The case study of the article from Wall Street Journal, dated from March 2008. AMERICANS START TO CURB THEIR THIRST FOR GASOLINE. SLIDE 2 In recent years, the world’s appetite for gasoline and diesel fuel grew so quickly that suppliers of these fuels had a difficult time keeping up with demand. We all know the situation with gasoline prices for the resent several years. The prices for gasoline had been changed rapidly. Mostly increasing, while the demand for it did not. For example, gasoline prices by Feb. 2008 rose to an average of $3. 13 a gallon, that is up to 40% from $2. 4 in Jan 2007. ( with the price elasticity 1%/40% = 0,025), and up to 62% from 2003. (with the price elasticity 1%/62% = 0,016). Yet, demand continued to grow at an average 1. 15% a year by 2006. Someone could ask why the rise of price did not caused the reduce of demand. The answer is that in this case we face the shift of demand (2003 – 2006) due to increase in customers income, and the cars appeared to be more affordable for most people, especially favorable were huge cars (and very fuel inefficient), that perceived to be more safe and prestigious.
As we know, increase in demand for complementary good 1 causes the increase of demand for complementary good 2 (cars and fuel). As cars can not run without fuel. The increase of demand for gasoline was the response to the increased demand for cars, and market responded for that with the increase of gasoline prices (shift in equilibrium price). SLIDE 3 Consumers were better able to absorb the increase in gasoline prices and pinch pennies at less price stores like Wall mart and keep driven, because : 1. Consumers could not stop driving, driving could be the last thing they could refuse to do.
And they could not drive without gasoline – as there are no substitutes for gasoline (unless they switch for other fuel-source car) 2. Consumers thought that was only shot- term increase in gasoline prices, and consumers expected the gasoline price to return to its previous price pretty soon, 3. Consumer’s income remained at the same or growing level. SLIDE 4 Later, in 2008- 2009 we could watch the decreasing in people’s income, prices for gas continued to grow, while the quantity demanded for gas did not decrease as much. According to the article, just 0. % decrease in demand in a short term by 2008, when gasoline prices rose 10% from 2007, and 4% cut of demand in long term (if sustained over 15 years). That was the most sustained drop in the demand in 2008 (except for declines from Hurricane Katrina in 2005). We can see the difference in demand cut in short and long terms, as we know the demand is more inelastic in short term, because: – people wait the situation to improve to the better – they are not customized to the situation and don’t know what to do – can not change a lot of things in short time period. SLIDE 5
We, we can calculate the price and income elasticity of gasoline demand. In short run price elasticity for gasoline demand is 0. 6%/10%=0. 06, and 4%/10%=0. 4 for long run. So, we can see now, that price elasticity coefficient is less than 1, or percentage change in quantity demanded is less than percentage change in price change, that means that elasticity for gasoline demand is inelastic. That means that consumers have little responsiveness for price change. SLIDE 6 Gasoline prices kept rising together with the reduction in personal income (1% reduction in personal income cuts gasoline demand by 0. 5% as consumers.
Income elasticity for gasoline demand was : 0. 5%/1%=0. 5 (normal good, necessity good), SLIDE 7 Later, the situation continued to change to the worse, consumers started to react: 1. Consumers turned their life to more fuel-efficient lifestyles. Big, prestigious fuel inefficient cars were replaces by smaller cars and hybrids. Sales on large cars dropped to 10. 5% in 2007. And only small cars and more fuel-efficient cars were rising in sales. 2. There was also a trend to drive less and adapt to more fuel saving driving style. They tried not to drive without necessity, buy products at one place, buy products for the whole week… 3.
There was a trend to reduce driving distance: migration toward city centers and workplaces. SLIDE 8 So, what were the reasons that caused the increase in price without the decrease in demand? (Consumers irresponsiveness to price changes / inelasticity of gasoline demand): 1. Consumers tastes and preferences. Big, safe and prestigious car vs. small fuel saving cars. 2. Consumers income and amount spend on a product in relation to income. With high income consumers are less affected by gasoline prices. In 1981 5% of personal consumers income was spend for gasoline vs. % in 2006. 3-5 % is a relatively small part of the total income. As we know, the less part of income is spend for the product the less elastic demand for it is. 3. Availability of substitute goods. As we know, there is No substitute for gasoline. 4. The amount of time needed to adjust to changes in price. The more time customers need to adjust to price rise, the more inelastic demand for product is and vice versa. SLIDE 9 Besides, there was another reason that limited consumers responsiveness for gas prices. That was the difference between nominal and real price.
While nominal price for gas had increased, the real or inflation adjusted price (in terms of spending power) dropped since 1980s. $2. 74 in 2006 vs. $3. 18 inflation adjusted price in 1981. SLIDE 10 [pic] As we can see, in 1980 nominal price per gallon of gasoline was approximately $1. 2, but in relation to today’s prices it was $3. 2. ( we tie the old price to today prices, that means that today one can buy much less for $1. 2 that in 1980, because of inflation). The more is the time gap, the more nominal and real prices differ each other, as inflation always takes place.
That is why we can see that difference between nominal and real price decreases over time. SLIDE 11 This article is related to 2008 and lets see how the situation changed by nowadays? SLIDE 12 Lets look at the picture. It shows the Main Components of the Retail Price of Gasoline. [pic] SLIDE 13 • Crude oil prices are determined by worldwide supply and demand. Events in crude oil markets that caused spikes in crude oil prices were a major factor in all major run-ups in gasoline prices. • Crude oil prices increased 18%, while the average retail price for gas increased in 0. 58 % because of reduction of taxes and companies profit. Companies and government had to reduce taxes and profit. • Suppose what would happen if prices for gas increased 18% (mass meetings of protest? ). SLIDE 14 Seasonal Demand for Gasoline Retail gasoline prices tend to gradually rise in the spring and peak in late summer when people drive more, and then drop in the winter. Good weather and vacations cause U. S. summer gasoline demand to average about 5% higher than during the rest of the year. Gasoline formulations and specifications also change seasonally. Environmental regulations require that gasoline sold in the summer be less prone to evaporate during warmer weather.
This means that refiners must replace cheaper but more evaporative gasoline components with less evaporate but more expensive components. If crude oil prices do not change, gasoline prices typically increase by 10-20 cents per gallon from January to the Summer. SLIDE 15 Gasoline Supply and Demand Imbalances Gasoline Stocks Are the Cushion Between Major Short-Term Supply and Demand Imbalances. Gasoline prices tend to increase as the available supply of gasoline grows smaller relative to real or expected demand or consumption. This demand growth is a key reason why prices of both crude oil and gasoline reached record levels in mid-2008.
By the fall of 2008, crude oil prices began to fall due to the weakening economy and collapse of global diesel demand, which had pushed oil prices to record levels earlier in the year. These factors helped gasoline prices drop to the lowest levels seen in several years. Retail gasoline prices are mainly affected by crude oil prices and the level of gasoline supply relative to demand. Strong and increasing demand for gasoline and other petroleum products in the United States and the rest of the world at times places intense pressure on available supplies.
Even when crude oil prices are stable, gasoline prices fluctuate due to seasonal demand and local retail station competition. Gasoline prices can change rapidly if something disrupts the supply of crude oil or if there are problems at refineries or with delivery pipelines. SLIDE 16 [pic] As we can see, the amount of gas demanded and supplied differs between regions. Rocky Mount is the lightest while Gulf Coast is the heaviest user of gasoline and as we will see late, Gulf Coast has the lowest price for it, while Rocky Mount and West Coast have the highest prices. SLIDE 17 [pic]
Here is another picture, representing differences in prices between regions. Why Are Gasoline Prices Higher in Some Regions Than in Others? SLIDE 18 Although price levels vary over time, average retail gasoline prices are often highest in certain States or regions. Besides taxes, there are other factors that contribute to regional and even local differences in gasoline prices: Distance from Supply Usually Means Higher Gas Prices Retail gasoline prices tend to be higher the farther it is sold from the source of supply: ports, refineries, and pipeline and blending terminals. About 67% of the crude oil processed by U. S. efineries in 2008 was imported, with most transported by ocean tankers. The U. S. Gulf Coast is the source of about 37% of the gasoline produced in the United States and the starting point for most major gasoline pipelines, so those States farther from the refineries will most likely have higher prices. Supply Disruptions Can Cause Run-up in Prices Any event that slows or stops production of gasoline for even a short time, such as planned or unplanned refinery maintenance or the refinery shutdowns that occurred when the Hurricanes Katrina and Rita hit the Gulf Coast in 2005, can prompt bidding for available supplies.
If the transportation system cannot support the flow of surplus supplies from one region to another, prices will remain relatively high. Retail Competition and Operating Costs Play a Role in Pump Prices Pump prices are often highest in locations with few gasoline stations. As we saw at slide 16, Gulf Coast has the lowest prices for gas as it is the main gasoline storage in USA and the starting point for the major gasoline pipelines. Even stations located close together may have different traffic patterns, rents, and sources of supply that influence their pricing.
Drivers face a trade-off between stations with high prices and the inconvenience of driving further to find a station with lower prices. Environmental Programs Add to Cost of Production, Storage, and Distribution Some areas of the country are required to use special “reformulated” gasoline with additives to help reduce carbon monoxide, smog, and toxic air pollutants that result when gasoline is burned or when gasoline evaporates during fueling. Other environmental programs put restrictions on fuel transportation and storage.
These programs tend to add to the cost of producing, storing, and distributing gasoline. About a third of the gasoline sold in the United States is reformulated. Each oil company prepares its own formulation to meet Federal emission standards. SLIDE 19 Why Are California Gasoline Prices More Variable Than Others? Gas prices in San Francisco, California, in the summer of 2008, were the highest they have ever been. California prices are higher and more variable than prices in other States because there are relatively few supply sources of its unique blend of gasoline outside the State.
The State of California’s reformulated gasoline program is more stringent than the Federal government’s. In addition to the higher cost of this cleaner fuel, there is a State sales tax of 7. 25% on top of an 18. 4 cent-per-gallon Federal excise tax and an 18. 0 cent-per-gallon State excise tax. [pic] SLIDE 20 California Refineries Running Near Full Capacity to Meet Demand California refineries need to be running near full capacity to meet the State’s gasoline demand. If more than one of its refineries experiences operating problems at the same time, California’s gasoline supply may become very tight and prices can soar.
Even when supplies can be obtained from some Gulf Coast and foreign refineries, they can take a relatively long time to arrive due to California’s substantial distance from those sources. The farther away the necessary relief supplies are, the higher and longer the price spike will be. SLIDE 21 Summary. Let’s conclude the main factors, fluctuating gasoline prices. 1. Demand and Supply for gasoline and crude oil. If demand for gas is higher than supply, the prices for crude oil and gasoline itself go up and vice versa. . Demand for gasoline is affected by: – customer’s income, – customer’s preferences, – customer’s expectations, – availability of substitute goods. 3. Supply for gasoline is affected by: – demand for gasoline, – resources available, – sellers expectations. If there is a shortage of gasoline, than the price for it will go up and Vice versa. 4. Taxes. Can affect the price very much. 5. Season. 6. Region location. The father the region is located from main gasoline pipelines, the higher the prices are. SLIDE 22 THANK YOU.