Do Consumers Overreact to Rising Oil Prices?

For the past few months, the biggest obstacle to the economic recovery has been rising oil prices. A few other global shocks have also hit, but gasoline directly affects the U.S. economy more than the others. Oil likely caused a dip in consumer confidence in March. It also appears to have small businesses feeling more pessimistic. This sounds like the recipe for a slower recovery, or worse -- a double dip. But are we overreacting?

The New Yorker's James Surowiecki thinks so. He notes that Americans actually spend relatively little on gasoline:

High oil prices are generally bad for the U.S.--oil spending goes largely to foreign producers, leaving less money for American goods and services--but if you look just at the dollars involved the terror they inspire is somewhat mysterious. Gas is a relatively small percentage of most household budgets, and prices are now about eighty-five cents a gallon higher than they were twelve months ago, which translates into a few hundred dollars more a year. That's not trivial, particularly for lower-income Americans, but it's not devastating. In fact, it's less than the increase in income that most Americans will get this year as a result of the new payroll-tax cut.

He goes on to suggest that by "watching the dollars pile up" at the pump, Americans suffer greater psychological distress than fiscally harm. So the problem of high gas prices might be more easily explained by behavioral economics than by microeconomics.

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Surowiecki's assertion makes sense: Americans do seem to have an unusually strong hatred for high gasoline prices, even though an extra dollar per gallon might only raise their monthly expenses by $50 or less. After all, even if your car gets a truly terrible 15 miles-per-gallon, then that would describe how much your driving expenses rise if you drive 750 miles per month. But his argument ignores the broader effect that rising oil prices can have on the economy, if the change is permanent. Oil prices do not rise in a vacuum.

Eventually, more expensive gasoline will affect the prices of other goods and services. Some of those price increases are direct: airline fares rise, higher freight costs increases the prices of imports, etc. Others prices rise indirectly, like when products sold by retailers increase in price due to the cost of production inputs rising.

For a time, however, prices are sticky. So retailers, restaurants, shipping companies, and others generally do not react immediately to raise prices when oil prices jump. But they cannot endure higher costs forever: once the price increase appears lasting, these firms must markup their products' prices. Consumers then begin to feel a broadly higher cost-of-living.

Of course, some consumers might not realize that higher oil prices could foreshadow higher prices on other goods and services throughout the economy. So Surowiecki may ultimately be correct to say that their extremely negative reaction to higher oil prices is not justified by only the immediate outcome of gasoline prices rising. But if those price hikes endure, then the higher cost-of-living will result, and their adverse reaction will look more rational after all.