The price of a litre of petrol in New Zealand is creeping up towards $3 on average (and is already over $3 in some parts of the country). However, as this Financial Times article (paywalled) notes, petrol in Iran is 3 cents (US) per litre, and that is causing problems for the government:
As western governments struggle to keep a lid on fuel prices, the leadership of Iran faces a very different problem: its petrol is just too cheap.
Heavy state subsidies ensure that Iranian prices start at just $0.03 a litre, a fraction of the $1.10 paid at US pumps or the $1.88 that motorists in the UK are charged to fill their cars...
Oil-rich Iran vies with Libya and Venezuela, which has proven oil reserves greater than Saudi Arabia, as the countries with the cheapest petrol in the world.
But now a widening gap between supply — which is limited by domestic refining capacity — and rising demand has forced the Iranian authorities to tap its strategic reserves and import petrol for the first time in a decade...
As the government makes a significant loss by importing fuel at market rates and then selling it to consumers at a much lower price, there is mounting pressure to end the years of ultra-cheap petrol to which Iranians have become accustomed.
Mohammad-Reza Mir-Tajeddini, a member of parliament, told local media this week that fuel subsidies were now three times more than the country’s total development budget, but “nobody dares to speak” about raising the petrol price.
When you have a subsidy in place that keeps a price fixed, and there is increasing demand, the subsidy becomes increasingly burdensome on the government, and society more generally. To see why, let's consider the general case of a subsidy, as shown in the diagram below. The diagram is more complicated than a usual subsidy, as we need to also consider that Iran should be an exporting country (although sanctions largely prevent the exports), and that fuel use is subsidised. As an exporting country (with comparative advantage in producing fuel), the domestic equilibrium price (P0) is below the world price (PW). Without trade, the market would operate at equilibrium, with a price of P0 and Q0 fuel would be traded. The subsidy is shown by the curve S-subsidy (because it is effectively paid to the sellers). The subsidy decreases the price for consumers to PC (3 US cents per litre), and increases the effective price (including the subsidy) for sellers to PW (note that, to make our diagram a bit easier, we'll assume that the subsidy makes Iran exactly self-sufficient in fuel, before the increase in demand). The quantity of fuel traded increases to Q1.
Now consider the impact of the subsidy on economic welfare. Consumer surplus is the difference between the amount that consumers are willing to pay (shown by the demand curve), and the amount they actually pay (the price). In the diagram, at the equilibrium price and quantity (and with trade not allowed), consumer surplus is the area AEP0. Producer surplus is the difference between the amount the sellers receive (the price), and their costs (shown by the supply curve). In the diagram, at the equilibrium price and quantity, producer surplus is the area P0ECO. Total welfare is the sum of the two areas (consumer surplus and producer surplus), and is equal to the area AECO.
With the subsidy (and still no trade allowed), the consumer surplus is the area ABPC, while the producer surplus is the area PWFCO. The government loses the area of subsidy, which is the rectangle PWFBPC (this rectangle is the per-unit amount of the subsidy, multiplied by the quantity of subsidised fuel). Total welfare is the sum of consumer surplus and producer surplus, minus the subsidy (the subsidy is subtracted because it has an opportunity cost of lower government spending in other areas), and is equal to the area AECO-EFB [*]. In other words, total welfare is lower by EFB as a result of the subsidy. This is the deadweight loss of the subsidy.
Now, consider what happens when demand increases (and the government wants to keep the consumer price at 3 cents per litre). This is shown in the diagram below, where demand increases from D0 to D1. The price for consumers remains PC, and the effective price for producers remains PW. [**] However, to keep the consumer price at PC, the subsidy must increase (shown by the new curve S-subsidy2). The quantity of fuel traded increases to Q2.
Now consider the areas of economic welfare. The consumer surplus is now the area GJPC, but the producer surplus remains the area PWFCO. The area of the subsidy is now PWHJPC. Total welfare is now AECO-EFHJB. [***] In other words, while consumers are better off as a result of the increase in demand (because consumer surplus is larger), all of that extra welfare arises from additional subsidy spending by the government, and the deadweight loss increases substantially.
It's no wonder that the Iranian government is worried. When demand is high, the subsidy becomes increasingly burdensome for government (greater spending on the subsidy) and society more generally (due to the increased deadweight loss).
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[*] The overlapping areas of consumer surplus, producer surplus, and subsidy make this tricky to see. However, there is a shortcut. The area of total welfare is the area that is in-between marginal social benefit (MSB) and marginal social cost (MSC) out to the quantity that is traded (in this case, Q1). When MSB is greater than MSC, this represents positive welfare (the area AECO). But when MSB is less than MSC, this represents negative welfare (the area EFB).
[**] If demand was the be satisfied only by domestic producers, the effective price for producers would need to increase. However, the government can import fuel from the rest of the world for the price PW, so this limits the effective price for producers to PW.
[***] On the surface, this slightly violates the rule above that the area of total welfare is the area that is in-between MSB and MSC out to the quantity that is traded. However, the cost to society of buying fuel from the world market is equal to PW, and so the MSC (with trade) is increasing only up to PW, and then becomes horizontal.
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