Saturday 28 June 2008

What's wrong with petrol prices?

Justin Wolfers at the Freakonomics blog asks What Exactly Concerns Us About Gas Prices? He notes that many voters seem to believe that petrol price are "high" and that "something oughta be done about it." Wolfers offers the following six possible reasons for people being concerned about petrol prices.
1. Relative prices: Are people frustrated that a gallon of gas now requires more foregone “stuff.” Or alternatively phrased, are they concerned about the low relative price of “stuff”? Stated this way, it sounds a bit odd that we are so upset that the benefit of giving up one more gallon of gas is now a heckuva lot more stuff. (Indeed, environmentalists should be thrilled.)

2. Absolute prices: Are people concerned about the change in the absolute average price level? The consumer price index is currently 216.632; is this too high? If so, what is the right average price level?

3. Real wages: Is the real concern about the average price level relative to (nominal) incomes? That is, if the average price level rises but our money incomes stay the same, we tend to cut back on both gas and “stuff.” If so, I have some good news: money income typically rises roughly in tandem with the average price level, keeping the real wage constant. And if you think the current episode will be an exception to this rule, then are your concerns about the gas market or the labor market — and does this change what “oughta be done”?

4. Inflation: There are also concerns about the rate of change of gas prices (#2 is about the level, not the change) and how this may impact inflation. However while gasoline and oil futures markets suggest that current high prices are here to stay, they aren’t expected to continue rising.

5. Reallocative costs of changes in relative prices: In the long run we will learn that a Pruis does as good a job at getting you to work as a Hummer and at a much lower cost. But in the short run, it will be expensive to shut down Hummer production and expand Prius production.

6. Redistribution due to changes in relative prices: It is unsurprising that the loudest gas-price whining is coming from those in the exurbs whose house prices have fallen due to higher commuting costs. But what is missing here is the urban homeowners who have simply kept quiet about their gains. In many cases one group’s losses are roughly offset by another group’s gains.
Number 1 is just prices doing what they should do, provide information about relative scarcity. This is the effect that gives people the incentive to reduce their consumption of petrol - which is why the environmentalists should be thrilled. As noted, the question with 2 is, What is the right price level? Number 4 is the focus of much discussion by macroeconomists, although its not clear just how concerned about the inflationary effects we should be. In the short-run number 5 is clearly important, but less so over the longer term. Also 5 tends, in many discussions, to be too easily confounded with 3 and 6. In addition, Wolfers notes
... because we rarely see pictures of workers enjoying their compensatory cost-of-living wage rises or investors in urban housing or green companies rejoicing that their investments have paid off, too often we focus only on the losses but miss the gains.
This leaves 3. In fact nominal wages will probably continue to rise in line with the increase in the average price level, that is inflation. The problem is that when each person gets their wage increase, they think that it is a reward for their hard work and ability, rather than just an adjust for the increase in the cost-of-living. Wolfers puts it this way
So each year we think that our employer realizes we are ever more brilliant, even as rising gas prices steal more from our paychecks. But workers should be tipped off that it isn’t just a coincidence that each year these two forces tend to balance out.
All this leads to the question, Are we over-emphasizing the importance of high petrol prices?

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