How would an increase in the price of gasoline used to fuel automobiles impact the demand for or supply of automobiles?

In economic theory, the use of complementary goods is associated with the use of another good, while substitute goods are goods viewed by consumers as similar or comparable in some way. Within the auto industry, vehicles and petroleum are considered complementary goods whereas gas-guzzling trucks and SUVs are similar enough to their smaller more fuel-efficient counterparts to be considered reasonable substitutes.

Understanding these two distinct categories of goods is helpful in thinking about how price changes affect the demand for different types of goods. With the significant decline in the price of oil over the past year, this distinction is essential in understanding how the auto industry has and will be affected.

Lower Oil Prices Fueling Demand for Automobiles

As gasoline is a petroleum-based product, price changes in crude oil directly affect its price. A decrease in the price of gasoline means automobile owners have more disposable income to use for other purchases. Owners who may have been trying to stretch out the lifetime of their vehicle may just decide that the extra income they save from lower fuel prices can be used to finance the purchase of a new vehicle now.

For those who were unable to afford the expenses of vehicle ownership, depressed fuel prices make driving a lot cheaper, and consequently, vehicle ownership becomes more attractive for some people while gas prices remain depressed. Yet, the effect of lower fuel prices on vehicle consumption will vary depending on different markets. Consumers in a high fuel-tax nation such as Norway, although experiencing the exact same absolute price change as consumers in the lower fuel-tax US, face a lower overall percentage change in the price. The price change will thus not appear as significant in Norway as it does in the US, and this consumer perception should result in more significant changes in American vehicle purchases than Norwegian ones.

Further, some would argue that in periods of highly volatile oil prices, consumer uncertainty about the future direction of prices increases, and consequently current price changes have a limited effect on new vehicle purchases. From this perspective, changes in automobile sales may reflect consumer expectations of fuel prices more so than current prices.

While the recent increase in overall automobile sales could reflect expectations that prices will remain low, most industry experts are directly crediting the increase to the recent plunge in fuel prices arguing that American automobile consumers are much more short-sighted than some would like to think.

Automobile Substitutes

While overall automobile sales in the US have increased due to the lower fuel prices, it has been the gas-guzzlers that have been growing more rapidly than their more fuel-efficient substitutes, as one would expect. Lower fuel prices make the difference in the cost of driving a low fuel-economy vehicle versus a high fuel-economy vehicle less significant and thus consumers opt for the advantages (extra space and a greater feeling of safety) that come with owning the bigger, less fuel-efficient vehicles.

American automobile manufacturers are not indifferent to the types of vehicles consumers purchase, and the trend towards SUVs, trucks, and bigger cars are a real boon for the industry for a couple of reasons.

Firstly, US automakers have generally offered vehicles with lower fuel economy than their foreign counterparts and are thus going to benefit more from the trend towards these vehicle types. The other reason is that profit margins on smaller vehicles are generally less than those on larger ones, while losses are generally suffered on electric vehicle sales.

The big worry for American automakers is that future regulations and/or subsidies that incentivize the purchase and manufacture of greener vehicles could be a potential limiting factor in the substitution effects of lower fuel prices.

The Bottom Line

Based on an understanding of complementary and substitute goods, the American auto industry is exhibiting expected effects from the recent plunge in the price of oil. Lower fuel prices make driving cheaper, consequently making automobile ownership more appealing.

The reduced cost of driving also means the difference between the gas-guzzlers and the smaller fuel-economy substitutes less significant, creating a shift in consumer preferences towards bigger and more powerful vehicles.

While American automakers are enjoying significantly higher profits from this trend, they would be wise to invest these increased earnings in strategies that improve the fuel-efficiency of their vehicles in order to comply with greener standards.

Why do gasoline prices fluctuate?

Retail gasoline prices are mainly affected by crude oil prices and the level of gasoline supply relative to gasoline demand. Strong and increasing demand for gasoline and other petroleum products in the United States and the rest of the world can place intense pressure on available supplies.

Gasoline prices generally follow crude oil prices.

Gasoline prices tend to increase when the available supply of gasoline decreases relative to real or expected gasoline demand or consumption. Gasoline prices can change rapidly if something disrupts crude oil supplies, refinery operations, or gasoline pipeline deliveries. Even when crude oil prices are stable, gasoline prices fluctuate because of seasonal changes in demand and in gasoline specifications.

Crude oil and gasoline prices reached record levels in 2008

World crude oil prices reached record levels in 2008 as a result of high worldwide oil demand relative to supply. Significant growth in demand in China, the Middle East, and Latin America, combined with market uncertainty in world supply, contributed to the run-up in oil prices and, in turn, to record-high gasoline prices in the United States.

Seasonal demand and specifications for gasoline

Historically, retail gasoline prices tend to gradually rise in the spring and peak in late summer when people drive more frequently. Gasoline prices are generally lower in winter months. Gasoline specifications and formulations also change seasonally. Environmental regulations require that gasoline sold in the summer be less prone to evaporate during warm weather. This requirement means that refiners must replace cheaper but more evaporative gasoline components with less evaporative but more expensive components. In 2000 through 2020, the average monthly price of U.S. retail regular-grade gasoline in August was about 32 cents per gallon higher than the average price in January.

Gasoline inventories provide a cushion

The supply of gasoline is largely driven by crude oil supply and refining, imports of gasoline, and gasoline inventories (stocks). Stocks are the cushion between major short-term supply and demand imbalances, and stock levels can have a significant impact on gasoline prices.

If refinery or pipeline problems or reductions in imports cause unexpected declines in supply, gasoline stocks may drop rapidly. This drop in inventories may cause wholesalers to bid higher for available supply over concern that future supplies may not be adequate.

Imbalances may also occur when a region changes from one gasoline formulation to another, and refiners, distributors, and marketers adjust supply for the new product.

Last updated: July 5, 2022, with data available at the time of update.

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