Capital Ideas - Summer 2013 - page 7

ChicagoBooth.edu/capideas
Capital Ideas |
Summer 2013
5
Front
&
Center
T
he fall of 2008 was tough for many Americans.
More than two million jobs were lost within a few
months, and millions more people feared their jobs
were next to be cut. Households cut back sharply on
spending as they felt the pinch of what turned out to
be the worst economic downturn since the Great De-
pression.
But amid all the belt-tightening, many households
did something surprising: they switched to premium
gasoline. Research by Chicago Booth Professor
Jesse
M. Shapiro
and Justine Hastings of Brown University
suggests this activity challenges an assumption that
underpins many economic models.
Economics uses the principle of fungibility, in
which every dollar in income or spending is equivalent
to any other. Generally speaking, this means that if a
person loses $100—whether it’s because his (or her)
income falls or the prices he pays for things rises—he
needs to make $100 worth of spending cuts in his bud-
get.
But the researchers discover a different pattern in
Gas pump riddle:
Why did drivers
switch to premium
during the recession?
ECONOMICS
Three explanations for reaction to higher pump prices
Drivers react strongly to higher gas prices, more
so than they do to other changes in income.
But why? Researchers propose three explana-
tions, based on models of decision-making
used in psychology.
n
The loss-aversion theory argues that the pain
of experiencing a loss is much more powerful
than the pleasure of experiencing a gain, and
rising gas prices force households to cut back
in other areas.
n
Households budget by spending category,
and they don’t like deviating from their budgets.
n
A stark price rise can get people’s attention.
data about gas purchases. In the fall of 2008, sharply
declining income levels should have led consumers
to cut back on luxuries such as vacations, new cars,
or premium gas. In the latter case, however, that’s not
what happened. “During this period, although almost
all indicators of consumer spending and well-being
were plummeting, households substituted to higher-
octane gasoline,” the researchers report. Many house-
holds drastically cut back on auto and retail purchases,
yet their propensity to buy mid-grade or premium
gasoline increased by almost four percentage points.
Why? The evidence points to the fact that gaso-
line prices fell in the fall of 2008 amid declining world
demand for oil, brought on by the recession. Even
though households were poorer overall, they acted
richer at the pump, perhaps because low prices en-
couraged them to feel like they had room to spend
more on gasoline.
Other patterns tell the same story. In the first half
of 2008, the average price of regular gasoline in the
United States increased from $2.98 to $4.10 per gallon,
and premium gas went up along with it. For econo-
mists, who treat a price increase as equivalent to an
income loss, that jump translated to a $1,313 loss in in-
come for a typical household. A regression analysis ap-
plied by the researchers implied that a $1,313 income
cb gas pump
83
82
81
80
79
78
77
Percent
Dollars
’06
’07
’08
’09
4.75
4.25
3.75
3.25
2.75
2.25
1.75
1.25
Regular gas
share
(Weekly)
Price of
regular gas
(Weekly)
1,2,3,4,5,6 8,9,10,11,12,13,14,15,16,17,...48
Powered by FlippingBook