Question

Europeans Consume 45% of all gasoline produced worldwide

- With the law of demand, you would expect that when gas prices continue to rise, the demand would fall, but this isn’t necessarily the case, especially in the short term. (10% increase in gas is associated with a 1-2% decrease in quantity of gas purchased.

- In 2004-2005, avg gas price went from up 55% ($1.87 -> 2.90), but consumption only went down 3.5% (9.15 mill barrels to 8.83 mill barrels)

- From 1998 to 2004, average gas went up 53%, but consumption also went up 10% when you would normally think it would go down by 26-53%.

a) The above are estimates of 1 year and 6 year response of gas quantities purchased to changes in gas prices. Utilizing the above data, what are the estimates (expressed in rages) for the 1 year (short term) and 6 year (long term) price elasticities of demand for European Gasoline.

b) Using your answer from a), what will happen in the short run to European consumer’s total expenditures on gas as the price of gasoline rises. Will it stay the same, increase or decrease?

c) The figures from 2004-05 may overstate the drop in consumption because the head of energy in Europe measures gas before it reaches the retailer, and retailers may have used more of their inventories when there was a disruption in the supply chain. This implies a different short run price elasticity of demand for European gas than earlier studies estimate. What is this short run price elasticity?

Answer 1

a) As the gasoline is a necessity item and there is no substituent being identified for gasoline so far, so the demand of gasoline is quite inelastic in nature. This means that inspite of increase in price of gasoline to a high extent, there is only a slight decline in the quantity demanded. This can be calculated as :

Price Elasticity of demand for European gasoline = Percentage change in Quantity demanded / Percentage change in Price

In 2004-2005

Price Elasticity = -3.5% / 55%

= -0.06

From 1998-2004

Price Elasticity = 10% / 53%

= 0.19

Thus it clearly shows that the demand is quite inelastic in nature. In a 1 year period, the demand is inelastic and there is not much change in quantity demanded inspite of increase in price.

During 4-year period, the demand doesnt even follow the Law of demand, inspite of increase in price, the quantity demanded also increases.

b) Expenditure = Price * Quantity demanded.

In the short run for 1 year period, the price elasticity is -0.06. It means that as the price increases much , there is only a minor change in quantity demanded. thus the overall expenditure on gas as the price of gasoline increases, would also increase.

c) Short run price elasticity of demand is the proportionate change in quantity demanded due to a certain change in price of the gasoline in the short period of 1 year. In the short run, as a result of increase in price of gasoline, there is only a slight change in the quantity demanded. This takes place in a short period of 1 year. This happens because gasoline is a necessity item and in the short run, the consumers do not get any option to switch from gasoline and thus cannot change the quantity demanded much inspite of increase in price to a high extent.