Message to the Coalition: people respond to incentives

I was listening the other day to Tony Abbott claiming that the price elasticity of petrol is zero (Joshua Gans quotes the Coalition’s Greg Hunt making the same claim). It was perhaps the first time that I had heard a politician use the word ‘elasticity’, and it made me wonder whether Abbott was resorting to jargon because it would sound more outlandish to say ‘we don’t believe people buy less petrol when the price goes up’.

Anyhow, this struck me as the kind of issue that people have probably researched, and sure enough a quick search turned up a nice meta-analysis by Daniel Graham and Stephen Glaister. Here’s the key graph:

As the authors conclude:

There are differences between the short- and long-run elasticities of fuel consumption with respect to price. Typically, short-term elasticities are in the region of -0.3 and long-term between -0.6 and -0.8. Therefore, it may be right to say that ”it won’t make much difference” or ”people will use their cars just the same”, but only in the short run. The evidence is clear – and remarkably consistent over a wide range of studies in many countries – that in the long run there is a significant response, albeit a less than proportionate one.

In other words, a 10% rise in petrol prices reduces petrol demand by 3% in the short-term, and by 6-8% in the long-term. (Although the study isn’t clear on this point, I’m guessing short term is <1 year, and long term is >1 year.)

Of course, these aren’t the first politicians to ignore economic evidence, but this seems to be an instance in which the evidence is simply overwhelming.

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17 Responses to Message to the Coalition: people respond to incentives

  1. Mark Davis says:

    Andrew,

    Here is an interesting study which finds that petrol price elasiticities in the US have declined over time: http://www.nber.org/papers/w12530.

    The authors treat the periods of rising oil prices in the late 1970s and the 2000s as an opportunity for a “natural experiment”. They find short-run elasticities of -0.21 to -0.34 in the 1970s versus -0.034 to -0.077 between 2001 and 2006.

    They suggest US consumers may have become less responsive to rising petrol prices due to factors declining availability of public transport, greater suburban sprawl, more two-job households and rising incomes.

  2. John Hannoush says:

    Hard to see how Abbott got himslef into this. Apart from the massive evidence of the kind cited, it seems to be one of those areas where anecdotal evidence is pretty solid.
    One detail – the estimates for Australia in Table 3 give -0.05 and -0.18 for short and long term elasticiities, very much at the lower end of the scale in that table and for the other studies. Blip or are we less responsive than the rest of the world? (the Table 3 study seemed to cover an earlier period, so maybe things have changed).

  3. perhaps not says:

    I am not in Australia and so don’t know the context in which the remarks were made, nor the political fallout from them. I do find it frustrating, though, to see this type of remark: “Of course, these aren’t the first politicians to ignore economic evidence, but this seems to be an instance in which the evidence is simply overwhelming.”

    Intentionally ignoring economic evidence, at least in rhetoric terms, makes perfect sense when you think of the different set of incentives pollies are confronting. This makes them neither ignorant (as you imply), nor does it mean that politics is likely to change markedly for the better if you stick economists in charge, as you seem to be implying also, by extension. Pretending otherwise is, dare I say it, a little ignorant?

  4. Christopher says:

    yes things changed in Australia post early 80s. First, the restriction on selling Australian oil to Australian’s first changed (1980?) – so we experienced the second oil shock, but not the first. Secondly, fuel excise jumped significantly in 1984.

  5. Mark Davis says:

    The following study — http://www.nber.org/papers/w12530 — treated the periods of rising oil prices in the 1970s and 2000s as an opportunity for a natural experiment on whether petrol price elasticities had changed in America over time.

    It found short run elasticities had declined from -0.2 to -0.3 in the 1970s to -0.03 to -0.08 in the 2000s.

    The authors suggest American consumers have become less sensitive to increases in petrol prices due to declining availability of public transport, more suburban sprawl, more two-job households and higher incomes.

  6. Paul Frijters says:

    There is a whole section of the Commonwealth treasury involved in estimating these elasticities for Australia. Bob Breunig knew about them when we talked about this issue in Brisbane. I think they were in the -0.6 camp but I dont have a reference for that number.
    I am not sure what ‘perhaps not’ is arguing: should economists ignore politicians who blatantly lie about economic entitities such as elasticity? To me the phrase “Of course, these aren’t the first politicians to ignore economic evidence, but this seems to be an instance in which the evidence is simply overwhelming.” neither implies Andrew is saying the politician is ignorant nor that economists should be in charge. I find it a very measured and accurate statement.

  7. Michael W says:

    This may be a silly suggestion as it comes from a non-economist, but if so I’d like to know the reasons why: given that (1) various commentators are saying that the petrol price hike is like a de facto interest rate rise (2) that various other commentators are saying that we need to get used to a higher price for petrol since this is necessarily implied by commitments to cut greenhouse emissions; why not give the power to put up petrol prices to the Reserve Bank? Then instead of putting up interest rates, the Reserve can put up petrol prices every time it thinks inflation needs a little cooling, until we get to the point that the price of petrol fully accounts for its economic externalities. Broader still, give the Reserve similar power over all “sin” taxes (smoking, drinking, other forms of polluting, putting). If they needed to give more oxygen to economic growht they could still do this by cutting interest rates. And the politicians could blame it all on the Reserve as they do with interest rates.

  8. christine says:

    I think, Michael W, an easy answer is: the RBA has some control over the supply of money, but not much control at all over the supply of or demand for oil, so they’d be pretty unsuccessful in managing oil prices. Even OPEC’s not too great at that. I imagine there are more sophisticated answers, but “it can’t” is a good start.

  9. perhaps not says:

    To Paul F.

    I’m simply suggesting that there are rational reasons for politicians to ignore the economic evidence when it suits them, as opposed to ignoring the evidence because they can’t be bothered finding out. The statement, to the extent that it does not differentiate between these two possibilities, can only be vague. If the tenor of the statement is not intended to disparage, then perhaps I misread it, although not without reason I would argue.

    As to whether pollies should be called out for the (willful) misuse of the facts, I did not intend to claim they should not. Nor can my statement be taken to imply this, methinks.

  10. Michael W says:

    In reply to Christine, I’m not suggesting the RBA could control world oil prices. But it could control a component of the price in Australia – eg it could put up and down the oil excise rate, or some new consumption tax component calculated by reference to the externalities caused by oil consumption.

  11. David says:

    Andrew, your collleague at the RSSS, Bob Breunig has a working paper on this subject on his website. Their findings are the SR price elasticity is -0.13 and the LR price elasticity is -0.20

  12. GJ says:

    re perhapsnot

    …as opposed to ignoring the evidence because they they can’t be bothered finding out.”

    At the risk of being accused of pedantry, I’m mystified as to how one can ignore what one doesn’t know!

  13. perhaps not says:

    To GJ,

    As Rumsfeld put it (quite clearly I thought, although he was criticised for speaking opaquely): “there are known knowns; there are things we know we know. We also know there are known unknowns; that is to say we know there are some things we do not know. But there are also unknown unknowns — the ones we don’t know we don’t know.”. You are referring to the third of these; I, to the second.

  14. Stephen Lloyd says:

    I agree perhaps not, I thought Rumsfeld was quite clear, and should have been commended for making a complex idea even as clearly as that.

  15. Scotty says:

    Not sure what the objective of the original post was, other than to show that Tony Abbot doesn’t know what he is talking about when it comes to the price elasticity of fuel.

    From an economic standpoint, let’s go back to what we claim to be an underlying core element. That’s is the ensuring an unhindered competitive environment for the sale of products and services.

    When commodities become scare, the price goes up and vice versa. When demand drops, the price falls and vice versa. How about we conclude discussions at that? Oil is a finite product and, as is grows increasingly scarce, the price will rise, eventually quite significantly.

    Rather than expecting Governments to artificially manipulate market pricing, leave the market to determine pricing and live with it, much as it might cause discomfort.

    An example of how a market can be manipulated by buying pressure / power is a web site I came across recently called http://www.yellowbox.com.au. As far as I can see, they are bringing large numbers of consumers together to exert ‘buying power’ over the oil companies an, by doing this, reducing the price paid by the consumers for fuel and a range of other products.

    At last someone seems to have grasped the concept of a competitive, and unregulated, as far as pricing is concerned, market place.

  16. Grahame says:

    > Oil is a finite product and, as is grows increasingly scarce, the price will rise, eventually quite significantly

    This doesn’t follow. as it becomes scarce, people search for other alternatives and then the price falls to the point it becomes worthless. There may be unpredictable fluctations as this time approaches as the scarcity and other alternatives interact.

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