Tuesday, April 25, 2006

The Cost of Driving

J.D. Power & Associates reported that sales of eight-cylinder engine vehicles maintained a 25% market share during the first quarter of this year. A good friend sent me an e-mail expressing surprise that car-buying habits have not changed despite higher gasoline prices. What's going on?

Two things. First, when it comes to buying a car, the current price of gasoline is not as important as the expected price of gasoline. If consumers believe gasoline prices won't go higher, they will consider buying gas guzzlers - especially if manufacturers offer generous incentives such as rebates or discounts. Gasoline prices held fairly steady until the latter part of the first quarter, so any effect of the recent spike in gasoline prices on automobile sales is more likely to show up this quarter.

More importantly, however, gasoline is just one component of the cost of driving. The total cost of driving includes the cost of the vehicle, the cost of insurance, the cost of maintenance and repairs, the cost of registration, the cost of parking, etc. For example, suppose you are paying $300 per month to lease a car. Insurance likely costs $100 per month or more depending on the vehicle and where you live. Let's throw in another $50 dollars a month for maintenance, repairs, and incidentals. Suppose you drive 1,000 miles every month and get 20 mpg. That means each month you buy 50 gallons of gasoline. So if gasoline costs $3 per gallon instead of $2, your incremental monthly cost is $50. In other words, your cost of driving has risen from $550 per month to $600 per month. In this example, a 50% increase in the price of gasoline results in only a 9% increase in the cost of driving. And if you drive less than 1,000 miles per month, or you get better than 20 mpg, your incremental cost is even smaller.

This is the real reason why escalating gasoline prices haven't yet had much of an impact on consumer spending. Most consumers have been able to absorb the incremental monthly expense. There is no question, however, that this can't go on forever. Eventually, higher gasoline prices will affect consumer spending and the overall economy. We don't yet seem to have reached that breaking point, but there is no question we are getting closer to it.