Tuesday, July 29, 2008

Gas Prices and Miles Driven: Demand in Action

One of the most important micro economic ideas is the law of demand. The law of demand states that as the price of a good/service increases, people buy less and as the price of the good/service decreases, people buy more. This is not a difficult idea. With gas prices rising over the last year, we should expect people to buy less gasoline - either by switching to alternative fuels such as E-85 or switching to more fuel efficient vehicles or by conserving gas by consolidating their trips, or by car-pooling or ... - you get the picture.

A story from the USA Today gives some evidence that this is indeed what is going on. From the chart on the left from that story, we see that over the past year, Americans have been driving fewer miles than the previous year. The May 2007 numbers state that the largest drop in miles (9.6 billion) occurred in May 2007 as compared to May 2006.

So on the face of it, we have higher gas prices and fewer miles driven, which is consistent with the law of demand. Yet the article also hints that the slowing economy is also a factor, which I would not dispute. If this is correct, then we have another factor at play - that the entire demand curve for gasoline is shifting, and in this case, it is shifting to the left - or inward, and if this is the case - we should see gasoline prices declining in the near future.

Thus another reason that the amount of miles traveled is decreasing is due to a decline in income, which shifts the demand curve (for normal goods/services) to the left. When this happens, the quantity of miles driven decreases, and if it is just a leftward shift in demand, gas prices should also be decreasing. While gas prices have fallen in the last few days, this would not fit the overall trend. The impact of the supply of gasoline is also a major determinant of the price of gasoline, and relative to demand, supply has been shifting to the left, resulting in those gas price increases.

For another few of a movement along the demand curve - see this article.

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