Wednesday, March 31, 2010

Some Wisdom on Gas Prices

Yesterday, I came across this great old article by Tim Harford on gas prices. As it is a wonderful piece of everyday economics, I thought I would share some key excerpts with you (with some comments about why I think it is such a great piece):
Few costs infuriate the modern consumer more than the price at the pump. Type “fuel price riots” into Google for a list of fatal incidents from Yemen to Indonesia. US pundits have been raging against “price gouging” in the wake of Hurricane Katrina’s damage to the energy infrastructure, while in Britain a fuel protest never seems far away. There are plenty of reasons why oil prices should be high at the moment: record world economic growth, disappointing exploration results, disruptions in Venezuela, Nigeria and Iraq, and a Gulf of Mexico full of storm-damaged drilling rigs. But motorists may wonder why the price of petrol leaps up so quickly when the crude oil it comes from was sold when the price was much lower.

It can take weeks or months for oil to get from the fields beneath the Gulf of Mexico into an SUV’s petrol tank. So while crude oil prices have risen, and with them the wholesale price of refined gasoline, the underground tanks at petrol stations have been full of cheaper petrol bought earlier. Yet the price at the pump has risen quickly. It’s infuriating to be paying tomorrow’s high prices today. Surely this is price-gouging?
FYI to instructors, this is a great homework/exam question for students. It is a common misconception that the only fundamental costs are labor, capital and materials. This is an example where opportunity cost (the value of the second best alternative) jumps to the forefront. In my book, Harford's answer earns an A:
Imagine a world where wholesale gasoline prices are increasing but prices at the pump don’t rise immediately. You and I would want to fill up immediately with cheaper petrol. But service stations would have little interest in selling us this cheap petrol, because pump prices are going to rise in a couple of days. The owners of independent stations might regard this as the perfect time to close for the weekend and check out the sights in Blackpool. Why sell cheaply, if their petrol inventory is about to climb 10 per cent in value?

In a world of eager buyers and reluctant sellers, it is no wonder that price increases do not, in fact, wait for the arrival of the expensive petrol in the storage tanks.
To put this into intro micro language, prices rise when the storm hits because waiting is the second best alternative. As soon as the storm destroys some supplies of crude oil, the value of waiting increases for the owners of the pump. To induce the gas stations to part with their valuable stock of gasoline, gasoline consumers will have to pay more.

Then, Harford in his wonderful style raises the true puzzle of gas prices:
The thoughtful motorist might be satisfied with this explanation, until they ponder the conundrum a few weeks later: crude prices and wholesale petrol prices start to fall, but pump prices do not. Petrol prices seem to follow “rocket and feather” behaviour: up quickly and down slowly. This is puzzling. The reverse argument should apply: retailers want to get the expensive petrol sold before the cheap petrol arrives, while motorists, anticipating the fall, should hold off on buying. (There are limits to this, of course: you can only hold off until the gauge starts showing empty.)

So if prices stay high, isn’t this yet more evidence of price gouging?
You will have to read the rest to get Harford's answer, but as an exercise to yourself, see if you can come up with a good answer before you click through [here]. Tim Harford is a fabulous thinker, so it is a nice way to gauge your thinking to see how your ideas compete with his. Who knows? Maybe you will come up with a better explanation. If so, I would love to hear it.

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