Measuring the welfare effects of reducing a subsidy on a commodity using micro-models: An application to Kuwait's residential demand for electricity

This paper provides a conceptual and empirical approach for evaluating the direct benefits and costs that are associated with reforming the price of a subsidized commodity using a micro-model. The welfare analysis is based on two alternative scenarios, a hypothetical percentage increase in the price of the commodity and a hypothetical percentage decrease in the amount of subsidy. The latter is considered to be a simultaneous problem in which the exact price of the commodity that reduces consumption, and subsequently the subsidy to the specific target level needs to be determined first. As a case study, the paper utilizes the most recent Household Expenditure Survey in the State of Kuwait to estimate residential electricity demand for different household groups (i.e., low-, middle-, and high-income), and employs a partial equilibrium model to measure the welfare implications that may result from a reduction in the electricity subsidy rates. The empirical findings show that a small increase in the price of electricity would reduce annual consumption by 4741 million kWh and annual subsidy by US$734 million. The results also show that the loss in consumers' welfare is approximately US$145 million, while the financial and environmental benefits to the society ranges between US$658 million and US$889 million. The magnitude of these welfare gains suggests that electricity price reforms combined with a rebate scheme to compensate households for their welfare loss, offsetting any political resistance to reform, is a win-win situation. (C) 2011 Elsevier B.V. All rights reserved.