Demand Elasticity of Gasoline: Theory and Consumer Impact

Introduction

With gas prices across the country reaching record levels, 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, and an analysis of that 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" (p. 127). Therefore, the degree by which quantity changes as price changes is the percentage change in quantity divided by the percentage change in price (% Change in Quantity / % Change in Price) (Renner, 2005, p. 5).

According to Renner, inelastic demand could reasonably be expected for goods that share 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.

Renner adds that the shorter the time period of adjustment to a price change, the less elastic the market demand will be. "For instance," he notes, "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 effect on budgets (for the non-poor)" (p. 6, emphasis in original). At least for the present, this is the nature of the market for gasoline at the consumer level, with individual choices revolving around how much a discretionary trip is worth compared to the ability to afford fuel for commuting the following week.

Beyond these considerations, 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" (p. 7). If given sufficient time and motivation, social changes could emerge in the form of improved fuel-efficiency technologies, expanded mass transit systems, and shifts toward telecommuting or living closer to work. However, these initiatives would only have any discernible impact on the demand for gasoline at the consumer level over the long term (Renner, 2005, p. 8).

Empirical Data Relating to Demand Elasticity

Notwithstanding Renner's observations as they apply to the "non-poor," the industry demand for gasoline remains fairly inelastic even in contrast to the consumer market. In order to remain in business and stay competitive, industries require a comparable amount of fuel from month to month. From the perspective of the average consumer, however, gasoline at $2.00 or more per gallon may appear to be a luxury for anything beyond commuting to work, shopping for groceries, or attending medical appointments. Weekend trips may be postponed or cancelled due to a lack of discretionary income. While these constraints may not be readily apparent to affluent households, families already struggling to make ends meet feel the effects of rising gasoline prices acutely, with significant consequences for their willingness and ability to buy.

Dermont J. Hayes (1989) illustrates this with the example of an adverse but temporary financial setback affecting an already heavily indebted consumer. "Additional credit may be available," he notes, "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" (p. 2). In such circumstances, consumers become more price-conscious and purchase only basic requirements. The decision to seek additional credit to meet short-term needs is complex and relates to prevailing interest rates, expected changes in the price of durable goods, and the ability to obtain further credit — all of which introduce significant inflexibility into future budgeting decisions (Hayes, 1989, p. 2).

According to Hayes, the intimate relationship between credit availability and the purchase of otherwise routine goods and services can readily be observed in categories such as gasoline and oil, other nondurables, household operations, and various transport services. A plausible explanation is that consumers tend to cut back on travel and household upkeep when their liquidity is low; it is also possible that fewer purchases made by these consumers can be charged to credit cards. Hayes suggests this would also explain why sectors such as clothing, motor vehicles, other durables, and housing services — goods normally regarded as luxuries — tend to maintain or increase their budget 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" (p. 3).

In their study "Dynamic Pricing in Retail Gasoline Markets," Severin Borenstein and Andrea Shepard (1996) note that prior research indicates pricing in retail gasoline markets is not well characterized by standard competitive models, but that U.S. gasoline stations have sufficient local market power to implement price discrimination across gasoline grades or service levels (p. 431). There are a number of theories concerning how gasoline is actually priced in the United States, and several important variables shape the final cost to the typical consumer. According to Borenstein and Shepard, "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" (p. 430). Even the location of the gasoline outlet itself can contribute to both demand and the prices consumers will tolerate (Borenstein, 1991, p. 354). Finally, research suggests that following the terrorist attacks of September 11, 2001, even the potential for shock news events can now compel many American consumers to attempt to "stock up" on necessities, including gasoline (Davis & Hamilton, 2004, p. 17).

Conclusion

The research showed that there are both domestic producers of gasoline as well as international producers; in addition, there are a staggering number of intermediaries and other parties who can manipulate the final price of gasoline to the end consumer to some extent or another (Butz, 1991). The research also showed that even though there are an enormous number of players in the gasoline market and the confounding variables are exceedingly numerous, economists are still able to gauge with a fair degree of accuracy how much driving the average American consumer will be willing to forgo at any given point, based on several known factors concerning how people react to adverse personal or external economic events.

In the final analysis, the typical American consumer may be willing to give up something of minor consequence involving gasoline — such as a discretionary road trip — but it is unlikely that such restraint could endure for any significant length of time. Americans have a deeply ingrained driving culture, and they will continue to purchase gasoline in order to sustain it. The gasoline industry should recognize, however, that the long-term alternatives described by economists as remedies for goods that become too expensive are becoming a reality. Just over the horizon are millions of hydrogen fuel cell vehicles that could render the traditional gasoline business model obsolete. Perhaps this prospect is another reason for the higher prices observed today: the industry may be attempting to maximize revenue while it still can.

Works Cited

Borenstein, Severin. (1991). Selling costs and switching costs: Explaining retail gasoline margins. Canadian Journal of Economics, 22(3), 354.

Borenstein, Severin, and Andrea Shepard. (1996). Dynamic pricing in retail gasoline markets. Rand Journal of Economics, 27(3), 430.

Butz, David A. (1991). Intertemporal resource allocation: Distributive issues surrounding gasoline price hikes. Economic Inquiry, 29(3), 593.

Davis, Michael C., and James D. Hamilton. (2004). Why are prices sticky? The dynamics of wholesale gasoline prices. Journal of Money, Credit & Banking, 36(1), 17.

Hayes, Dermont J. (1989). Incorporating credit in demand analysis. Journal of Consumer Affairs, 23(1), 1.

Kuenne, Robert E. (1968). Microeconomic theory of the market mechanism: A general equilibrium approach. Macmillan & Co.

Renner, Donald E. (2005). Supply and demand: The market mechanism. Retrieved April 14, 2005, from http://kr.mnsu.edu/~renner/supdem.htm.