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Economics Can Answer That! Oil Prices Edition…

December 17th, 2014 · 11 Comments
Econ 101 · Markets

To quote from The Consumerist:

You may have noticed prices gradually falling at your neighborhood gas station over the last few months, what you may not know is that the price of oil has been falling even faster than that. Why aren’t station owners passing the savings on to drivers?

The article goes on to explain that gas prices for the end consumer have decreased by about a dollar, whereas the wholesale price of oil has decreased by 40 percent. To put this in a more reasonable context, I checked around in the neighborhood and saw that gas prices were currently around $2.70 per gallon. Applying the information in the article, I can conjecture that gas prices went from $3.70 to $2.70 per gallon- a 27 percent decrease. So yes, while consumers in fact aren’t seeing a proportional price decrease, the spread is not as dire as the article would like to make it seem, especially since oil prices are only one component of the gas stations’ overall costs (and we therefore shouldn’t expect to see a 40 percent price decrease even if all cost decreases were passed on to the consumer.) Besides, doesn’t Econ 101 tell us that cost decreases do in fact get shared between the consumer and producer? Behold:

(In case you forgot, the market is experiencing a supply increase thanks to OPEC, which drives down the input price of the gasoline that the stations sell.) Hopefully it’s clear that A will be bigger than B whenever there are typical upward-sloping supply curves and downward-sloping demand curves. The article goes on…

During that same period, investment bank Goldman Sachs estimates that gas stations’ profit margins are 18.5% higher than they were at the same time last year.

Well…duh? First off, I’m pretty sure that, mathematically speaking, profit margins are going to increase whenever price decreases are less than cost decreases. But, to think about producer welfare more generally, let’s go again to the picture:

A few flash backs to Econ 101 tell us the following:

  • As a result of the supply increase, consumer surplus goes from A to A+B+C+D.
  • As a result of the supply increase, producer surplus goes from B+E to E+F+G.

Even though it’s not immediately obvious, I could make a convincing case that producer surplus does in fact go up as a result of the supply increase, which is consistent with the estimate given. (Note that, while profit and producer surplus are not technically the same thing, they do generally move together unless changes in fixed costs are involved.)

My point is that, while the facts in the article are most likely correct and fine, they do not imply that the big bad gas stations are screwing over the poor little consumer. Instead, what is happening is entirely consistent with the forces of supply, demand, and competition, which generally lead to good outcomes for consumers. (Yes, you can technically argue that market forces can still screw people from a fairness perspective and such, but I don’t think that that is what the tone of the article was getting at.)

Behaviorally speaking, there are reasons that gas stations (and other businesses) might not want to decrease prices when they experience a cost decrease- since consumers tend to be more sensitive to price increases than to price decreases, producers have an incentive to keep prices high because it often ends up being better in the long run than decreasing prices and trying to increase them again at a later point in time. (In other words, consumers hate price increases more than they like price decreases, so market actions aren’t perfectly reversible.) In this case, however, it’s not clear that this behavior is present to any significant extent since we’d be seeing what we see in the gas market even if producers weren’t thinking about this aspect of consumer psychology.

Tags: Econ 101 · Markets

11 responses so far ↓

  • 1 Kevin // Dec 17, 2014 at 8:05 pm

    As you point out, the article incorrectly assumes that oil price is the only contributing factor to gas prices. In CA, there is a tax of 71 cents per gallon. That’s not going down by 40% because of oil prices.

  • 2 econgirl // Dec 17, 2014 at 9:45 pm

    In fact, I think I read a few things where policy makers wanted to increase the gas tax because the falling prices might make people not notice.

  • 3 Charles // Dec 19, 2014 at 11:07 am

    I have always had trouble with changes in producer surplus when supply increases. Am I correct in thinking that producer surplus will only increase if the demand curve is relatively elastic? Thus, producer surplus will decrease if the demand curve is relatively inelastic?

  • 4 econgirl // Dec 19, 2014 at 8:57 pm

    Producer surplus should increase whenever supply isn’t perfectly elastic- the reason being that, as the article, shows, prices don’t decrease as much as cost decreases (remember that the supply curve represents marginal cost) and the producers sell more. This, by definition, has to leave them better off.

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  • 8 Iñigo // Mar 19, 2015 at 4:55 am

    Nice explanation Jodi!
    I have found a similar example of how a production increase could affect the producers in “Principles of economics” of Mankiw in chapter 5. The explanation is given with a wheat production increase. While you focus on an increase of producers profit (or surplus), Mankiw focus on producers income reductions due to wheat inelastic demand (I think petrol demand is also inelasctic), argumenting this will go against their interest becouse of less money. I think your analysis is better, becocuse profit is what really matters, not jus income.

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