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posted on 10 September 2017

Why Gas Stations Should Raise Prices Following Disruptions

from the St Louis Fed

-- this post authored by William Emmons and Christopher Neely

Yesterday, we looked at three possible reasons behind the surge in gas prices in the wake of Hurricane Harvey. We concluded that the most likely reason was the significant disruption to the gasoline-refining and -distribution system. Today, we’ll focus on a hypothetical gas station market to help illustrate how such price changes occur.

Suppose there are only two gas stations in your local market, Station A and Station B. They are fierce competitors, charging $1.999 per gallon of regular gasoline on the day before Harvey hit Houston.

They each had bought their inventories a few days before at a cost of $1.48 per gallon. With federal, state and local taxes combining for 50 cents per gallon, each station would make about 2 cents per gallon at a retail price of $1.999.

As the full extent of storm-related disruption to gasoline production and distribution became clear, suppose that wholesale gasoline prices increased 25 cents. This meant that, if nothing else changed, the next delivery of gasoline to both stations would cost $1.73 per gallon. What should each station do?

Neither Station Raises Its Price

Suppose first that both stations show home-town solidarity by keeping their prices at $1.999, at least until the new, higher-cost gasoline inventories arrived in a few days. Local residents certainly would be appreciative, but so would all of the eager drivers from higher-priced neighboring towns who would drive in to enjoy “cheap" gas.

In this case, consumers would have to line up for gas, and both stations would run dry before their replacement inventories arrived. Anyone in this town who was unfortunate enough to need gas after supplies ran out would be out of luck.

Taking the entire region into account, it is likely that about the same amount of gasoline would be sold during the first days after the crisis as usual. But there would be many miles of wasteful driving by out-of-towners seeking cheap gas, while some local residents would be inconvenienced by the gas lines and the shortage when both local stations ran dry.

Statewide Price Remains Flat

What if all the gasoline stations in the state agreed (or were ordered) to keep their prices at $1.999 until higher-cost supplies started arriving? Even if the flow of out-of-state bargain hunters turned out to be small, a statewide shortage of gasoline would be almost guaranteed in short order.

Recognizing that gas prices were only temporarily low and were bound to rise soon, all rational owners of cars, trucks, tractors, off-road vehicles, lawn mowers or leaf blowers would fill up their tanks as quickly as possible. That is, constraining the retail price in the face of almost-certain higher future prices simply induces a scramble among buyers to beat the price increase.

Only One Station Raises Its Price

Suppose that Station A held its price at $1.999, while Station B raised its price to $2.249. Station A obviously would capture all of the traffic until its storage tank ran dry. Station A would be forced to close for lack of inventory until the next shipment arrived.

Meanwhile, Station B could wait until Station A ran out of gas to sell its entire inventory at $2.249 per gallon. In other words, Station B made a much larger profit, while Station A made a big mistake.

Both Stations Raise Prices

Finally, suppose both stations raise their price to $2.249 per gallon. Despite much grumbling by customers, sales at both stations would proceed much as before: Both stations would sell out their existing inventories right on schedule and then take delivery on a new load of gasoline at the new, higher wholesale prices.

Both station owners would make a tidy, unexpected profit of $0.27 per gallon on their existing inventories, rather than the normal two cents. Note that, had the wholesale gas price suddenly declined by 25 cents, these competitive station owners would have been forced to cut their prices and take a loss of 23 cents per gallon.

Why the Last Scenario Is What Will and Should Happen

The simultaneous price increase by both stations is not price gouging at all. Although no one likes to pay more for gas, market-determined gasoline prices prevent shortages and maximize economic efficiency. In a competitive market, each station has no choice about pricing if they want to remain profitable over the long haul.

Additional Resources



Views expressed are not necessarily those of the Federal Reserve Bank of St. Louis or of the Federal Reserve System.

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