Gas Prices: How Much Is Too Much?

Waldo Jaquith posts a chart on his blog that suggests the minimum wage (per hour) is converging with the price of a gallon of gasoline and asks, "What happens when the minimum wage exceeds the cost of a gallon of gasoline?" (meaning, as one of his commenters notes, "when the cost of a gallon of gasoline exceeds the minimum wage").

Waldo does not find this scenario hopeful.

For me, he provides an opportunity to discuss gasoline prices, something I've wanted to do for some time now but just haven't got around to it. I think he frets too much.

The fact is, gasoline prices are not as much of a hardship as one might think, even for those few people who both earn the minimum wage and own a car to use for their personal transportation.

Nobel laureate economist Gary Becker notes on the blog he writes jointly with federal judge Richard Posner:

Gasoline prices have risen by about $1 during the past year to almost $3 a gallon. This is a very large increase over a short period of time, but it should be put in perspective. Spending on gasoline by the average household has risen from about 2% of its total consumer spending to a still low 3%-it reached over 4-1/2% of personal consumption spending in 1981. The real cost of gasoline, adjusted for changes in the price level, is less than in 1981. Since a typical family has a higher real income than it did 25 years ago, the burden of high gas prices is easier to bear now than at that earlier time. The higher price will pinch for families who commute long distances to work in their SUV's, but the price of gasoline does not have a major effect on the many poor families who take public transportation to work.

Meanwhile, Glen Whitman, who worked under me as an intern at the International Freedom Foundation (when he was a Koch Fellow and an undergraduate at American University in D.C.) and is now an associate professor of economics at California State University-Northridge, posts this graph on his own blog, Agoraphilia:



Glen explains:

So what can we see? Even looking at the poorest fifth of the population, the fraction of income required to buy gasoline is still lower than it was in the early '80s. Not surprisingly, the fraction has risen a great deal over the last few years, but it still has not surpassed its historical peak. The same holds true for every other income quintile, but the effect is more muted, since higher income means any given price difference will correspond to a smaller fraction of income. (If gas prices stay at their current price of about $2.90/gallon, however, then we could pass that early-80s high-water mark this year.)

How is it possible that the same qualitative pattern holds for both rich and poor, given the rising disparity in income? It’s true that the income gap has increased since the 1970s. But that’s not the same as saying the poor have gotten poorer, because in fact real incomes have risen for every income group over this period. The gap has grown because the rich have gotten a lot richer, while the poor have gotten a little richer.

Glen's explanation goes a long way to answering an unspoken question I have had on my mind: Why does demand for gasoline seem inelastic even in the face of what appear to be dramatic price increases? The reason is that, no matter what income bracket an American might be in, the price is not hitting the pocketbook as hard as it seems to do so on the surface.

Another aspect of the situation is this: As prices rise, despite short-run inelasticity of demand, consumption will decline (due to the substitution effect), and prices will follow. Here is Richard Posner replying to Gary Becker:

In fact the cause of the price spike is primarily, as I said, the increase in crude oil prices, and that increase is in turn primarily the result of rapid growth in demand for oil by China (now the world's second-largest consumer of oil) and India, a growth that has outpaced supply. The notion that this represents a crisis--that the world is running out of oil--is ridiculous. In the short run, with demand rising faster than supply, price rises steeply, producing "obscene" profits since roughly the same quantity is being sold at higher prices. In the longer run, consumption falls as consumers search out substitutes; supply rises as previously uneconomical sources of oil become economical; and so profits fall back to a normal level. . . .

From the broad national standpoint, we should welcome high gasoline prices because it is in the national interest to reduce our consumption of gasoline, and high prices will do that, dramatically so in the long run when more substitution is possible.

We'll leave the question of the minimum wage for another day, unless you'd like to visit my previous posts on it, here and here.