Willful Amnesia - Part I: Gasoline

One of the most tired utterances I often hear sounds something like 'well of course the cost of energy will be greater in the future' and everyone in attendance nods in agreement. But the sentiment doesn't align with reality, and in fact the price of energy has remained remarkably constant (more sources) over the last century or so, so why do people feel this way, especially in regards to gasoline?

First, people have difficulty implementing the concept of inflation, a.k.a. money illusion, into their day to day lives and instead tend to focus on numbers instead of purchasing power. That is, what their money can actually buy. It's one of those truly boring problems with large effects. Gas was $2.50 when I started driving in 2000 but I'd need to spend $3.40 in 2015 dollars to equal $2.50 in 2000 dollars. If prices were $3.40 today my knee jerk reaction is to say that prices went up and it's tempting to do so, but it's just not true. The most common example of this I hear is home prices 'we bought it for $70,000 30 years ago'. 

To those who are suspicious of inflation you'll hear that the price of energy isn't counted in the CPI (the consumer price index, the measure used to track inflation), and that's true. The reason it isn't included in the data is because the price of energy is volatile. Basically, the CPI would cease to be a useful measure. Krugman has a great explanation of this, and if we look at a graph over time we see that the price of energy really just oscillates around the general trend line.

Last up is loss aversion (seminal study from Khaneman). To offset the feeling we get from losing/spending something we need about 1.5-3 times the gain to make up for it, so if you drop $20 on the ground you'd need to find $30-$50 to cancel out the feeling you get from losing the $20. The fact that we purchase gasoline more regularly than some larger expenses also doesn't help. Spending $40/week is more painful mentally than spending large sums of money more infrequently. This could be a whole post on its own but suffice it to say for now that this insight explains a vast array of irrational human behavior.

The reason I writing about this now is because gasoline prices are almost half of what I'm used to at roughly $2.50/gallon (€0.58/liter) here in Chicago. While people like cheap prices it doesn't, in human minds, make up for when gasoline is $4.50/gallon. Next time gasoline prices spike people are going to complain about how energy prices are always going up and we'll have a sense of collective amnesia all over again, so while prices are low I'd like to point it out because as previously discussed, we tend to discount these periods.

The real question here, which I'd like to talk about soon, is qualitative. Are low gas prices net positive or net negative for society? I'd wager that many individuals are making some poor long term decisions during this windfall, and of course SUV and auto sales are up.