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The price of cheap gas June 3, 2008

Posted by Jeff in Economics.
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Motorists lined up for $1.05/gallon gas in DallasDallas radio station KRNB recently sold gas for $1.05 per gallon as a part of a promotional event at an Exxon station.  The promotion was quite popular – the nearby image shows cars packed into the parking lot of the gas station and even lined up along the street nearby to buy fuel for $2.80/gallon less than the average price in Dallas that day – $3.85/gallon. 

Source:

http://www.wfaa.com/sharedcontent/dws/wfaa/latestnews/stories/wfaa080530_wz_gasprices.4354ff62.html

This promotional event is a good lesson in how prices work in the (free) market.  Here’s how it works:  For a lot of reasons which include the increased global demand for oil, the war in Iraq, the whims of OPEC members, the value of the dollar, and the limitations imposed on building new refining capacity or acquiring oil from new sources, the price of oil is at an all-time high.  This means that – government subsidies and taxes notwithstanding – the price most people pay for a gallon of gas is also at an all-time high.  The price of a gallon of gas is determined by the market and in Dallas on this particular day, that price was $3.85/gallon.

Question:  of all the gas stations in the DFW metroplex that are roughly the same size and located in similarly trafficked neighborhoods as the one pictured above, which one probably sold the largest number of gallons of gas on the day of the promotion?  The answer, of course, is the one where the price was artificially reduced to $1.05/gallon.  However, selling the largest number of gallons does not mean that this station also had the largest profit.  In fact, it’s almost certain that this station had the biggest net *loss* on gasoline for the day (the subsidy from the radio station notwithstanding, of course).  So in this case, the station that moved the most product also lost the most money.  This is because the price of a gallon of gas was $3.85, not $1.05.

On the day of the promotion, the market was willing to pay $3.85/gallon for a certain number of gallons of gas.  That same market was willing to buy many, many more gallons of gas, if it only had to pay $1.05.  It doesn’t matter how that price was artificially reduced, it just matters that an external force caused it to be reduced.  If KRNB had not reduced the price to $1.05 by paying a subsidy to the gas station but the government had imposed a “price cap” of $1.05 for that same station, the outcome would’ve been the same:  cars would be lined up all afternoon to buy as much gas as possible for this impossibly low price.

Of course, in the latter scenario (the government-imposed price cap), the gas station would not have been able to make a profit, so they would have simply opted not to sell gas.  This means that some of the supply of gas would have been taken off the market and that the people that wanted to buy gas at the market-determined price of $3.85/gallon would have had to buy it from another station.   What may escape the notice of some is that the imposition of the price cap would have actually *increased* the price of gas.  This is because the demand from people that needed gas would have stayed the same, but the supply would have been restricted, so the stations that were still selling gas would have had to charge a higher price.

What if the government imposed a price cap on all stations, though, instead of just on one?  The lower the price, the more stations would choose not to sell gas.  Sure, some might be willing to break-even (or even take a small loss) on gas in order to drive sales of in-store items like sodas and candy, but many would not be able to pay their employees and rent if they lost too much money on gas.  With the price cap removing the stations’ ability to make a profit on gas sales, the stations would simply opt not to sell gas, so that they’d not impact the profits they were making on other items.  Every time another station decided to take their supply of gas off the market, the market-driven price of gas at other stations would go up. 

It is an economic certainty that artificially controlled prices yield negative unintended consequences, not the least of which is higher prices.  The way to fix the problem is not through price controls, but rather through increasing supply (such as drilling for new sources of oil or increasing refining capacity), reducing demand (such as bringing quality, low-cost, fuel efficient vehicles to market), and/or adjusting an independent variable (such as the value of the dollar) that makes the price you pay at the pump seem less expensive because your purchasing power is greater.

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