Why Do Gasoline Prices React to Things that Have Not Happened?

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Letter Writer:

Michael Fladlien, teacher at Muscatine (Iowa) High School

Date Posted:

Sept. 24, 2007

Letter:

Hats off to a brilliant article. I am using it in my economics class to show efficiency and market structure.


Letter Writer:

O.T. Harris of Fulton, Mo.

Date Posted:

Aug. 7, 2007

Letter:

This article makes the case that your corner gas stations are not gouging even though they surely get the brunt of complaints about high gas prices. These local retailers usually make, at best, 2 or 3 cents per gallon. But then, we look to the major oil companies and the huge, historically record high profits. I can't prove it, but one has to wonder if that is not where there might be some price gouging. I know: Just because they are big doesn't make them bad. There is no doubt that these companies have the expertise to work with the futures markets effectively. So did Enron. But somewhere between the well and my gas tank, there is a big disparity between the cost of the raw product and the price at the pump, and it shows up in the financials of the majors, doesn't it?

Response
of Authors,
Bill Emmons
and
Chris Neely

(Updated Sept. 12, 2007)

If we understand correctly, Mr. Harris suggests that although the retail market for gasoline is competitive, the wholesale market might be oligopolistic—dominated by a few producers. This lack of competition might have contributed to the recent rise in gasoline prices through a restriction in oil production.

Before we respond to Mr. Harris’ question, we should first note that economists typically do not use the term “price gouging” as it is pejorative and difficult to define objectively. It usually connotes a situation in which the speaker believes that prices are “unfairly” high. (“Price gouging” has a specific legal meaning in narrow circumstances. It refers to price increases during civil emergencies that are not caused by an increase in costs.)

Suppose that the oil industry is oligopolistic, does this industry structure produce abnormal returns on capital over long periods (for example, 30 years)? We don't know of any evidence for this, but we are not experts on the oil industry.

Whether the oil industry profits are abnormal or not, why do they vary so substantially over time?

The accompanying chart illustrates that oil industry profits covary strongly with the inflation-adjusted price of oil. This makes sense. Oil is, of course, the major asset of oil companies, and when its price rises, sellers must make money. When housing prices rise, sellers of existing houses benefit.

Since 2001, strong global growth, terror threats and war fears in the Persian Gulf have driven up oil (and gasoline) prices. The oil companies are making lots of money because they own a lot of a commodity whose price has risen very fast. They made very little money from 1985 to 2000, when oil prices were falling or stagnant.

Oil company profits have varied considerably with oil prices. What looks like “price gouging” is just the oil companies benefiting from external events that have increased the price of a scarce commodity. In some periods, the oil companies get the bear, in others, the bear gets them.

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