While carbon taxes could be justified on the bedrock principle that prices for fossil fuels should include the “externality costs” their use imposes on society – that polluters should pay for polluting – the premise of our carbon tax advocacy is that a carbon tax will reduce the demand for and emissions of carbon from the use of fossil fuels.
This is because demand is at least somewhat sensitive to price, i.e., because there is some "price-elasticity" (to use economic jargon) in energy usage. This means that taxing fossil fuels for their carbon emissions can be a powerful lever for controlling and reducing demand.
From our literature review, CTC believes that a "price-elasticity" of 40% is an appropriate assumption for first-level analysis. This means that a rise in fuel prices would engender a drop in demand that is a little less than half as steep as the price rise. (For large price increases such as we propose over time, the drop in demand would be proportionately less, reflecting the law of diminishing returns.)
Because key determinants of energy use such as infrastructure, location and capital goods like houses and cars can’t be changed overnight, drops in demand due to higher prices usually take years. Our 40% estimate is a "long-run" figure, requiring around a decade to manifest fully, as opposed to "short-run" elasticities that apply to rapid but smaller changes, i.e., within a year. Short-run elasticities also exist, of course, as everybody who hesitates before paying an increased price for a product is aware, but they are less than the long-run values.
This page gives links to articles and papers on energy price-elasticity in the United States. Some are for a general audience, some are technical. Many focus on automobiles and gasoline, the area of energy use that has been studied the most.
- Kenneth Small & Kurt Van Dender, Fuel Efficiency and Motor Vehicle Travel: The Declining Rebound Effect, 2006, forthcoming in Energy Journal in 2007. Small, a Professor of Economics at U-C Irvine and a peerless transportation economist and thinker, has co-authored the most perceptive and persuasive analysis of U.S. gasoline demand we’ve seen. The paper analyzes 1966-2001 data for each of the 50 states and finds (i) a short-run price elasticity of gasoline of roughly 9% (comprised equally of changes in fuel efficiency and miles driven); and (ii) a long-run price elasticity of gasoline of around 40% (also arising equally from changes in fuel efficiency and miles driven). Note: Prof. Small has told us that adding more recent data, through 2004, doesn’t alter these findings.
- J.E. Hughes, C.R. Knittel, D. Sperling, Evidence of a Shift in the Short-Run Price Elasticity of Gasoline Demand, 2006, National Bureau of Economic Research. The authors sift 2001-2006 gasoline use data and find the price-elasticity to be minuscule — just 4% in the short-run and, though they don’t quantify it, not much greater in the long-run.
- C. Komanoff, Komanoff letter to Sperling. CTC’s Komanoff asks Prof. Sperling to reconcile his findings with the contrary findings of Small & Van Dender. The letter was sent Dec. 4, 2006; no reply has been received.
- Nicholas Lutsey & Daniel Sperling, Energy Efficiency, Fuel Economy, and Policy Implications, Transportation Research Record, 2005. Though not strictly about price elasticity, this paper deconstructs technical changes in the U.S. auto fleet from 1975 to the early 1980s, a period in which most technical gains were devoted to improving fuel efficiency, and since then, when technical improvements have been used "to satisfy private desires (more power, size and amenities)." Anyone seeking to understand automobile fuel economy should read this paper.
- Dermot Gately & Hillard G. Huntington, The Asymmetric Effects of Changes in Price and Income on Energy and Oil Demand, 2001, Economic Research Reports, RR# 2001-01, C.V. Starr Center for Applied Economics, NYU. Using 1971-1997 data, and lumping the U.S. with the other (OECD) industrial nations, the authors derive long-run price-elasticities of only 24% for all energy, but 64% for petroleum products alone. (Could fuel substitution be the reason for the disparity?) Encouragingly, they report a relatively low long-run income-elasticity, 55-60%, for both oil and energy in the OECD countries, indicating that, all things equal (i.e., with constant prices), each 3% growth of GDP gives rise to less than a 2% rise in energy use.
We invite CTC friends and visitors to comment on these papers and to suggest further reading.
