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Tequila Sunrise: Fuel Subsidies In Mexico Stimulate Black Market Activity In The US

Joseph Brusuelas
Chief Economist
Merk Investments
June 26th, 2008

Along the frontier between Southern California and Baja California it has always been a tradition for consumers to engage in a bit of arbitrage due to the temporary differences in prices for basic goods. Normally, this has been confined to non-durables and foodstuffs. But, beyond Mexican “cerveza” and other spirits, the changing price of oil has jump-started black market activity north of the border.

While an open secret in California, this activity became national news due to a recent Wall Street Journal article titled “Fill'er Up: Gas Is Cheap In Tijuana, So Californians Buy Big Fuel Tanks.” South of the border, where the Mexican government subsidizes the cost of fuel, the price environment for consumers is quite different. Gasoline costs $2.50 per gallon and the cost of diesel is less at $2.19. What is occurring is more than a temporary way for industrious residents of the border to profit from price differentials. It is a prime example of how government subsidies distort the efficient allocation of goods and services and can lead to a change in consumer behavior.

To the point, due to the near $5.0 per gallon price of gasoline throughout much of California, consumers have incentive to cross the border and purchase gasoline. While, on an individual such activity is no problem and due to the open border an eminently rational endeavor. Yet, if the pricing differentials persist long enough, behavior on the both sides of the border will change.

And that is exactly what has occurred. Residents in San Diego County, California are now doing much more than filling up their tanks. According to the aforementioned article, they are crossing the border with extra-large fuel tanks and returning home with profits in mind. Based on basic price differential, if an individual crosses the border and fills up a 100-gallon tank and returns home, he is in line for a tidy profit. At the subsidized price in Mexico filling up the tank would cost $250.00 dollar as opposed to $475.00 in the US based on an estimate of $4.75 per gallon. If that individual comes home and sells that tank of gas to his neighbors at $4.50 per gallon, he is in line to make a $200.00 profit for just a few hours work. Not bad.

Besides the utter irony of Americans crossing the border to Mexico to find economic opportunity, the real human behavior along the border is instructive regarding the basic economics of pricing. The behavior of US consumers and entrepreneurs is causing supply problems in Baja, California. Supplies of diesel are short and the lack of refinery capacity in Baja has, if you can believe this, Mexico importing refined gasoline from the US!

This state of affairs cannot last for two reasons. First, what economists refer to as “the law of one price,” ensures that in an efficient market all identical goods must have one price. Roughly translated, this means that after a short period of time efficiencies in the market dictate that opportunities to profit will come to a close.

Along the national frontier, the idea of efficient markets does not always hold. Yet, the distortion caused by the fuel subsidies for Mexican consumers cannot last. The logic of efficient markets will cause a change in the structural policies behind the change in individual behavior. Like many other emerging markets, Mexico will soon recognize the folly of its ways and understand that they are not only subsidizing the price of gasoline for their own citizens, but that of rich Americans. Moreover, the longer the price distortions continue to persist, the greater the cost for not only the government of Mexico, but for the citizens of the republic south of the border. In effect, the shortage of diesel and refined gasoline will continue to grow and the state will recognize that paying to import gasoline from the US and the subsidizing the consumption of it by US residents is a losing proposition.

Once that occurs, the current black market of cheap subsidized gasoline in the border region of Southern California will come to an end. But in the meantime, head down to the Ensenada, enjoy the warm summer nights and cold beer. And on the way back, fill up for the week. You will save a few bucks, and remember a time when the inefficient policies of a government actually worked to your favor.

Joseph Brusuelas
Chief Economist
Merk Investments
June 26th, 2008

Merk Investments LLC is the manager of Merk Mutual Funds, including the Merk Asian Currency Fund and the Merk Hard Currency Fund. The Merk Asian Currency Fund invests in a basket of Asian currencies. Asian currencies the Fund may invest in include, but are not limited to, the currencies of China, Hong Kong, Japan, India, Indonesia, Malaysia, the Philippines, Singapore, South Korea, Taiwan and Thailand.

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