Price Elasticity Of Demand

Introduction

In recent years no economic topic has commanded more attention and elicited more emotion than the rising price of gasoline in the United States. Major storms in the southeastern states in 2005 and the ongoing strife in the Middle East have caused the price at the pump to rise to record levels at times and to stay high for extended periods of time. I intend to show how the recent fluctuations in the price of gasoline in the United States apply to the basic economic principle of Price Elasticity of Demand. I will show, through research of economic data how the demand for fuel has responded to the sales price at the pump in recent years as well as during the oil crisis of 1973 and 1980.

1973 -1974 Arab Oil Embargo

First, let us start with a bit of history. Although the recent rise in price at the pump has been a burden on most of us, the economic and personal impact seems to have been far less than that of the oil shortages in 1973 and 1980. In 1973 Arab oil exporting countries refused to sell oil to nations that supported Israel in the Arab-Israel war. The effect of this decrease in supply in the United States was dramatic:

"Within a few months, the price of oil went from around $3 a barrel to about $12. That sounds like a bargain, compared with just over $70 in April 2006. But expressed in today's dollars, the price went from around $10 a barrel to $40 a barrel. That's a huge increase and the impact on the global economy was devastating." (CBC News)

In the years to follow, after the oil embargo was lifted, the price of oil fell, but failed to recede to the levels observed prior to 1973. In 1973 the average price for a gallon of Regular Leaded gas at the pump was $0.39. In 1974, effected primarily by the oil embargo, the average price rose to $0.53. After the embargo, in 1975, the average price of a gallon of gasoline was at $0.57. (Figure 1) Between 1973 and 1974 the average price of a gallon of gas at the pump rose by approximately 35.9% and by 1975 the average price was approximately 46.2% higher than in 1973. (EIA - Table 5.24)

In 1973 the average consumption or quantity of gasoline demanded was 6,496 Thousand Barrels per Day. In the years leading up to the oil embargo, the quantity demanded was increasing steadily year to year. In 1974, the consumption of gasoline dropped to 6,372 . This drop of 1.9% was the first drop in the average gasoline consumption during any of the previous 25 years. In 1975, after the effects of the oil embargo were lifted the average consumption of gas was 6,512*. (EIA - Table 5-13c)

The Price Elasticity of Demand for gasoline during the period between 1973 and 1975 was 0.005 or very inelastic. But from 1973 to 1974 the Price Elasticity was 0.05 which is still considered inelastic but 10 times more elastic than the longer period from 1973 - 1975. The oil embargo decreased the average consumption of gasoline during the period from 1973 - 1975, but the quantity demanded continued to rise unabated for a few more years until it reached 7,264 in 1978.

1979-1980 Energy Crisis

In 1979, unrest in Iran led to yet another spike in the price of oil. "Oil went from a little less than $15 a barrel to around $35. In today's dollars, that's like boosting the price of oil from about $40 a barrel to $80." (CBC News). This translated into an average price for a gallon of gasoline rising to $0.86, a 36.5% increase from the average of $0.63 charged in 1978. The effects of this energy crisis lasted for a much longer time than the situation in 1973. The price for a gallon of fuel continued to rise and in 1980 hit $1.19 a gallon, an 88.9% increase. In 1981 the price of a gallon of gasoline reached $1.31, a 107.9% increase over the average price paid in 1978. (EIA - Table 5.24)

As in 1974, the consumption of gasoline dropped in 1979 and 1980, but unlike the previous crisis, the quantity demanded dropped sharply and stayed low for many years. In 1978 the average daily consumption of gasoline was 7,264*. In 1979, average consumption dropped to 6,896*, a 5% decrease from 1978 and in 1980 the average consumption was 6,441*. This was an 11.3% decrease from 1978. In 1981 consumption was still 11.1% less. (EIA - Table 5-13c)

The Price Elasticity of Demand for gasoline between 1978 and 1981 was 0.102 which was 190% more elastic than the three year period during the 1973 oil embargo. The sharpest drop in consumption occurred between 1978 and 1980. During this period, the Price Elasticity of Demand was 0.127 which was 154% more elastic than the similar period from 1973-1974. Although much more elastic than the period of the oil embargo in 1973, the Price Elasticity of Demand during this energy crisis was still considered inelastic.

The effects attributed to these events were great in number and included everything from a major shift in automakers designs to smaller and more economical models, to a nationwide speed limit of 55mph, even a change in daylight saving time, all to attempt to lower the consumption of oil and decrease the consumption of pump gasoline. The average price of a gallon of gas slowly declined until it reached a relative minimum of $0.86 in 1986. The average quantity demanded stayed below the 1978 average until 1993 when consumption rebounded to a new high of 7,367 (Figure 2). (EIA)

The Eighties and Nineties

The period from 1982 until 1997 generally saw the price for a gallon of gasoline decline (Figure 3) and the consumption of gasoline increase (Figure 2). Starting in 1998 the average price of gas started to increase at a steady pace until 2005. By January of 2005 the average price of a gallon on Regular Unleaded gasoline was $1.83 and quantity demanded was at an all time high of 9,099*. (EIA)

"For most of the 1980's and 1990's, the oil price rarely strayed far from $20 a barrel. With the exception of a brief interlude following Iraq's invasion of Kuwait in 1990, the world grew used to the joys of cheap oil. But over the past four years, the price has more than tripled, to more than $70 a barrel. It is still climbing and prices in the futures market imply that oil will remain dear for several tears to come." (The Economist 11)

Recent Years 2004-2006

In 2004 the price of a gallon of gasoline averaged $1.85. In 2005 the average increased to $2.27, a 22.7% increase over the course of one year. At its peak, the national average price of fuel reached $3.07 in September, compared with $1.78 in the first week of January, the low point for the year. In this 9 month period, the average price of gas went up by $1.29 per gallon, a whopping 72.5% increase.

The average consumption of gas in the first