Gasoline, the price mechanism, and Friedman’s ghost

Travis Fast

The price of gasoline has been going up and so has consumption. It used to be that the $1.00 mark would induce reduced consumption (just like the text book says it should). Well not anymore. So what is up? Has the price mechanism failed? Depends who you ask. Conventional economists are going to talk add infinitum about elasticities of demand. But in order for that story to make any sense they will have to explain a rather sudden change in the elasticities of demand.

I don’t buy it. What we are really witnessing is capitulation on the part of the consumer to higher prices. The gas companies tested higher prices and discovered there was no backlash in terms of consumption, or a sustained push by government to open the books. Gasoline is like other addictive substance. The initial effect of a price increase is hesitation by the consumer then capitulation to a new price level. That is, for various reasons the price mechanism simply does not work the way the textbooks describe.

Despite the fact that producers have known, since at least Katrina, that capacity was low and despite the fact that oil companies have been making mountains of cash, new refining capacity has not been planned for the last two decades and there are no new refineries on the short term horizon. Indeed, it appears that both the demand and supply side of the price mechanism have failed.

All of this amounts to a prima facie case for government to regulate the price of gasoline even on terms determined by orthodox economic analysis. Don’t hold your breath. As we have discussed before, mainstream economists are loathed to advocate for the regulation of private markets even when they are failing. Queue Friedman’s Ghost.


11 thoughts on “Gasoline, the price mechanism, and Friedman’s ghost

  1. A couple of points. First, do you think consumers purchase in real or nominal terms. I suspect there is a lag between what 1 dollar purchases in real terms and what consumers think it does. Nonetheless, what one has to explain is how the elasticity can shift so suddenly. Doing so will require a high dose of ad hocery lumped on top of the and also concept of elasticities of price which was itself a bit of ad hoc theorizing to save NC price theory. Let us remember just how big a role the mechanism plays in coordinating the actions agents in liberal price theory.

  2. And I the other point is that the Shell project you link to is just in the initial planning stage which has yet to even begin its environmental assessment. If this is what you call the short term what do you call the long term?

    Ontario remains Canada’s largest market for refined petroleum products. The Sarnia Manufacturing Expansion Project could improve the province’s security of supply as it provides an opportunity for Shell Canada to produce products directly where the demand is – in Ontario.

    These are early days. Many elements of this project have yet to be defined, including the overall investment, the number or permanent workers needed at the facility as well as the size of the construction workforce. Shell Canada will share these numbers once we have a better idea of what they might reasonably be.

    If we proceed with this project, our Sarnia facilities will leverage our oil sands operations in Alberta by using feedstock from there to create light oil products for consumers: From the mine to the motorist.

    With the initial scouting phase complete, we can now embark on the next phase of project development, which includes an environmental assessment and engaging with a wide range of stakeholders.

  3. If your point was a general critique of the neoliberal concept of an exogenous demand curve/elasticity, I agree. I saw your point as a phenomenon specific to the sector. I’m still trying to dig up some data.

  4. 1. i don’t know if you have to look too far for reasons behind the supply side failure…from oligopoly to (i believe) low margins in increasing refining capacity or better return on capital than those found in refining (vis-a-vis other activities within the firm’s grasp) prior to the current price levels to overall short-termism.

    2. i am congenitally innocent of the theory behind elasticities, but query the strength of the original argument that gas was more (less?) price-elastic? what’s the substitute for most people? how can you exercise a substitute if you live in Oshawa and drive a SUV to work? Is there an argument that without adequate alternative use technology in the short term (e.g., wide-spread availability of public transit or electric cars) there has to be a short term price inelasticity. Capitulation explains what happened, but not why.

  5. On your second point: hence my mention of addictive substances. But the orthodox claims there is always a certain amount of discretionary spending even where there are not substitutes. In cities like Toronto, Montreal and Vancouver there is of course a substitute public transit. All things being equal we should have viewed an increase in transit ridership. Which of course we did not. But the real point I was making is why in the recent past has the one-dollar mark led to decreased consumption but in the present it has not? And this fact is really is problematic for orthodox price theory because it threatens the ad hoc protective belt.

    As to your first point. Consider that oil companies are themselves heavy in the derivatives market where they hedge against price movements by taking up a series of futures contracts. The fact is that all things being equal higher demand means a higher rate of return as capacity utilization approaches 100%. By this logic prices, could decrease in the face of increased demand as fixed cost per unit declined. The standard justification for rising prices in such a situation is that such prices serve to direct resources towards their most efficient use. But as we have seen the price mechanism for gasoline has in fact failed to provide a rationing mechanism. Prima facie a case for government regulation of either consumer behaviour or supply.

  6. on the point about alternative uses, the $1 sthreshold, aside from crowd psychology, might have also led to changed behavioru because there was increased ability to anything about it (i.e., more transit, more fuel efficient cars). i wonder if today, in the new gilded era, there is less discretion to not consume gas than you’d think, for e.g., lower availability of gas rationing in existing cars and reduced public transport capacity generally (TTC has cut routes the past 10 years).

    on the point about producer behaviour, cf. one form of regulation, windfall taxes. if these profits are not being re-invested in capacity (and capacity gains being passed along in prices) then we have argument for windfall taxes. i saw some studies a while ago suggesting windfall taxes not as distorionary as might be expected. also, much easier to implement (and remove) than a more comprehensive regulation of drilling-extraction-refining-diustribution.

    and finally, see you have a fellow traveller in Dominic D’Allessandro, who thinks resources should be protected in the same way financial services are.

  7. Oh brother here we go. Two points. First, the supposed relationship between price quantity broke down within the space of six months. Perhaps with spring, Ontario was eager to get out of the house so the putative utility of driving was above the price increase. Sure, plausible, and I have million others I could dream of. But all this suggests is that standard price theory becomes an exercise in ad hoc conjectural thinking. Which is fine by me, but where does that leave liberal economics in relation to competing paradigms?

    Second. My preference would be for the government to establish a reserve system under its control with sufficient reserves to move prices for say three to six months. The other would be to get back in the refining game. But for sure, forget micro regulation.

  8. oh brother your mama.

    did we establish the price-quanity relationship was there in the first place? i don’t know that we did. you said it was, and that a 1$ gallon was enough to see people start to save gas, which implies there was an ability to do so. if all that holds true, no impediments to curtailing consumption (i’m still skeptical) then we have a separate problem: what could explain the change in behaviour? do you honestly think there was a sudden jump in preferences or shift out of some utility curve? or as you put it, a sudden “capitulation”? What could be more liberal-economic than that? Are you also a believer in NAIRU? If the change actually happened as you said it did within the last six months, then shouldn’t we (well, you’re the economist, so you) figure out some some reasonable and objective explanation of the break in the pattern, if, indeed, the pattern existed, rather than “everyone gave in”. Or, if you insist they gave in, then why?

    Or, if your’e just out to point out that price mechanisms (or liberal economic theory) don’t always work, then you’re in a venerable 50 year tradition, Polanyi made the same point about certain commodities (land and money, if I remember correctly) in 1944, and I’m sure others had before and have since, and extraction industries/commodities would likely attract such an analysis. And, as you point out, someone actually had connected those dots in the good old days of the mixed economy, because there was state-led energy policy and even ownership, so, whatever the economic policy justification (market failure was yours – and we should be clear, market failure is only one reason among others to intervene in markets), the logic had already been developed. I suppose we should consider the experience of the US reserves and their effect on prices and consumption.

  9. Pingback: CCPA finds also finds price mechanism flawed in Oil Sector « Relentlessly Progressive Political Economy

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