Elasticity indices for economic analysis: a case study for hydrous ethanol and gasoline in Brazil

Paulo Henrique de Mello SantAna1

1

Center of Engineering, Modeling and Applied Social Sciences; Federal University of ABC (UFABC). Rua Santa Adlia,

166. Bangu. Santo Andr - SP Brazil. P.O Box 09210-170. Phone/Fax :+55 11 4996-8278 paulo.santana@ufabc.edu.br , phmsantana@gmail.com

Abstract
Elasticity is frequently used in economics to analyze how the change of a variable affect others. Price elasticity of demand and cross price elasticity of demand are often used in energy economics, but these indices have limitations if there are close substitutes for a good with similar prices. The objectives of this paper are to: (1) Calculate price elasticity of demand and cross price elasticity of demand for hydrous ethanol and gasoline for flex-fuel vehicles in Brazil, also showing the limitations of both indices; and (2) Propose an elasticity index that has better results than elasticity of demand and cross price elasticity of demand for the case studied. The results show that a fuel may be elastic or inelastic in different periods, depending on the price difference of its direct substitute. If the price difference is high, price elasticity of demand tends to be inelastic. However, if the price difference is low, price elasticity of demand tends to be elastic. Price elasticity of demand and cross price elasticity of demand dont take into account seasonal effects from one period to another. This paper proposes an index called relative price elasticity of relative demand ( considering the relative changes of price and demand. In general, to overcome seasonal effects,

index has better results than elasticity of

demand and cross price elasticity of demand for the case studied. Relative price elasticity of relative demand ( may be useful in econometric modeling and market analysis.

Keywords: elasticity; flex-fuel vehicles; fuel market.

1. Introduction

Elasticity is frequently used in economics to analyse how the change of a variable affect others. Two of the most used elasticity in energy economics are price elasticity of demand and cross price elasticity of demand. Price elasticity of demand (equation 1) measures the sensitivity of quantity demanded to price change, where p is the price and q is the demand of good x. Cross price elasticity of demand (equation 2) measures the sensitivity of the demand for a good to a change in the price of another good, where p is the price, q is the demand, x and y are goods.

[equation 1]

[equation 2]

Hsiao et Hsiao (1985), Abdel-Khalek (1998), Liu (1983), Bentzen et Engsted (1993), Boonekamp (2007), Brons et al (2008), He et al (2011), Fan and Hyndman (2011), Fatima et al (2012) are examples of calculation of price elasticity for energy modelling, market analysis and policymaking. Frondel (2004) calculated cross price elasticity of demand to understand and appreciate energy substitution. When calculating price elasticity of demand and cross price elasticity of demand for flex-fuel1 vehicles in Brazil, the results were not consistent with market behavior. The limitation of both indices when analyzing real data was the motivation for the research of another elasticity index. The objectives of this paper are to: (1) Calculate price elasticity of demand and cross price elasticity of demand for hydrous ethanol and gasoline for flex-fuel vehicles in Brazil, also showing the limitations of both indices; and (2) Propose an elasticity index that has better results than elasticity of demand and cross price elasticity of demand for the case studied. Section 2 shows how the fuel market for light vehicles works in Brazil. Section 3 describes the limitations of price elasticity of demand and cross price elasticity of demand, calculating these indices for hydrous ethanol and gasoline in the Southwest region of Brazil. Section 4 shows the relative price elasticity of relative demand
1

Flex-fuel vehicles runs with hydrous ethanol and gasoline in any rate (from 0%

to 100%)

index created. Furthermore, it explains why it is a better index than price elasticity of demand and cross price elasticity of demand for the case studied.

2. Fuel market for light vehicles in Brazil: ethanol, gasoline and flex fuel

The oil crisis of 1973 stimulated the Brazilian government to launch a program to foster ethanol production from sugarcane called PRO-ALCOHOL. PRO-ALCOHOL was launched by the Government in two variants: (1) compulsorily using 10% anhydrous ethanol as an additive to gasoline, not requiring changes in the motors; and (2) voluntarily using 100% hydrous ethanol (95% ethanol + 5% water) in modified Otto cycle motors (Goldemberg, 2006). The car manufacturers have made a few adaptations, and hydrous ethanol vehicles dominated national sales in the 80s. Hydrous ethanol shortage in the late 80s has reduced customer confidence, drastically reducing hydrous ethanol car sales. In the 90s flex-fuel technology for light vehicles was developed. Flex-fuel vehicles run with gasoline and hydrous ethanol in any rate (from 0% to 100%). According to the National Car Manufacturing Association (ANFAVEA), flex-fuel car sales began in 2003. This technology put hydrous ethanol back in the market. Since then, flex-fuel vehicles owners can choose hydrous ethanol or gasoline in the gas station, depending on their relative price. The harvest of sugar cane officially begins in April, but is harvested primarily between May and November. Ethanol price is usually lower during this period. In 2011, flex-fuel cars reached 91% of total sales for light vehicles in Brazil. Flex-fuel car fleet reached 45% in 2010 and is expected to increase up to 86% in 2020 (UNICA, 2011). Table 1 shows the evolution of light vehicles sales in Brazil. It is possible to notice that flex-fuel car sales are dominating national sales since 2006, reaching 91% in 2011.
Table 1: evolution of light vehicles sales in Brazil (2005-2011) Gasoline Ethanol vehicle sales vehicle sales 1.151.069 815.849 646.266 534.949 322.868 560.348 280.704 43.278 758 3 0 0 0 0 Flex-fuel vehicle sales 776.164 1.249.062 1.719.745 1.948.941 2.241.820 2.256.158 2.876.173 % of flex-fuel vehicle sales 39% 60% 73% 78% 87% 80% 91%

Year 2005 2006 2007 2008 2009 2010 2011

Total 1.970.511 2.065.669 2.366.014 2.483.890 2.564.688 2.816.506 3.156.877

Source: ANFAVEA (2012)

Table 2 shows the evolution of light vehicle fleet in Brazil. Flex-fuel car fleet is expected to increase in the future, since national sales are increasing in a higher rate.

Table 2: evolution of vehicle fleet since 2005 in Brazil.

Gasoline

Year 2005 2006 2007 2008 2009 2010 2011

Flex-fuel fleet 1.183.574 2.603.914 4.586.512 6.878.189 9.467.825 12.244.937 14.944.734

fleet 15.872.979 15.541.077 15.085.856 14.555.523 13.991.052 13.455.428 12.995.272

Ethanol fleet 2.230.679 2.032.710 1.845.330 1.670.508 1.508.263 1.358.358 1.220.419

Total fleet 19.287.232 20.177.701 21.517.698 23.104.220 24.967.140 27.058.723 29.160.425

% of flex-fuel car fleet 6% 13% 21% 30% 38% 45% 51%

Source: UNICA (2012)

Section 3 describes the limitations of price elasticity of demand and cross price elasticity of demand. A case study for flex-fuel vehicles in Brazil is used to show these limitations.

3. Limitations of price elasticity of demand and cross price elasticity of demand

Southwest region is the business-economic center of Brazil. Its was the responsible for 70% of hydrous ethanol and 47% of gasoline consumption in 2011 (ANP, 2012). All gas stations sell hydrous ethanol and gasoline in Brazil. Hydrous ethanol (called just ethanol from this part of the paper) has a lower heating value (LHV) of 5.097 kcal/l. Gasoline with 20% of anhydrous ethanol has a LHV of 7.254 kcal/l. Table 3 shows the evolution of gasoline and ethanol sales and prices in the Southwest region of Brazil. Sales are shown in cubic meters. Prices are shown in current Brazilian Real per litre (R$/l), and also in current 10,000 x Real per kilocalories (10,000 R$/kcal). The conversion is made to consider the LHV, since gasoline and ethanol have different energy amount per litre. Flexible fuel car fleet in Brazil is shown in the same table. The higher the number, the greater the propensity of flex-fuel consumers to switch fuel when there are changes in relative prices of gasoline and ethanol. The difference between the price of ethanol and gasoline, in terms of LHV, is also in Table 3. It shows the propensity of flex-fuel vehicles owners to switch fuel. If this difference is zero, it means that the price of ethanol and gasoline is equivalent in energy terms. The percentage in total sales of ethanol is in the last column of Table 3. This number shows how fuel price changes reflect the consumers choice. Values highlighted in the last column mean that the total variation from one period to the next is greater than 1.0% in modulus. This means that the flex-fuel vehicles owners have changed from one fuel to another significantly within a month. The other values mean that total variation from one period to the next is equal or lower than 1.0% in modulus.

Its possible to notice in Table 3 that if price difference is close to zero, a small change in the relative price leads to a significant change in the percentage of ethanol in total sales. This result is reasonable because there is a considerable flex-fuel fleet since 2009 in Brazil, as shown in Table 2. As flex-fuel vehicles fleet increases in Brazil, this fact tends to increase as the relative price between fuels is close to zero and price changes occur. A conclusion that can be inferred from Table 3 is that when price difference between fuels is high (positive or negative), the change in the relative price dont affect significantly the percentage of ethanol in total sales from one month to another. However, if price difference between fuels is low (close to zero), the change in the relative price usually affect the demand structure from one month to another. Highlighted values help to check it. Price elasticity of demand and cross price elasticity of demand should show that this situation was supposed to happen. However, next section shows that the results were not reasonable.
Table 3: market data for ethanol and gasoline in Brazil
Gasoline average price in the Southwest region (current R$/l) *

Y e a r Month

Ethanol average price in the Southwest region (current R$/l) *

Gasoline average price (R$/ kcal)x 10.000

Ethanol average price (R$/ kcal)x 10.000

Gasoline sales in the Southwest region (m3) *

Ethanol sales in the Southwest region (m3) *

Gasoline average price less ethanol average price(R$/ kcal) x 10.000

Percentag eethanol sales/total sales

jan/09 feb/09 mar09 apr/09 may/09 jun/09 jul09 aug/09 sep/09 oct/09 2009 nov/09 dec/09 jan/10 feb/10 mar10 apr/10 may/10 jun/10 jul/10 aug/10 2010 sep/10 oct/10

2,452 2,453 2,448 2,440 2,434 2,422 2,422 2,538 2,417 2,490 2,512 2,489 2,530 2,557 2,530 2,501 2,489 2,478 2,479 2,482 2,486 2,509

1,355 1,383 1,355 1,289 1,252 1,203 1,239 1,270 1,340 1,603 1,573 1,615 1,822 1,860 1,662 1,522 1,415 1,344 1,383 1,437 1,457 1,579

3,38 3,38 3,37 3,36 3,36 3,34 3,34 3,50 3,33 3,43 3,46 3,43 3,49 3,52 3,49 3,45 3,43 3,42 3,42 3,42 3,43 3,46

2,66 2,71 2,66 2,53 2,46 2,36 2,43 2,49 2,63 3,15 3,09 3,17 3,57 3,65 3,26 2,99 2,78 2,64 2,71 2,82 2,86 3,10

948.156 906.922 977.478 988.118 936.894 948.296 981.118 941.276 973.486 1.063.220 989.547 1.198.451 1.160.392 1.145.379 1.238.103 1.101.933 1.065.805 1.051.085 1.092.939 1.085.833 1.092.070 1.115.421

822.008 782.476 879.177 925.110 873.350 903.364 932.895 918.155 971.967 985.354 860.693 629.813 544.930 740.336 826.948 900.087 901.211 942.803 911.877 922.452 882.958

0,72 0,67 0,72 0,83 0,90 0,98 0,91 1,01 0,70 0,29 0,38 -0,09 -0,12 0,23 0,46 0,65 0,78 0,70 0,60 0,57 0,36

46,4% 46,3% 47,4% 48,4% 48,2% 48,8% 48,7% 49,4% 50,0% 48,1% 46,5% 45,6% 35,2% 32,2% 37,4% 42,9% 45,8% 46,2% 46,3% 45,6% 45,8% 44,2%

1.005.525 0,26

nov/10 dec/10 jan/11 feb/11 mar/11 apr/11 may/11 jun/11 jul/11 aug/11 sep/11 oct/11 2011 nov/11 dec/11 jan/12 feb/12 2012 mar/12

2,524 2,539 2,550 2,555 2,606 2,770 2,807 2,709 2,705 2,702 2,735 2,739 2,731 2,732 2,724 2,717 2,726

1,626 1,698 1,759 1,785 2,018 2,199 1,907 1,756 1,839 1,853 1,953 1,943 1,970 1,994 1,966 1,904 1,928

3,48 3,50 3,52 3,52 3,59 3,82 3,87 3,73 3,73 3,72 3,77 3,78 3,76 3,77 3,75 3,75 3,76

3,19 3,33 3,45 3,50 3,96 4,31 3,74 3,45 3,61 3,64 3,83 3,81 3,87 3,91 3,86 3,74 3,78

1.130.640 884.883 1.340.027 956.336 1.131.713 773.733 1.170.342 791.707 1.492.981 530.640 1.563.489 366.190 1.338.124 637.147 1.265.763 749.828 1.309.175 683.364 1.393.274 716.182 1.426.721 590.393 1.397.185 618.605 1.423.133 583.844 1.645.723 604.932 1.407.604 516.520 1.417.312 566.791 1.525.624 571.115

0,29 0,17 0,06 0,02 -0,37 -0,50 0,13 0,29 0,12 0,09 -0,06 -0,04 -0,10 -0,15 -0,10 0,01 -0,03

43,9% 41,6% 40,6% 40,4% 26,2% 19,0% 32,3% 37,2% 34,3% 34,0% 29,3% 30,7% 29,1% 26,9% 26,8% 28,6% 27,2%

Source: * National Agency of Petroleum, Natural Gas and Biofuels (ANP) ** Brazilian Sugarcane Industry Association (UNICA)

Price elasticity of demand for gasoline and ethanol and cross price elasticity of demand for gasoline (x) ethanol (y) and ethanol (x) gasoline (y) were calculated to analyze the response of demand to variation in prices of both fuels. The indices consider the values of price and demand in the same row and the next one