Elasticity! Why cutting gas taxes won't lower prices, but will fatten oil companies.
June 14, 2008.

When Clinton and McCain proposed cutting gas taxes, I asked my environmental economics students, "So how much do you think drivers will save?" The students diligently Googled the numbers. "Well," said one, "the federal gas tax is 18.4 cents and the average state tax is 28.6 cents, so that's 47 cents a gallon drivers will save!" "But what about elasticity of demand and supply?" I asked. "Oh!!! Forgot about that!"

Elasticity. Nemesis of Econ. 1. A vital concept even professional economists often forget. Elasticity is just the percentage change in quantity purchased or supplied, divided by the percentage change in price. An increase in price will lead consumers to buy less, and suppliers to offer more; vice versa for a price decrease; elasticity measures the size of that effect.

Elasticity of demand for gas is low, around 0.5. That means a 10% increase in gas prices will cause only a 5% decrease in gas consumption. That's because it's difficult, in the short run, for people to change their habits, for example, to buy smaller cars, to move closer to work, or to change vacation plans. But in fact some people do change; already unsold SUV's clog the dealers' showrooms and lots.

But--and here's the crucial point--elasticity of gas supply is even lower, much lower than elasticity of demand. In fact, short run elasticity of supply is near zero. Two reasons: First, it's very hard to increase supply quickly because that means expanding refining capacity. Many suppliers, especially national suppliers like Russia, Venezuela and Libya, are failing to invest in upgrading capacity. Then there's the oil production disaster in Iraq. Second, oil companies have some monopoly power, which means they are, to some degree, already holding back production in order to raise their prices. That makes it even harder for them to decrease or increase supply in response to a tax or subsidy.

A tax on a product like gasoline falls in inverse proportion to elasticity. If elasticity of demand is 0.5, and the elasticity of supply is, say, one tenth as much, or 0.05, then suppliers pay ten times as much of the tax as consumers. That is, most of the tax falls on suppliers. Another way to put it is that suppliers cannot pass on a gas tax to consumers.

Conversely, a tax cut will deliver a windfall to suppliers, without appreciably lowering prices at the pump. When some New York State counties tried lowering local gas taxes in response to consumer protests, gas prices didn't budge.

There are broader policy implications here: First, we can substantially raise gas taxes without much pushing gas prices above their market level--in the process capturing more of the windfall profits currently enjoyed by oil producers. Second, if we wish to discourage carbon emissions from cars, we need to look to other approaches besides gas taxes, for example, setting emission standards for automobiles, improving public transportation and encouraging denser development.

The US subsidizes ethanol production by something over a dollar a gallon, supposedly to replace gasoline. On the final exam, I asked my students this question: if Congress eliminates ethanol subsidies, will suppliers or consumers suffer more, and why? Only one student got the answer completely correct: By the same logic of relative elasticity, subsidies to ethanol production accrue mostly to suppliers, not consumers. So eliminating subsidies hurts suppliers more than consumers. Elasticity is a slippery concept!

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