The Undercover Economist – FT Magazine, 5 November 2005
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?
Not so fast. If petrol stations were able to raise prices on a whim, they wouldn’t need to wait for a hurricane. After all, retailers don’t just price-gouge in emergencies; they price-gouge every day to the maximum extent of their powers. Fortunately, their powers are extremely limited and in fact the only time retailers can put prices up immediately is when high prices are obviously looming.
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.
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? Again, not so fast. The petrol retailers are not to blame – we lazy consumers are. Why? Because if we were prepared to look around more for lower prices, we would pay less. As Matthew Lewis, a young economist at Ohio State University, has pointed out, drivers who see a petrol station with a higher price than the previous week may drive past and look for a better deal. But checking prices is a hassle; customers who see a petrol station with lower prices are unlikely to bother searching further. This means that rising prices encourage competition, but falling prices do not. That makes sense. If you get a clean bill of health from your doctor you are unlikely to ask for a second opinion.
So next time you find yourself emptying your wallet to fill up, don’t blame the petrol station owner. Not unless you’re prepared to spend another half hour looking for a cheaper price.
Financial Times Magazine, 5 November