July 31, 2013

In late July, Manufacturing Australia (MA) claimed that rising gas prices put at risk almost 200,000 manufacturing-reliant jobs and $28 billion in economic value annually, citing research by the National Institute for Economic and Industry Research (NIEIR) and the AEC Group.

But closer examination reveals shortcomings in the MA analysis.

MA’s call for “policy initiatives”, including domestic gas reservation, is based on the use of input-output multiplier analysis. These arguments assert that the value of a unit of gas when used domestically is greater than its market price. It is argued that, since gas is an input into other goods and that these goods will not be produced if that unit is not used domestically, the cost of exporting the unit is the whole of the loss of production that would otherwise have been produced domestically.

MA’s approach is to track the use of gas in the economy and measure the amount of output a unit of gas, when combined with other inputs, contributes to production. The argument is then that the whole of this final output, with a market value some multiple of the gas used in its production, is lost to the economy if the gas is not used for that purpose.

That a unit of gas has less value than the final output it contributes to producing is self-evident.

But it does not follow that the value of this output would be lost if the gas is not directed towards its production. Such an assertion would only be true if the other inputs used in production of the final good sat idle were they not used in this way and this is unrealistic in an economy with high levels of employment. Instead, these resources have an opportunity cost when used in the production of one good, in that they could have instead been used in production elsewhere in the economy.

Analyses based on input-output tables and multipliers are most appropriate when measuring the way in which a policy flows through an economy, allowing policy analysts to identify which industries will be affected. However, the question to be answered here – the one posed by MA – is not how production will change when a unit of gas is exported rather than sold domestically, but instead which approach generates more wealth for the Australian economy. An approach based on multipliers is not suited to answer such a question and is typically not the appropriate approach to use in policy evaluation.

This is recognised formally in the Australian Government’s Handbook of Cost-Benefit Analysis  which states: “Inclusion of a multiplier effect from income and spending generated by a project is justified only when (a) the affected resources would otherwise have been unemployed and (b) the activities displaced by the project would not also have made use of the idle resources.”

Despite the headline conclusions that MA has emphasised, the NIEIR Report includes analysis of cases in which the demand for gas to service LNG exports is accommodated by domestic users substituting other fuels for gas, rather than just by crowding out domestic gas-using activities. In these cases, the development of LNG exports poses no overall threat to the domestic economy.

By failing to account for the productive use to which the remaining inputs into final production would have otherwise been put, a multiplier analysis fails to give an accurate representation of the value of directing gas for domestic use.

If, as MA and others have claimed, one dollar’s worth of export could be used to generate 21 dollars’ worth of output if used domestically, it prompts the question why the supply chain was not willing to pay more for that unit of gas. The answer is that it would be more efficient to use the remaining inputs elsewhere rather than pay the world price for the gas input.

The implication is simply that, in the absence of significant market failures or unemployed resources, the value of a good to the economy is simply the price at which it trades. Requiring gas producers to sell to domestic users at as subsidised price on the grounds that its value is not fully reflected by the market price, is based on a false premise.

Indeed, if we take the MA argument seriously, the government would be called on to estimate multipliers for each market in the economy and redirect resources to those markets with the largest multipliers, instead of relying on market prices to achieve an efficient allocation. Such central planning is not supported by any economic principles and would come at a large cost to the Australian economy.