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| Fig. 1: Comparison of Weekly U.S. Crude Oil Prices and Retail Gasoline Prices from 2004-2010. Source: U.S. Energy Information Administration. [1] |
Whenever the price of gasoline in the United States spikes we hear about it - whether from the media, from friends, in the workplace, etc. As an obvious example, in July of 2008, when retail prices in the States reached a record high upwards of $4 per gallon, outrage was universally expressed. But this event also sparked thoughtful discussions and certain vital issues were raised and brought to the forefront of American minds. What determines the price of gasoline and how elastic is our demand for it? What are other nations' approach to this good, and how do they survive having historically paid much more for their gasoline? The following paper will give a brief overview of these questions and clear up some of the basic issues with the hopes of raising some inquiries for further future discussion.
Common sense dictates that the single most influential factor on the price of gasoline is the cost of the crude oil from which it is made. Gas companies must purchase and refine crude oil to market their product. However, because the world's appetite for gasoline has rapidly increased over the last decade, a burden has been placed on suppliers to find, produce, and export more crude, ultimately causing the costs of producing gasoline to spike. With this rising demand, prices reached a maximum in the early summer of 2008 and then fell sharply due to the ensuing recession and the unwillingness and inability of Americans to pay such high prices.
Fig. 1 shows the intuitive correlation between the price of crude and the retail price of gasoline. When the costs of crude per barrel peaks, so does the retail price, such as in the aforementioned summer of 2008 case. However, a quick glance at the figure reveals that the price of gasoline is more volatile than the cost of crude with sharper and more frequent drops and spikes. Clearly, there are other factors at play, which help determine the retail price.
On average, the United States Energy Information Agency (USEIA) estimates that the cost of crude oil makes up about 50% of the pump price with the other half determined by federal and state taxes (~10-20%), refining costs and profits (~5-10%), and finally distribution and marketing (~10-20%). But, in the month of October 2010, the price of crude was said to make up 71% of the price, a large shift up from the historical average. [1]
What causes the fluctuations of these components? In the case of the cost of crude, considerations of both demand - determined mostly by world economic growth - and supply - determined mostly by the influence of the Organization of the Petroleum Exporting Countries (OPEC), which controls about two-thirds of the world’s crude oil reserves - factor into the equation. Even in light of this, it seems difficult to account for the frequency and volatility of these percentage fluctuations.
The next largest factor, which determines the retail price of gasoline, is tax levied by the states and federal governments. Obviously, these taxes will fluctuate based on governmental policies, economic strength, etc. However, as with the cost of crude, the considerable deviation (from 9.8% at its lowest in June of 2008 to 38.7% at its highest in December of 2001 according to the USEIA history) may be reason of concern.
From thinking about the components that fix price of gasoline and from looking at Fig. 1, it is obvious that the price of retail gas can fluctuate quite a bit. The next important question to ask is how do such fluctuations change the way Americans consume gasoline? In other words, how elastic is our demand for gas?
There have been hundreds of studies conducted in the last few decades, which examine this very same question. In particular, there are a couple meta-studies of note such as Molly Espey's "Explaining the variation in elasticity estimates of gasoline demand in the United States: a meta-analysis" published in Energy Journal in 1996 and "Elasticities of Road Traffic and Fuel Consumption with Respect to Price and Income: A Review" by Phil Goodwin, Joyce Dargay and Mark Hanly published in 2004. [2,3] Both Espey and Goodwin et al. discovered that the elasticity for gasoline is relatively inelastic with both groups estimating a short-run Ed roughly equal to -.26 and about twice that for the long run. This number indicates that a 10% increase in fuel prices will cause about a 2.5% reduction in the consumption of fuel within a year and more than a 5% decrease over longer periods. Furthermore, Goodwin and his colleagues found that despite this decrease in fuel consumption, traffic numbers on the road would remain more stable. This means that in the face of increasing prices, Americans are more likely to find ways to use fuel more efficiently, whether by switching to more fuel-efficient cars, adopting more fuel conserving driving styles, and using routes with less traffic.
While it is very difficult to generalize over large populations and regions of the country, what this and other evidence largely points to is the trend that gasoline is a very important commodity for the American people. In other words, fluctuations in price are less likely to elicit consumption changes compared to other goods and no matter what Americans will try and find a way to stay on the road.
Even America's most expensive gasoline prices pales in comparison to what many other nations are used to paying for theirs. When Americans were complaining about the $3.45/gallon price tag on July 15, 2008, the French were paying $8.07/gallon, the British $8.38/gallon, and the Norwegians $8.73/gallon. [4] At the same time, those in gas producing countries like Venezuela and Saudi Arabia were paying 12 cents/gallon and 45 cents/gallon, respectively. What explains these large discrepancies?
The one word answer is tax. As shown above, traditionally about 15-20% of the price of gas in the United States is dedicated to taxes both federal and state. In Europe and other countries around the world, this number is much higher. For example, in the U.K. about 65-75% of the price of the gasoline is collected as taxes. On the other hand, in Venezuela and Saudi Araiba, these numbers are much lower because instead of raising revenue from the cost of gasoline, these governments encourage their people to spend on gasoline and hike up its demand.
The obvious effect of a higher tax on gasoline is a government’s greater capacity to spend on public goods, and in particular transportation related goods, such as more extensive and cheaper public transportation options. Furthermore, because the price of crude oil occupies a smaller proportion of the overall retail gas price, the effects of its changing supply and demand are felt less by citizens of the highly taxed countries.
Despite the seemingly clear benefits of higher tax rates, one issue remains the elephant in the room. If retail prices of gasoline are twice that in Europe, how do its biggest corporate consumers compete with American ones? For example, how do European airlines charge the same ticket prices as American ones do if they have twice the costs for their fuel? The answer is, of course, that European airlines do not have twice the costs as American ones because they are exempted from paying the fuel taxes that individual roadside consumers do. According to a 1997 directive issued by the European Commission, the most powerful executive body of the E.U.: Member States shall exempt the following from taxation:While the conditions of these exemptions are complicated and filled with appropriate caveats, what is clear is that currently in Europe, the biggest polluters such as the aviation, heat, and electricity industries are benefiting from the most lenient tax policies. Therefore, claims that European nations care more about environment due to their heavy taxation on fuel, which are often made in the popular press, do not hold water.
What this discussion points to is that the price of gasoline is a powerful and complex number which can greatly influence people’s behavior. Ignoring historical precedent, nations seem to have the choice in how high to tax the good. Even though Americans display a relatively inelastic demand for it, they do change their behavior in the face of high prices. Therefore, it is a considerably worthwhile discussion to reexamine how we consume gasoline and how much of the price at the pump should reflect the market forces that determine the price of crude, a limited natural resource under tense global demand.
© 2010 Daniel Gratch. The author grants permission to copy, distribute and display this work in unaltered form, with attribution to the author, for noncommercial purposes only. All other rights, including commercial rights, are reserved to the author.
[1] "Gasoline and Diesel Fuel Update," U.S. Energy Information Agency.
[2] M. Espey, "Explaining the Variation in Elasticity Estimates of Gasoline Demand in the United States: a Meta-Analysis," Energy J. 17, 49 (1996).
[3] P. Goodwin, J. Dargay and M. Hanly, "Elasticities of Road Traffic and Fuel Consumption with Respect to Price and Income: A Review," Transport Review 23, 275 (2004).
[4] S. Hargreaves, "U.S. Gas: So Cheap It Hurts," CNNMoney, 15 Jul 08.
[5] "Proposal for a Council Directive Restructuring the Community Framework for the Taxation of Energy Products," European Commission, COM (97) 0030, 17 Mar 97.