Econ 1101/1165—Reading 2

International Application

Fuel Consumption in Europe and the United States

And Long-Run Elasticity of Demand

By Thomas J. Holmes, Dept. of Economics, University of Minnesota

September 5, 2022

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In class we are learning about demand. This case study discusses the demand for gasoline. It attempts to make some (very rough!) estimates of the long-run demand elasticity by making a cross-country comparison. As you will see in Homework 3, gasoline in European countries is taxed significantly more than here in the United States. We can use this tax-induced price variation to explore how demand responds to changes in price. In making a comparison such as this, we always need to be wary that there are other differences besides price that impact demand that also need to be taken into account. The case study will touch on these issues but not get into them in detail. (Fully addressing these issues requires knowledge of the empirical tools of economics called econometrics that you can learn in advanced classes.)

The Short-Run Demand Elasticity

Let’s put aside the long run for a moment and start with a discussion of the short run. Among other things, the demand for gasoline depends upon the kinds of cars people drive, how far people live from work, and the existence of public transit alternatives such as buses or rail. It takes many years to change all of these things. In the short run, these things are fixed. To produce an estimate of the short-run elasticity, we will look at demand responses to price changes over relatively short time intervals, when the nation’s stock of automobiles and rail networks hasn’t had much time to change.

We will actually look at three different episodes and produce three different estimates. The first is a big run-up in gasoline prices that happened between early 2007 and 2008 (right before the economy crashed in last 2008). The second is the big decline in gasoline prices that happened in 2015. The third is the big run-up in gasoline prices experienced in 2022.

Our First Estimate: The Run-up in Oil Prices Just Before the 2008 Great Recession

There was a substantial run-up in 2008 in the price of a barrel of oil; it cracked the $100 barrier and then went well above it. The standard explanation for this run-up in price is that it was being driven by increases in demand for commodities by China. In June 2007, oil prices were $65 a barrel. A year later, oil was $121 a barrel. Changes in the price of oil lead to changes in the price of gasoline. (There are 42 gallons in a barrel and a $40 increase in the barrel price of oil roughly corresponds to a $1 increase at the pump.) The following table shows prices of gasoline and consumption in June for these two years: (The sources for all data used here are described at the end of the case study.)

Table 1(a): Price and Per Capita Quantity Consumed of Gasoline in the United States

The Month of June for 2007 and 2008

Time Period	Per Capita Daily Consumption of Motor Gasoline	Average Price Per Gallon in Dollars
June 2007	1.32	3.05
June 2008	1.26	4.07
Δ	–0.06 = (1.26 – 1.32)	1.02
Average of Both Years	1.29 = (1.32+1.26)/2	3.56
%Δ	–0.05 = –.06/1.29	0.28

Gas prices increased by $1.02 over the period. Consumption fell, but only by a small amount. We can use this data and the midpoint formula to calculate an estimate of the short-run elasticity for gasoline. We first calculate the change in the quantity and price. (We use the Greek letter “Δ” to denote “change”) Next we calculate the average over the two time periods. Next we take the change as a percent of the average. The final step is

Elasticity(short run) = %ΔQ/%ΔP = 0.05/0.28= 0.16

Note that we dropped the minus sign. The price elasticity of a good is negative so for convenience we don’t carry around the negative sign when we discuss it. (But note that some of the other elasticities, like the income and cross-price elasticities, can be positive or negative and for these it is important to keep track of the sign.) According to this calculation, the short-run elasticity of the demand for gas is significantly below one. The change in quantity is small compared to the change in price. As gas prices shot up in 2008, consumers were stuck in the short run with the cars they purchased when gas prices were lower. If an individual needs to get to work and driving an SUV is the only option, the individual will pay the higher price and buy the gas needed to get to work. But the next time that person is shopping for a car, he or she will typically choose a more fuel efficient vehicle.

A short-run elasticity of this magnitude is consistent with previous research in economics. The back-of-the-envelope calculation made above is simple and leaves out much that would be taken into account in a sophisticated econometric study. Nevertheless, the calculation does take into account some basic things. First, there is an important seasonal element to demand for gasoline. For example, demand picks up in the summer when people travel. The calculation deals with this by keeping the month fixed: June 2008 compared with June 2007. Second, demand depends upon population and this grows by about one percent each year. The calculation deals with this by using Census data on population for each year to derive a per capita consumption level. Third, income can change from one year to the next and income impacts demand. We all know about the economic crisis and this has had an impact on demand for gas. The main impact of the crisis on national income happened after June 2008, so the difference in income between June 2007 and June 2008 is relatively small. If instead we compared Dec 2007 with Dec. 2008, the differences in income would be more significant, as the crisis was severe by Dec. 2008.

Here is a good question that always comes up: Why is this exercise of comparing price and quantity over two different periods is a movement along a demand curve and not a supply curve? The two key points in the answer are (1) we are focusing on the short run demand of the United States which we have just argued was relatively stable, and (2) demand of developing countries did change over the period, driving up the world price of oil. This increase in the world oil price, driven by factors external to the U.S., shifted up the supply curve of gasoline in the U.S., providing us with the movement along the demand curve that we need to estimate the elasticity.

Episode Number Two: Thanks North Dakota for Cheap Gas!

Oil prices have collapsed going into 2015. The standard explanation is that it is due to the success of new technologies for the fracking of shale oil deposits (including in particular the production of our neighboring state, North Dakota). This downward shift in the supply curve of oil provides us with another opportunity to examine a movement along the U.S. demand curve. In the following table, we repeat the earlier exercise, using the numbers for June 2014 and June 2015.

Table 1(b): Price and Per Capita Quantity Consumed of Gasoline in the United States

The Month of June for 2014 and 2015

Time Period	Per Capita Daily Consumption of Motor Gasoline	Average Price Per Gallon in Dollars
June 2014	1.18	3.70
June 2015	1.25	2.78
Δ	0.07 = (1.25 – 1.18)	−0.92
Average of Both Years	1.22 = (1.18+1.25)/2	3.24
%Δ	0.06 = .07/1.22	−0.28

Dropping the minus sign, the estimated elasticity is

Elasticity(short run) = %ΔQ/%ΔP = 0.06/.28= 0.20.

Our new estimate of 0.20 is relatively close to our first estimate of 0.16. (This is pretty good since these estimates should really be thought of as “back of the envelope” calculations.)

Episode Number Three: Russia Invasion of Ukraine Drives Up Oil Prices

After Russia invaded Ukraine in late February 2022, world oil prices immediately jumped from about $90 a barrel to $120 a barrel. There were some downward fluctuations after that, but by June oil was back to $120 a barrel and retail gas prices were over $5.00 a gallon. Repeating what we did before with June to June calculations, we get

Table 1(c): Price and Per Capita Quantity Consumed of Gasoline in the United States

The Month of June for 2021 and 2022

Time Period	Per Capita Daily Consumption of Motor Gasoline	Average Price Per Gallon in Dollars
June 2021	1.154	3.15
June 2022	1.128	5.06
Δ	–0.026 = (1.128 – 1.154)	1.91
Average of Both Years	1.141 = (1.154+1.128)/2	4.12
%Δ	–0.022 = –.026/1.141	0.46

We see a huge price increase. We see a small quantity decrease. Again, dropping the minus sign, the estimated elasticity is

Elasticity(short run) = %ΔQ/%ΔP = 0.022/.46= 0.05.

This is a lot smaller than the first two estimates of 0.16 and 0.20. At this point, we need to talk about the elephant in the room: COVID 19. Between June 2021 and June 2022, there was significant progress in the economy in terms of recovery from COVID. The recovery from COVID can be expected to shift the demand curve for gasoline up and to the right. Happening at the global level, the COVID recovery has been a force driving up world oil prices.

This discussion suggests that our estimate of 0.05 likely underestimates the true short-run demand elasticity, because it does not take into account demand shifting out because of the recovery. The estimates from June 2007-2008 and June 2014-2015 are likely better ones to focus on. Even though the estimates from the earlier periods are not perfect and surely leave out things, it is unlikely that they are leaving out anything as big as the economic recovery from COVID.

The Long-Run Elasticity

To estimate the long-run elasticity, we need to make comparisons in which differences in prices have been maintained over a long time, long enough so that consumers have had time to adjust their decisions about what kinds of vehicles to drive and where to live. For many decades, gasoline has been taxed heavily in Europe compared to the United States. So let’s look at how consumption in Europe compares with consumption in the United States.

Table 2 reports data from 2007 for the United States and selected countries in Europe (plus a few additional countries that we will mention below.) The table reports the average retail price throughout the year, including all taxes. The exchange rate is used to convert foreign currencies to $US. The table also reports Gross Domestic Product per capita which we use as a measure of income. A “Purchasing Power Parity” method is used to convert foreign income to an equivalent spending power in the United States. In the last column, the table reports per capita consumption of gasoline.

Table 2

Price of Gas, Consumption of Gas, and Income for Various Countries

For Year 2007

Country	Average Retail Gasoline Price (Reg. Unleaded) $US per Gallon	Per Capita Income (GDP, PPP method)) $US in 1,000	Consumption of Motor Vehicle Gasoline Per Capita Gallons Per Day
United States	2.80	45.5	1.29
Selected Countries in Europe
Norway	7.00^*	51.9	.30
United Kingdom	6.90	35.7	.28
Germany	6.88	34.3	.25
France	6.37	32.7	.15
Spain	5.13	31.6	.15
Italy	6.50	30.4	.21
Some Other Countries
Japan	4.49	33.6	.33
Mexico	2.45	14.0	.29
China	2.29	5.3	.04^**

Let’s look at the European countries first. All of the countries are similar in maintaining high prices of gas through high gas taxes. In several places, the price is at or close to $7.00 a gallon. Next look at income. The countries are sorted from highest to lowest in per capita income. Norway is the richest and next is the UK and Germany. There is a pattern here: the richest European countries consume the most gas. In particular, Norway is the richest and its consumption is the highest. This pattern is to be expected. Gasoline is known to be a normal good, i.e. consumption increases as incomes rise. This pattern can be most readily seen by looking at China at the bottom of the table. It has the lowest price of gas of all of the countries but its per capita consumption is miniscule, only .04 gallons per person. The reason? It is still a poor country ($5,300 per capita income) and relatively few households own cars. The impact of income on gasoline demand is biggest at the threshold where households switch from having no car to having one car. Based on China’s growth trajectory, we can expect that the car ownership rate in China will be increasing substantially in the near future and that the demand for gasoline will increase substantially along with it.

To obtain an estimate of the long-run price elasticity of demand, we need to determine what happens when prices are different over a long period of time, but other things that impact demand are held fixed. Let’s compare Norway and the U.S. because the incomes are very similar, so we are at least holding income fixed in the comparison.

Table 3: Price and Per Capita Quantity Consumed of Gasoline

The United States and Norway in 2007

Time Period	Per Capita Daily Consumption of Motor Gasoline	Average Price Per Gallon in Dollars
United States	1.29	2.80
Norway	0.30	7.00
Δ	-0.99	4.20
Average of Both Years	0.80	4.90
%Δ	-1.24	0.86

Using the above table we can construct an estimate of the long-run demand elasticity.

Elasticity(long run) = %ΔQ/%ΔP = 1.24/0.86= 1.44

This estimate is quite large; it is well over one. According to this estimate, demand for gasoline is quite responsive to price over the long run. This is quite different from our earlier estimates of 0.16 and 0.20 for the short-run elasticity.

This is an interesting back-of-the-envelope calculation, but some important issues are being left out. One is that Norwegians tend to have better access to public transit than Americans do. Think of this as Norway having a lower price for a substitute good. This factor contributes to the lower demand for fuel in Norway, so our estimate overstates the true price elasticity of demand. In other words, if we tax gas in the United States to raise the price to $7 like in Norway, but leave public transit options the same (so they continue to be worse on average than in Norway), we won’t end up with fuel consumption rates that look like Norway (.3 gallon per person per day). But what if the revenues from higher fuel taxes were used to finance public transit infrastructure improvements? Good question… In any event, there is no question that if gas prices were raised to $7 a gallon in this country, people would be very interested in fuel efficiency when shopping for cars.

Data Sources

Data on energy use and prices is available from Energy Information Administration of the Dept. of Energy (http://www.eia.doe.gov/). The monthly consumption variable used in Table 1 is the variable “U.S. Product Supplied of Finished Motor Gasoline.” (For Table 1(a) we use the monthly average as earlier reported, while for Table 1(b) we use the four-week average for the last available date in June of each year, as is currently reported.) The monthly price information is from the August 2009 Monthly Energy Review. For Table 2, the price information is from Retail Motor Gasoline Prices in Selected Countries, 1990-2008. The consumption information by country is from the EIA International Energy Statistics Program. The population data and per capita GDP data is from the OECD Stat Extracts program.