Photo by Maria Lupan / Unsplash
Elasticity of Demand and the Global Energy Transition: A Case Study on Fossil Fuels vs. Renewables
How sensitive are consumers to changes in price or perceived availability? This is the key question behind the economic concept of elasticity of demand. The most common elasticity of demand is price elasticity of demand, which compares consumers’ change in quantity demanded after a change in product price. If the percent increase in price is greater than the percent decrease in quantity demanded, we say demand is inelastic because it did not change much. If a percent increase in price leads to a greater percent decrease in quantity demanded, however, we say demand is elastic because it changed a lot.
Elasticity of demand is measured for other factors, especially the availability of substitutes and complements. This is known as cross elasticity of demand and measures the percent change in quantity demanded of good X after a percent change in price of good Y (either a substitute or complement). A cross elasticity is negative, meaning quantity demanded for X decreases when the price of Y increases, the two goods are complements and are often purchased together. For example, if the price of milk increases, consumers buy less milk and also buy less cereal.
If cross elasticity of demand is positive, meaning quantity demand for X increases when the price of Y increases, the two goods are substitutes and compete against each other. Common examples are rival brands, such as Coca Cola and Pepsi. If the price of Coca Cola rises, at least some consumers will switch to Pepsi, meaning a percent increase in the price of Coca Cola leads to a percent increase in the quantity demanded of Pepsi (to some extent).
Measuring Elasticity of Demand
The equation is simple: you divide the percent change in quantity demanded by the percent change in price. If the resulting coefficient is greater than one, demand is elastic and consumers are very sensitive to changes in price. If the resulting coefficient is less than one, demand is inelastic and consumers are not very sensitive to changes in price. Many producers prefer to make and sell products with inelastic demand, because they can raise prices without worrying about losing many customers.
Total Revenue Test
If a business sells a good or service with inelastic demand, total revenue increases when price is raised. The slight decrease in quantity demanded when price is increased is easily outweighed by the higher revenue per unit sold. Conversely, if a business sells a good or service with elastic demand, total revenue falls when price is raised. The significant loss of customers more than outweighs the higher revenue per unit sold. Thus, producers try to enhance demand for their products through various means, such as advertising or bundling with complementary goods, to make demand more inelastic.
Elasticity of Demand for Fossil Fuels in Vehicles
Historically, demand for gasoline has been relatively inelastic, at least in the United States. More recent studies, however, show less inelasticity than previously thought, indicating that consumers are becoming more sensitive to high gas prices. Newer research looks at the elasticity of demand for gasoline and gas-powered vehicles now that electric vehicles are more available. Undoubtedly, the increase in electric vehicles is making demand for fuel-powered vehicles, both gasoline and diesel, more elastic to some extent.
A major factor in changing the elasticity of demand for fuel-powered vehicles is the reliability of the support network (i.e., recharging stations) for electric vehicles. Many consumers may like the idea of owning an electric vehicle, but fear the possibility of getting stranded due to insufficient supply or distribution of recharging stations (also known as range anxiety). This concern likely inflates consumers’ perceived cost-per-mile of operating an electric vehicle, perhaps more than it rationally should.
Drivers’ willingness to tolerate rising gas prices likely includes many other considerations, ranging from maintenance costs to potential repair costs to changes in miles-per-gallon or miles-per-kilowatt-hour (kWh) by temperature. As the quality of electric vehicles (EVs) increases, these costs will likely decrease and convince more consumers to purchase EVs. This will increase the elasticity of demand for fuel-powered vehicles, with consumers quick to switch to EVs when there is “pain at the pump”.
Elasticity of Demand for Fossil Fuel vs Renewable Energy
Just as EVs are often perceived to be less reliable than fuel-powered vehicles, many consumers are hesitant to abandon fossil fuel as an electricity-producing energy source in favor of renewable “clean” energy. Proponents of both fossil fuels and renewable energy vociferously debate the reliability of each, particularly in regard to the aftermath of natural disasters or unfavorable weather. Critics of switching to renewable energy sources like to declare that solar power and windmills are too vulnerable to adverse weather, such as cold fronts, and that fossil fuel plants are more reliable.
Consumers remain unsure about the intermittent nature of wind and solar energy, but consumer feelings about renewable energy are not uniform and can vary from region to region. Some regions of the world are well-suited to renewable energy sources like wind and solar, while others are not. This will likely result in energy production becoming segmented, with many nations investing heavily in renewable energy (primarily wealthy countries) while others make little such investment and continue to rely on fossil fuels (primarily developing countries).
Role of Subsidies in Encouraging Renewable Energy Usage
Most societies agree that clean, renewable energy is preferable to the use of fossil fuel energy when cost and reliability are not factors. After all, who wants pollution? But governments have frequently had to use subsidies to help increase the adoption of renewable energy, especially due to high initial costs. The subsidies for renewable energy are greater than those for fossil fuel, with the majority of such subsidies going to wind and solar energy. Consumers can also receive subsidies for using clean energy, with both rooftop solar panels and EVs receiving tax credits and even government-subsidized loans to purchase. For instance, drivers in the United States can receive a $7,500 tax credit for purchasing a new EV instead of a gas- or diesel-powered vehicle.
Subsidies for renewable energy will make demand for fossil fuel more elastic, with firms and consumers more willing to make the switch when fuel costs rise. However, many governments also subsidize fossil fuel, especially gasoline and diesel fuel, to protect consumers. By protecting fossil fuel from sudden spikes in price, governments are making it more difficult for renewable energy to be seen as a viable alternative. Fossil fuel subsidies are greatest in developing countries, where renewable energy sources have made little foothold.
Policy Implications of Energy Elasticity of Demand
The relatively inelastic demand for fossil fuel makes it difficult for governments to transition societies to renewable energy. Renewable energy sources are often still seen as unreliable by consumers, although some researchers argue that the perceived reliability of fossil fuel is overstated. There also remains strong political support for fossil fuel, which makes it difficult for elected officials to firmly support the expansion of renewable energy. Lobbyists from oil companies are firmly entrenched in many legislatures, and political donations from the fossil fuel industry far outweigh donations from smaller renewable energy companies.
For moderate politicians, continuing to support fossil fuels, or at least not strongly push for an expansion of renewable energy use, may be seen as the safe path due to the inelasticity of fossil fuel demand. Consumers still use fuel heavily, even when prices increase, and thus politicians likely consider it a “safe bet” when it comes to game theory. It is likely up to renewable energy companies and supporters to change public perception of renewable energy reliability through savvy publicity and marketing. For example, simple ads explaining how solar energy can be stored for use during prolonged periods of cloudiness may convince many skeptics that it is a viable energy source. When consumers feel that renewable energy is reliable, their demand for fossil fuels will become more elastic.
