Response to my Mother

My wonderful mother is upset, like pretty much everyone else, at the price of gas.  "Well, the hurricane has knocked out a lot of production on the gulf coast," I say.  "Yes but there’s plenty of gas in the pipes that was produced before the hurricane – the suppliers are gouging." she responds.  Arrghhh….must resist, must resist, must be ….nice.  "mmm," I say.  You and my Econ 101 students (103 actually), however, are not so lucky.

Many people think that price is determined by historical cost.  Price is never, ever, determined by historical cost. Price is determined by supply and demand.  If supply or demand change then the price changes regardless of historical cost.  Last year’s fashions?  The price falls regardless of cost.  Chopped up dead sharks?  If demand is high, the price is high regardless of historical cost.  If the demand for gas were to suddenly fall, the price of gas would fall too, regardless of cost.  In the present situation the supply of gas has been reduced and the price has gone up.  Historical cost is always irrelevant.

Is the high price due to supplier gouging?  Not at all.  If you want to blame anyone for the high price blame your fellow buyers not the suppliers.  A high price means that some other buyer is outbidding you to obtain the limited supply.  It’s buyers who push up prices in a competitive market and it’s suppliers who push prices down!

It’s true that some suppliers are making big profits but people have the cause and effect backward.  It’s not the high profits which are causing the high price.  It’s the high price which is causing the high profits.  If you were to tax the high profits, for example, you wouldn’t reduce the price.  Indeed, quite the opposite because the high profits motivate suppliers to increase the quantity of gasoline as quickly as possible.

The last point brings us full circle because as the situation stabilizes suppliers increase the quantity supplied until price is pushed down towards long-run costs (which are also historical costs).  Thus, in the usual situation it appears that price is determined by historical cost.  It’s only in the brief time period when a shock shifts (short-run) supply away from historical cost that we can see the truth.  Price is determined by supply and demand.

Addendum: Is it just me or did Ken Arrow ever feel the need to correct his Mom on economic matters?  Did Adam Smith?  "Look Mom, I know you’re upset about the price of mutton but let me tell you about this new theory I’ve been working on…"    

Comments

Alex - free advice - upset your mom enough and she'll give you an invisible hand
right across your face.

Why can't you explain this to your mom? Your main points that: someone is willing to pay this price, and profits encourage more gas, are easily understood, even by my grandmother ( I tested this. She used to be a market gardener, and well experienced in auctions).

Your point that shocks cause temporary shifts is not too far away from your mother's point, I think: if there really was lot of gas in the pipes ( say enough for a few months), then you wouldn't see these large price changes.

"Yes but there's plenty of gas in the pipes that was produced before the hurricane - the suppliers are gouging." she responds.

The tactic that I would take is to point out that the suppliers are charging based on what it costs to replace the gas in their pipes after you buy it, so that they are back in the situation they were before you bought it.

I wouldn't run so quickly from the "gouge" accusation. As near as I can tell, to gouge is to charge a price greater than the cost.

Well, then... Anyone who is employed at a wage that pays more than required to keep himself alive and working -- say rice, beans, vitamins, and a bed in a large dormitory -- is gouging his employer. In the US, that's a mere fraction of minimum wage, so even those earning minimum are completely ripping off their employers.

"Oh, I'm just charging replacement cost," the gouger pleas. Well, no dice. All that says is that you are willing to gouge as much as the next bastard to have your job.

To paraphrase Feynman, if you can't explain something to your mother then you don't fully understand it ;-)

"If the demand for gas were to suddenly fall, the price of gas would fall too, regardless of cost."

I'd like to see you perform a real-data analysis of this assertion. My suspicion is that you would at best see an indirect or delayed correlation between domestic demand and cost. It seems that prices at the pump did not start sagging until August despite significantly reduced demand all Spring and Summer.

Its not the motorists that are outbidding us, its China and other nations, and their fuel energy infrastructures.

While I agree on the general economic implications the business concerns are being totally ignored in a situation where, because of the VERY HIGH barriers to entry the market cannot easily correct itself by allowing additional participants to enter and undercut the establishment while still making a profit. Expecting the current participants to adjust supply on their own without considering price elasticity shows ignorance; plus the ability to increase supply itself has its own barriers to overcome.

"Gouging" is a purely subjective term so without actually saying: "a gross/net profit margin over 15% is gouging" it is nothing more than a use of poetic license meant to rally people to a cause. In my opinion instead of trying to attack the effect the government should attack the cause of why such price variability and long-term profit margins are able to be sustained without new competitors or new investment.

We already tax income so it isn't like the government isn't getting their share, and unless the owners are stuffing their cash under their mattresses (and profits != cash) then the money is being put into the banking and investment system and thus providing liquidity and assets for others to invest.

It's buyers who push up prices in a competitive market and it's suppliers who push prices down! As somebody pointed out its who you include in the buyer pool that seems relevant, not only other countries such as China and India, but also speculators in the market. Mack Frankfurter wrote a 3 part article on The Commodity Conundrum: Securitization and Systemic Concerns. It's in 3 parts so I am giving my post on it http://briandrpm.blogspot.com/2008/07/securitization-doesnt-seem-that-secure.html . It also seems that if there is limited competition in the industrial production sector with relatively more in the buyer pool, that the suppliers could see that greater supply will lower prices and over time not put investment in infrastructure that would increase supply to meet demand. The second concept seems to have some logic though I don't have any real empirical support. Taxing for unrelated purposes is one thing but to tax for other energy sources or to not tax for focused investment seems to be another. While both may discourage greater supply for the second we are hopefully increasing supply from other sources.

Alex,
Don't argue with your mom. You won't win either the battle or the war.

Oddly enough, I think that Alex got it somewhat wrong here.

The proximal causation step that forces prices up or down is pretty well modeled by supply and demand, but the price curve is the relationship between prices and availability and *that* can change and changes in the way that consumers respond to changes in supply is very much determined based on their recollections of yesterdays pricing.

Having a memory of a low price from yesterday can make consumers today very cranky about increased prices and thus can make demand much more responsive to price changes than it might otherwise be. This means that in a strong sense, yesterday's price determines today's price more fundamentally than a static curve would imply.

Or, people generally disbeleive "announcements."

Gas retailers can more readily pass supply shocks on to their customers than other retailers because delaying the gas purchase is only so much of an option. For the consumer, it's a very short-run market.

"Hasn't demand been decreasing?

Posted by: Karl B. at Sep 14, 2008 10:16:29 AM"

This is a common error propagated by the media. The quantity of gas sold has decreased (year over year). Demand is a curve matching different price points to the corresponding quantities sold. Demand may have decreased (i.e. the curve shifted left/down), but that's difficult to prove. It could just be the case that on the demand curve that was already in place, higher prices led to less gas being sold (I suppose the demand curve is constantly changing to some small extent, but this isn't what the media is referring to when they claim "demand is declining").

@ Posted by: Ashley Moore at Sep 14, 2008 1:25:14 PM:

The alternative to higher prices is shortages, which isn't very helpful either. When gas prices go up, driving is reduced by the purchasers of gas. For instance, raising gas prices in a city in the path of a hurricane discourages driving that's less important to the drivers (e.g. driving to see a movie), and leaves more gas available to those who may need it to evacuate. If gas shortages are expected in other areas of the country, it discourages less important driving and leaves more supplies available for those who need to drive to work, hospitals, grocery stores, etc. Purchasing supplies to prepare for the chance of a hurricane or snow isn't "un-needed" or wasteful; in fact, allowing prices to rise in such events is what cuts down on people purchasing things in excess of their needs.

One more point: it's also misguided to blame the gas station owners for the price increases. Typically, the oil and gas companies charge the owners just a few cents below what they sell it to drivers for. The oil and gas companies will even charge different prices for the same type of gas delivered to different stations in the same area if one can command higher prices (e.g. due to a more affluent customer base). The slim margins the gas station owners make on the gas is due to a commoditized product in a market with plenty of competition, and a weak bargaining position with the oil and gas companies. Credit card fees then take a substantial bite of the remaining margin. The station owners tend to make most of their profits on items in their stores, car washes, mechanic work, etc, rather than gas.

The poor gas station owners make very little off of selling the gas itself, but they bear the brunt of consumers' frustrations.

Would this whole thing be simpler if we just defined the price of gas to be the cost to refill the tanks at the gas station?

Supply goes up: Gas gets cheaper. Lots of gas to fill the underground tanks.
Supply goes down: Gas costs more. Less gas to fill a relatively static number of tanks.
Demand goes up: Need to refill those underground tanks more often. Prices fluctuate more.
Demand goes down: Don't need to top off the tanks at the same frequency. Price fluctuations are less profound.

All of this is complicated by lots of mitigating factors, such as the gas production/distribution system is not completely fluid (pun not intended), but it seems to work over time.

I find it much easier to explain economics to my parents than my recent-graduate liberal friends. They believe in minimum wages, windfall profits taxes, fair trade...generally of equivalent validity as creation science.

"Price is determined by supply and demand." A good enough answer for Econ 103, but the real question is what makes supply and demand change. How much price change can be attributed to vacation driving? To a Saudi decision to raise production? To anticipation of Ike? The money question: can you predict the price?

Favorite observations from this weekend's gas prices:

1. Station A had raised prices to $4.50/gallon. Station B still had prices at $3.70/gallon. Station A had customers, but no lines. Station B had, well, let's say "craziness" going on - I believe there may have been a cop car there to direct traffic (seriously). For $.80/gallon people were willing to wait in line for lengths of time of about 30 minutes. For 10 gallons (assuming that's what was needed) that's $8.00. Was there a location difference? No, these stations were across the street from each other.

2. Was at the store of my "supplier" (baseball stuff). Mentioned the gas prices increase (he had been working all day so didn't know). The big plus (and this is true of many people I've met in their mid-50s) is that NO ONE WANTS TO GO BACK TO CAPS AND RATIONING. He moaned about that - my parents moaned about that when I explained that if one puts a cap on something, then one ends up with long lines. So that's good. Of course, as a businessperson he understood the whole "replacement cost" concept, so he understood the increases, but then commented something along the lines of "But if they keep prices up there after the hurricane then they are gouging". I left it alone, mainly because I don't like to argue with people who give me deals on merchandise, but I really wanted to say that "So if you sold something on Ebay for 200% of high Beckett value (established price reference for secondary market baseball items) is that gouging"?

As for the whole gouging thing, doesn't it really come down to the necessity/luxury thing? No one gives a rats a$$ if you "gouge/overcharge" on a luxury, do they (provided you are not using deception or lying to the buyer)? But as soon as gas prices increase it's all about "gouging". If you see two identical items on Ebay, and one sells for $12 and the other sells for $45 is that "gouging" or getting "fair market price"? By the way, if one runs out of supply (like some stations have), how the hell can one be gouging? Apparently prices were not high enough.

@EGL

There are plenty of people who have models to predict gas prices. I don't know if Alex is one of them, but there are plenty of people.

As for the "I don't see constant price increases in the grocery store throughout the day", it takes a helluva lot to change prices in the grocery store. For one, you have to actually change the marked price. For two, my guess is there is some change that has to be made in the computer that links the UPC code of the product to the price. For three, there are a lot of items in the grocery store, not just one (or 3 or 4 if you include regular, plus, premium, and diesel) for gasoline. Change the sign, change the price in the computer and the gas change is done. Changing prices on 1000+ items (10000+ - I honestly have no idea how many items are in the grocery store) in the grocery store will take a much longer time, and the last thing you want to do is have someone in line who saw a price of $1.29 in the store and when they get to the front of the line to pay it is now $1.39. There would be a riot in the place.

@glh17

That's a great story. I wonder how many people in Winchester, TN will be pissed because they don't have gas at any price. Dude should just hold an auction for gallons of gas and then people could see how much they value it at.

Focusing on supply and demand oversimplifies gasoline pricing, I think. It's complex, not well understood (I don't claim to be an expert), quite volatile (pun intended), and rather emotional. Here's how I see the present situation.

A hurricane is predicted to hit the Gulf Coast (where about 25% of our refining capacity is located). Big Oil says "all our refineries could be damaged." Then media hype and so-called experts predict doom-and-gloom. Like frenzied sharks after blood in the water, everyone rushes to buy gas as if this is the last chance they'll get! Did I miss something about Martians invading?

In one article I read, a lady was filling up five cars! In another case, a man filled up his car and was filling 3 gas cans. He wasn't in a storm zone, so he didn't have any higher risk for needing a generator than the day before. While we expected some price increase, behavior like this drove them up higher. This self-fulfilling prophecy became like chum for the gas sharks so we end up with lines and stations out of gas.

There are only so many delivery trucks in an area. When excessive demand outstrips delivery capability, it's no surprise. But, that serves to ratchet up the hysteria some more. Wild rumors (I saw a post this morning saying Little Rock had $6 gas on Saturday, but GasBuddy says not) and continuing media rhetoric feed the panic.

Most areas have adequate supply of gasoline on hand. But, the hoarding over the weekend has reduced inventory. With less production capacity on line for at least several days, there will be less gasoline flowing. As a result of stupid, selfish people, a short-term price hike will be with us for a much longer time until things return to normal. Since OPEC is reducing production, we've probably been robbed of any dividend from $100/barrel crude. That price is going back up once the refineries are back on line, so lower gas prices might not be back for a while.

In some cases, such as excessively high prices or wide variations between stations in the same area, I wouldn't rule out profiteering. If a state of emergency has been declared, that's gouging.

To the comments about supermarket prices v. gas prices, you certainly *will* see price volatility in the supermarket. Namely agricultural products.

The price of kiwifruit will go from 3 for a dollar to 7 for a dollar over the course of a year. That's about the same volatility as gas in the last year.

And, ag prices are *full* of expectations.

Two thoughts: Our work has simplified this to the phrase "price has nothing to do with cost".

Being in Houston, I was amazed to hear a public offical say, in defense of anti-price-gouging laws during the hurricane: "Market forces are suspended during major catastrophies." Saying it doesn't make it true.

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