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Estimating The Elasticities of Gasoline Demand: An Instrumental Variable Approach
Estimating The Elasticities of Gasoline Demand: An Instrumental Variable Approach
Weiwei Liu
To cite this article: Weiwei Liu (2016): Estimating the elasticities of gasoline
demand: an instrumental variable approach, Applied Economics Letters, DOI:
10.1080/13504851.2016.1139671
Article views: 25
Download by: [University Library Utrecht] Date: 16 March 2016, At: 11:03
APPLIED ECONOMICS LETTERS, 2016
http://dx.doi.org/10.1080/13504851.2016.1139671
ABSTRACT KEYWORDS
This article uses a new identification strategy to estimate the demand for gasoline. I show that Gasoline demand; price
the monthly gasoline price is endogenous to gasoline demand at the state level, and that elasticity; income elasticity;
gasoline tax and domestic oil first purchasing price together are strong and valid instruments instrumental variable
to correct for the endogeneity bias. In addition to estimating the price elasticity, this article also JEL CLASSIFICATION
provides an estimate of the income elasticity. These updated estimates are critical factors in C33; Q41
evaluating the environmental effect of gasoline tax and forecasting gasoline consumption.
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CONTACT Weiwei Liu vivil9930@gmail.com Department of Economics, Saginaw Valley State University, 7400 Bay Road, University Center, MI 48710,
USA
© 2016 Taylor & Francis
2 W. LIU
(a) Real Personal Income instrument for gasoline price is proved difficult
(Hughes, Knittel, and Sperling 2008). To identify the
12000 causal effect of price changes on gasoline demand, the
IVs must be strongly correlated with gasoline price,
Billions of Dollars
1989 1992 1995 1998 2001 2004 2007 crude oil price, the ‘domestic oil first purchasing
Year
price’ is a better alternative, because it is more likely
Source: U.S. Bureau of Economic Analysis.
to reflect the production cost and the market situa-
Figure 1. US monthly personal income, 1989–2008. (a) Real tion in the US rather than price-setting mechanisms
personal income. (b) Changes in real personal income. utilised in other countries. It must be assumed that
the domestic oil price is not correlated with gasoline
rate, Tit is a set of year indicators, Mit is a vector of demand shocks. This assumption may be violated
month dummies and ωit is the i.i.d. error. under severe scenarios when oil shocks significantly
Unlike Davis and Kilian (2011), income and the affect the overall spending in the economy and the
unemployment rate are introduced to the model. demand for gasoline in particular, causing the
Income is a major driving force behind travel-related instrument to be endogenous. This potential spur-
spending, such as the purchase of vehicles and gaso- ious correlation can be eliminated by including the
line; if excluded from the gasoline demand model, unemployment rate as a macro-economy indicator
omitted variable bias may occur. Since income has and the ‘year’ fixed effect which absorb the impacts
experienced significant increases/changes over the of business cycle on gasoline demand.
study period (1989–2008) as shown in Figure 1, it
is less likely to be eliminated when differencing data.
The unemployment rate and year indicators capture
Data
the impact of business cycle. The month dummies
control for seasonal effects on gasoline demand. The data include monthly gasoline consumption, prices
and other variables for 50 states and the District of
Columbia from 1989 to 2008. Gasoline prices and con-
Identification
sumption are from Energy Information Administration,
Past research has tried to address the endogeneity of US Department of Energy. State personal income is
gasoline price, but finding a strong and valid obtained from Regional Economic Accounts, US
1
Using gasoline tax as instrument in an FD model, Davis and Kilian (2011) find a surprisingly large price elasticity of −1.14. When reducing the sample to
include nominal tax increases only, the price elasticity drops to −0.46, but is still significantly larger than estimates in other studies.
APPLIED ECONOMICS LETTERS 3
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Regardless, they should produce similar estimates if the changes, future work may benefit from exploring
model is correctly specified (Wooldridge 2002); there- the effects of gasoline tax. In addition, I examine
fore, the FE estimation can be used as a robustness the role of income and find income elasticity is
check. The price of gasoline is again instrumented by between 0.3 and 0.5. This implies that gasoline
gasoline tax and domestic oil price, and clustered SE are demand is relatively more responsive to economic
used to correct for any within-state correlation. The growth than price fluctuations. These estimates are
results are reported in Table 1 column (2). Except for robust across alternative specifications.
a slightly lager income elasticity, most estimates are
quite similar to those from the FD model. The partial
R2 of the first-stage regression is much higher in FE Disclosure statement
regression, which evidences that differencing data weak- No potential conflict of interest was reported by the
ens the strength of gasoline tax as an instrument. The author.
overall similarity of the results confirms the robustness
of both IV specifications.
References
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