Price elasticity of gasoline/diesel

The war in Iran is now in its fourth week, and the end isn’t in sight. The price of crude oil has risen by 65% to over $100 per barrel, and along with it the prices of natural gas, fertilizer, asphalt, and all derivatives from crude oil. The prices of transport and all commodities with delivery components, together with power generation that use fuel oil, are also up.

All these price increases immediately push up the inflation rates in all countries, which may lead to economic recession or even depression, depending on their dependency on fuel oil and the status of their economies. Poverty, especially food poverty in developing countries. will worsen economic hardships.

With the ongoing Ukraine and Gaza war, this Iran war is an unnecessary war that killed thousands of people, destroyed productive facilities, and wreaked havoc on the world economy. Four weeks have destroyed billions of dollars in oil production, stalled the delivery of billions of goods and services, and cost the U.S. and Iran $20 billion and $2 billion in military expenses, respectively. It has stopped 50% of all economic activities in Middle Eastern countries with their airports closed and no tourism activities.

Looking at the near and longer future, and going by people’s and the world’s adaptation/coping with changed environments, especially during the times of earlier oil price increases, there’s high probability that all the countries will adjust/cope with these oil prices. It will be in varying degrees of sacrifices by each country, some with severe deprivation and some migration for survival. At this time, the principle of price elasticity of demand (PED) will be at play.

PED is a measure of how sensitive the quantity/volume of a good’s demand is to a change in its prices. It’s calculated as the percentage change in the quantity demanded, divided by the percentage change in price. If the percentage demand goes down more than the higher percentage change in price, then the PED of that product is elastic. Basic necessities like food and water have inelastic demand as people need to buy. Luxury goods and goods with many substitutes are elastic, because people need not buy them. Surprisingly, gasoline/diesel, a long time ago was considered inelastic because it was a necessity. But, in the first oil embargo in the 1970’s, smaller, more fuel-efficient vehicles were developed. After  2000 when it become obvious oil and energy prices weren’t coming down, alternative energy sources like solar, wind, batteries, hydro, and other energy sources were developed. Then the coming of electric and hybrid vehicles in the 2020’s.

In the last two weeks, with gasoline and diesel prices in the Philippines almost doubling, there’s already a perceptible easing of traffic. In Cebu City, I estimate 30% less vehicles in the road, and travel time has been reduced by 35% in almost all directions. This is likely to be happening all over the country, so there will also be a 35% reduction in the volume of gasoline and diesel purchases nationwide. These will also happen to many goods and services with high PED. This will deter some businesses from increasing prices to maintain sales volume. While this may be good for some consumers, and positive for over-exploitation of natural resources, these have also economic downsides.

The problem with lower demand for products and services is the impact on overall demand. A country’s economy needs an increasing aggregate demand to increase the size of its economy, to improve its income and wealth distribution faster. Creating a bigger “pie” to share is easier than re-slicing the pie to re-apportion it. China proved this in the last 50 years.

Over a longer period of time, all goods and services are price elastic. There will be substitutes and alternatives, so the world will survive fuel price increases. It’s just too bad that some world leaders aren’t good and bright enough to see the greater good for the greater number of people, and should have avoided this Iran war.