11 July 2008

Price Elasticity of Demand for Oil

For a number of years, as oil prices went u, Americans complained relentlessly but made few to no changes in their driving habits. Some people interpreted this as meaning that oil was rather special in that demand was inelastic. I have even seen oil called an "inelastic good," which technically speaking is incorrect (demand can be elastic, but goods can't, unless we're discussing rubber bands). It does, however, get the point across.

The claimed consequence of oil's alleged demand inelasticity was that it was necessary for government to regulate it more strictly. Even if we accept the assumption that oil is a special good in that sense--or to make the claim even stronger, state it as accepting that demand for oil reveals a market failure--it doesn't follow that government regulation will be superior. The claim of inelastic demand for oil is essentially a claim that price signals have failed, but since government regulation lacks price signals, there can be no assumption that regulation would be superior. It would suffer from the same flaw, but to an even greater degree, because at least in the market the price exists, however weak it's signalling effect, whereas in government regulation the price almost completely disappears.

This may not seem intuitive to those who haven't read the socialist planning literature. But in a nutshell, consider the case of a group who goes out for dinner and agrees beforehand to split the check evently; the direct link between benefit and cost is broken, so each has incentive to consume more than they otherwise would. Now assume that you or I have collected advance payments for this group, and are going to use those funds to pay for a variety of different things for that group, of which the dinner is only one component. The diners will not see the check. At that point there is no price signal, no connection at all between cost and benefit, and the diners will certainly not be as efficient in their menu choices as they would when paying for themselves. That is effectively what government regulation of oil would do, so the odds are that it would be at least as inefficient as a failed market, and quite probably more so.

But I was never convinced that the demand for oil was inelastic. I did at times wonder if maybe it was, but given that greater elasticity is the norm for most goods, I couldn't believe oil was different without an explanation for why it would be different. Parsimony required it. The explanation I heard most often related to the physical infrastructure of the U.S.--the way we have built our cities makes it too hard to shift away from driving. Having lived in L.A., where it is prohibitively time consuming to get around on mass transit, I thought this explanation had some degree of plausibility. But on those occasions when I drove between Los Angeles and San Francisco, I realized the claim didn't hold up. People could have flown between the cities, and more quickly than they could drive (even counting transit and airport time). This suggested they werent taking advantage of opportunities to avoid driving even when they were available, so price inelasticity itself wasn't the problem. (Interestingly, it also meant that the price of gast plus the cost of their time was less than the cost of an airline ticket.)

It seemed more plausible, then, that oil was actually much cheaper than we believed it was, a point supported by the difference between our expressed preferences and our revealed preferences. That while we naturally complained about price increases, gas was still too cheap to affect our behavior. Imagine, for example, if beef was 50 cents a bottle (in 2008 dollars), but next year doubled to $1 a bottle. All of us beer drinkers would certainly grumble, but I doubt it would put much dent in or consumption.

Even at $3 a gallon, a price that had doubled in just a couple of years, very few people changed their driving behavior, although the grumbling had grown louder. Part of the issue was certainly that few of us expected the price to remain that high, but that only explains why we didn't trade in our SUVs for Ford Fiestas; it doesn't explain why there still wasn't much reduction in actual miles driven.

Somewhere between $3.50 and $4 per gallon, however, we seem to have finally reached a point where we can see the elasticity of our demand kicking in. It's not always apparent, as I still see an incredible amount of traffic on the streets of my small town, and my own bad habit of taking about 3 car trips a day hasn't changed. But usually by this time in the year I would have been to my mother's house, about 80 miles away, three or four times, but this year I have only gone once, and not yet once this summer. And of course people are beginning to buy fewer trucks and sport utility vehicles--my neighbor who builds parts for Ford trucks is on a 6 week layoff.

But the idea for this post came about through a chance conversation at my physical therapist's office, one of those little incidents that make you realize how impossible it is for any central planner to have all the relevant information. The PT assistant lives at one of the many beautiful lakes in our county, and she offhandedly commented on what a nice summer it has been out there, much quieter than usual. "Quieter?" I asked. "Oh, yes, almost no motorboats and jet skis this summer."

The lake is only 15 minutes from our town, and there are a few thousand people living along the lake itself, so it's surely not the cost of getting of course there that's deterring boaters; it's the operating costs of the watercraft.

And there you have it. The market works. But nobody ever said it would be painless.


James K said...

In fact it never will be painless. The pain is what causes the change in behaviour.

I suspect the demand curve for oil differs radically in the short and long term. The short-term curve is probably very steep, but the long term curve is much flatter. Once it is clear that a price change is persistent and not just a spike people start taking longer-term steps to reduce consumption.

itchy said...

"Imagine, for example, if beef was 50 cents a bottle (in 2008 dollars), but next year doubled to $1 a bottle."

Beef-in-a-bottle has to be worth at least $1, just for the innovation alone!

James Hanley said...

Great catch, itchy! I like that typo so much I'm going to let it stand.

It does remind me of a bottle of Bavarian smoked beer I once bought. It smelled so strongly of smoked beef that I couldn't finish it. But beef in a bottle indeed.