This morning while watching CNBC they were talking about how oil prices are down but we aren’t seeing relief at the pump yet. When they asked their guests, “why do gas prices go up quickly with the price of oil yet come down slowly when oil prices drop?” both guests essentially said “I don’t know.”
Do you know?
Economic theory says … OK, you don’t care about economic theory. Here’s the practical answer.
When oil prices go up, two major things happen. First, it is a clear signal to all involved in the channel that we can raise prices. That’s nice, but it probably isn’t the driving factor by itself. The most critical factor is the cash flow of the gas station. Imagine a station owner has a 10,000 gallon tank underground, and he filled it up for say $4.00 per gallon, so he paid $40,000. In general he makes about a $0.05 per gallon profit, so he expects to get $40,500 back from his investment.
Now if the price of oil goes up 10%, he knows the next time he buys he will have to come up with $44,000 to fill his tank. These guys aren’t sitting on a lot of money, so they raise prices now to have the money to pay for the next delivery. The good news for him is all of their competitors are doing the same. In fact, he and his competitors receive that same clear signal (oil prices are up) at the same time. It looks like they are coordinating, but they just happen to do the same thing at the same time.
If you care, this is what economic theory says as well. Prices should be set at the replacement value of the inventory. Of course that’s not the whole story, because we still have to look at what drives prices down.
Why don’t prices come down as quickly as they go up? Because a different market force, competition, drives them down slowly.
Imagine two gas stations across the street from each other (and the only ones for miles and miles). Both have high prices due to high oil prices. Then the price of oil and hence their price of gas goes down. If they both keep prices high, they both make good profits. But one of them decides to lower prices by a penny just to win a few more customers. Then the one across the street lowers his by two pennies. This goes until they both are at the threshold of what they are willing to sell for and consumers are finally buying gas at the price we would consider “normal” for a specific price of oil.
To summarize, gas prices go up quickly because the station owners use the oil price as a signal to raise prices. Gas prices go down slowly because competitive forces aren’t as fast as the instantaneous signal.
If you know anyone at CNBC, have them give me a call. I’d be happy to explain it.
Mark Stiving, Ph.D. – Pricing Expert, Speaker, Author
photo by Neato Coolville
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