The Problem With High Prices

Do high gas prices affect consumers? Conventional wisdom says that increasing prices will decrease demand. Examining price elasticities for gasoline tells a different story. Elasticities are economists' way of describing how responsive consumers are to changes in one factor, like price, versus another, like demand. In the late 1970's gas prices shot up, and consumers responded by driving less and buying more efficient cars so that by 1982 they consumed 12 percent less gasoline than in 1978. In the graph above, the bump in the red line after the Iranian Revolution is that increase in "price elasticity of demand." Look further along the red line: It's clear that over the next 20 years consumers' responsiveness decreased so that when gas prices rose to $4 in 2008, demand dropped by only 3 percent. (That's the second pointy red bump.) The message of the red line is that Americans don't seem to hear the "price signal" of high gas prices as clearly as we once did.

The yellow line tells another story: It shows the relationship between income and energy use, or demand elasticity of income. When energy economist Skip Laitner graphed the income elasticity it was obvious that income is a much bigger player in our demand for gasoline than price, and its influence has grown dramatically since the 1970's. It may be that consumers are locked into driving patterns to maintain their incomes --i.e. we have to drive to work and take the kids to school--so that we simply can't respond when prices jump. And it may be that many Americans have enough room in their budgets to accommodate big bumps in gas prices. Laitner's analysis shows that different income levels do not respond predictably to prices, which makes sense because households making less money obviously have a harder time changing cars or jobs for a cheaper commute. It will take more research to better understand how the relationship between income and demand works at both the household and economy level.

But whatever is driving the dynamic between income and energy, the implications for the future are stark. With an income demand elasticity of 0.5, when we increase incomes by 3 percent, demand for energy rises by 1.5 percent. But the price elasticity of 0.1 suggests that order to keep oil demand steady, without increasing the volume we use, gas prices would need to rise 16 percent from, say, $3.65 to $4.23 a gallon. So as incomes rise we're likely to see escalating energy prices, which will hurt those consumers who can't quickly reduce their gasoline use or are already stretched to the limits of their budgets. At an economy-wide level, we need to take steps to change the relationship between income growth and energy demand. On a household level, consumers need more options so they can hear the high price signal and reduce their gasoline consumption when they want to.

A note about the graph above. Skip Laitner used data from the Bureau of Labor Statics Consumer Expenditure Survey to model elasticities of demand. The yellow line--income--is a positive relationship: When income rises energy demand rises. The red line--prices--is negative: When prices rise demand falls. For the purposes of comparing consumer responses, both are displayed as positive lines.

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