Thursday, July 24, 2008

Too Scary to Watch?

Dan Ariely asks a provocative question: are we overreacting to the price of gas?

No other price has as strong a political effect as the price of gas. Some presidents have been brought down by it. But while the price of gas is indisputably an important variable in our economy, it is not the only consumer good that has increased in price, nor is it the one that has increased the most.

Gas, however, is unique in that when we buy it, we stare at the running meter. As a result, we experience the increased cost of gas more vividly than other price increases. Similarly, there seem to be psychologically-relevant price thresholds for gas. The price increase from $3.50 to $3.90 per gallon is not as salient as the increase from $3.90 to $4.10 because the latter increase has crossed the $4 mark.

Judging by the letters to the editor, Ariely's argument hasn't been well received. As one woman wrote, "If Dan Ariely’s purpose in writing his Op-Ed article was to make me like the fact that I am now paying more than $4 a gallon for gas, he is mistaken."

But there may be something to what he's saying. Areily, a well known behavioral economist, is oriented to look for economic situations where people systematically deviate from the rational price theory model. A rational agent wouldn't care about arbitrary price thresholds or whether they watched the price climb as they pumped; rather he or she would only care about the price of the good, the price of substitute goods and their budget constraint.

In this week's NY Times op-ed podcast, Areily discusses anecdotal evidence of people taking thousands of dollars of losses selling their gas-guzzling SUVs in an attempt to save money on gas. This does not make universal economic sense. Consider the example of a Cadillac Escalade owner, which Areily uses in the podcast. He bought this behemoth less than a year ago for $54,000, back when the price of gas was more reasonable. Now he's stuck getting 14 mpg with gas prices over $4.00 a gallon. However, in an environment of high gas prices he can't get anywhere near what he paid for the car. In Areily's example, the SUV owner sold the car at roughly a $20,000 loss. Does this make sense? Well, if he drives 15,000 miles per year and gas increases from $4.00 per gallon to $5.00 per gallon, then his gas bill will increase by $1,072 per year. That's a lot. But it will be years before he recoup the loss on the car, assuming he even owns the car that long.

Bryan Caplan made a similar point. He observes that people have been searching harder to find cheaper gas than they did when the price was lower. While gas everywhere is more expensive, there has been no increase in the variability in gas prices. The difference between the highest and lowest gas prices is no different than it ever was, which means that the savings from searching is also the same. On the other hand, driving around searching for cheap gas is relatively more expensive.

Of course both examples are anecdotal, but they highlight some of the irrationality people exhibit when the price of gas goes up. High gas prices have caused real pain for people. But we shouldn't make things worse on ourselves.

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