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Thursday, August 18, 2005

But gasoline is $6.00 in the Netherlands

Local media here in Dallas is starting to suggest a few things in reference to the price increases in gasoline. First, the inflation adjusted price is still lower than it was in 1980 and therefore the adjustment to 1980 type prices is expected and natural (what!?). Second, the price of gasoline is a lot more expensive in other countries and therefore we shouldn't complain.

Both statements are false and confusing to the general public that has little to no economic training and is especially susceptible to emotional manipulation when it comes to international trade. This is unfortunate.

CNN Money has a list of sample pump prices from around the world. Interesting data - so I grabbed it, merged with some data from the World Bank, and we are off to the races. Additional data I added was national income per capita (in US dollars), population density (people/km-squared), and whether the country is a net exporter of energy. I also grabbed the official exchange rate, but this wasn't important in the end. Because trade only occurs on a mutually beneficial basis, we would expect to see the domestic price of gasoline to be less in oil exporting countries than in oil importing countries.

This is the way we teach standard trade theory, but there are a lot of assumptions that underly the simple model, including common currency, no transaction costs, no iceberg-type shipping costs, non-changing exchange rates, similar preferences (if not income) and so forth. For theoretical consistency these assumptions are made but they are rarely met in the real world.

Energy exporting countries tend to be much less democratic and therefore it is not clear that the pump price for gasoline is a reflection of relative costs of production - local governments may subsidize gasoline at the pump in order to stave off revolution. If this is the case, any price reduction that is associated with energy exporting might well be the combination of two influences - comparative advantage which would be expected to reduce domestic price and government policies which might further reduce price.

In the end, the CNN Money data combined with World Bank data yielded 31 observations from March of 2005 (some explanatory variables were lagged a year). Robust regression yielded the following:
. reg lnprice lngni exporter lndensity , r

Regression with robust standard errors Number of obs = 31
F( 3, 27) = 12.00
Prob > F = 0.0000
R-squared = 0.5500
Root MSE = .62097

| Robust
lnprice | Coef. Std. Err. t P>|t|
lngni | .3621574 .0708988 5.11 0.000
exporter | -.7017622 .3553368 -1.97 0.059
lndensity | -.105248 .0558586 -1.88 0.070
_cons | -1.477948 .5218724 -2.83 0.009

Here we see that gasoline pump prices are positively related to per capita income, a greater population density provides a premium (perhaps through reduced transaction costs), and being an energy exporter correlates to an average reduction in pump price of $0.70 per gallon. This premium is reduced form - it is not possible at this point to determine what amount of this premium is caused by comparative advantage and what is caused by bribery-type policies.

Next, I wanted to generate some graphs in log-linear space. This first plots price on income aggregating all 31 countries in the sample:

This next takes into account the Exporter premium, reflecting the different intercept that the dummy variable brings about:

This last graph interacts income with exporter status. In this case we find that the income elasticity of price is relatively benign (weakly significant at the 10% level) but that income elasticity is much greater in the exporting countries - likely because they are relatively low-income countries to begin with:

So, what's it all mean? First, the price of gasoline at the pump is a function of local demand characteristics (although supply-side influences are also at play). Whether the price is $6.00 in the Netherlands is a non sequitor when discussing prices in the United States. What was the pump price in the Netherlands last year? That is the important question. What is the per-capita demand for gasoline in the Netherlands?

As for the "the inflation adjustment is natural and expected" argument, this is the first time I have heard that argument. Perhaps there is a theory of exhaustible resources that would predict a U-shaped price trend over time (start high, go low, end high) but in most other products prices tend to decline over time and rarely do they increase in real terms.

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