A Premium Puzzle

If you define different grades of gas as substitute products you certainly could get a higher elasticity of demand for the premium as prices rose significantly (assuming a linear demand curve for simplicity) shifting demand across to regular. That would put a bit of downward pressure on the price of premium and a bit of upward pressure on the price of regular, though how much is an empirical question. It would be a matter of the cross elasticities of demand for different grades.

I think there might be a bit of a techincal reason as well, modern engines (in many cases) that advice premium will operate on regular gasoline. The difference is that premium gasoline burns more slowly and is less reactive (which allows an engine to operate at higher compression. Which is why if you have an engine that calls for premium you were supposed to put the good stuff in it, regular will explode too early and either retard your perfomance or damage your pistons/connecting rods if it happens too often. However, automakers developed sensors that detected “knock”and adjust the timing (causing a controlled burn earlier in the compression cycle) when lower quality gasoline is put in the car.
This results in most cars operating with all grades of fuel, although they give up some performance and potentially some efficiency. Most drivers do not understand this but realize that premium is somehow better for their car (even if not necessary) so it makes sense that the income effect would be high on an unneeded extra.
Basically, don’t downgrade, if you hear a pinging, notice a drop in efficiency, or have an older (non-electronic ignition) high compression (typically Japanese or German engine).

The reason all this is complicated is that
there are both demand-side issues and supply-
side issues. It seems to me that Tyler
addresses mostly the supply-sdie issues,
focusing on cost differences in production
when (presumably) the price of cruce rises.
The problem for producers is to price
correctly a set of substitutes, all of
which they produce. In short, there is
no easy answer.

Also, there may well be differences in the
aggregate price data used by Tyler and
prices in local markets–aggregates might not
reflect changes in all markets. (Note that
the problem raised in the initial question
remains a valid one even if the absolute
price differential between grades remains
fixed in nominal terms–as prices rsie, the
price of premium relative to the price of
regular falls.)

Hm. I’ve noticed the reduced differential at gas pumps in Mississippi.

Not being an economist, I just thought the stations figured that people were even less likely to buy premium now, so they were knocking a couple of cents off its price to encourage its purchase.

But obviously that is too simple.

I’ve only recently seen the price difference on premium go up to eleven cents.

In my experience, my car gets 10-15% better gas mileage on premium than on regular. So when the difference in price is 3-5%, it’s just obviously a lot smarter to buy premium.

And I see that this is yet ANOTHER blog incapable of verifying an SSL link, and thus insisting that my URL is “invalid”.

I think I’ll just add that a lot of this
discussion involves the absolute difference
in prices, when we ought to be thinking
about the changes in relative prices.

As one person noted, if the difference
between premium and regular is $0.10
at a price of $2.50 for regular, that’s
a 4% differential. So when regular rises
to $3.20 (as it is here), a 4% differential
would imply a $0.13 absolute differential.

The relative price of premium has fallen,
as the chart in Alex’s post actually makes
clear.

JV, your explanation sounds pretty plausible to me.

bob, I can’t really point at any solid documentation myself, but I have experienced such effects where I am… when gas prices spike at a high enough level, it is not unexpected to go to a gas station and see that they have no regular gas available, but I saunter over to the premium gas nozzle and fuel up (I have one of these “high-performance, high-compression engines that are designed to operate on premium fuel and thus would not perform as well on regular fuel)…

This seems like a micro problem. Poll a few gas station owners, theorizing will probably just be a waste of time.

My feeling is: Margins are higher on premium gas, plus or minus one cent isn’t a big deal. Gas stations switch from a 10c premium to a 9c premium for goodwill – it makes them seem like they’re trying to price gas as cheaply as they can in the face of fast-rising prices.

My thinking on this is pretty clear. As the price goes up and the price premium remains nearly the same in absolute terms, the relative prices grow nearer to each other. So as the price goes up my demand for higher octane fuel should go up. When gas was 75 cents for regular, 95 for premium was ‘high’ but at 3 dollars for regular, whats 3.20 for premium now? Why not take advantage of the big discount you are now getting from refiners?

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