Economic News & Analysis - April 10, 2012Gasoline prices: Is there a tipping point?
By Brian Jacobsen, Ph.D., CFA, CFP®, Chief Portfolio Strategist
When it comes to prices, including gas prices, every penny matters. The $4- or $5-per-gallon “tipping point” for gas prices is actually a “media point” that would have us believe that these prices are extremely important. If this were true, then the data would support it. What the data actually show is every penny counts, whether that extra penny brings us to $4, $5, or any other price of gas. The fact is that consumers respond to prices—all prices—not just certain round numbers.
Gasoline prices and changing consumer behaviorShort-term demand for gas is what economists call “inelastic.” That is, no matter how much gas costs, consumers buy about the same amount. For example, those who drive to work need gas and will pay for it, regardless of the price. But when higher gas prices persist, people change their behavior. They learn to carpool and to economize on their fuel use, for example, by altering their routes to minimize the distance traveled to complete errands. Over even longer periods of time, people buy more fuel-efficient vehicles, move closer to work, or learn how to use public transportation. In other words, in the face of dramatically higher prices over time, demand is more elastic.
In the short run, people may change ever so subtly. Dramatic change may take a while, but when it does, it leaves a lasting legacy. For example, when drivers learned that gasoline prices can exceed $4 per gallon, they probably entered this fact into their calculations when it came time to replace their gas guzzlers. Because they’ve adjusted in this way, I’m not as concerned about this recent run-up in gasoline prices as I was about the previous one in July 2008.
Another reason I’m not as concerned is because natural gas prices are incredibly low. As a result, total spending on energy—driving, heating, cooling, and so on—as a percentage of personal consumption expenditures is still lower than its recent peak during the third quarter of 2008.
Economists call one of the results of the reduction in the consumption of gas when the price rises, the “substitution effect.” Higher gas prices mean not only a rise in absolute price but a price increase relative to other forms of transportation. That means people may opt to take the bus rather than drive, or join a carpool, or work from home. Another effect is called the “income effect.” Higher gas prices make you feel poorer, and this can influence other parts of the economy. For example, when gas prices more than doubled between 2006 and 2008, people shifted from eating out to eating in. And because lower-income individuals typically spend a greater percentage of their incomes on fuel than higher-income individuals, a gas price increase is particularly regressive, meaning that it is felt more acutely by the poor than by the rich.
Measuring the cost of high pricesThe increase in the price of gas from 2006 to 2008 changed the pattern of consumer behavior. Grocery sales are a good example. Not only do groceries have to be shipped, which requires energy, but significant effects are felt on the demand side as well. The increase in gas prices in 2008 showed that consumers made fewer trips to the store, shifted from shopping at grocery stores to supercenter-format stores (multi-product stores where you can get groceries and clothes all in one trip), and bought more promotional items rather than regularly priced national brands. Studies also show that consumers engaged in more comparison shopping, whether that meant online searches or even waiting to buy goods until they went on sale.
The effect of higher gas prices on the economy intimately depends on whether consumers perceive the increase as being temporary or permanent. If the higher price is viewed as temporary, then consumers will typically respond by temporarily reducing their savings rates to maintain their consumption patterns. If the price increase is viewed as permanent, or long lasting (for example, longer than a few months), then it can bring about bigger and more permanent changes. Automobile makers are also affected, as consumers are likely to shift to more fuel-efficient vehicles. That is precisely what has happened in the wake of the 2008 price increases and will likely be reinforced by the recent run-up in gasoline prices.
A number of different models are used to determine how sensitive consumer spending is to changes in gas prices. At $4 per gallon, retail sales seem to be the most sensitive part of the economy, with a 1% increase in the price of gasoline leading to a 2.5% reduction in the amount spent on retail and food sales. The convenience stores that sell gas are usually the hardest hit. Gas retailing is fiercely competitive with the average profit in 2011 coming in between 3 and 5 cents per gallon. Most of the money is to be made inside the building, not at the pump. Beverages and food sales are where the real money is, and those are typically the first sales that slump when pump prices rise. After crying just a bit at how much it costs to fill the tank, a driver might just slink off home and forget about buying the coffee and bakery item inside.
Gas price increases hurt, but it’s important to make a distinction between the high prices in the recent past and what might happen if they go to new highs. For now, the drag from high gas prices is likely to be felt most by convenience stores that sell gas but not by the economy overall.