 price), the Indonesian government decided to cut the
fuel subsidies by increasing official fuel prices about 114% overall in October 2005, since the
budget allocation for fuel subsidies almost 20% of total expenditures (in 2006, the portion of
budget for fuel subsidies reduced significantly to less than 10% of total expenditures).
However, those huge fuel price increases in October 2005 became a trigger for a
high year-on-year (YOY) inflation that reached 17.89% in that month (slightly twice YOY
inflation in the previous month that was 9.06%). Most households had to deal with both
higher fuel prices and more expensive of basic goods prices.
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In this study, we analyze the impact of fuel subsidy cut policies in Indonesia on
consumer welfare by income (expenditure) class using the concept of Compensating
Variation (CV). Consumption behavior in Indonesia is analyzed by estimating the Almost
Ideal Demand System (AIDS) model from household expenditure survey and CPI data for
2000 to 2006 by categorizing five groups of commodities: cereals, other foods, housing,
clothing and other non-foods. The parameter estimates of the AIDS model were used to
calculate elasticities and a percentage change version of CV.
From our estimations (see Table 1), we found that the AIDS coefficients are mostly
significant at the 1% and 5% level showing that the expenditure shares for each commodity
are responsive to prices and income, except for
43
(=
34
) and
4
(clothing) are not
significant. However, one of characteristic roots is positive (but very close to zero), showing
that our AIDS expenditure function is not negative semidefinite. In spite of that result, all
values of Marshallian and Hicksian own-elasticities are negative (see the Table 2).
From Table 2, we can see that income elasticities for food commodities are less than
unity indicating that cereal and other-foods are necessity goods. The estimated own-price
elasticity for clothing is very elastic while other non-foods is close to inelastic.
From Figure 1, we can see that the reduction of fuel subsidies can have adverse
effects more on the poor in Indonesia. The poorest group of households, on average, should
increase their expenditure by 4.60% (in order to keep their utility unchanged) and the
richest, on average, should increase their expenditure by 4.00%.
The World Bank argued that fuel subsidies are not only economically inefficient but
biased toward the rich because their fuel consumption is bigger than the poor. Hence,
although the fuel subsidies are economically inefficient and seem to go in the wrong
direction, those subsidies are still important for the poor and a drastic reduction would
torture the poor. According to our analysis, however, the poor suffer more because prices of
a lot of goods are affected by the fuel prices.




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Table 1: Parameter estimates for the AIDS model
Commodity i

1

2

3

4

5

R
2

Cereals 0.12021
c
-0.04268** 0.03199** 0.17939** 0.01253** -0.18124
c
-0.13628** 0.2174


(0.00783) (0.00520) (0.00970) (0.00322) - (0.00848)
Other Foods 0.45791
c
0.03199** -0.02874** -0.02127* -0.00781* 0.02583
c
-0.04903** 0.0222
(0.00520) (0.01023) (0.00968) (0.00203) - (0.01228)
Housing 0.22169
c
0.17939** -0.02127* -0.14948** 0.02378 -0.03242
c
0.13653** 0.1377
(0.00970) (0.00968) (0.03645) (0.01520) - (0.01311)
Clothing 0.03977
c
0.01253** -0.00781** 0.02378 -0.08220** 0.05369
c
0.00173 0.0505
(0.00322) (0.00203) (0.01520) (0.01084) - (0.00242)
Other Non-
Foods 0.16042
c
-0.18124
c
0.02583
c
-0.03242
c
0.05369
c
0.13414
c
0.04704
c
-

Note:
(Heteroskedasticity-Robust SE in parentheses)
c
Calculated
*Significant at 5% level
**Significant at 1% level

Table 2: Total expenditure and own-price elasticities
Commodity e
i

ii

Uncompensated Compensated
Cereals -0.134 -1.219 -1.235
Other-Foods 0.893 -1.014 -0.605
Housing 1.616 -1.811 -1.453
Clothing 1.043 -3.068 -3.027
Other Non-Foods 1.293 -0.211 -0.003

Figure 1: Compensating variation by household income (expenditure) deciles of period
September 2005 to March 2006

4
.
6
0
%
4
.
4
6
%
4
.
3
8
%
4
.
3
3
%
4
.
2
8
%
4
.
2
3
%
4
.
1
8
%
4
.
1
3
%
4
.
0
8
%
4
.
0
0
%
3.90%
4.00%
4.10%
4.20%
4.30%
4.40%
4.50%
4.60%
4.70%
4.80%
1 2 3 4 5 6 7 8 9 10
C
o
m
p
e
n
s
a
t
i
n
g

V
a
r
i
a
t
i
o
n
Household income deciles