EclectEcon

When crude oil prices rise, gasoline prices rise, too. But not all the cost increase can be passed on to consumers. At least not without affecting the quantity of gasoline that people buy.

• When prices rise, the quantity demanded falls. Demand curves are downward-sloping. This is the "law of demand".


• People respond to incentives.

The oil companies can try to pass on the cost increases, but they cannot make consumers buy as much gasoline as they did before. My point is that gasoline is not a necessity. When it becomes more costly to use gasoline, people find substitutes, and they actually tend to do so fairly quickly, especially if they expect the price increases to persist.

• They buy smaller cars.
• If they have two cars, they begin to use the smaller car more often.
• They bicycle more.
• They walk more.
• They make greater use of public transportation.
• They take fewer trips.
• They make shorter trips.
• They move closer to work or closer to public transportation connections.

And all these things that economists have been saying for decades have been confirmed. From the USA Today,

Americans drove 30 billion fewer miles from November through April than during the same period in 2006-07, the biggest such drop since the Iranian revolution led to gasoline supply shortages in 1979-80.

The numbers released Wednesday may reflect more than a temporary attitude change in consumers toward high gas prices, Transportation Secretary Mary Peters said. Previously, she said, "people might change their pattern for a short period of time, but it almost always bounced back very quickly. We're not seeing that now."

... "It's not a blip," said Marilyn Brown, professor of energy policy at Georgia Tech, citing data showing surging transit ridership, dropping sales of sport-utility vehicles and sharply increased demand for gas-efficient vehicles. "I think the difference between now and 1979, when prices were comparable when you adjust for inflation, is there's a sense of sustained pain. There's a sense that the era of cheap energy is a thing of the past."

Clearly an important determinant of the price elasticity of demand for gasoline is the expectation that people have about future prices. If rising prices create an expectation that prices will soon fall back to their previous levels, and if it is costly to change consumption patterns, then the price elasticity of demand will be quite low. But if rising prices create an expectation that prices will remain higher and will likely even rise some more, then people will begin to undertake the costly changes in their consumption patterns.

After Katrina, gasoline prices were about as high where I live as they are now. But back then, we all expected the high prices were a temporary blip, and so we did not alter our consumption patterns very much. But this time, when people expect gasoline prices to remain high, people are changing their consumption patterns.

Addendum: Quite clearly, this difference in expectations helps to explain the higher short-term price elasticities from 1976-1980 than from 2001-2006. See this from former student, Paul Kedroski.