Demand Elasticity of Gasoline With Gas Prices Term Paper

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Demand Elasticity of Gasoline

With gas prices across the country reaching record levels today, understanding the theory of demand elasticity of gasoline has assumed new importance for policymakers and consumers alike. To help understand what motivates consumers to make a purchase decision about a commodity such as gasoline, this paper provides an overview of the economic theory of demand elasticity, empirical data relating to demand elasticity for gasoline, followed by an analysis of the data. A summary of the research is provided in the conclusion.

Economic Theory of Demand Elasticity

Demand elasticity relates to how much consumers are willing to pay for something based on their individual needs and wants on an aggregated basis; economists measure this degree of elasticity along a price elasticity of the demand curve. According to Robert E. Kuenne (1968), "The degree of downward reaction of the amount demanded to a price rise or upward reaction to a price fall is measured by the economist at any given point on the demand curve with a concept called the price elasticity of the demand curve" (127). Therefore, the degree by which quantity changes as price changes is the percentage change in quantity to the percentage change in price (% Change in Quantity / % Change in Price) (Renner 2005:5).

According to Renner, inelastic demand could reasonably be expected for goods that shared the following characteristics:

Goods (or services) that have no close substitutes;

Goods (or services) that are considered necessities (i.e., not easily replaced); and,

Goods (or services) that are inexpensive and represent a small part of a consumer's budget.

The author adds that the shorter the time period of adjustment to a price change, the less elastic the market demand will be. "For instance," he says, "gasoline is considered an inelastic good. A 20% increase in its price would not in the United States result in a 20% decrease in quantity demanded, the response would be much less. Gasoline has no close substitutes; gasoline (in much of the United States) is a necessity and has only a moderate affect on budgets (for the non-poor)" (emphasis added) (6). At least for the present, therefore, this is the nature of the market for gasoline at the consumer level, with individual choices relating to how much that trip to Aunt Martha's might really mean, compared to the ability to get to work all next week.

Beyond these considerations, though, Renner suggests that in the short-term, "given the individual's car's gasoline requirements, and the distance between home, job, and school, there can be little adjustment of demand to gasoline price" (7). If given a sufficient amount of time and motivation, social changes could be made in the form of improved technologies that provided superior gas mileage over models today, improved mass transit systems could be developed and introduced and people could move closer to where they worked or opt for telecommuting positions; however, these initiatives would only have any discernible impact on the demand for gasoline at the consumer level over the long-term (Renner 8).

Empirical Data Relating to Demand Elasticity

Notwithstanding the observations made by Renner as they apply to the "non-poor," in contrast to the consumer market, the industry demand for gasoline remains fairly inelastic. In order to remain in business and stay competitive, for example, industries will require a comparable amount of fuel from month to month; however, from the perspective of the average consumer, gasoline at $2.00+ a gallon might appear to be a luxury for anything besides getting to and from work, shopping for groceries, doctor's appointments and the like. In many cases, weekend trips out of town or to the lake might be postponed or cancelled because of lack of discretionary income for the gasoline required. While these considerations might not become so readily apparent to the affluent, if a family is already struggling to make ends meet, increases in gasoline prices would have an inordinate effect on the consumer's ability and willingness to buy.

For example, Dermont J. Hayes (1989) cites the example of the impact of an adverse but temporary setback on an already heavily indebted consumer. "Additional credit may be available," he says, "but only at considerable expense and with some delay. In the interim, cash would be scarce. Items that cannot be purchased on credit (food and some services) bear the brunt of the adjustment while other categories suffer only to the extent that credit is unavailable. The attempt to stretch the budget to the next paycheck alters all the parameters of the demand system" (2). In these cases, consumers become more price conscious and purchase only the basic requirements. The analysis of the consumer's decision to seek additional credit to meet short-term needs is complex and relates to the relative interest rates on credit and savings, the expected change in the price of durables, and the ability to obtain additional credit to counteract the inflexibility that such additional repayments will undoubtedly introduce into future budgeting decisions (Hayes 2).

According to Hayes, the intimate relationship between the availability of credit for the purchase of goods and services that would otherwise be considered routine can readily be found in gasoline and oil, other nondurables, household operations, and various transport services. A possible explanation for this type of behavior is that consumers tend to cut back somewhat on travel and household upkeep when their liquidity is low; however, it is also possible that fewer of the purchases made by these consumers are able to be made using credit cards. According to Hayes, this would also serve to explain why sectors such as clothing, motor vehicles, other durables, and housing services (goods that are normally regarded as luxuries) would increase their share during periods of tight liquidity. "Whenever one share falls, however," Hayes notes, "at least one other must rise. The results do not necessarily imply that people spend more on these goods, only that they fail to reduce purchases as deeply as they do for those commodities whose shares fall" (3).

In their study, "Dynamic Pricing in Retail Gasoline Markets," Severin Borenstein and Andrea Shepard (1996) note that prior research indicates that pricing in retail gasoline markets is not well characterized by standard competitive models, but studies have shown that U.S. gasoline stations have sufficient local market power to implement price discrimination across gasoline grades or service levels (431). There are a number of theories concerning how gasoline is actually priced in the United States, and there are some important variables that help shape the final cost to the typical consumer. For example, according to Borenstein and Shepard (1996), "Wholesale gasoline price constitutes about 85% of the retail price. The other significant contributors to the marginal retail cost are (some) labor costs and the costs of delivering gasoline from the terminal to the retail outlet. Neither of these other components is nearly as volatile as the wholesale price" (430). Even the location of the gasoline outlet itself can contribute to both demand and the prices that are tolerated (Borenstein 354). Finally, the research suggests that, following the terrorist attacks of September 11, even the potential for shock news can now compel many American consumers to try to "stock up" on necessities, including gasoline (Davis & Hamilton 2004:17).

Analysis of the Data

In his analysis of price elasticity of demand, Donald E. Renner (2005) notes that the quantity demanded for a consumer at different prices can be aggregated into a market demand. "Market demand, then," he says, "s simply, the sum of all individual demand relationships" (1). As can be seen in Figure 1 below, there are two individual demand relationships from different consumers which have their quantities demanded combined (or sum up) to the market quantities in the far right graph.

The vertical axes show price (which remains the same for individual and market demand curves), while the horizontal axes shows quantity. The author also points out that because prices remain the same for all three graphs, the single line (P) (representing the same price) has been used to show the price in the horizontal line across all three graphs.

Figure 1. Individual and Market Demand Curves (Source: Renner 2005:3).

The market quantities shown in the graphs may be in thousands or millions of units (depending on the size of a market); at any rate, the demand curve reflects an inverse relationship between the price of a good and the quantity demanded. According to Rennder, "This relationship is considered so pervasive, particularly for the market demand, that in economics it has been termed the law of demand: The higher the price the lower the quantity demanded, and the lower the price the higher the quantity demanded" (4). While there are exceptions, the author suggests that most goods and services, including gasoline, are thought to follow the law of demand.

As shown in Figure 1 above, the middle graph reflects a consumer who is less sensitive to pricing consideration because the demand curve is closer to vertical with a relatively inelastic…[continue]

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