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Brooks Wilson's Economics Blog: Using Supply and Demand to Illustrate How Policy Impacts the Gasoline Market

Tuesday, March 20, 2012

Using Supply and Demand to Illustrate How Policy Impacts the Gasoline Market

Voters’ blood pressure has soared as rising gasoline prices have hammered their budgets. Many heap blame on President Obama as they have on past presidents for events that occur under their administrations, perhaps because politicians running for office claim they can fix all problems. Seizing an opportunity to win votes, Republican politicians blame President Obama’s policy for rising gasoline prices and promise to dramatically lower prices just as Democratic claimed power to solve pertinent economic problems four years ago. Politicians are not omnipotent and even when policies affect outcomes; their policies can be overwhelmed by market forces.

The graph “EIA U.S. All Grades Formulations Retail Gasoline Prices” plots the price of gasoline over the past eleven years beginning with President Bush’s first term. As President Obama’s Republican critics state, the price of gas has nearly doubled since he took office. Picking a starting point is a good way to trick unwary readers. By using a longer time frame, it is clear that rising prices preceded the Obama administration and that the trend was only interrupted by the Great Recession. In March 2001, the price of gasoline was $1.45 per gallon compared to $3.64 per gallon last week.

In this post, I use tools presented to principles of economics students to describe the markets for gas and related products and the possible influence events and policy have on them. Skip the remainder of this paragraph if you are not interested in the pedagogical background of supply and demand. The demand for gas can be described using an equation without functional form, Qg=D(Pg, I, Ps, Pc, N, Txd), where Qg is the quantity of gas demanded, Pg is the price of gas, I is the income level of consumers, Ps is the price of substitutes for gasoline, Pc is the price of complementary goods, goods used with gasoline, N is the number of consumers, and Txd is taxes on consumers. The supply for gas can be similarly described, Qg=S(Pg, Pi, Tc, Txs, E), where Qg is the quantity of gas supplied, Pg is the price of gas, Pi, the price of inputs, Tc, technology, Txs, taxes on suppliers, and E, suppliers’ expectations.

The Law of Demand states that holding all variables but price and quantity constant, as price rises, the quantity demand of a good or service falls. The Law of Supply states that holding all variables but price and quantity constant, as price rises the quantity supplied increases. The graph “U.S. Gasoline Market: 2001-2012” is a simplification of the market at the beginning and end of the eleven years. It depicts supply and unchanging and contains two demand curves, the first for March 2001 and second, March 2012; the equilibrium prices are taken from the trend line in the first graph.

In the remainder of post, I change one supply or demand variable at a time to explain the trend; this technique is called comparative statics. The first variable of note is income (I). Over the last two decades, world income has grown rapidly, leading to increased demand for gasoline with much of that demand coming from China and India. While income has grown, the increase in gasoline prices has had a subtle negative impact on income. The increase in gasoline prices reduces remaining purchasing power producing the same result as a decrease in income. Because consumers can substitute away from gasoline, the increase in income will not be completely offset by the increase in gasoline prices. The increase in world income is probably the most important variable causing demand to increase (shift to the right from D01 to D12) between 2001 and 2012.

To understand the market for gasoline, it is necessary to understand the market for its most important input, oil. The cost of producing gasoline largely reflects the price of its major input (Pi), oil. The supply equation for oil is slightly different than that of gasoline, Qo=S(Po, Tco, Txo, R) where the variables, where Qo is the quantity of oil produced, Po is the price of oil, Tco is oil technology, Txo is taxes on oil and R is oil reserves.

I believe that it is the reserve of oil (R) that explains the lack of a supply response to the upward march of prices. As demand has increased, increasing prices, gasoline manufacturers have a profit incentive to produce more, requiring more oil. The oilfields that are cheapest to exploit are producing. New oil must be produced from fields that are more costly and time consuming to exploit. New technology, (Tco), such as the conversion of tar sands to oil in Canada and hydraulic fracturing will allow supply to expand more rapidly (a movement from S to SI), slowing the pace of oil price increases directly and gasoline prices through its major input, oil, but when all is said and done, oil is a finite resource and its reserves will eventually be depleted.

In 2008, candidate Obama ran in part as an environmental warrior ready, willing and able to use the resources of United States government to combat carbon emissions primarily from the consumption of oil and coal. In office, President Obama has introduced programs that affect the price of substitute goods to gasoline. He promoted the electric car with $7,500 per vehicle tax credits (a subsidy is a negative tax, Tx), and invested directly in alternative fuel companies lowering the price of substitutes, a type of related good. The graph “U.S. Gasoline Market: Shifts in Demand” illustrate the impact of these policies. Because they make alternatives to gasoline less expense, they decrease the demand for gasoline (shifting demand to the left, D to DD where DD is a decrease in demand). He has also increased EPA standards for all vehicles (a constraint on the technology of complements (Tc). This technology variable is part of the supply of vehicles. On the demand side, higher EPA standards increase the fixed price of a compliment to gasoline while lowering the operating price making the overall impact on the demand for gasoline is ambiguous.

The graph “U.S. Gasoline Market: Shifts in Supply” depicts possible supply responses. On the supply side, the administration quietly followed a policy to slow down the domestic production of oil which again, other things equal, decreases supply (a shift from S12 to SD where SD is a decrease in supply) and increases the price of gasoline. In a 2008 interview with the Wall Street Journal, Steven Chu who is now the energy secretary, said, “Somehow we have to figure out how to boost the price of gasoline to the levels in Europe.” The price of a gallon in Europe is above $8.00 per gallon. This policy might makes sense if you believe that carbon emission will cause extensive and costly damage to the economy and if unilateral action of the part of the United States will significantly slow global carbon emissions.

The president claims an “all of the above approach” to energy production but policy seems aimed at slowing production without saying no. In Alaska, the administration has slow walked approval of infrastructure projects necessary to extract oil. In the Caribbean, the time it takes to get a permit to drill has nearly doubled. Leases to drill on federal land in the West are down 40%. The administration killed the Keystone XL pipeline that would bring tar sands oil to the United States. Each project has a legitimate environmental concern, but when all are summed, they total a policy aimed at maintaining high gasoline prices by slowing exploration and extraction that would lead to increasing the supply of gasoline.

These policies reduce the purchasing power of U.S. consumers. They can only be welfare improving if the environmental benefits exceed the loss in purchasing power. They are unlikely to bring technological breakthroughs. European countries maintain policies that have kept gasoline prices high for a very high for a very long time and they have not resulted in technological breakthroughs. It seems unlikely that policies designed to do the same here will have any more success.

Candidate Gingrich has claimed that if elected, his policies would lead to $2.50 per gallon gasoline. If elected, he would control U.S. policy, not markets and market forces are likely to overwhelm policy. Like candidate Obama, he promises too much.

If you believe that carbon emissions are costly to future generations and that unilateral U.S. action can reduce emission, policies to restrict gasoline supply make sense. If you do not, they do not. If you believe that the government is better at venture capital, investing in startup companies, than markets, then the president’s policies make sense. If you do not, they do not.

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