The Price Elasticity of the Demand for Oil

Kevin Drum, Megan McArdle, Jim Manzi and Stuart Staniford are all worried by an IMF report that has very low price elasticities of oil such that “a 10 percent permanent increase in oil prices reduces oil demand by about 0.7 percent after 20 years.” Three quick notes.

First, do note that the IMF estimates are below others in the literature which estimate an elasticity of 0.2 to 0.3, meaning that a 10% increase in price would reduce demand by 2 to 3 percent, still small but three times the IMF estimates. Moreover, the US estimates tend to be higher still in the range of 0.4-0.5. All of the estimates are certainly low so we are not going to solve the climate change problem overnight with a tax on oil.  I’m not sure where the surprise is, however. Oil is necessary for civilization–given today’s technology–so people aren’t going to give it up easily.

Second, as Ryan Avent notes, a smaller elasticity makes a better case for taxing oil and reducing labor taxes. Moreover why the focus on oil?  What matters for climate change is total carbon and there are likely to be many carbon users with high elasticities relative to oil, which has special properties.

Third, this all depends on substitute technologies. In the past, there were few good substitutes for oil. If there are more good substitutes in the future then the elasticities will get larger. We do know that as the price of oil increases so does energy innovation (as measured by the number of energy patents).