Gas Price Rant #12 The Chug-a-lug bug in your rug

Gas Prices in Victoria B.C. CanadaAs gasoline prices continue to bottle-rocket in the Canadian (and American) marketplace, a torrent of theories attempting to explain the pricing behavior in gasoline markets have emerged. Internet pundits from the CoffeeCrew blog and beyond have their own pet theory about the rising price of motion juice.

So – who is right? And how off the mark am I?

Some sound economic analysis is in order and it seems only appropriate to play a bit of “gasoline price fact or fiction” with stalwarts: supply and demand.

(Theory #1) Gas prices are controlled entirely by wholesalers and refinery oligopolists who collude, cooperate and profiteer at your expense.

Fact or Fiction?

One of the most widespread theories about gasoline markets is that prices are controlled entirely by monopolists in the oil industry – That suppliers may charge whatever high price they prefer with impunity due to collusion and cooperation between cogs in the chain of process. From appearances alone (Prima facie): prices between gas stations tend to move up (and down) in a synchronized pattern, with the suggestion that collusion must be occurring between suppliers.

If one uses the Victoria, B.C. Canada market as an example, one would note that prices move lock step – often shifting city-wide to the exact same point within minutes of any rumor of increase (or decrease)

And while gasoline wholesalers and refiners certainly possess modest “market power,” suppliers do not “control” prices. On the contrary, prices are controlled by the interplay between supply and demand; the collusion whimsy tends to dismiss the demand side of the market. Gasoline refiners and wholesalers have market power because demand for gasoline tends to be insensitive to price changes. “Price in-elasticity” – means that when prices change, consumers’ spending habits change proportionately less than the accompanying variation in price.

Price in-elasticity occurs for several reasons. First, gasoline, has no close substitutes. Without choice, consumers tend to be less price conscious.

Gasoline is also viewed as a “necessity” by most people. There is no option to stop buying fuel as protest. Most people will sacrifice other goods in order to spend more of their income on gasoline – or forgo recreational travel.

Consumers do not have time to alter their buying behavior in response to price spikes. They do not typically adjust to higher gas prices by purchasing hybrid vehicles, riding their bicycles or walking to destinations. Any adjustments in buying patterns take time. In the long term consumers could adjust by finding alternatives, making the gasoline more price elastic. Hasn’t happened yet, has it?

Finally, studies indicate that gasoline expenditures are still a small slice of most household budgets. In 2003, the average Canadian household probably spent less than 5% of annual income on gasoline. At this juncture, Canadian households tend to be insensitive to price changes. We are currently feeling the pinch in the food marketplace as the real impact of fuel costs versus costs of delivery impact the very mechanisms that bring goods and consumables to our communities.

Gasoline is a price-inelastic product. Here is another reason why:
Whether prices fall or rise, people generally buy the same amount. I mean, you can only fill up one gas tank at a time.

Look at it this way: If the demand for gasoline is perfectly price inelastic, and if refineries and wholesale have firm control over prices, why do prices ever stop rising?

They do actually. They ebb and flow. The current price of 1.29/liter is scarcely higher than it was a year ago – It goes up and down. Obviously the trend is upwards
and although we will not stop buying gasoline any time soon, we are certainly going to feel the pain of skyrocketing fuel prices in other ways – some of which we have yet to imagine.

update: Note blog entry from almost a year ago – yup, 129.9