Gas prices have risen steadily over the spring, with the national average approaching the $4.

00/gallon mark. The price of crude oil sits at $134 as of the close of trading June 17th, just nine months after breaking the $80 mark and less than six months since the first trade over $100 on January 2nd of this year. The results on American consumers and businesses have been profound. Impacts are being felt across all lines of industry, and almost every aspect of consumers lives.

The most public manifestation of higher gas prices is the price at the pump. The figures are displayed loudly at each gas station and affect the daily lives of most US consumers. Therefore, the first place to look for the impact of rising fuel prices is driving habits. The consumption of gasoline for automobiles has long been considered to have a high degree of elasticity. What the recent fuel price increases have done, however, is push towards the boundaries of elasticity.

In a poll conducted by Ipsos from May 30-June 2, 2008, 67% of those polled indicated that they had already changed their driving habits because of the increase in fuel prices. The median level at which they did so was $3.20 per gallon. We can take that to be the point at which the inelasticity of fuel prices begins to erode. It stands to reason that todays prices, which are in the range of $4 per gallon nationally, has resulted in shifts in consumer behavior. The same survey indicated that 74% will change their driving habits at $4/gallon, and 85% will do so at $5/gallon. Only 10% of those Americans surveyed indicated that they are truly price inelastic1, and no account was made for the percentage of those who do not even own a car and whose consumption is thus inelastic by default.
1

Boyon, Nick. (2008). As Gas Prices Near $4.00 a Gallon Nationally, Two-Thirds of American Say they have Changed their Driving Habits. Ipsos.

Gas prices, along with the corresponding cheap cars and abundant freeways, has been a key driver of an incredible array of other industries. This newfound elasticity in gas prices can be expected to have a profound impact on many of these if the high prices are sustained for any significant length of time. A Reuters poll conducted this month indicates that 39% of consumers are considering changing their vacation plans, and 58% plan to drive less2. A whole host of industries will be affected by this decrease in demand, from hotels, restaurants and theme parks to automobile manufacturers and their suppliers.

Of particular note is the difference between demand shift for automobiles between the current runup in fuel prices and during the oil crisis in the 1970s. That crisis saw immediate impacts to the economy as well, but they were different in a few key ways. For example, automobile sales shifted towards smaller vehicles, sparking a trend that did not reverse until the advent of the SUV fad in the 1990s. The current crisis, however, has not seen this. In part, this is due to the fact that demand for such vehicles already exists, which was not the case to any significant degree in 1973. New alternatives to consumption-heavy vehicles include hybrid cars, but the Ipsos poll indicated that only 3% of respondents was going to look at such a vehicle as a response to the fuel prices. Instead, the greatest percentage stated that they would cut back on travel and recreational driving, or consolidate their errands.

The case could be made that the apparently lack of interest in reduced-consumption vehicles reflects the recency of the crisis. Last September, fuel prices were in the $80/barrel range, which when translated to the price at the pump remained below the threshold at which the inelasticity of fuel demand begins to erode. The time frame of the present crisis has simply not been long

Kaiser, Emily. (2008). Fuel Spike Curbs Vacations, Dining Out. Reuters.

enough to give consumers cause to consider big-ticket purchase decisions as a response. After all, the demand for smaller cars that resulted from the 1973 crisis was a trend that grew throughout the 70s and did not even begin in earnest until after the crisis has subsided.

However, the Reuters poll indicated that 10% of respondents were considering a move closer to work, and almost as many were considering taking a job closer to where they live. Such largescale considerations on the part of consumers hint at a seismic shift in lifestyle. Home purchases and job selection are bigger investments for consumers than automobiles. If the strength of these immediate impacts hold true over the coming years, it is the first real indication that a broad segment of society is giving serious consideration to the opportunity cost of the automobile when examining their choice of housing options.

The demand for suburban housing has been driven in large part by the affordability of automotive transport. With other important economic and non-economic factors taken into consideration, such as real estate prices or crime rates, the opportunity cost of suburban housing has generally weighed in its favor. However, if fuel prices escalate to a point where such housing becomes less economically viable, consumers may begin large scale relocation to the newlyaffordable urban areas.

Because of the high level of dependency our economic system places on transportation, consumer goods are facing upward price pressure, and this is also having an impact on consumer decisions. Food is a classic example. The demand for food is inelastic people will always need to eat. However, food prices are increasing, forcing consumers to examine the opportunity cost of food as well. There has been speculation that consumers will eat better because of the

crisis, since the cost of processed food compounds due to the extra layers of transportation required to bring the goods to market.

The concept of opportunity cost is a factor as well when it comes to food. While the demand of food in general is relatively inelastic, the demand for restaurant food is not. Dining out is considered a luxury by many. As increasing amounts of discretionary income goes towards the rising fuel prices, inevitably less will go towards luxury expenditures for which easy substitutes exist, a category dining out easily falls into. The Reuters poll showed 31% were planning to dine out less as a result of the fuel price increases.

The same supply-and-demand equations work for businesses as well. FedEx reported lower earnings and issued a grim forecast for 20093. That company is considered a bellwether for the US economy because its customer base is so broad-based across all industries, and includes corporate, institutional and residential sectors. In their statement, they attributed the decline in revenues and profits directly to the high cost of fuel. So it is clear that businesses are also examining their needs as well, and fuel-dependent premium services such as those FedEx offers have seen a significant drop in demand.

With the decline in the use of fuel-dependent services such as those offered by FedEx, and the plans of consumers to reduce their consumption of fuel by one means or another, what does this mean for the price of fuel? Economic rationale is based on the concept of perfect markets, which means that as prices rise, demand falls, until equilibrium is achieved. The instability of fuel prices in the past several months is not indicative of a market in equilibrium.

Carey, Nick. (2008). FedEx Posts Loss; Gives Low Forecast; Blames Fuel. Reuters.

If the price of fuel is not in equilibrium, we have a market failure, at least temporarily. Market failures can occur many ways. In the case of the recent fuel price runup, speculation surrounds both negative externalities and monopolistic practices. The key externality under consideration is the role of commodity speculators. Both the Senate and Congress have addressed this issue directly. Senator Claire McCaskill directly challenged the US Commodity Futures Trading Commission to deal with the issue4.

For their part, commodities traders suggest that the answer to high prices still lies within the laws of supply and demand. While domestic demand has decreased in recent months in response to the price increases, demand in international markets, particularly in China and India, has continued to grow. The nature of demand in those markets means that demand there continues to be inelastic. With expanding economies that are increasing the wealth of the populace en mass, those countries are essentially creating millions of middle class consumers with middle class needs where they didnt exist before. There is no elasticity to the creation of new consumers, as few would reject the opportunity to join the middle class simply because gas prices are on the rise. Twenty years ago, global demand reflected almost entirely demand in the West, which was inelastic. Now that demand in the West is becoming elastic, some clearly feel that this should be the case for global demand as well. But demand in emerging markets is still inelastic, which means that the case of supply and demand driving the current rise in oil prices can be made. To the extent of at 65% rise in nine months? Perhaps not, but even if there is a market failure on account of speculators, it will correct itself eventually and we will still have inflated fuel prices and rising demand to contend with, bringing with it a whole host of supply and demand shifts

Douglass, Elizabeth & Gaouette, Nicole & Simon, Richard. (2008). Are Commodities Traders Bidding Up Food, Fuel Prices? LA Times.

across our economy.

Sources:

Boyon, Nick. (2008). As Gas Prices Near $4.00 a Gallon Nationally, Two-Thirds of American Say they have Changed their Driving Habits. Ipsos. Retrieved June 18, 2008 from http://www.ipsos-na.com/news/pressrelease.cfm?id=3953 Carey, Nick. (2008). FedEx Posts Loss; Gives Low Forecast; Blames Fuel. Reuters. Retrieved June 18, 2008 from http://www.reuters.com/article/ousiv/idUSWNAS861120080618 Kaiser, Emily. (2008). Fuel Spike Curbs Vacations, Dining Out. Reuters. Retrieved June 18, 2008 from http://www.reuters.com/article/ousiv/idUSN1744550120080618 Douglass, Elizabeth & Gaouette, Nicole & Simon, Richard. (2008). Are Commodities Traders Bidding Up Food, Fuel Prices? LA Times. Retrieved June 18, 2008 from http://www.latimes.com/business/la-fi-traders21-2008may21,0,2916861.story