Although gasoline prices have exceeded the $2 per gallon mark in many parts of the country, the driving habits of most Americans seem unaffected. James Hornsten, assistant professor of economics at The College of Wooster, offers some insight into why that might be the case. He also looks at the possible short- and long-term effects of high gasoline prices on the economy.

Q. What economic factors have led to this steady increase in the price of gasoline?

A. When prices rise, either rising demand or falling supply is the cause, and both are happening right now. Gasoline demand is surging due to summer travel, a reasonably strong domestic economy (despite concerns of unemployment and rising interest rates, many macroeconomic indicators suggest a solid U.S. economy, which bodes well for "pro-cyclical" products such as gasoline), and the emergence of China as a voracious consumer of oil derivatives. Supply is depressed because, according to industry commentators, OPEC (the Organization of Petroleum Exporting Countries) is producing crude oil at near capacity and U.S. refineries don't have much slack. Finally, recent terrorist attacks in Saudi Arabia have added to the political instability in the Middle East and raised concern about the availability of future oil supplies; the added terrorism-related risk increases costs.

Q. Why do the higher fuel prices seem to have little or no effect on fuel consumption?

A. The demand for fuel is very price-inelastic in the short run, which means that when faced with a given percentage increase in price, fuel consumers reduce the quantities they purchase by a much smaller percentage. This unresponsiveness to price changes is primarily due to the price and availability of substitutes (e.g., replacing one's daily solo automobile commute with public transportation, car-pooling, bicycling, or telecommuting), but also depends on the importance of transportation as a regular household expenditure and the time that it would take to adjust to high prices (e.g., by purchasing a hybrid vehicle or moving closer to work). In other words, we will need a much larger shock to our system to change our ingrained habits.

Q. How will escalating fuel prices affect the economy in the short term?

A. High prices at the pump will directly affect gasoline buyers, primarily drivers and the transportation industry (e.g., airlines, trucking and shipping). Firms producing goods and services that are consumed with gasoline will be indirectly affected. For example, as some families postpone or cancel summer travel, we expect hotels, car rental firms and other tourism-based businesses to suffer. Nearly all businesses will incur rising costs because complex modern production processes, which transform raw materials and other inputs into finished goods and services, require transportation to link the manufacturing, assembly, wholesale and retail stages. Inflation worries may grow as firms attempt to recoup the added fuel costs by raising prices. For instance, under intense competition from low-cost carriers, the major airlines repeatedly have tried to augment airfares with fuel surcharges and some may be driven from the market.

Q. What are some of the possible long-term effects if gasoline prices remain high?

A. Those dependent on gasoline in the short term have a chance to adjust in the long term. Buyers will try to either use gasoline more efficiently or switch to alternative energy sources. For instance, when 1970s oil price shocks created incentives to develop better products and invest in better technologies, foreign producers captured a substantive share of the U.S. automobile market by offering fuel-efficient compact cars, and U.S. families switched to more energy-efficient building materials, appliances and heating options. Partially as a result of recent prices, sales of not-so-fuel-efficient sport utility vehicles have dipped while waiting lists for new hybrid electric vehicles have grown longer. On the supply side, higher prices will make it worthwhile to undertake more costly production methods, such as extracting oil from tar sands. As economists are fond of pointing out, we will never actually run out of oil, because as natural reserves dwindle, production costs and prices will skyrocket, forcing us to examine our priorities and seriously consider alternative fuel sources and means of transportation.

Q. What is the likelihood that fuel prices will remain high?

A. By historical standards, fuel prices are not particularly high. According to the Department of Energy, U.S. gas prices in 1981 were approximately $2.99 when adjusted for inflation. By international standards, American fuel prices remain low; consumers pay well over $5/gallon in many parts of Europe. In addition, fuel prices are notoriously volatile, so we will continue to occasionally experience unanticipated spikes in addition to the predictable increases due to summer travel. That said, there is a big reason to expect prices to remain high in coming years: China's increasing presence in the global economy as a low-cost manufacturer with a seemingly endless supply of inexpensive labor. As China continues to industrialize and build new factories and infrastructure, it will demand enormous quantities of oil. Imagine the global growing pains were India to follow China's lead; what if two-fifths of the world's population adopted American consumption patterns? Granted, this is decades away, but if you think fuel prices are high now...just wait.

Q. Will fuel prices be an important issue in the upcoming Presidential election?

A. American voters require government awareness and action regarding fuel prices, not admissions of powerlessness, as the Carter administration learned the hard way; thus, in the upcoming pre-election months, expect the Bush administration to cultivate public perception of governmental concern and propose solutions that will probably be more symbolic than substantive (in general, the President has far less control over the state of the economy than most voters believe). For example, domestic efforts to stockpile oil near the Gulf of Mexico or drill in Alaska may help smooth out short run bumps, but are merely a drop in the bucket in terms of significant price reductions because most of the world's known oil reserves (the potential supply) are located far from the U.S.

Q. What might we do about our oil dependency?

A. It is controversial - but almost certainly correct - to assert that Americans are addicted to gasoline and that some weaning would benefit both the environment and our international relations. College students seem increasingly likely to make energy-conscious decisions. In anticipation, automakers are rolling out new hybrid electric vehicles (including SUVs), accelerating their evolution from novelty to mainstream. Many have compelling reasons to drive larger, heavier gas-powered vehicles and should retain that right, but even at current levels fuel prices do not fully capture the true social costs of fuel use, which by some estimates exceed $4/gallon when one factors in congestion, accidents, respiratory illness, global warming, unemployment and spills. Consumers would "internalize" these hidden external costs and change behavior if we altered incentives by raising gasoline taxes. A multi-year phase-in period would give both households and the business sector the chance to gradually adapt and revenues could be used to fund research and development of new technologies, such as hydrogen fuel cells. Unfortunately, this straightforward economic solution would likely cool our economy and traditionally has been politically infeasible in an expansive nation with many who dislike public transportation, car-pooling and particularly the idea of taxes near European levels. One would not expect much action in the absence of a 9/11-style wake-up call given our incredible global oil reserves and the uncertainty surrounding future climate change. Still, just as we prudently save for retirement, watch our diets, and wear sunscreen in anticipation of distant days of reckoning, we can and should take modest steps today toward changing our oil habits.