Brad DeLong pits Megan McArdle against Greg Clark. Clark argued that it would only take incomes 3 years to recover from a permanent doubling of food and energy prices. Clark based his claim on income trends "[a]t current rates of economic growth," so he evidently thinks a permanent doubling of food and energy prices wouldn't lower the rate of economic growth. McArdle agrees with me that a permanent doubling of food and energy prices would lower the rate of economic growth, and thus that incomes would take longer than 3 years to recover. DeLong's conclusion: "I call this one for Greg Clark. I am a utopian neoliberal optimist." Huh? Now, DeLong is a very smart economist and I hold him in high regard, but that's just silly. He equates McArdle with Thomas Malthus, so he clearly thinks the dispute is about the long-run effects of a doubling of food and energy prices. Precisely the opposite: the dispute is about the short-run effects. (Note the irony of a Keynes admirer ignoring the short-run.) A cursory look at the short-run vs. long-run price elasticity of demand for gasoline illustrates why Clark's claim is so ridiculous. As Paul Krugman noted: "In the long run, the best estimate of the price elasticity of demand for auto fuel seems to be -0.7. That is, a 10 percent rise in prices will reduce gas consumption by 7 percent." In the most recent issue of Energy Journal, three of Greg Clark's own colleagues at UC-Davis published a paper titled, "Evidence of a Shift in the Short-Run Price Elasticity of Gasoline Demand." They concluded: "For the period from 2001 to 2006, our estimates of price elasticity range from -0.034 to -0.077." In other words, a 10% increase in gas prices will reduce gas consumption in the short-run by only 0.34% to 0.77%. That means a doubling of gas prices would barely reduce gas consumption in the short-run at all (from 3.4% to 7.7%). The short-run price elasticity for electricity and natural gas is around -0.2, which is a bit better, but not much. So if energy currently accounts for 7% of U.S. consumption, then a doubling of energy prices would push the share of consumption devoted to energy up to around 12% in the short-run. The extra money being devoted to energy would have to come from somewhere -- that is, a doubling of energy prices would be like a 5% decline in overall consumption. How does that usually affect economic growth? In the long-run, we'd reduce our energy and food consumption more, find newer and cheaper sources of energy and food production, etc., etc. But even in the rosiest scenario, that would only come after a rough period of slower economic growth. And if incomes would take 3 years to recover at current rates of economic growth, then they would take longer than 3 years to recover at slower rates of economic growth. Long-run optimism and short-run pessimism aren't incompatible. Ignore the short-run at your own peril. (Aside: Clark stated in his op-ed that "the share of modern U.S. consumption devoted to raw food...purchases is small: 1.4% for food raw materials... ." Higher prices for "food raw materials" would be passed on to consumers, so doubling the price of raw food materials would significantly increase the price of food. And seeing as the share of personal consumption devoted to food (as opposed to just "food raw materials") is 13%, a doubling of the price of raw food materials would significantly reduce personal consumption. Again, how does that usually affect economic growth? Badly.) UPDATE: Gary Becker notes the difference between the short-run and long-run effects of high oil prices:

Of course, even with energy's smaller role in the production of output, any rise in oil prices to over $200 a barrel in the next few years would have serious disruptive effects on the world economy. To many persons who have commented on this prospect, such a high oil price seems plausible, given the expected continuation of the rapid growth in the GDP of China, India, Brazil, and other major developing countries. For the evidence is rather strong that the short run response of both the supply of and the demand for oil to price increases is rather small. The small elasticity of both the supply and demand for oil explains why the moderate reductions in world oil supply during the earlier price spikes, and the moderate increase in world demand during the current price boom, produced such large increases in price. However, the long run response to price increases of both the demand and supply for oil and other energy inputs is considerable. For example, given enough time to adjust, families react to much higher gasoline prices by purchasing cars, such as hybrids and compacts, that use less gasoline per mile driven. They also substitute trains and other public transportation for driving to work and for leisure purposes. High energy prices, and hence the opportunity for large profits, induce entrepreneurs to work more aggressively to find fuel-efficient technologies, including the use of batteries as a replacement for the internal combustion engine.

5 comments:

pushmedia1 said...

A 5% hit to consumption isn't as bad as the great depression.

But it wouldn't be as bad as a 5% hit because I doubt the short run elasticities estimated by Knittel tell us anything about a doubling of prices. Those elasticities were estimated with much less variation in prices. Its unlikely the demand curve is linear such that those elasticities make sense with much higher price volatility, i.e. you're predicting way out of sample.

Also, keep in mind that we're not going to be surprised by $200 barrels (in the, we'll wake up one morning and prices will have doubled sense). Such expectations will induce behavior change before the price change occurs. I don't ever see myself buying an SUV and that's not because of the price of gas today, but because of my expectation of the price of gas in the future.

Economics of Contempt said...

Sure, a 5% hit to consumption isn't the Great Depression, but I never said it was. I just said that a 5% hit to consumption precludes "current rates of economic growth," which is what Clark's prediction was based on. And a permanent doubling of food and energy prices would cause at least a 5% drop in consumption. I know I was predicting out of sample with gasoline prices, but keep in mind that a doubling of food and energy prices includes a lot more than just gas prices. It also includes food, electricity, and natural gas, which makes up a much greater share of consumption than just gasoline.

Say it takes 2 years for prices to double. Clark said incomes would recover in only 3 years from a doubling of food and energy prices. But 3 years from when? From when prices started to double? Or from when prices finished rising?

And to what point are incomes recovering? To where they were when prices started to double? Or to where they would have been had prices not doubled in the first place?

The fact that Clark said incomes would recover in only 3 years suggests that he was talking about a short time horizon, i.e., prices doubling in less than a year. It's simply not plausible to say that such an event wouldn't slow economic growth in the short-run. In fact, such an event would almost certainly cause at least one quarter of negative growth. So it's irrelevant that incomes would recover "at current rates of economic growth," because we would be operating at a slower rate of economic growth.

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