Applied Economics Letters

ISSN: 1350-4851 (Print) 1466-4291 (Online) Journal homepage: http://www.tandfonline.com/loi/rael20

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

To link to this article: http://dx.doi.org/10.1080/13504851.2016.1139671

Published online: 04 Feb 2016.

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 APPLIED ECONOMICS LETTERS, 2016
http://dx.doi.org/10.1080/13504851.2016.1139671

Estimating the elasticities of gasoline demand: an instrumental variable

approach
Weiwei Liu
Department of Economics, Saginaw Valley State University, University Center, MI, USA

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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I. Introduction estimate, i.e. overestimating the effect of price

changes, would suggest a large increase in the gaso-
The combustion of gasoline in ground transporta-
line tax rate. However, this would not achieve the
tion has been a major source of greenhouse gas
expected reduction in gasoline consumption due to
emissions in the US. Understanding the gasoline
the actually inelastic gasoline demand, but only
market and the price/income elasticity, in particular,
cause a loss of consumer welfare.
may lead to effective ways of reducing motor vehicle
In this article, I propose a new identification
emissions. The price elasticity measures how con-
strategy to model gasoline demand and to estimate
sumption of gasoline responds to changes in gaso-
elasticities. I argue that the combination of gasoline
line price, and thus can be used to evaluate the
tax and domestic oil first purchasing price is a sui-
consumption reduction effect of gasoline pricing
table instrument for the price of gasoline. This new
policies, such as the gasoline tax (Davis and Kilian
IV specification yields a price elasticity of −0.099 and
2011; Li et al. 2014). The income elasticity indicates
income elasticity of 0.306. These estimates highlight
how consumption of gasoline changes in response to
the impacts of price/tax and income changes on
changes in consumers’ income, which is the key to
gasoline consumption.
forecast future gasoline consumption and the
induced carbon emissions in a growing economy.
To accomplish these tasks, reliable estimates of the II. Empirical methodology
demand elasticities are critical.
Model
A well-known issue with demand estimation is
the potential endogeneity of the gasoline price. The Following Davis and Kilian (2011), the state-level
spurious correlation between price and the error monthly gasoline demand (yit) is specified as the
term as a result of simultaneity causes OLS esti- first-differenced (FD) model:
mates to be biased and inconsistent. Instrumental
Δyit ¼ β0 þ β1 Δpit þ β2 Δincit þ β3 unemptit
variables (IVs) regression can be a solution; how-
þ β4 Tit þ β5 Mit þ ωit (1)
ever, without an appropriate identification strategy,
the parameter estimates could still be biased, and where pit is the real tax-inclusive price of gasoline
the implications could be very misleading. For (in log), incit is the real monthly personal income
instance, an upward bias of the price elasticity (in log), unemptit is the monthly unemployment

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
12000
Billions of Dollars
10000
8000
1989
600
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400
Billions of Dollars
200
0
−200
1989 1992
Source: U.S. Bureau of Economic Analysis.
Figure 1. US monthly personal income, 1989–2008. (a) Real
personal income. (b) Changes in real personal income.
rate, Tit is a set of year indicators, Mit is a vector of
month dummies and ωit is the i.i.d. error.
Unlike Davis and Kilian (2011), income and the
unemployment rate are introduced to the model.
Income is a major driving force behind travel-related
spending, such as the purchase of vehicles and gaso-
line; if excluded from the gasoline demand model,
omitted variable bias may occur. Since income has
experienced significant increases/changes over the
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
the impact of business cycle. The month dummies
control for seasonal effects on gasoline demand.
Identification
Past research has tried to address the endogeneity of
gasoline price, but finding a strong and valid
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.
(a) Real Personal Income instrument for gasoline price is proved difficult
(Hughes, Knittel, and Sperling 2008). To identify the
causal effect of price changes on gasoline demand, the
IVs must be strongly correlated with gasoline price,
but not influence the demand aside from their effects
on gasoline price. Various instruments have been
used, e.g. gasoline tax, oil price and crude oil produc-
tion disruptions, but the resulted elasticity estimates
are inconsistent.1
In this study, gasoline tax and domestic oil first
purchasing price are selected as instruments. Gasoline
1992 1995 1998 2001 2004 2007
Year tax is not only exogenous to gasoline consumption (Li
(b) Changes in Real Personal Income et al. 2014), but correlated with the tax-inclusive gaso-
line price. The correlation may be weakened when data
are differenced, as shown in Figure 2 in which the
gasoline tax rate from January 1989 to March 2008
changes much less frequently than the gasoline price.
Therefore, the differenced tax rate may not sufficiently
capture the fluctuation in gasoline price. An additional
instrument that is more strongly correlated with gaso-
line price is necessary.
Compared with the previously used international
1995 1998 2001 2004 2007 crude oil price, the ‘domestic oil first purchasing
Year
price’ is a better alternative, because it is more likely
to reflect the production cost and the market situa-
tion in the US rather than price-setting mechanisms
utilised in other countries. It must be assumed that
the domestic oil price is not correlated with gasoline
demand shocks. This assumption may be violated
under severe scenarios when oil shocks significantly
affect the overall spending in the economy and the
demand for gasoline in particular, causing the
instrument to be endogenous. This potential spur-
ious correlation can be eliminated by including the
unemployment rate as a macro-economy indicator
and the ‘year’ fixed effect which absorb the impacts
of business cycle on gasoline demand.
Data
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-
sumption are from Energy Information Administration,
US Department of Energy. State personal income is
obtained from Regional Economic Accounts, US
 APPLIED ECONOMICS LETTERS 3
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Figure 2. Changes (%) in gasoline prices and taxes, 1989–2008.

Table 1. First-differenced and fixed effect estimates.

Bureau of Economic Analysis. State unemployment (1) FD (2) FE
rates are from Local Area Unemployment Statistics, Coefficient estimates
Δpit −0.099***
Bureau of Labor Statistics. (0.026)
Federal and state taxes on gasoline are from Federal pit −0.082*
(0.049)
Highway Administration’s annual Highway Statistics Δincit 0.306***
Series. Domestic oil first purchasing prices by state and (0.117)
incit 0.524***
month are obtained from US Energy Information (0.107)
unemploymentit −0.0007*** −0.004
Administration. All monetary values, including prices, (0.0001) (0.006)
taxes and income, are adjusted by the CPI of January R2
0.341 0.437
Observations 11,730 11,730
2008. First-stage regressions
Partial R2 0.249 0.427
F-statistic 409.164 279.441
(p-value) (0.000) (0.000)
III. Results and discussion Notes: This table reports the IV estimates of the first-differenced model and
the fixed effect model. Gasoline tax and domestic crude oil first purchas-
Estimation results ing prices are used as instruments for gasoline prices in both specifica-
tions. The SE are clustered by state.
*p < 0.10 and ***p < 0.01.
Table 1 column (1) presents the estimation results of
model (1) using the differenced gasoline tax and
domestic oil first purchasing price as instruments. large, indicating a strong impact of income on the
SEs are clustered by state. The R2 of 0.341 suggests a consumption of gasoline.
decent fitting model. The high F-statistic in the first-
stage regression indicates strong instruments. The
A robustness check
estimated price elasticity is −0.099 which is consis-
tent with findings of recent state-level studies (Li Besides first-differencing, fixed effects (FE) estimation is
et al. 2014; Liu 2014). This estimate implies a much an alternative method to eliminate unobserved effects in
smaller consumption reduction effect of gasoline tax panel data, and both estimators are consistent under
than Davis and Kilian (2011)’s prediction. The esti- certain conditions. For this particular data set, neither
mate of the income elasticity that is missing from estimator is more efficient than the other due to the
Davis and Kilian (2011) is in fact significant and serially correlated (but not random walk) error process.2
2
The residuals of the FD regression have an autocorrelation of −0.156.
 4 W. LIU
Regardless, they should produce similar estimates if the
model is correctly specified (Wooldridge 2002); there-
fore, the FE estimation can be used as a robustness
check. The price of gasoline is again instrumented by
gasoline tax and domestic oil price, and clustered SE are
used to correct for any within-state correlation. The
results are reported in Table 1 column (2). Except for
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
regression, which evidences that differencing data weak-
ens the strength of gasoline tax as an instrument. The
overall similarity of the results confirms the robustness
of both IV specifications.
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IV. Conclusion
A new identification strategy is proposed in this
article to estimate the short-run gasoline demand
in the US. I address the endogeneity issue and
argue that gasoline tax and domestic oil first pur-
chasing price together are strong and valid instru-
ments to correct for the endogeneity bias. The price
elasticity of gasoline demand is about −0.099, thus
the demand for gasoline in the US is not very
responsive to price changes. Since recent literature
suggests that the gasoline tax may deliver a stronger
impact on gasoline consumption than pure price
changes, future work may benefit from exploring
the effects of gasoline tax. In addition, I examine
the role of income and find income elasticity is
between 0.3 and 0.5. This implies that gasoline
demand is relatively more responsive to economic
growth than price fluctuations. These estimates are
robust across alternative specifications.
Disclosure statement
No potential conflict of interest was reported by the
author.
References
Davis, L. W., and L. Kilian. 2011. “Estimating the Effect of a
Gasoline Tax on Carbon Emissions.” Journal of Applied
Econometrics 26: 1187–1214. doi:10.1002/jae.v26.7.
Hughes, J., C. Knittel, and D. Sperling. 2008. “Evidence of a
Shift in the Short-Run Price Elasticity of Gasoline
Demand.” The Energy Journal 29 (1): 113–134.
doi:10.5547/ISSN0195-6574-EJ.
Li, S., J. Linn, and E. Muehlegger. 2014. “Gasoline Taxes and
Consumer Behavior.” American Economic Journal:
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Liu, W. 2014. “Modeling Gasoline Demand in the United
States: A Flexible Semiparametric Approach.” Energy
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Wooldridge, J. M. 2002. Econometric Analysis of Cross
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