A while back I theorized that that price of oil and the price of gas are actually unrelated. One of my readers with extra time on his hands did a longitudinal comparison and found that they are in fact related. I guess what I should have said was that really there is no direct causal connection.
Anyway there's a long article here that leads me to believe its actually more something like a passive monopoly and price fixing rather than the crazy market speculation and Huttesque profit taking.
Features: Why Is Gas So Freakin' Expensive? - Consumerist: "As gas costs rise to $4 a gallon and oil companies earn around $100 billion each year, it's a good time to question what really goes into the price of gas."
So maybe a profits tax isn't the answer. Perhaps its about breaking up some companies so there can be competition.
Thursday, May 31, 2007
Gas, Again
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Great article David... i hadn't seen it and it is an excellent reporting of the mechanisms behind gas pricing.
The last time I commented on your gasoline price theory, I somewhat irresponsibly fooled around with the data... and yes, at the most, I was able to show that there is at least a relationship between crude oil spot/future prices and gasoline.
This time around, however, I actually know quite a bit more about the underlying economics, and I thought I'd share a bit of the microeconomic theory that drives pricing and competition.
First of all, the gasoline/oil market is an oligopoly... a market in which there are a limited number of firms that supply gasoline, such that an individual firm can influence the price of gasoline. Compare that to a "perfectly-competitive" market in which all firms are "price takers", such that they are forced to take the market price because they are too small compared to the rest of the market.
In an oligopoly, prices do NOT have to be set through collusion. If they are, its called a Cartel. In this case, firms deliberately limit supply (or raise prices) and they keep prices artificially high, to the benefit of all members of the Cartel. This, by the way, is an accurate description of OPEC... but that is another (somewhat related) topic. Cartels are actually fairly unstable... because if any member of the cartel decides to defect and lower prices, he will suddenly take a larger share of the market, and gain extra profit. Thus, cartels normally have rules or penalties to keep the members in line... otherwise the price-fixing mechanism falls apart. Also, in order for a cartel to be successful, it must be able to exert a significant amount of control over the entire market... it will fail if, for instance, the cartel only represents say 30% of the total market, because non-cartel suppliers will undercut its ability to control pricing.
However, there is another form of oligopoly that is non-cooperative. The idea here is that because there are "barriers to entry" (the economists term for it being hard to start up a new oil company, infrastructure costs, regulatory costs, etc)... the limited number of firms allows each firm to affect the price of oil by looking at how the other firms would respond to a change in his prices. There are a number of economic models that explain this behavior, but one common one is called the Cournot model. This model explains that because the number of firms are limited, each firm will be able to safely lower its output to a new Cournot Equilbrium level... which is less than the firm would supply if the market were perfectly competitive, but more than the level that a Cartel would supply at. (incidentally, this equilibrium is also called a Nash Equilbrium, named after John Nash of "A Beautiful Mind" fame)
The Cournot model predicts that a firm's "market power" is equal to: -1/ne ... where n is the number of firms, and e is the demand elasticity (how much the demand will change for an incremental price change)
Ignoring the "e" (which is negative btw)... you can see that the more firms there are, the less power a firm has to control the market price. Also notice that at n=1, it becomes a Monopoly market, and the firm has total market control.
Anyway... the bottom line: this is just very basic Econ 101 theory stuff. The real world is far more complex... however, the fundamental point is that market prices can be set higher than competitive levels simply because of the nature of the market, and not necessarily because the companies are colluding.
Now, are companies price gouging? Who knows... certainly not me.
But it sounds reasonable that they would, given the ignorance of the consumer as to the underlying market price.
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