Thursday, April 28, 2011

Inessential Yglesias -- understanding the elasticity of oil demand

I'm afraid I'm going to have to differ with Joseph on this one. This piece from Matthew Yglesias manages to leave out most of the good stuff from this excellent post by Adam Ozimek.

For example:

However there are important caveats to these estimates that suggest the real current elasticity is higher. First, the evidence has indicated that the response of demand to price changes is asymmetric: price increases cause a larger response to demand than price decreases. This is because price increases are more likely to cause shifts to newer, more energy efficient technologies than price decreases are to undo such shifts. Any estimate of the average price elasicity then will be a downward biased estimate for the likely response to a price increase.

A recent paper by Davis and Killian The Journal of Applied Economics covers some other econometric issues in the literature. For instance, we know price and quantity demanded are jointly determined, which means that there will be a correlation between the price variable and the errors such that single equation or panel data methods, like those used in the reported IMF estimates, will bias estimates towards zero. Some studies attempt to use exogeneous oil shocks as instrumental variables. This approach is used in the appendix to the IMF study. But this requires the assumption that consumers will respond the same to these shocks as to normal real price appreciation. If consumers expect shocks to be more temporary than a demand led increase in price, this is a questionable assumption.

To understand why this is such an important point, we need to step back and discuss why we choose certain analytic approaches in certain situations, specifically why we shouldn't think about elasticity of demand for gasoline the same way we think about it for fruit juice.

[brief warning: I'm a statistician, not an economist, so the terminology here might not be what you'd hear in INTRO TO ECON, but I suspect the underlying concepts will be basically the same.]

Let's discuss demand in terms of decisions. If I go into the grocery store thinking I'd like some orange juice I almost certainly have some threshold price X in mind. If a carton of juice costs more than X, I won't buy orange juice that day.

Assuming I don't have some sort of weird Minute Maid fixation, doing without juice is probably not a big deal. My consumption is determined by a single simple (rather than complex) decision.

[brief warning II: I'm assuming, for the sake of simplicity, that all the grocery stores and gas stations available to me charge roughly the same prices for comparable items.]

By comparison, my consumption of gasoline is determined by a complex set of decisions spread out over a long time and based on anticipated gas prices. Of these decisions, the impact of the one that's analogous to the OJ decision (go to the store and check the price) is trivial next to choosing where do I live, where do I work and what kind of vehicle do I drive.

Even if there is a there happens to be a hurricane or a revolution at the exact time I'm making one of those decisions and gas is at five dollars a gallon, I probably won't bother factoring that in. Trying to estimate the impact of temporary and unpredictable events is a game best left to the specialists.

But let's say that the five dollar price is the result of a recent buck and a half increase in the gas tax and I only see it going north from here. Now five dollars a gallon is starting to look like a floor instead of a ceiling and I am much more more likely to look at MPG and commuting distance when I make my decisions.

Or, in other words, pretty much what Ozimek said.

1 comment:

  1. I think we are closer than you think. I liked the point that, even if gas taxes do not change use much then they are are still socially useful (to raise revenue). This was a good counterpoint to people like Megan McArdle who were arguing that because there was no elasticity that we should abandon the idea. Because if there is no elasticity then it is a perfect taxable good, so it'd still be good to tax.

    I think that you are arguing that it is implausible that they won't reduce demand, which I agree with.

    But it was just cool how, even if the poorly thought out research held up, that it would just create another (equally valid) reason for the tax. Anti-gas tax types really need a new argument. :-)