I had a discussion with a coworker the other day on the dynamics of oil price and demand response. One of the arguments that she brought up highlighted a critical point in the debate over peak oil. A common argument against the idea that the world will someday simply run out of oil, or that efforts to find alternatives now are counterproductive, is that price signals will soon do their part to "crush" demand such that existing supplies will last longer and more alternatives will be found before there is a catastrophic drop in production.
This is a possible outcome under the law of demand, which states that as the price for a good rises, the quantity demanded will drop (i.e. demand curves have a negative slope). However, it depends heavily on just how much the quantity demanded responds to changes in price. This property, measured by the price elasticity of demand, is the key to understanding the magnitude of these effects. It turns out that the price elasticity of demand for gasoline is remarkably well-studied in the empirical literature. However, even most people with a reasonable understanding of the subject may have missed out on recent work that suggests that the American predicament is more dire than in previous years.
To properly define the price elasticity of demand, we would have to use calculus. In lieu of that, I'll simply note that price elasticity of demand is given as a dimensionless number between 0 and negative infinity. For a 1 percent increase in price, demand will fall by a percentage equal to that price elasticity number. So, for example, suppose the price of strawberries goes up by 1 percent and the price elasticity of demand for strawberries is -0.5. Then the quantity demanded of strawberries will fall by 0.5 percent.
It is important to note that the elasticity of demand is largely dependent on factors that are exogenous to a conventional understanding of a market. These include brand loyalty, income effects, ability to substitute other goods, and the good's status as a luxury or necessity.
In addition, the price elasticity of demand will vary depending on the current point on the demand function. To demonstrate why, consider that if the price of strawberries is $50 a bushel, a 1% increase will mean a lot more than if the price is $1 a bushel. It's not just a function of the actual change in price, either: at $50 a bushel, it may well not matter to people if the price goes up, because they need their fix. At $1 a bushel, the price going up would signal to people that they may not want the tenth box. This latter effect tends to dominate, as has been shown in many substantial economic experiments. Either way, if you plot a demand curve on a Price-Quantity graph, the farther to the right you are (and the lower the price level), the higher elasticity gets, and the farther to the left you are, the lower elasticity gets.
Now, we can talk about gasoline.
Most studies of the price elasticity of demand for gasoline were conducted in the 1970s and 1980s in the wake of the oil crises of that era. Sudden increases in price and energy statistics compiled by the newly formed US Department of Energy's Energy Information Administration (which, by the way, is still a superb source of information) gave economists a laboratory for measuring price elasticity. Two good meta-analyses of their results can be found here and here. The picture that these two papers present is of short-run and long-run demand elasticities of between -0.25 and -0.26 (short run) and between -0.58 and -0.60 (long run).
Why do the short run and long run efficiencies vary? Probably because the short run changes are driven by consumption choices. One could choose to call off the road trip or bike to work instead of taking your car in the face of high gasoline prices. However, in the longer run people can change their capital allotments, meaning moving closer to work or other necessities, buying a more fuel efficient car, or what have you.
But on to what the numbers mean: On the face of it, they aren't good. Those elasticities fall firmly into the inelastic category, generally defined as being between -1 and 0. Quantity demanded will not fall as much as the price rises. Why? I can't give a definite answer, but it's probably because as our main transportation fuel, gasoline is something that we'll sacrifice other bits of our consumption to continue purchasing. Anybody who's been feeling the price squeeze and not getting a new plasma TV set, not saving, or what have you because they spend $200 a month more on gasoline should understand this effect.
On the other hand, for those of us worried about running out of oil, those numbers seem to be reassuring. It isn't so bad to imagine that after about 5-6 years, a 10 percent increase in prices will cause a six percent drop in consumption. Not bad at all. Of course this is an irresponsible generalization, given that I've already pointed out that price elasticities change depending on your position on the demand curve, but we could imagine that doubling the price would cut demand down to 60 percent of its size, still leaving plenty of room for economic growth!
At this point, alarm bells should be ringing in your head. Why? Well, because gasoline prices have done precisely that over the last ten years, and there is no way that such a thing has happened. This is because those price elasticities measured in the 1970s and 1980s represented a snapshot of American infrastructure, society, and technology in that era. More recent work paints a picture more in keeping with reality.
The economists at the University of California, Davis published this paper in 2006 that presents a very stark alternative picture. Their measured price elasticity of demand for the period between 2001 and 2006 has values between -0.034 and -0.077. In fact, the price elasticity for the entirety of that period appears to be stable at approximately -0.04. This is the meat behind statements such as this one from back in 2005. It is also consistent with the data you find at the EIA. The implications of such a low price elasticity are dire. For a doubling in price, demand will only decrease about 4 percent. Four percent! It is extraordinarily obvious that price mechanisms are simply not enough to encourage less fuel consumption. People have demonstrated that they will shift their income from other sources towards maintaining their fuel consumption over almost all other things.
What does this mean about America's current state? There are some possible explanations. It may mean that in part, as a society we are even more dependent on gasoline-fueled cars for transportation than we were in 1970 and 1980. This might be explained by more suburbanization. In part, it may also due to the fact that much of the low-hanging fruit of the 1970s and 1980s for increased fuel efficiency has been picked. We no longer make our cars out of 1/4" Detroit steel, we use lighter polypropylene. People have started driving smaller cars using more efficient routes. A final explanation may be that we simply cannot reduce the number of miles we travel any more.
Whatever the cause, it is absolutely clear that demand will not die. The price level that will successfully "crush" demand to 50 percent of its current level, at those elasticities, will entail an increase of 12.5 times the current price - in California, $60 a gallon! And remember, as prices increase, elasticities tend to decrease, which means that the likely level is even higher. No, price signals will not decrease American demand enough to justify little to no investment in alternative fuel sources and sustainable infrastructure.
And remember that these statistics alone concern the United States, where fuel consumption can, these days, be reasonably approximated as static. Here, fuel consumption has actually decreased as price levels have increased because the country's economic growth-driven fuel consumption has not been enough to outpace demand reduction. What will it take to kill Chinese demand, they of the 10 percent annual growth? No, it seems that all the empirical literature indicates that people, especially Americans, will continue using gasoline until the bitter end.
There are some out there, Daniel Yergin being the most prominent among them, that believe that price elasticities are high enough that we will see real reductions in demand enough so that production will be enough for people to continue consuming for the next century. Without taking a look at the latest work and getting a serious reality check, these people are going to find themselves in the position of Austin Powers facing his knifed, shot, bazooka'd, and defenestrated would-be assassin.
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