Short Run Price Elasticity of Demand for Energy in the US

Abstract

We propose using cost shifters as valid instruments for the estimation of short-run price elasticity of demand for residential electricity. We argue that most of the previous studies do not address the endogeneity of price in the demand equation and hence suffer from simultaneity bias. Furthermore, we argue that using lagged prices or consumption as instruments clearly violates the exclusion restriction and overstates the magnitude of the short-run elasticity of demand. We propose using the price of coal and natural gas as instruments, since they are two of the most important inputs in the production of electricity in the U.S. We are able to estimate much smaller magnitudes of price elasticity, which implies that in the short run consumers are much less responsive to changes in prices than previously believed. Policies based on previous (higher) estimates are likely to take longer time to be effective, since these estimates are confounding short-run and long-run consumer responses to price changes.