July 28, 2008

Invisible Hand At Work

Americans are, at last, driving less. This is almost undoubtedly due to the continued increase in the retail price of gasoline. Things have even declined moderately recently, but I still paid $4.20 a gallon at Costco today (California is usually about $.25 more than the national average) and I'm feeling the bite despite staying very local (only one out of town trip for several months, and that was just to the Valley). Nearly everyone I know or speak to has complained that increases in gas costs have begun to impact their lifestyles, even people who are still dong well financially. For some people facing greater financial challenges, they are having to make some hard choices about how to subsist.

A little bit of research reveals some interesting numbers. I've compared the number of miles driven on U.S. highways to the national average price of regular unleaded gas going back to 1990 (using data from the links above). It's useful to see the numbers side by side, I think. I've also adjusted the price of gas for inflation (using 2007 dollars), although that's a dicey proposition -- the price of gas is itself an inflationary pressure on the economy. But there was other inflationary pressure going on all this time, and as you can see, when you adjust for inflation, the real price of gas fell during the 1990's and didn't really start its huge climb until 2003. Finally, I include a number I've computed called "elasticity" which is the product of demand (as measured in total road usage) divided by the inflation-adjusted cost of gasoline. I've assumed no inflation between 2007 and the present point of 2008, although that's obviously not going to be quite accurate. Here's the data:

YearMillions of
Miles Driven
Average Price
(Raw Dollars)
Average Price
(2007 Dollars)

Now, that tells you something. At least, it tells me something. What I think, looking at this data, is that the real breaking point of price to demand is somewhere around $2.75 a gallon (in adjusted 2007 dollars). I say this because demand for driving time remained pretty close to constant from the previous year in 2007. Before that, the demand for gasoline (as measured in number of miles driven) increased each year no matter what happened to the real price of gas.

My "elasticity" number is also useful, although I haven't bothered to determine if simple division is the actual way an economic would figure out price-demand elasticity. Still, it provides a rough index of price to demand and it gives us an understanding of the shape of the demand curve. Comparing real price to the elasticity of the demand curve, we see that price and elasticity passed one another in 2005, and the trend since then has been to drive less. We're only noticing it now because the people who would have been first affected were the people with the least amount of money to spare, and it's taken since then for the impact on demand to make itself felt. The tipping point, when the change becomes dramatic enough to change the flow of overall demand on the market as a whole, looks like it happened which real prices exceeded $2.75 a gallon or so.

So I'm going to have to modify some of my previous opinions. It looks like the demand curve for gasoline is a little bit more gentle than I'd thought; it's just that measuring the impact of rising gas prices on demand for gas turns out to be a bit more complex than I'd initially thought. But in 2007 we passed the point that the curves became steep enough to change the direction of the market, and demand has begun to decrease. This suggests to me that equilibrium will be reached sooner rather than later -- either that, or we are hitting the point at which the pain at the pump has been felt far enough up on the economic food chain that the "kink" in the curve has been reached.

The good news? If I'm right, prices will not rise that much more from where they are now. We will not see $5.00 a gallon gas soon, at least not until inflation indexes the raw price up to that level. The bad news? This is equilibrium. Right now, baby. The price isn't going to fall very much from its current national average of about $3.90 a gallon. Pretty much ever.


zzi said...

"The price isn't going to fall very much from its current national average of about $3.90 a gallon. Pretty much ever."

Please be wrong

Burt Likko said...

If current market conditions are the result of some sort of artificial inflation in the price of oil, then I would be wrong. But it seems to me that the oil industry, both globally and locally, is pretty competitive. What you see is more likely to be the market price than not.