Short Run versus Long Run Substitutions

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For many policy issues, there is an important distinction between the short-run and the long-run responses by firms and individuals. For economists, the short run is a period when firms and individuals are "locked in" to some past decisions, so that they have "fixed costs" that they cannot avoid. If gas becomes more expensive on a Monday, you don't trade in your gas-guzzling car on Tuesday. But over a period of months or years, individuals might respond to price changes by buying more fuel-efficient cars or by making other gradual adjustments in their behaviors and choices. If capital equipment becomes more expensive, firms may rely more on labor-intensive technologies after their existing equipment wears out. Households may, over time, convert to natural gas if the price of heating oil stays high for a period of time. These are substitutions that can be made, but they are generally made only over a period of time.

This distinction is important because it can have important implications for policy. Consumers and producers are more responsive in the long run than in the short run because they have more time and more opportunities to respond to a lower, or a higher, price in the long run than in the short run. Demand is generally more elastic in the long run, and so is supply. And because necessity is the mother of invention, research and development (think of this as investment in "knowledge capital") can lead to additional substitutions from high-cost to low-cost inputs or goods.

Let's take the example of a gas tax, introduced as a way to reduce pollution. If we look only at the short-run elasticity of demand (which is much easier to estimate based on market data), we might conclude that a gas tax will have little effect on driving since demand is quite inelastic (a steep demand curve, like the short-run demand depicted in figure 3.6). However, if we had an estimate of the long-run elasticity of demand, we might see that the demand curve is flatter, like the long-run demand depicted in figure 3.6. Starting at Q1, demand might decline to Q2 in the short run, but over a longer period of time demand would decline to Q3. Since the effectiveness of many market-based environmental policies depend on the responsiveness of firms and individuals to a change in incentives, economists and policymakers should bear in mind the difference between short-run responses and long-run responses.

Debates about energy conservation and achieving energy independence often raise the question of how effective incentives might be. Pessimists may refer to elasticities reflecting the short-run responses to suggest that incentives will have little effect. However, more responsive changes can be expected over longer periods of time and at various levels. Consumers can alter their use of energy, the kinds of cars and home heating equipment they rely on, even where they live in relation to where they work. Firms can make substitutions between labor and capital (e.g., more expensive but energy-efficient motors) or between different sources of energy and change their use of transportation or location of production. Over very long periods of time, research and development induced by higher energy prices may give rise to newer and more energy-efficient technologies. When all these long-run possibilities for substitutions at multiple levels are taken into account, the prospects for reducing dependence on fossil fuel energy may be much more encouraging than short-run analysis would suggest.

Some projections estimate that worldwide consumption of fossil fuels will continue to rise for another one hundred to two hundred years before starting to decline, with troubling implications for carbon emissions and climate change. However, one economic study of this question looked very closely at the range of substitutions among different kinds and grades of energy resources (oil, coal, natural gas, and solar energy), the range of energy uses, and the recent trend of technological change with respect to solar

■ FIGURE 3.6 Long-run versus short-run responses to a gas tax energy. Based on a simulation model of the world's economy with different assumptions about future cost reductions for solar energy and the substitutions that could be expected to occur with such changes in relative prices, the analysis finds that carbon emissions are likely to begin to decline within fifty years and that 90% of the world's coal will never be used.2

Recognizing the difference between short-run and long-run elasticity can mean the difference between a sensible policy change and a futile or counterproductive one. Let's look at an example. In March 2000, gas prices in the United States were unusually high. Presidential candidate George W. Bush proposed reducing the gasoline tax to offset the rise in prices. On the face of it, the action sounded reasonable, but the economics tell a different story. First, this was a short-run problem and Bush was proposing a temporary, short-run solution. Gasoline supplies are extremely unresponsive in the short run, given the time it takes to produce, ship, and refine petroleum, and then to distribute gasoline. So the short-run supply curve is nearly vertical (completely inelastic). Demand may not be highly elastic, but compared with supply it is much more flexible and responsive.

2Ujjayant Chakravorty, James Roumasset, and Kinping Tse, "Endogenous Substitution among Energy Resources and Global Warming," Journal of Political Economy 105, no. 6 (1997): 1201-1234.

The situation is illustrated in figure 3.7, where Sj is the existing supply curve including the national gas tax. If we reduce the gas tax (paid by producers), the supply curve will shift down by the amount of the reduction: suppliers would be willing to sell the same amount of gasoline at a lower price since they would then be paying a lower gas tax. The market, however, would find a new equilibrium. Given the lack of responsiveness in supply, consumers would bid the price up and, as you can see from the figure, the change in price would be negligible. No relief from high gas prices would likely result because no significant increase in supply is occurring in the short run.3

If prices would stay the same following a gas tax reduction, what would happen to the revenues that had been collected from the gas tax? They would end up in the pockets of oil refineries and OPEC producers. So the policy change would have no effect on supplies in the short run and no real benefits to consumers, and it would cost the U.S. government revenues. In all respects, a really, really bad idea.

■ FIGURE 3.7 Short-run responses to a gas tax

3This example draws on Paul Krugman, "Gasoline Tax Follies," New York Times, March 15, 2000.

Consumption of gasoline

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