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  • When Gouging isn’t Gouging

    Posted by Shannon Love on September 1st, 2005 (All posts by )

    Every time there is a spike in the cost of gas cries arise that gasoline providers are “price gouging” by taking advantage of the spike to unfairly raise prices. Politicians launch investigation which never find anything illegal. The fundamental problem here is that few people understand the dynamics of how gasoline providers set their prices. What looks like exploitive behavior to the naive is actually economically sound and helps assure a steady supply of gas.

    Most people think that the “fair” price for the gas they buy is the wholesale price of the gas the station has already purchased plus a reasonable markup for profit. If this was actually how the stations set prices then watching the stations raise prices on gasoline already in their storage takes would be an obvious sign price gouging. The price differential between price the station paid and the new higher price would be a windfall profit.

    However, the price of a gallon of gas you buy doesn’t reflect the cost that particular gallon but rather the expected cost of the gallon of gas the station will have to buy to replace it. As the expected replacement price soars, so does the cost to the customer for the gas already in stations tanks because that is where the station is getting the money to buy the replacement fuel. The station can only get a windfall if the the cost of replacement gas drops suddenly. Until that happens, its like bailing a leaky boat to stay ahead of rising cost. It might look like price gouging when the local station raises prices three times in one day but what they are doing is following the futures price for the gas they will have to buy tomorrow.

    This is a good example of why politics and economics don’t mix well. People clamor for the government to do something about gas prices based on a fundamental misunderstanding of how the pricing mechanism works. Any political attempt to “fix” what actually isn’t broken itself breaks the system resulting in shortages. This is pretty much what happened with the “Energy Crises” of the 70’s. Bad monetary policy created inflation which prompted wage and price controls which suppressed oil production which created shortages which allowed OPEC to enforce their cartel. Ending price controls and the windfall profit tax solved the energy crises in a couple of years. Had the government not tired to micromanage the economy in the first place the “crises” would never had arisen.

    Each of us is a best a specialist in only some narrow economic field. We might understand the oil business or carrot farming but outside of our specialties we are all morons. When we demand the government take action in a field we no nothing about we are courting disaster. We can’t tell the government the correct course to take or judge the quality of the results of the actions it does take.

     

    4 Responses to “When Gouging isn’t Gouging”

    1. MP Says:

      You appear to be conflating cash flow accounting with supply and demand analysis. From an economics perspective, the expected cost simply acts as a price signal for how to price current inventory. The inventory owner can then potentially collect “windfall profits” on the current inventory, but this will be a one time event.

    2. Young Tom Morris Says:

      MP is right; it’s supply and demand. The expected increase in the future price of gasoline increases the current demand (as people buy to beat the price increase) and decreases the current supply (why sell today if you think the price is going to be higher tomorrow?). Both these changes have the effect of making the (current) price go up.
      Notice that in one sense, this higher price does reflect cost: it’s the opportunity cost to the seller of selling to you rather than to the highest unsuccessful bidder.

    3. Richard Heddleson Says:

      A way of thinking about this, and the offset to the one time windfall profit, is how it will work on the way down. Somehow those calling gouging aren’t going to want to pay cost plus for gas then. Nor will I if I can avoid it. But it will be a one time event for the oil dealers who have to move the product. In the grocery business I believe the phrase is “sell it or smell it.” Didn’t some guy from the midwest write abook once called Risk, Uncertainty and Profit?

    4. North Coast Online Says:

      Gasoline “Price-Gouging”

      I’ve had several water-cooler conversations during the last couple days about the spiraling price of gasoline. And my co-workers’ arguments always boil down to the fact that gas station owners are raising the price for gas already in the tank