Interdependent Behavior ~ Why Gas Prices Are Still So High

“Teach a parrot how to say the terms, ‘Demand and Supply,’ and he’ll think he’s an economist.”

Thomas Carlyle

October 4, 2008  —  I had just started introducing the subject of the day’s lesson to my high school economics students when I noticed one of our vice principals standing just inside the classroom entrance – there for what reason I did not know. I caught his eye, anticipating that he needed to see one of my students for something. But when he said nothing, I decided that he was just stopping by to observe. Accordingly, I continued with my introduction.

“Mr. Garry?” one of my brighter students asked, raising her hand for a question.

“Yes, Tra’Nisha?”

“With the price of oil down now to around a hundred dollars a barrel, why are gas prices still so high? I thought you told us last week that when the price of production inputs fall, producers will produce more.”

“Thank you for the question, Tra’Nisha,” I said. “It’s a good one, but recall all that I said… that producers will normally produce more when the price of production inputs fall. The Law of Supply, you see, is not infallible. It’s not a hard-and-fast law. The reason for this is that markets are not all alike. In markets with less than sufficient supplier competition, Adam Smith’s invisible hand is hindered; it doesn’t work like it should.

“Less than sufficient supplier competition?  I don’t get it,” said Tra’Nisha;” there are lots of different gas stations.”

“Yes, Tra’Nisha… but most of these are independent retailers. They buy their gas and other petroleum products from one of the few big oil companies still doing business in the United States – Exxon/Mobile, Chevron/Texaco, Conoco/Philips, Dutch Royal Shell and British Petroleum, all of which have vertically aligned business models. They control all aspects of production, from resource exploration, drilling and recovery, to transportation, to refining and finally, to distribution. It is these, the wholesalers, more so than the retailers, who set the price. The retailers just add-on to wholesale prices what they need add so as to make a small profit and still be competitive in their communities. The big profits are retained farther “upstream” by the majors, and they, few as there are anymore, are able to control wholesale prices with interdependent behavior by controlling supply. This interdepen- dent behavior is called collusion. We’ll get into this more in a later lesson on competition and market structure. But when only a few large businesses dominate an industry like petro-chemical, it’s called an oligopoly.

“So what is the problem, Mr. Garry?” this from the vice principal who was still standing just inside the doorway. “Is it a supply problem?”

“No, sir, I don’t think it’s a supply problem. I think it’s a greed problem.” At this, he smiled, then walked out leaving me to further explain what I meant by this to my students. So much for what I had come prepared to teach…

Last Spring, when oil was trading on the International market near $140 per barrel, I told my economics students that the only way to bring down the price of gas at the pump would be for Americans to reduce our demand for the product – drive less, buy smaller more fuel-efficient cars, etc.  Most economists were saying the same thing, and Americans did just that. Demand today is way down now. In its weekly inventory report, the Energy Department’s Energy Information Administration said that gasoline demand fell by 6.4 million barrels to 202.8 million barrels for the week that ended August 8th.  This is nearly three times more than the 2.2 million barrel drop that analysts had expected. In response to this drop in demand, oil companies have cut way back on production, shutting down refineries. And who can blame them? Why should they produce something in amounts that exceed the quantity demanded?

But, if Big Oil acted fairly and responsibly, and market forces worked like they are suppose to, not even considering the above mentioned decline in demand, gasoline prices should be lower. With oil’s price down from a high of $147 in July to less than $100 in mid-September, a 32 percent decrease, gas prices should have dropped by the same amount — right? So, let’s see… the national average price for regular unleaded in July was near $4.00. Today it’s something like $3.55. Therefore, the price of regular unleaded has dropped just 11 percent. Hmmm… perhaps our decline in demand actually worked to consumers’ disadvantage. Accordingly, I told my students that, even though I teach this stuff, I’m very much like Thomas Carlyle’s parrot. I just think I’m an economist. And that’s why economics is called, the dismal science. We do a pretty good job of explaining what’s already happened, but we’re not so good at predicting the future.

Another student asked, “How are they able to control supply so easily, Mr. Garry?”

In response, I reminded my class about our lessons on demand and supply elasticity, which is a measure of how responsive demand and supply are to changes in price levels. Demand for gasoline is very “inelastic,” or less susceptible to price changes. This is because we depend on it, there are no adequate substitutes for it, we can’t delay our purchases of it (when our tanks are dry we’ve got to buy), and it takes up a considerable amount of our disposable incomes. The elasticity of supply for gasoline, on the other hand, is very elastic. This is because producers, with the excess refining capacity they have today, can respond quite rapidly to market forces. When the price they have to pay for crude increases, they pay whatever they must, then just pass the additional cost on down-stream where the consumer ultimately makes up the difference. When demand for their product falls, they close refineries and lay-off employees so as to protect profits and take care of their shareholders. To do otherwise, they would be giving money away, and for-profit corporations hate to give money away.

This situation is illustrated in the demand/supply graph for gasoline at the right (hypo- thetical), wherein the demand curve (in blue), representing all possible prices and corresponding quantities demanded at each price, is relatively steep and down-sloping. This shows an indirect relationship between price and quantity, the Law of Demand (the lower the price the more people are willing and able to buy). But responsiveness to changes in price, either up or down, is small. On the other hand, the supply curve (in red), representing all possible prices and corresponding quantities supplied at each price, is relatively shallow and up-sloping. This shows a direct relationship between price and quantity on the supply side, the Law of Supply (the higher the price, the more producers would normally be willing to supply). But, unlike in the case of demand, respon- siveness to price changes for the supply of gasoline is relatively large, which means it is elastic, at least in the short-run. Notwithstanding, because oil companies can and, in my opionion, do act in collusion, they are able to rapidly adjust to market forces and control market supply. Therefore, prices can be controlled. In the example illustrated, demand and supply have both declined; the demand and supply curves both shifting to the left in equal amounts. Markets both before and after the shifts are at equilibrium where demand and supply curves intersect. So now one can readily see that, had the price of oil not declined in recent months (ceteris paribus), we could actually be paying more per gallon for gasoline as a result of our reduced demand for it.

So, my student was right to ask her question.  Congress has asked the major oil companies’ CEOs the same thing over and over again in recent years. The answer they always get from industry leaders, however, is this: “We don’t set gasoline prices, the market does.” But the market isn’t operating today on a level playing field, and Congress knows it isn’t. It’s slanted in Big Oil’s favor, and it’s government’s fault, in the name of FREE trade, for having allowed the oil industry to organize itself so efficiently. This is why Big Oil is able to generate the huge profits we’ve been hearing about lately, profits that are at the expense of every other aspect of our economy. They have done this through a series of many mergers over the years, mergers that administrations, both Republican and Democrat, have allowed even though Treasury Department economic analysts have advised against it. Why? Well, I don’t know, I just think I’m an economist. But, as a free thinker, I’m pretty sure the answer can be found at the end of the money trail.

It is time for change — the right kind of change — change that we can believe in, which does not, in my opinion, include giving Big Oil more freedom to control prices and drag down the rest of our economy. Tax breaks for Big Oil will not lead to greater supply and lowering prices for consumers. Tax breaks for Big Oil will simply lead to higher profits for Big Oil.

I invite your comments, both pro and con.

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Published in: on October 4, 2008 at 8:15 pm  Comments (7)  

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7 CommentsLeave a comment

  1. This is by far the most cogent explanation I’ve ever heard for the situation you address. My husband and I have repeated discussions on the absurdity of ‘this bunch’ calling itself free-market believers. We are SO FAR from any sort of level playing field – in my estimation. I HATE believing that there are so many who knowingly claim adherent to a philosophy when they are entirely uncommitted to its real implications.
    Lincoln supposedly said in response to ‘if you call a tail a leg, how many legs does a dog have?’ that the dog still has four legs, because calling a tail a leg ‘don’t make it so’.

  2. I often wondered how much the filling station owner makes when I buy 25 gals of gas @ $4.00 per gal.
    I pay $100.00,,how much is his as profit ??

  3. For the filling station, very little of your $100 is cash flow or profit for the proprietor… According to the Petroleum Marketers Association, local service station owners nationwide get between 3 cents and 15 cents of every gallon of gas sold.

  4. I think that the blame for the fall of our economy should not be placed solely on the government. The people of America should not have been purchasing things that they cannot afford. If you can only afford to buy a $100,000, why in the world would you accept a loan for $250,000 or more? Credit cards are also to blame for the debt of America. In the 1980’s, credit cards were owned mostly those who had good credit in the first place, such as yuppies and business people, and were used only in emergencies. Now, as soon as a person turns eighteen, he or she get a credit card offer. Even though I have no job, I got such an offer last week. Fortunately, unlike some people, I was smart enough not to take it. Everyone wants to blame the government officials for our failing economy,but I think that we need to look at ourselves and realize that our own greed is a major source of the problem.

  5. Hi Opa,

    I’m Vice-President (Communication) of my university’s student economics association, and I was wondering, could we please use your demand and supply diagram in this page for our website? I would email you this request personally but I can’t find a contact page on your blog so I don’t know your email address… Apart from that, I like the blog, and find it very well-written!

    Sam

  6. Hi Thomas,

    I have worked in IT for a major oil company for the last two years, and noticed several factors missing from the article above.

    I work on the trading floor with the people that buy oil and sell petroleum products everyday, and have access to all of their trade information. Despite the generally accepted notion that all of our gas is refined from oil we pumped out of the ground I have found that we (like most oil companies) buy 90%+ of the oil we need from the supplier nearest to our refineries with the type of oil we need (There are hundreds of variations of oil and no company can process all of them), and sell out finished products to whomever is willing to buy them.The buyers include independent customer, wholesalers and our own stations. The prices we use to buy and sell is the price of the product on the NYMEX, ICE CME, etc. exchanges at the time possession is taken. At no time do I recall hearing a trader say “Sure, we will buy your oil for more than the market price”, or “Thanks for agreeing to buy our gas for an extra $1.00 per gallon”.

    I have heard people say “We have to much of ‘x’ in the ‘y’ market. We need to discount it to move so that we have room for the next batch coming down the line”.

    There are many other factors including world demand, ICE Brent vs. WTI differential, local blending regulations, distribution costs, refining capacity & outages, petroleum reserve levels, supply interruptions, etc., etc., etc. After all of this we had a record year in 2012 with a 4% net profit margin. In 2008 at the time of this article we had a 0.6% margin.

    The tax breaks that people love to mention include counting a $1.00 per barrel tax that some countries charge for their oil as a cost of doing
    business and using the LIFO accounting method that everyone from a Mom and Pop hardware store to Apple and GM are allowed to use. For some reason getting 4% of $100 billion means that you cant use the same tax system as the people making 30% on $20 billion.

    I would am happy to discuss this more with you if you would like.

    Sincerely,

    Aaron

  7. I am well aware that there is a great deal more to the pricing of petroleum products than what I tried to explain in my article. However, too much emphasis is placed on the fluctuations in world oil commodity prices in justifying down stream prices for gasoline at at the pump. Oil companies will have their profit margins regardless because they control supply.
    By the way, my name is not Thomas.


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