An article in the May 1 WSJ (As gasoline prices soar ..., $) provides a great lesson on the determinants of price elasticity of demand:
With gasoline prices in the U.S. approaching an average $3 a gallon, Americans are moaning about the rising cost, but so far they are resisting big changes in their gas-guzzling ways.
The early results: High prices do have some effect, but prices would have to be higher than they are today -- and would have to stay high for a long time -- to meaningfully curb gasoline consumption by the nation's massive fleet of cars and trucks, which accounts for about 10% of global oil use.
At the margins, there are some signs that high gasoline prices may be starting to alter consumer behavior. Traditionally, gasoline use in the U.S. rises about 1.5% each year. But in three of the six months from September -- immediately following the Gulf Coast hurricanes -- through February, gasoline consumption fell compared with a year earlier, according to data from the U.S. Energy Information Administration. In the three months in which it grew, it never rose by more than 0.4%. Yet in March, as gasoline prices soared, demand appeared to return to more-robust levels, growing by 1%, according to preliminary data.
I wonder how these numbers look in per capita terms. There hasn't been much time for the 1% or so of population growth to have much effect, but still, this is the correct way to look at aggregate consumption over time.
Though the recent run-up in gasoline prices has been steep, it hasn't been debilitating for most Americans. The price of a gallon of regular gas averaged $2.74 in April, according to the Energy Information Administration. Adjusted for inflation, that was still 14% below the peak in March 1981, when, in today's dollars, gasoline averaged $3.18.
Moreover, Americans are better-positioned to handle a run-up in fuel prices than they were a quarter-century ago. Gasoline now accounts for only 3% of total personal-consumption spending, down from 5% in 1981, according to the U.S. Bureau of Economic Analysis. That gives many consumers less reason to contemplate cutbacks when prices rise.
As promised, item #2 in the list of determinants of price elasticity: budget share. As the share of the budget that expenditures on the item account for, price elasticity declines (see also Daniel Gross's article in the Sunday NYTimes: Why prices at the pump may have little bite).
In Plano, Texas, a suburb north of Dallas, Alfred Goh, a 42-year-old commercial-real-estate broker, yesterday paid $63.86, or $3.06 a gallon, to fill up his sport-utility vehicle, a white 2004 Lexus GX 470. The vehicle averages 16 miles per gallon, according to federal figures, and Mr. Goh, who drives extensively for work, reckons he fills it up two or three times a week.
Mr. Goh says he has no plans to change his driving habits or his vehicle. "I won't limit driving because of gas prices, because it's a necessity," he says. As for his vehicle, "I think this is a safe car," he says, and "it's safety first." His only concession to rising gasoline prices is that he now uses midgrade gasoline instead of premium, a move that saves him about 10 cents a gallon.
Number 3 on the list of determinants is the length of time available to adjust to price changes. Much of gas demand is locked in on account of two long-run decisions that most everyone makes. The first (above) is the type of car we buy. Much of the rolling fleet (I love to say that) was purchased in the low-price era (i.e., "non-peak oil era" for all you peak-oilers). The second long run decision is where we decided to buy a house (below). If we are to, er, "drive less" in the short run, we need to skip work a day each week (don't throw me in that briar patch!) or spend one night a week in the office (not so easily done unless you're paid like an NFL coach).
Even Americans who want to slash their gasoline use will find it hard to do so in a society built on cheap energy, where far-flung suburbs and powerful cars are the rule. "If you've got to drive to work every day, you've got to drive to work every day," says John Felmy, chief economist of the American Petroleum Institute, the oil industry's Washington-based trade group.
The first item on the list of price elasticity determinants is the number and availability of substitutes:
The limits of mass transit add to the difficulty of cutting fuel consumption. Though nationwide figures aren't yet available, many systems around the country are reporting significant increases in passengers, says William Millar, president of the American Public Transportation Association. In Washington, where his group is based, the Metrorail transit system reports that three of the 14 busiest days in its history occurred the third week in April. The problem: Public transit isn't available in much of the U.S. and doesn't match the commutes of many Americans in places where it exists.
What are you going to do if you don't drive to work? Stay at home or sleep in the office.
So, the big three determinants of price elasticity all point toward a low number (consumption is insenstive to price changes in the short run). And here it is:
Research suggests it takes years for higher gas prices to meaningfully damp consumption. Opinions differ, but many experts say that, in the short term, the "price elasticity" of U.S. gasoline use is as low as 0.1. That means gas prices have to rise 10% to produce an initial 1% drop in demand.
...
If gasoline prices stayed high for several years, researchers say, they would tend to meaningfully curb consumption. Over time, people would factor the higher prices into decisions that have big effects on their gasoline use. They might choose more-efficient models when it comes time to replace cars, as happened in the early 1980s. They might decide to switch jobs or move to shorten their commutes.
The second and third paragraphs of this story tell you where we are today.
With elections every two years, politicians avoid any mention ...
A 25% jump in prices at the pump since December has set off a firestorm in Washington. Politicians are threatening auto makers with tougher federal fuel-economy standards and oil companies with higher taxes on record profits, while warning against price gouging. Auto and oil executives are predicting that a long-term shift toward greater fuel efficiency is under way. But none of these influences is likely to have much effect on gasoline prices or oil consumption in the near term.
... of an undeniable long term solution:
Unlike the energy crises of the 1970s, which resulted from reduced supplies of Mideast oil, today's crunch is due largely to a swift rise in global oil demand. The surest way out of the problem, most experts agree, would be to curb consumption of vehicle fuel, particularly in the U.S. For years, economists have argued that the most effective way to moderate U.S. demand would be to hit Americans with significantly higher gasoline taxes.
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