Asymmetrical Information

From the desk of Jane Galt:

Whew! The CAFE debate is

Whew! The CAFE debate is still raging: for those interested in further exploration of the topic, a good place to check is The Cato Institute -- or just search Google on CAFE and "rebound effect" together.

Now I'm going to try to explain why fuel economy standards by themselves don't work very well; in order to do so, I want to introduce you to a concept called Price Elasticity of Demand.

Actually, I'm sure a lot of you have already met this concept; it was in bold type on the page of the book that left an ugly crease in your face when you fell asleep on it the night before your Econ 101 midterm. Rather an obscure, stuffy old fellow, Price Elasticity of Demand. But important. Don't worry, we'll try to make it as painless as possible - I promise I won't even try to explain how we calculate the bastard. Just the basics.

Let's start with the demand curve, a representation of how prices work that's so obvious you smack your forehead and wish you'd thought of it. Check out the simple graph below. On the Y axis we show price. On the X axis, the quantity demanded at a given price. They are labeled, for your reading pleasure, P for Price, and Q for Quantity.

Now, as you would expect, the amount of most things that we demand changes with the price. No matter how much you want a triple-mocha half-skim latte, you won't be buying many of them if the Starbucks manager jacks up the price to $30 a pop. Similarly, if the guy down at Tri-State Mercedes drops the price on the SL500 to $5, you'll want a lot more of them than you do right now. Hell, everyone in the family pick one out! Your demand will be limited only by your available driveway space.

All of which is a long way of stating the obvious: when the price of something is higher, we want to buy less of it. When the price drops, we want to buy more. That's why the demand curve, which is what this graph shows, slopes downward: because quantity demanded varies inversely with price. The higher the price, the lower the demand, and vice versa.

Price elasticity is a way of describing how much it varies. When we say that something is highly elastic, we mean that a small percentage change in price produces a big change in the quantity we demand. The bigger the item is as a percentage of your budget, the more likely this is to be true; few people will go out of their way to get 3% off on toothpicks, but most will when they're shopping for that Mercedes. . .

Now, the more elastic demand for something is, the flatter the demand curve, so that something which is highly elastic has a very flat curve, like this one:

Conversely, there are products that are extremely inelastic. Big changes in price produce very small changes in demand. Remember shopping for textbooks in college? Remember how it felt to come out of the bookstore with all those heavy tomes you were never, ever going to read again? Like being robbed at gunpoint by a disaffected 19-year old librarian with a mohawk, that's what. Your professors told you to get this edition of this book by the 1st of September. You didn't have the option of waiting until the December sales; nor would your professor allow you to substitute another Calculus text, no matter how hard you argued it was "just as good". And if you'd actually bought your Microeconomics textbook, instead of just borrowing it from the library one night and trying to osmose the knowlege inside by sticking it under your pillow, you would have known that your demand was highly inelastic. No matter how low a price the bookstore set, you weren't going to buy 3 copies of Remembrance of Things Past. And no matter how high they set the price, you were going to buy one copy because otherwise you'd flunk the course. The bookstore responded to the market by jacking up the rates to levels that would make loan sharks blush. You responded by paying the freight and calling home to ask Mom and Dad for more cash.

This chart shows what a highly inelastic demand curve looks like. It's very steep, because big changes in price don't produce much change at all in the quantity demanded.

Now, if your demand were perfectly inelastic, that curve would be a straight line -- no matter what the price, you'd buy exactly the same amount. There are few items that are perfectly inelastic; after all, if they raise the price of textbooks to $10,000 a pop, your parents might decide that a bright future awaits you in air conditioning repair school. There are some, however: coffins, for example. They're pretty much one to a customer; you're not going to suddenly buy three just because they're on sale. Nor can you really do without in this age of lavish funerals and tight (although apparently not tight enough) government regulation. So your demand for coffins would be a vertical line described by the formula Q=1. Like this:

So that's an overview of Price Elasticity of Demand. You'll now know what the Economist is talking about. If you read the Economist. And if you don’t, you should.

Now Jane, I hear you say, you’ve just bored the hell out of me for fifteen minutes I’ll never get back, when I thought you were going to talk about something I really care about – like Corporate Average Fuel Efficiency. How about changing the topic to something fun and exciting like that?

Patience, my children. I am getting there.

Price elasticity turns out to be very important for discussing the debate over CAFÉ versus a gas tax. Here’s why: how effective CAFÉ is, compared to the gas tax, depends on how elastic the demand is. You wouldn’t think that demand for gasoline would be very elastic. But it turns out to be when you think about it not in terms of gasoline, but in terms of the Price Per Mile Traveled (PPMT).

If PPMT is not very elastic, than CAFÉ will work almost as well as a tax at reducing overall fuel consumption. This seems counterintuitive to many people, but let’s look at what happens to the PPMT when we institute CAFÉ versus a gas tax. With CAFÉ, the price of the car goes up (and its safety and performance go down, but that’s another argument). But the Price Per Mile Traveled Goes Down. Let’s compare a 3 mpg increase in fuel efficiency to a 30 cent increase in the gas tax:

As you can see, the price per mile traveled goes up with the gas tax, but down with the increase in fuel efficiency. Now, as we just learned, when the price of something goes down, the quantity consumed goes up. We’re used to thinking in terms of the price of gasoline, which hasn’t changed. But if we realize that the consumers are actually consuming mileage, not gas, then we can see that CAFÉ inevitably increases the mileage consumed. This is called the “rebound effect”

Now, how much mileage increases depends on – let’s not always see the same hands – yes, that’s right, price elasticity. I’ve thrown together some charts that show consumption functions for high, medium, and low elasticity, depending on the price per mile. (Anyone who cares to know my ham-fisted methodology may email and I will explain it. These numbers are NOT intended to be representative of any real world, actual demand for mileage; they’re just for illustration.)

As you can see, if demand is very elastic, a change in the gas tax produces a big decrease in consumption – while raising the fuel economy of the car they’re driving produces a big increase in consumption, so that there’s a huge difference in how much gas they use between taxing and making vehicles more fuel efficient, even if the overall cost to the consumer is the same.

Conversely, if elasticity is low, then it doesn’t make much difference which you choose; people won’t drive much more if mileage is cheaper; and they won’t drive much less if it’s more expensive. CAFÉ may actually make a better choice here.

So which is it?

Well, in the short run, demand is pretty inelastic; you’re not going to skip a trip to the grocery store because gas is too expensive. But over the medium and long term, it’s pretty elastic; people make travel and commuting decisions based on how much it will cost. The rebound effect eats between 20-30% of the gain in fuel efficiency.

Well, that’s not so bad, you might say.

Ah, but that’s not the full story. Congestion eats even more of the conservation – you don’t get that 27.5 mpg when you’re stuck in traffic with all the other people who decided to take a drive because it’s a nice day.

Cars are made less safe. There are two ways to increase fuel efficiency: decrease acceleration power, or decrease the weight of the vehicle. Both cause more accidents – and more deaths.

Cars stalled in traffic cause more pollution than cars on the open road.

Roads need more maintenance.

Etc.

So why do we have CAFÉ? Because it’s a hidden cost, that’s why. People say they’re in favor of CAFÉ because it’s easy. What they’re really saying is that they don’t want to tell people that they have to make hard choices; they’d rather add $3,000 to the price of their cars, and increase their risk of accidents, and impose all those other hidden costs, without telling them. This is the exact opposite of what economists are supposed to be for: open, transparent markets.

Unless, of course, you think the proles don’t know what’s good for them.

Posted by Jane Galt at April 6, 2002 07:12 PM | TrackBack | Technorati inbound links