A Kinky Thought About High Gas Prices

If you live in a part of the U.S. with a lower cost of living than Southern California (and there are quite a few such regions) then you may not be paying four bucks a gallon. Yet. Fact is, $4.00 a gallon days are here, just in time for the summer driving season.

Political Animal suggests that we may be experiencing an oil bubble, the same way that housing prices bubbled and stocks bubbled before those markets crashed. I'm not so sure; the thing about a bubble is that it eventually pops. A bubble happens when demand on the market increases faster than the actual demand for the product in question, and eventually reality catches up and the bubble pops.

What we're experiencing, I think, is the fact of irreversibly increased demand for petroleum-based fuel. Basic, functionally undebatable microeconomics tells us that increased demand, given a constant supply, creates an equilibrium of increased prices. That leads me to a dismal and Euro-centric conclusion.

On that point, Megan McArdle offers what I think is a pretty good microeconomic analysis of the situation. She points out that 1) there are several things limiting the amount of gasoline on the market, including crude oil supply, pumping capabilities, logistics, and refining capacity; and 2) demand for gasoline is functionally inflexible. In other words, the overwhelming majority of consumers are going to continue driving and therefore buying gas, no matter what it costs. The first point is reflected in her sharply-kinked demand curve -- after a certain point, it doesn't matter how much money the oil companies can make selling it, there just isn't going to be that much more to sell. The second point is reflected in her nearly-vertical demand curve -- it doesn't much matter how much it costs, the demand for gasoline is going to remain about the same. Please read her whole article -- it very nicely explains why the proposed gas tax holiday is really just a 18.4-cent-per-gallon subsidy for gasoline refiners which would offer no price relief whatsoever to consumers -- but I reprint her chart here because it so eloquently describes the "kink" in the supply curve:


There are lots of reasons why it should be the case that the demand curve is nearly vertical. A powerful reason is that vehicles are "durable goods," and it takes a fair amount of time and expense for consumers to switch to more-efficient models. There is also the issue of local geography and availability of other products and services -- if you have to drive twenty minutes to Wal-Mart, you're probably going to be doing a lot of driving because logistically, there is no other efficient alternative.

Prices are rising because that blue curve has been shifting to the right of the graph relative to the green supply curve, reflecting an increase in global demand for the product. The curve isn't changing (that would be what would happen if consumers' preferences altered) and the supply curve is a constant because supply, also, is limited by a variety of very inflexible matters (like the number of refineries in the world).

And remember that demand is not just limited to the United States. Our demand seems to be levelling off after rising by more than a million barrels a day -- nearly a 15% increase in our gasoline demand -- since 1996. (Which is functionally all being used to operate our vehicles and heat some of our homes in the northeast in the wintertime.) It's global demand that's driving the market, folks, not domestic.

But, I don't think Ms. McArdle's chart gets it quite right. The demand curve does eventually bend more appreciably to the left, but it will only do so when the price of fuel has reached a very, very high point, when demand will start to drop considerably. This is the point when people simply cannot afford to buy fuel at all, so I suspect that this curve "kinks" almost as precipitously as the supply curve:

The trick, of course, is to figure out what the price is when the kink in the demand curve be reached. Here, Europe provides a guide. A few years ago on our honeymoon, The Wife and I rented a little three-banger, not much bigger than a Smart Car, to drive from Venice to visit some of my relatives who live on Italy's west coast, a little bit north of Pisa. Stopping at the petrol station, the gas was a little bit more than two Euros a liter, and the Euro was going for about a buck twenty back then. Do the math -- between the currency exchange and the sales cost, it was somewhere between five and six dollars a gallon -- three times what we were paying back home. So I got back into the car after paying and The Wife said, "You just paid about a hundred dollars to fill up the car." She was stunned at the price. "Yeah," I said back. "Welcome to Europe." That was in 2004. The reason for the higher prices were the fact that European nations taxed gas sales at a much higher rate than the U.S. did. Which is still the case.

Now, of course, we're paying those kinds of prices here. Our European counterparts are surely paying proportionally higher prices still. But even back when I was visiting Europe more or less annualy to see my parents, it seemed to me that there was much the same level of driving going on there as there was back in the States, despite the high prices. I'd often wondered, "How to the Euros do it? Gas costs three times as much but Euros still seem to drive as much as we Americans do." This seemed true for both well-to-do Europeans as well as those who were more or less just getting by. The reason, it is now apparent to me, is that the utility of driving was so great that they chose to absorb the relatively higher cost of gasoline to behave like Americans.

So we will see the price-to-demand curve reach its demand equilibrium in Europe first, and the signal will be when there is noticeably less driving going on there and prices stop rising there. That will be the price at which the demand curve shift so far to the right that its kink intersects the steep, vertical part of the supply curve:
That is when prices will finaly stop rising. Gas will be painfully expensive, enough so that very poorest levels of society will have to actually cut back on consumption because they won't be able to afford to buy it at all.

After this happens in Europe, it will take some time before the price rises to that same point in the States, because of the relatively higher level of taxes in Europe means the market price of gas has been artificially inflated there. And when prices here do rise to that point, the money will go, proportionally, more to the profit of the various oil and oil-service companies than to taxes.

A dismal thought, I'm sure. But I can't see how this gets avoided, short of something miraculously changing the demand curve like affordable and widely-distributed electric or hydrogren-burning car motors. So even more dismally, the economic impact of fuel costs is such that I cannot imagine how we can go through this economic shift without a significant round of inflation.

P.S. Praying for it to change isn't going to help.