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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Economists' on Immigration

As best I can tell, economists favor increased immigration by a large margin. Nick Schulz, an author of "From Poverty to Prosperity” makes an economic pitch for immigration that illustrates typical economic thought in “Yes, There Is Such Thing As A Free Lunch: It’s Called Immigration.”

Kick open the nation’s doors to high-skilled immigrants. There isn’t a bigger no-brainer move than this…
Put aside concerns about low-skilled immigration for a moment. There is wide consensus among those who have studied the issue that skilled immigrants are a net positive for the receiving country.
As Barry Chiswick, the editor of “High-Skilled Immigration in a Global Labor Market” and one of America’s deans of immigration research, notes, “ High-skilled immigrants expand the productive potential of the economy in which they reside, thereby increasing the growth rate of total-factor productivity [technology for principles students]. High-skilled immigration to the United States, therefore, enhances the international competitiveness of the U.S. economy and attracts foreign capital to the country. High-skilled immigration adds workers to the labor force who tend to pay more in taxes than they receive in public benefits… As a result, they tend to have a positive net fiscal balance.”

Immigration of high-skilled labor can be depicted using a simple supply and demand model familiar to principles students.  The first graph depicts the supply and demand for laborers with a BA degree in genetics.  The normal disclaimer applies.  I have no idea how many geneticists with BA degrees are hired nor do I know their monthly salary.  Equilibrium occurs at a monthly salary of $3,600 with 89,760 geneticists employed.

The supply of geneticists is a function of the wage, the number of native born workers (N) and the number of foreign born workers (F) [Q=S(W, N, F)].  As immigration of foreign born geneticists increases, supply shifts outward (from S0 to S1 in the second graph), and the wage decreases to $3,500 per month. 

Many Americans fear that immigration will lower wages stop their analysis here, but this excludes perhaps the most important change, the change in demand.  The demand for geneticists is a function of the wage and technology, and, in turn, technology is a function of the number of native born and foreign born workers [Q=D(W, Tc(L(N, F))]. 
Technology advances with the interaction of high-skilled laborers, the more laborers, native or foreign born, the more interactions between these high valued workers, the greater the technological advance.  As technology advances, the demand curve for geneticists increases in the third graph.  The new equilibrium wage is $4,000.  Because the market is in equilibrium, any geneticist who wishes to work at $4,000 will be employed and the number of geneticists employed increases.  Firms hiring geneticists are better off as well because the burst of creativity achieved by the greater interaction between geneticists allows them to produced new and varied products.  Consumers are better off as well as they have a wider variety of products to buy. 
Students who wish to disagree with my analysis may want to examine the relative shifts in the supply and demand curves. 
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Some Consequences of Government Rationing

In “Rationing Health Care” and “More on Rationing Health Care” I describe why employer provided health care how employer provided health care was created as a response to the price and wage controls imposed during WWII.  Employers could not raise wages but the government permitted them to offer health care benefits to employees in addition to wages.  New laws made health care expense deductible for the employers and did not count the health care benefits as taxable income for the employees.  Because health care payments paid with the employees wages were taxable, both the employer and the employee had a financial motive to push more medical employee paid health care expenses onto the group plan paid by the employer.

The law created a tragedy of the commons and the common resource was the group plan.  Health care is over consumed because the employees have no incentive to control expenditures but all pay for the increasing costs because the cost of the group plan has increased.  There are basically two ways to control rising costs.  Employees must be again be exposed to market prices or the employer through the group provider must ration health care.

Medicare and Medicaid have created similar tragedies of the commons.  The elderly and the poor get benefits paid for largely by taxpayers, and consequently have little incentive to control consumption.  President Obama’s health care reform would ration health care benefits through expert committees.  A couple of articles describe the impact of government rationing in the Tennessee and the United Kingdom (“Patients to wait longer for care under new health law, think tank says,” “Cataracts, hips, knees and tonsils: NHS begins rationing operations”).

In Tennessee, approximately 700,000 citizens will gain health coverage (demand expands from D0 to D1), most will be younger men with low incomes who will become eligible for Medicaid.  The remainder are people who qualify for subsidies to buy insurance though newly created state health exchanges.  As demand expands without a corresponding increase in health care providers, the price of health care increases as does the quantity of health care provided (the increase in demand has caused a change in quantity demanded along the original supply curve and equilibrium has shifted from A to B).  More health care will be demanded at a higher price.  Somebody has to pay.  Sources cited in the article suggest that taxpayers and healthy young adults that do not qualify for subsidies will subsidize the poor and infirm. 

The second article explains that the National Health Service will ration hip replacements, cataract surgery and tonsil removal as well as other operations to control burgeoning budgets. 

Society cannot afford to provide all the health care that people desire.  As health care becomes more effective and more expensive, people will not be able to afford all beneficial care.  Public payment for health care has or will hit the same ceiling.  We as individuals or collectively cannot afford everything we want.  Resources are scarce.  It seems cruel to force a dying person to examine their financial records to determine if they wish to spend their remaining wealth on a procedure that might be effective.  Many will not have the resources to pay.   It also seems cruel to tell a dying patient that she does not meet the cost benefit criteria for a procedure that might extend her life.

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I love my new 2010 Prius. They are fun to drive slow, something I thought I would never say about a car, and there is nothing like a long glide after a short pulse to increase gas mileage.  I got 53.8 mpg on my last tank of gas and anticipate exceeding 55 mpg on this tank.  The hybrid technology used in the Prius is a technological wonder but it comes at a price.  It is more expensive than similarly sized cars.  I figure that at $3.50 per gallon I will need to drive the car about 60,000 miles to recoup the initial sales price but that is dependent on a high resale value in six or seven years. 

(HT Watts Up With That) Two new inventions threaten to knock the stuffing out of the resale value of current hybrids.  Both projects are funded by Department of Energy’s ARPA-E grants.  Researchers at the University of Minnesota have figured out how to combine carbon dioxide, sunlight and bacteria and turn it into oil (“The greens worst nightmare? A CO2 to Oil process”).  If oil can be successfully produced using this technological advance, the price of gasoline would at least stabilize and could potentially fall making cars powered by the internal combustion engine cheaper to drive and environmentally less threatening. 

The second invention is a new gasoline engine that was developed at the Michigan State University (“New gasoline engine design has 4x efficiency of pistons”).  The team that made the Wave Disk Generator believe that it will provide a driving range exceeding 500 miles.  They also believe that it will be 30% lighter and 30% less expensive than a plug-in hybrid, and that it will cut carbon emissions by 90% relative to gasoline engines. 

Often, the invention is the easy part.  The more difficult part is successfully producing a good in a market setting with the invention.  Economists refer to this step as innovation.  Let’s hope that these projects are successful innovations.  What I lose in value on my Prius will make up with reduced driving costs on my future vehicles.   Permanent Link
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Driving Costs and the Demand for Cars

Gasoline is an important complement to cars.  Other things equal, as gasoline prices rise, miles driven and car sales decline, but more can be learned by separating cars into makes and models, making one a substitute for another.  But the strength of that relationship depends on a number of characteristics.  One make and model, a Honda Civic, may be a strong substitute for another, a Toyota Corolla, and a weak substitute for another, a Chevy Tahoe. 

With the price of related goods for the demand car model in mind, I constructed a table based on the per mile total cost to operate the seven different models over five years assuming the cars were driven 15,000 miles per year.  All the costs except fuel were taken from Yahoo Autos.  Fuel costs were estimated using the average of EPA City and Highway estimates at gasoline price beginning at $2.75/gallon, increasing at $.25 increments to $4.25/gallon.  Fuel economy ranged from 18 City/27 Highway for the Ford Taurus to 51 City/48 Highway for the Toyota Prius. 

This is a simple model; the only cost that changes as gasoline prices rise is fuel.  I expect that other elements of cost would change as the price as well, For example, the price of fuel efficient cars would rise relative to less efficient automobiles both in the new and used markets.  Because I don’t have data to predict the changes in new car purchase price and the used car sales price, I did not modify Yahoo’s cost estimates.  The graph of the per mile total cost of the seven vehicles yielded some expected results and some surprises.  As expected, the total cost per mile of the hybrids rose more slowly than non-hybrids, but not dramatically so.  I anticipated that the total cost per mile of the non-hybrids would be lower at low gasoline prices but would be higher than the hybrids at high gasoline prices.  The Civic and the Fusion both came in non-hybrid and hybrid models and in both cases, the hybrids had lower total cost per mile than their counterparts at $2.75, and that cost differential grew as prices rose.

The reason that gasoline prices did not influence total cost per mile is that they are a relatively small part of overall cost.  Fuel cost never rose above 33% of total cost (Mazda 3 Sports i), and were as low as 17% of total cost at $4.25/gallon (Toyota Prius).  In general, models that were relatively less expensive at low gasoline prices were less expensive at high gasoline prices.

Consumers will try to lower the cost of owning a car, but how?  A more sophisticated inquiry might study the complementarity of makes and models.  Is a minivan a stronger or weaker complement to a large SUV than a crossover?  Likewise, is a compact hybrid a stronger or weaker complement to a compact than a subcompact?
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McDonalds and Healthcare Waivers

Thirty companies and organizations including McDonald's were granted health care coverage waivers from the Department of Health and Human Resources allowing them to offer insurance plans that do not meet new health insurance guidelines of the new healthcare legislation to approximately one million workers.

The “mini-med” plans run afoul of the legislation for two reasons.  First, insurance plans must spend at least 85% of their revenue on medical care (David Leonhardt, “Health Care’s Uneven Road to a New Era”).  This is a big hurdle for insurance plans geared to young, healthy consumers.  After all, a $200 medical bill for a simple checkup is likely to have much the same administrative cost as $200,000 bill for bypass surgery.  Second, the new health care legislation requires that companies provide a minimum of $750,000 in coverage in 2011, increasing to $1.25 million in 2012, $2 million in 2013 and unlimited in 2014 (Drew Armstrong, “McDonald's, 29 other firms get health care coverage waivers”).  That amounts to a huge salary increase for low skilled workers.  The mandated increase in salary will result in less demand for low skilled workers and an increase in the price of goods and services that they produce.   Leonhardt gives a good positive description of mini-med plans and their limitations mixed with his normative views in the article linked above.  Three sentences exemplify many of my objections to healthcare reform.

…people will be required to buy insurance, to spread costs among the sick and the healthy. Second, insurers will be prohibited from cherry-picking only the healthiest customers, again to spread costs. Finally, the government will give subsidies to people, like McDonald’s workers, who can’t afford insurance on their own.

Leonhardt puts much less value on freedom and trust in markets than I do.  Words like “people will be required to buy” and “insurers will be prohibited from” make me cringe.  Who is the government to tell me what I need to buy or designing products for private companies?  Nor do I have a problem with cherry-picking of the healthiest consumers.  That leaves a market segment for insuring the chronically ill, a group more deserving of subsidies than workers who are generally young and healthy.  In fact, most analysis that I have read conclude that the young will subsidize the old and the ill.  Finally, the government may “give subsidies to people” but they do so with taxpayer money.

In regards to the reform in general, it weakens market incentives that would lead consumers to watch medical costs and providers from producing low cost products because taxpayers will subsidize insurance plans with unlimited costs.

Taxpayers and healthcare consumers would have been better served by legislation that increased market incentives.  See “More on Rationing Health Care” for a short explanation of how the tax code weakened market incentives for healthcare and a comparison of government rationing vs market rationing of healthcare. 
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Products for Your Protection!

At times, the ability of a good to protect us is a significant determinant of demand.  This posts describes two potective products.  The linked story and video, "Bogota's bulletproof tailor," was produced by VBS.TV's Ryan Duffy and is found at CNN World.  I wish we lived in a world in which such products were not need, but now I am sounding like a Miss. America contestant.  Duffy introduces his story.

Brooklyn, New York (VBS.TV) -- Colombian tailor Miguel Caballero specializes in making garments that enable the wearer to get shot at point-blank range with nary an injury besides, maybe, a bruised ego. At-high-risk-of-catching-a-bullet demographics, such as rappers and politicians all over the world, rely on Miguel's handiwork. And, lucky me, when I was recently in Bogota for VBS.TV covering a few stories, I had the chance to visit Miguel's shop, learn about his protective clothing, and get shot in the gut by him. Seriously.

A second product is described in an ABC News video about "protecting the boys" with the Nutty Buddy.  The product's theme song is "Hit me with Your Best Shoot."  Follow the link to an ABC News story.  Will the Nutty Buddy replace the traditional cup? 
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Tattoos and the Air Force

(HT Drudge Report) When recruiting, the Air Force and other branches of the armed services must decide the characteristics that will make a good soldier. These are the Air Force's determinants of demand for soldiers. I would include intelligence, the ability to follow orders, strength and speed, and patriotism. The Air Force list briefly included no tattoos on the right arm. After a week, they fell back to a more lenient policy (George Warren, "Air Force Changing Tattoo Policy").

SACRAMENTO, CA - One week after the Air Force adopted a strict prohibition of tattoos on the "saluting arm," the new policy has been scrapped.

A spokeswoman for the Air Force Recruiting Service in San Antonio, Christa D'Andrea, said the regulation that took effect Nov. 25 has been dropped and the entire tattoo policy will be reviewed.

"It's an effort to standardize the policy for all members of the Air Force," D'Andrea said.

As many as 17,000 recruits who joined under the delayed entry program were potentially affected by the ban on right-arm body art. The Air Force said it did not want tattoos to be seen when an airman salutes. The updated policy also prohibited tattoos on either hand.

This week some recruits were told they had been disqualified under the new rule even though their tattoos had been approved under previous, more lenient guidelines.

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Drill Baby, Drill

It's amazing what the expectation of higher prices will do for oil exploration; people do respond to incentives. Sarah Wolfe writes for Energy Digital in "US crude oil production could see largest increase in four decades, says Platts analysis," that

According to a recent analysis from Platts , a leading global provider of energy and metals information, the United States is primed to see its largest one-year increase since 1970 in crude oil production.

The US averaged 5.268 million barrels per day through the month of October. With this amount, this year’s overall gain is the highest since the country produced 9.637 million barrels per day in 1970, according to Platts’ summary of data released by the US Energy Information Administration.

According to Platts, if the 5.2687 million barrels per day output continues through the end of December, there could be a 6.4 percent jump over 2008’s 4.95 million average. This year would then rank as the best in US oil production since 2004, when the average output was 5.419 million barrels per day.

A major cause for the oil production increase is more activity in the Gulf of Mexico. The industry has bounced back in the region since last year’s hurricane season and a group of new deepwater fields are emerging.

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