In our first economics class, we learn that demand curves slope down. When the price of a good or service is high, then people buy less of it. But is this true? If it is true, how much less do people buy when the price is high, i.e., what is the elasticity?
UC Davis researchers Katrina Jessoe and David Rapson studied this problem for residential electricity. When people turn on an electrical appliance, they typically do not know how much it costs to run that appliance. Do you know how much it costs to run your air conditioner for an hour? This lack of information means people may not reduce consumption if the price goes up because they don't see the connection between consumption and price.
Three Steps in an Econometric Study
Step 1: What Do You Want To Do?
It's all in the question at the top of this page: Does the law of demand hold for electricity? Answering this question requires presenting people with different prices and observing how they respond.
Step 2: Formulate Your Research Design and Specify the Econometric Model
Jessoe and Rapson wanted to see whether a change in price causes consumption to change. But, they couldn't just use historical data on prices and consumption because the historical correlations might reflect causality in the opposite direction. What if the historical data contain periods where high consumption caused prices to increase. They want to measure how much consumption declines when there is a price increase, and not how much the price goes up when there is a demand increase.
Jessoe and Rapson worked with an electric utility to charge higher prices to a random subset of customers during some pre-announced time periods. Then, they used an econometric model to measure how consumption responded to the higher prices.
Step 3: Apply Statistical Theory
You'll learn how to do that in this class.
Jessoe and Rapson exposed a random subset of customers to two- or four-hour long pricing events during which the price of electricity increased by 200 to 600 percent. In addition, they gave some customers an in-home display (IHD) that gave real-time feedback on electricity consumption. Using the IHD, households could view their electricity consumption both before and after turning off a light or running the air conditioner.
Customers that experienced the price increase but did not have an IHD reduced their use by between 0 and 7 percent on average during pricing events. In contrast, those exposed to the same price changes but who also have IHDs, exhibit much larger usage reductions of 8 to 22 percent.
Click here for more details on the study.