Econ 1101 International Application Case Studies

Transcription

1 Econ 1101 International Application Case Studies InterApp 2: Fuel Consumption in Europe and the United States And Long-Run Elasticity of Demand By Thomas J. Holmes, Dept. of Economics, University of Minnesota Written September 17, 2009 for Econ 1101 In class we are learning about demand. This case study discusses the demand for gasoline. It attempts to make some (very rough!) estimates of the long-run demand elasticity by making a crosscountry comparison. Gasoline in European countries is taxed significantly more than here in the United States. We can use this tax-induced price variation to explore how demand responds to changes in price. In making a comparison such as this, we always need to be wary that there are other differences besides price that impact demand that also need to be taken into account. The case study will touch on these issues but not get into them in detail. (Fully addressing these issues requires knowledge of the empirical tools of economics called econometrics that you can learn in advanced classes) The Short-Run Demand Elasticity Let s put aside the long run for a moment and start with a discussion of the short run. Among other things, the demand for gasoline depends upon the kinds of cars people drive, how far people live from work, and the existence of public transit alternatives such as buses or rail. It takes many years to change all of these things. In the short run, these things are fixed. 1

2 There was a substantial run-up in 2008 in the price of a barrel of oil; it cracked the $100 barrier and then went well above it. In June 2007, oil prices were $65 a barrel. A year later, oil was $121 a barrel. Changes in the price of oil lead to changes in the price of gasoline. (There are 42 gallons in a barrel so a $40 increase in the barrel price roughly corresponds to a $1 increase at the pump.) The following table shows prices of gasoline and consumption in June for these two years: (The sources for all data used here are described at the end of the case study.) Time Period Table 1: Price and Per Capita Quantity Consumed of Gasoline in the United States The Month of June for 2007 and 2008 Per Capita Daily Consumption of Motor Gasoline Average Price Per Gallon in Dollars June June Δ.06 = ( ) 1.02 Average of Both 1.29 = ( )/ Years %Δ.05 =.06/ Gas prices increased by $1.02 over the period. Consumption fell, but only by a small amount. We can use this data and the midpoint formula to calculate an estimate of the short-run elasticity for gasoline. We first calculate the change in the quantity and price. (We use the Greek letter Δ to denote change ) Next we calculate the average over the two time periods. Next we take the change as a percent of the average. The final step is Elasticity(short run) = %ΔQ/%ΔP =.05/.28=.16 Note that we dropped the minus sign. The price elasticity of a good is negative so for convenience we don t carry around the negative sign when we discuss it. (But note that some of the other elasticities, like the income and cross-price elasticities, can be positive or negative and for these it is important to keep track of the sign.) According to this calculation, the short-run elasticity of the 2

3 demand for gas is significantly below one. The change in quantity is small compared to the change in price. As gas prices shot up in 2008, consumers were stuck in the short run with the cars they purchased when gas prices were lower. If an individual needs to get to work and driving an SUV is the only option, the individual will pay the higher price and buy the gas needed to get to work. But the next time that person is shopping for a car, he or she will typically choose a more fuel efficient vehicle. A short-run elasticity of this magnitude is consistent with previous research in economics. The back-of-the-envelope calculation made above is simple and leaves out much that would be taken into account in a sophisticated econometric study. Nevertheless, the calculation does take into account some basic things. First, there is an important seasonal element to demand for gasoline. For example, demand picks up in the summer when people travel. The calculation deals with this by keeping the month fixed: June 2008 compared with June Second, demand depends upon population and this grows by about one percent each year. The calculation deals with this by using Census data on population for each year to derive a per capita consumption level. Third, income can change from one year to the next and income impacts demand. We all know about the economic crisis and this has had an impact on demand for gas. The main impact of the crisis on national income happened after June 2008, so the difference in income between June 2007 and June 2008 is relatively small. If instead we compared Dec 2007 with Dec. 2008, the differences in income would be more significant, as the crisis was severe by Dec The Long-Run Elasticity To estimate the long-run elasticity, we need to make comparisons in which differences in prices have been maintained over a long time, long enough so that consumers have had time to adjust their decisions about what kinds of vehicles to drive and where to live. For many decades, gasoline has been taxed heavily in Europe compared to the United States. So let s look at how consumption in Europe compares with consumption in the United States. Table 2 reports data from 2007 for the United States and selected countries in Europe (plus a few additional countries that we will mention below.) The table reports the average retail price throughout the year, including all taxes. The exchange rate is used 3

4 to convert foreign currencies to $US. The table also reports Gross Domestic Product per capita which we use as a measure of income. A Purchasing Power Parity method is used to convert foreign income to an equivalent spending power in the United States. In the last column, the table reports per capita consumption of gasoline. Table 2 Price of Gas, Consumption of Gas, and Income for Various Countries For Year 2007 Country Average Retail Gasoline Price (Reg. Unleaded) $US per Gallon Per Capita Income (GDP, PPP method)) $US in 1,000 Consumption of Motor Vehicle Gasoline Per Capita Gallons Per Day United States Selected Countries in Europe Norway 7.00 * United Kingdom Germany France Spain Italy Some Other Countries Japan Mexico China ** Let s look at the European countries first. All of the countries are similar in maintaining high prices of gas through high gas taxes. In several places, the price is at or close to $7.00 a gallon. Next look at income. The countries are sorted from highest to lowest in per 4

5 capita income. Norway is the richest. next is the UK and Germany. There is a pattern here: the richest European countries consume the most gas. In particular, Norway is the richest and its consumption is the highest. This pattern is to be expected. Gasoline is known to be a normal good, i.e. consumption increases as incomes rise. This pattern can be most readily seen by looking at China at the bottom of the table. It has the lowest price of gas of all of the countries but its per capita consumption is miniscule, only.04 gallons per person. The reason? It is still a poor country ($5,300 per capita income) and relatively few households own cars. The impact of income on gasoline demand is biggest at the threshold where households switch from having no car to having one car. Based on China s growth trajectory, we can expect that the car ownership rate in China will be increasing substantially in the near future and that the demand for gasoline will increase substantially along with it. To obtain an estimate of the long-run price elasticity of demand, we need to determine what happens when prices are different over a long period of time, but other things that impact demand are held fixed. Let s compare Norway and the U.S. because the incomes are very similar, so we are at least holding income fixed in the comparison. Table 3: Price and Per Capita Quantity Consumed of Gasoline The United States and Norway in 2007 Time Period Per Capita Daily Consumption of Motor Average Price Per Gallon in Dollars Gasoline United States Norway Δ Average of Both Years %Δ Using the above table we can construct an estimate of the long-run demand elasticity. Elasticity(long run) = %ΔQ/%ΔP = 1.24/.86=

6 This estimate is quite large; it is well over one. According to this estimate, demand for gasoline is quite responsive to price over the long run. This is quite different from our earlier estimate.14 of the the short-run elasticity. This is an interesting back-of-the-envelope calculation, but some important issues are being left out. One is that Norwegians tend to have better access to public transit than Americans do. Think of this as Norway having a lower price for a substitute good. This factor contributes to the lower demand for fuel in Norway, so our estimate overstates the true price elasticity of demand. In other words, if we tax gas in the United States to raise the price to $7 like in Norway, but leave public transit options the same (so they continue to be worse on average than in Norway), we won t end up with fuel consumption rates that look like Norway (.3 gallon per person per day). But what if the revenues from higher fuel taxes were used to finance public transit infrastructure improvements? Good question In any event, there is no question that if gas prices were raised to $7 a gallon in this country, people would be very interested in fuel efficiency when shopping for cars. Data Sources Data on energy use and prices is available from Energy Information Administration of the Dept. of Energy ( The monthly consumption variable used in Table 1 is the variable U.S. Product Supplied of Finished Motor Gasoline. The monthly price information is from the August 2009 Monthly Energy Review. For Table 2, the price information is from Retail Motor Gasoline Prices in Selected Countries, The consumption information by country is from the EIA International Energy Statistics Program. The population data and per capita GDP data is for the OECD Stat Extracts program. 6