Elasticity

Chapter 4 - Elasticity

What is Elasticity?

Elasticity is the degree to which changes in price and incomes affect demand and supply.It also can measuring the responsiveness of a function to changes in parameters in a unit less way. If price decrease quantity demand will increase , then demand is said to be elastic.  If price increase quantity of supply will decrease, then supply is said to be inelastic.Elasticities include , price elasticity of demand , price elasticity of supply ,cross elasticity and income elasticity of demand.Price elasticity of demand is measures the responsiveness of demand to changes in price. Price elasticity of supply is measures the responsiveness of quantity supplied to changes in price. Income elasticity of demand measures the responsiveness of demand to changes in income.

The End Of Elastic Oil

The last ten years have brought a structural change to the world oil market, with changes in demand increasingly playing a role in maintaining the supply/demand balance.  These changes will come at an increasingly onerous cost to our economy unless we take steps to make our demand for oil more flexible.

In economic terms, the oil supply is becoming less elastic as new oil supplies come increasingly from unconventional oil.

Elasticity of Demand

On the demand side, the elasticity of the demand for oil reflects the options we have to using oil for our daily needs. At a personal level, we can quickly cut our demand for oil a little bit by combining car trips, keeping our tires properly inflated.  If we live in an area without good public transport  we can’t stop driving to work without losing our job, so we keep driving to work, and paying more for the gas to get there.

Over the longer term, our personal options to cut oil consumption increase.  We can move closer to work, or to somewhere where we can walk or use public transport to get to our job. This is why the most fuel-efficient vehicle is a moving van.

Below you can see the correlations between three year changes US and worldwide supply and demand with three year changes in US oil prices (WTI) and world oil prices (Brent), after various lags:

Note that they are looking for negative correlation between price and demand (we use less oil when we have to pay more for it), and positive correlation between price and supply (companies produce more oil if they can get more money for it.)

From the chart, the world oil supply has historically taken about one year to respond to changes in world prices (the blue line peaks at 40% correlation with a one year lag), while domestic US oil production (supply) has typically taken about four years to respond to changes in the oil price, but that response is much stronger than the response of world supply.

In conclusion, if the price elasticity of the oil market had not been falling over time, the increasing magnitude of changes in oil prices would have produced a similar increase in the magnitude changes in oil supply and demand.

What measures can we take to increase the elasticity of oil demand, and reduce the pain of demand destruction?  Measures which increase our citizen’s options for reducing oil use.

• Increased investment in alternative modes of transport, such as mass transit (both buses and rail), bike lanes, bike and car sharing, and walking improvements to allow many more workers the option of getting to their jobs without the use of a personal car.
• Improvements in our nation’s rail system to allow more freight to be shifted from truck to rail.
• Increasing gas taxes slowly and predictably over time to both fund the above improvements, and to signal to consumers that they need to prepare for long term higher prices by purchasing more efficient vehicles and changing where they live so that they have the ability to reduce their driving.
• The use of road congestion pricing, pay as you drive insurance, and other price signals that give people the right market signals and enhance the most efficient use of our nation’s roadways.
• Encouraging the electrification of transport (including the alternative transport options mentioned above) to provide transport options which are not dependent on oil.