Demand and Supply
There are a number of different factors that Edgar needs to take into consideration with his idea to invest in the gas station business. Let's pretend for a minute that he is not just paying the fair market value for the gas station -- he is -- and simply discuss his theory about the economics of the gas market. If the market for gas stations is even remotely efficient, the price of that gas station will be the present value of expected future cash flows, meaning that all of the knowledge about the determinants of the gas market are already priced into what Edgar is going to pay. His profit comes from the value that he can add to the station through his own management. But let us digress and get Edgar up to speed with what the market has already priced into that gas station.
There are a number of determinants in the gas market. The first is elasticity, because this will affect not only gasoline sales but also the state of the economy as well. He is also relying on sales of other goods, which means we have to talk about cross-price elasticity as well. The paper will also talk about supply, because Edgar has taken the price of gasoline into consideration with his analysis. We don't really need to graph out this stuff -- words are fine -- but we'll give it a go anyway, to illustrate some of the things that Edgar needs to think about. The scenario outlined is rather vague -- I cannot critique Edgar's actual numbers or logic because it was never provided, but I can provide some basic information and analysis that will help him.
Price Elasticity of Demand for Gasoline
Edgar is right in one sense, that $4 gas has been largely accepted. But there are different types of price elasticity of demand with respect to gasoline. First, we have to separate if we can the demand for consumer gasoline vs. For businesses, because we are only selling to consumers at this point. Major commercial users like trucking firms and taxi companies run their own pumps. There is also the fact that demand for gasoline changes over time.
First, the price elasticity of demand for gasoline is larger in the long run than in the short run. One of the most important factors that drives elasticity is the ability of consumers to react to price changes. In the short run, there is limited capacity to react. Consumers can maybe do all their shopping at once or cancel a road trip vacation, but that only produces a small bit of elasticity. In the long-run, they can buy a smaller car, or move to an area where they do not need to drive as much. Note the increasing vibrancy of many American cities -- a lot of millennials don't even own a car now. This is evidence of long-run price elasticity of demand in action. Their parents -- weaned on cheap gas, wanted big houses in the suburbs. That is still in our culture, it is weakening. There might be a short-run acceptance of $4/gallon gas, but in the long-run, consumers are showing some elasticity.
Short-run elasticity has been weakening. Most Americans -- by virtue of living in suburbs and commuting to work or school -- are price inelastic in their gasoline consumption. But note that this is in part because they are often driving smaller cars. Studies in the late 1970s showed higher short-run elasticity than there is today, because cars were huge. So today, consumers are better equipped to handle short run volatility in the price of gas. The current estimate for short-run price elasticity of gasoline nationwide ranges from -0.034 to -0.077, numbers than indicate a relatively inelastic demand (Hughes, Knittel & Sperling, 2008).
It is also worth taking into consideration that the short-run price elasticity of demand is higher when gas prices are more volatile. Consumer are less elastic when volatility is medium or high, and more elastic when volatility is low (Lin & Prince, 2009). If this seems counterintuitive, it might relate to consumer psychology. Consumers feel more in control when price volatility is lower, and that encourages them to be more active in their consumption decision making. When volatility is higher, consumers might become resigned to the fact that they have little control over prices. Remember that in general in the short turn they have a very low level of elasticity anyway, but it definitely seems that consumers are more...
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