Microeconomics - Gasoline

In order to decipher the economics concept revolving around the gasoline industry, we must first understand– Ceteris Paribus. This Latin phrase in English means "with all other things remaining equal." Before dwelling into the gasoline market, we assume everything else about that market is being held constant apart from quantity demanded and price.

This peculiar graph, taken from The New York Times, demonstrates the effect of global events on miles driven against price changes.

           

            We’re expected to be driving more when gasoline prices are lower – law of demand. However, the graph shows that there are period when gasoline prices increase, miles driven had increased as well. The reason behind this odd phenomenon is because the graph did not apply ceteris paribus. There are many factors changing, resulting in a mixed result. We have on one hand, where the graph shows a typical demand curve, sloping down - as price decreases, quantity demanded increases. On the other hand, the graph actually shows a shift in demand, influenced by factors other than price.

Demand

Applying the concept of ceteris paribus, the willingness of consumers to pay for gasoline forms the downward sloping demand-curve.

 

Demand-Curve

At every point along the demand-curve, it reflects the quantity demanded at different price level. The shape of the graph suggests that when price increases, the quantity demanded of gasoline decreases. Assuming if consumers are rational, when the price of a good increase, they would buy less amount of that particular good. This shows a negative relationship between price and quantity demanded, and hence the downward-sloping demand-curve.

           

            However, the graph is not in its final form yet. The concept of elasticity has yet to be applied. Elasticity shows the responsiveness of quantity demanded against changes in price. It is important in applying the concept, as it measures the consumption of gasoline over price changes. The calculation on price elasticity of demand can be summarized as followed:

        

       Through a thorough research by Hughes et al (2006) using U.S. per capita gasoline consumption against U.S. retail prices; they concluded the average estimate on price elasticity for gasoline is at -0.55 from 2001 to 2006 per year. (Short-run figure)

          They also concluded another figure by comparing U.S. per capita gasoline consumption over personal disposable income data, these men found out that average income elasticity of demand is at 0.48 from 2001 to 2006 per year. (Short-run figure)

           

             Income elasticity of demand measures the change in % of quantity demanded against the change in % of consumer income. This explains how gasoline consumption adjusts in accordance to the changes in household income. This is another determinant of demand other than price, which proves the type of good and elasticity. If the % change in quantity demanded of a good is higher than % change in income, we assume that good is a luxury good. Summarizing the calculation of income elasticity of demand as followed:

Given the 2 figures above, it is safe to say the demand for gasoline is inelastic and it is a necessity good. With that being said, the new demand curve would be:

Inelastic Demand Curve

According to (Eia.gov 2013), the price of gasoline is $2.61 per gallon in 2006. On the other hand, voelker (2010) calculated the consumption of gasoline to be at 136.51billion gallons in 2006. With the figures in placed, a 10% price increase from $2.61 to $2.87 per gallon would result only a -5.5% consumption in gasoline, decreasing from 136.51 to 129billion gallons.  [Calculated using price elasticity of demand: -0.55]

            The graph is steeper, because of inelastic demand. The change in price of 10% only forced a -5.5% drop in quantity demanded for gasoline. The reason behind this phenomenon, I believe is because there is little to no substitute for gasoline. Gasoline is a necessity, almost every transportation vehicle relies on the usage of it. Vehicles are created in such way that most of them rely only on petrol or diesel to operate. Thus, implying that even with a price increase in gasoline, consumers have no choice but to take up the burden and pay more.  Some may even consider changing to more fuel-efficient vehicles or even “green” vehicles, but these options are just out-of-the-question as they are regarded as more long-run in nature. As it is, consumers are still highly dependent on gasoline and are insensitive to price changes, proving that demand for gasoline is inelastic.

Supply

            Supply in general is upward sloping. As price of a good increase, firms would supply more to increase profit. This is a direct relationship between quantity supplied and price. Taking elasticity into account, my assumption on elasticity of gasoline supply in United States is more elastic. Meaning, a % increase in price will result in a higher % change in quantity supplied. The supply curve for gasoline can then be plotted as followed:

                Elastic Supply Curve

Using figures from demand, firms are supplying 136.51b gallons at $2.61. A 10% increase in price to $2.81 would increase supply by 16% to 158.35b gallons. Elasticity of gasoline supply in the short-run is at 1.61 (Boundless.com n.d.).

           

             Justifying my claim on gasoline supply being elastic, there are several factors which defines price elasticity of supply. The United States houses the largest reserve inventory for crude oil through the Strategic Petroleum Reserve (SPR).  This implies that the United States has storage capacity to buffer for any sudden spike in demand for gasoline. On the other hand, there is also the recent discovery of recoverable oil in North Dakota and Montana's Bakken Formation. Currently, the Bakken Formation estimates to have about 3.65 billion recoverable oil with the current level of technology (USGS Newsroom 2008). The data suggests that with these oils, U.S. can be exempted from oil imports for a year. It is not alot, but the report from EIA claims that Bakken Formation has the potential of churning out 413b barrels worth of resources. The point is, with the availability of these resources, U.S. supply for gasoline can be increased whenever price changes, making supply elastic.

Demand and Supply

            So why is there a need to supply more? The simple answer is because there is an increase in demand. Combining supply and demand together, the intersection between S-curve and D-curve is the equilibrium point that shows the optimum price and output.

              Equilibrium Point

Point A shows that in 2006, the United States gasoline prices is agreed by suppliers and consumers at $2.61 per gallon; and the total production is met by all the demands at 136.51b gallons of gasoline.

            

           Answering my previous question, in 2007 consumption of gasoline amounted to 142.38b gallons of gasoline (Eia.gov 2013). This is about a 4.4% increment from 2006's figure of 136.51b. I believe the main factor contributing to this increment is due to population growth. From 2000 to 2007, U.S. population growth is at 7.16% (Geomidpoint 2007). This would mean more people is on the road, more gasoline consumption, and more gasoline demand.

                       Shifting Demand

           

What we actually see in the graph is a shift in demand from D to D1. Now that there is a higher demand, gasoline firms would supply more to meet higher demand causing price to increase from $2.61 to $2.68 (Assuming elasticity of supply stays at 1.61).

                    New Equilibrium

Looking from point A to point C, if the price of gasoline were to stay at $2.61 per gallon, a shortage would occur. This is because at point C, many people are still only willing to pay at $2.61 per gallon, but firms would only supply more gasoline at a higher price. Hence, there is a movement from C to B, some people are unwilling to pay more, resulting in less quantity demanded. Firms are supplying more now at a higher price $2.68 per gallon, and the movement along the supply curve point A to B shows the increasing supply to meet new demand. Point B is now the new equilibrium point, firms and consumers agreed on a price at $2.68/pg and the supply and demand of gasoline would meet at 142.38b gallons.

           

            This brings us back to the very first graph, when gasoline price increase the miles driven has increased as well. We now understand that the reason behind this odd phenomenon is because of a shift in demand. By increasing gasoline demand, the price of it increases as well.

           Cross checking my calculated figure and EIA's report, the price of gasoline in 2007 is actually $2.843 per gallon. There are a number of reasons that contributed to the price difference. Firstly, taxes play a major role in U.S. gasoline prices. My calculations were inclusive of taxes but taxation variates year by year.  

Federal Gasoline Tax by year

From 1997 to 2007, there is little to no fluctuation of gasoline tax, so maybe tax was not the issue.

            Moving on, the other factor that can contribute to price difference is price of crude oil. Since gasoline is produced by refining crude oil, we are actually demanding for crude oil. However, we must not forget that there are cost for refining and distribution as well. When we demand for more crude oil, suppliers would have higher marginal cost in the production of gasoline. Refining an extra 6 billion gallons of crude oil requires more labor, capital, and refinery capacity. Not to mention, the process of distributing them all over the country will take up money and time as well. These additional cost would then be redirected to us as consumers, through a higher price.

We are actually paying for crude oil, refining and also taxes in a gallon of gasoline. The root of all these cost is demand. As our demand for gasoline rises, all these cost would increase as well.  

Summing up price changes due to these additional costs, it explains the difference in my calculation and the projected price. I would like to stress on demand again, as it is the key to all increasing gasoline prices.

References

Bonsor, K. and Grabionowski, E. 2001. HowStuffWorks "OPEC and Global Gas Prices". [online] Available at: http://auto.howstuffworks.com/fuel-efficiency/fuel-consumption/gas-price3.htm [Accessed: 7 Jun 2013].

Boundless.com. n.d.. Definition and Determinants - Elasticity of Supply. [online] Available at: https://www.boundless.com/economics/elasticity/elasticity-supply/definition-and-determinants/ [Accessed: 7 Jun 2013].

Eia.gov. 2013. U.S. All Grades All Formulations Retail Gasoline Prices (Dollars per Gallon). [online] Available at: http://www.eia.gov/dnav/pet/hist/LeafHandler.ashx?n=PET&s=EMM_EPM0_PTE_NUS_DPG&f=A [Accessed: 6 Jun 2013].

Gaspricesexplained.org. 2008. Why Are Gas Prices Rising?. [online] Available at: http://gaspricesexplained.org/#a-global-commodity [Accessed: 6 Jun 2013].

Hughes, J., Knittel, C. and Sperling, D. 2006. EVIDENCE OF A SHIFT IN THE SHORT-RUN PRICE ELASTICITY OF GASOLINE DEMAND. NBER WORKING PAPER SERIES, (Working Paper 12530), p.3, 4. Available at: http://www.nber.org/papers/w12530.pdf?new_window=1 [Accessed: 3/6/2013].

Voelcker, J. 2010. U.S. Gasoline Usage Peaked In 2006, Will Plummet In Future. [online] Available at: http://www.greencarreports.com/news/1052787_u-s-gasoline-usage-peaked-in-2006-will-plummet-in-future [Accessed: 7 Jun 2013].