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Inelastic gas

THE NATIONAL POST - 23 juillet 2008
Inelastic Gas
Vincent Geloso

With the sharp rise in the price of oil, everybody expects a big drop in consumption of oil products. At the gas pumps, for example, the increase in the price of gasoline over the last two years is now similar to the magnitude of the increases in the 1970s and early 1980s. Will consumers today dramatically change their behaviour as they seem to have done 30 years ago?
Conventional wisdom says they will. So do the proponents of carbon taxes. Put a big carbon tax on gasoline, they say, and consumers will stop using gasoline to such a degree that carbon emissions will decline dramatically. Statistics Canada retail sales data released this week appear to show a change in gasoline demand. Certainly that’s how the media reported the numbers. But is gasoline and oil consumption falling dramatically, as implied by the headlines and theory?

In economics, the degree to which consumers will respond to a price change in a product is called its elasticity. If the price of gasoline rises by 50%, and consumers cut their use of gasoline by 50%, gasoline would be considered a very price elastic commodity. If consumers can react quickly, demand is elastic, otherwise it is inelastic.

There are many reasons to be skeptical of claims that a carbon tax or a equivalent rise in oil prices will cause drastic changes in consumption patterns. Despite the hype, the rise of oil prices has not been matched by correspondingly sharp declines in demand. This suggests inelasticity. Even if prices go up, demand remains strong. Gasoline, it turns out, is a very inelastic commodity in the short run. It may be more elastic with time, as people move slowly to adapt to the new price levels. Let’s put it this way: It may take a lot of time for a carbon tax or the price rise in gasoline to have a dramatic impact on demand and, thus, carbon emissions.
Looking at data from the United States, we can compare the impact of rising gasoline prices today with the oil shock years of the 1970s. Today, Americans spend 7% of their income on gasoline. In the 1970s, they spent twice as much. Part of the reason for that is increased fuel efficiency. The U.S. Energy Information Agency statistics show that the composite motor vehicle fuel rate (trucks, SUVs and passenger cars) in miles per gallon rose 42% from 1973 to 1991. As for the passenger car alone, since 1973 it’s fuel efficiency has gone up by 71%. This efficiency gain is bound to have a significant impact on consumption and the price elasticity of gasoline.

Put another way, gasoline as a percentage of the total cost of owning a car dropped from 33% in 1975 to 17% in 2006. At the same time, the real income of Americans has increased by 60%. Since the ’70s, the amount of energy needed to produce one dollar of GDP has gone down by 51% from 1970 to 2007 (see graph 2). We produce more with less energy. These two factors combined — less fuel use and richer consumers — mean that the incentive to cut fuel consumption is much less than it was in the 1970s.

If gas takes a smaller share of the budget of American consumers, it means that prices changes like those we see now will not affect consumers as it did before. Sure, consumers are reacting by changing some of their consumption patterns: public transit usage has gone up, people are switching to smaller vehicles and driving less. But not by much. Travel on all roads and streets decreased by 1.8% for April, 2008, as compared to April, 2007, according to the Federal Highway Administration. During that time, the price of gasoline rose 75%, suggesting a severe degree of inelasticity. Fuel consumption averaged 20.4 million barrels a day in the four weeks ended June 6, 2008, down 1.3% from a year earlier. On top of this, since April, 2006, the total driving distance by all Americans has been going down, but only by 2.6%.

But which part of these small declines can actually be attributed to rising oil prices? We are, clearly, in some kind of economic slowdown. Is the truck business declining because of gas prices, or because of the meltdown in U.S. housing activity, where small trucks play a big role? An economic slowdown in the United States (or a recession according to some) may be driving gasoline consumption even more than price. The modifications on the consumer side are undeniable, but they are not strong.

With a real price surge similar to the ’70 and ’80s, we might have expected consumers to react strongly. But they haven’t, at least not thus far. In the short run, changes in oil price will only cause a proportionally smaller reduction in consumer demand. What can change consumer tendencies can only be achieved in the long run, with increased and/or more efficient means of production, new substitutes (that will be relatively cheap) and new technologies. These are precisely the elements — rather than price — that have gotten us to use less gas since the 1970s.

Libellés : ,

Vincent Geloso


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