The Power of Inelastic Supply and Demand for Gasoline

Over the last year, the price of gasoline has increased by close to 50 percent while the price of crude oil has only moved by about 5 percent. Some have argued that this difference in price increases is clear evidence of price gouging. What we can tell for sure is that the demand and supply for gasoline is extremely inelastic. Inelastic demand or supply states that production and consumption is insensitive to price. Gasoline has become a poster child for this type of market.

Demand has actually increased over the last year. There has been no cutback in driving by consumers. There has been an increase in the productivity of gasoline usage through purchasing of hybrid and fuel efficient cars but that has not translated into fewer barrels consumed. Hybrid cars are more expensive than normal combustion engines so the payback for a purchase is shortened when the price of gasoline increases, but the fuel savings for the economy will be minimal until there is significant replacement of the existing fleet of cars. In the short-run, there are few substitutes for driving. Consumers have to drive and they are not changing behavior.

Supply is also inelastic. The price of a new refinery can be measured in billions of dollars and takes years to bring on-line. The regulatory review process is significant and there are few communities that want to embrace this industry. Currently, 14 percent of all gasoline is from imports and is rising. If there is high demand from other parts of the work, the slack in the supply chain is nonexistent. Any down time in refineries that are working at 100% of capacity, whether from seasonal conversion or safety, leads to a meaningful supply short-fall. There is no buffer stock from inventory to absorb the shock.

Draw inelastic demand and supply curves for gasoline and the impact will become obvious, volatile prices. The behavior of prices will also be distorted. The upside shock on prices will be greater and there is less likelihood that prices will quickly decline. The distribution of price changes will likely be positively skewed. This will not be solved if more crude is produced or imported. It will not be solved in the price of oil falls to below $60 per barrel. Consumers will have to get used to it.