Towards Gasoline Market Efficiency

For the past year or so, I’ve been using the same website to save money on gasoline. The parent site of the one I use is Gas Buddy. Commuting to work I spend about $130 per month on gas, or roughly $1,550 per year. There are several reasons for this. Gasoline is one of my biggest work-related expenses, California gas prices are consistently among the highest in the nation, and I’m also an economist. I feel impelled to fill up at the station offering gasoline at the cheapest price, without going significantly out of my way to get there, of course.

Economic theory would typically classify a local gasoline market as a competitive market, yet, I often see differences of 20-25¢ per gallon for the same gasoline grade among nearby stations. Why does the standard model of competition not seem to apply here? Because most consumers probably accept the notion that gasoline of the same grade is nearly identical regardless of the station, competition should drive prices to the same competitive market clearing price. However, gasoline retailers often try to differentiate their product through methods such as affiliated credit cards, which give the holders a discount when they purchase gas with the card from a retailer that is part of the corporate chain. Another strategy they use is to offer a discount on a car wash to consumers who have purchased gas at their station. Nevertheless, it doesn’t seem like such differentiation would be important enough to keep the market from a perfectly competitive equilibrium.

What else might explain these facts? One possibility is that some gas stations employ a strategy of luring customers into their stores with gasoline sold below cost, to sell them high margin convenience goods. Another possibility is that some stations enjoy location advantages that allow them to command higher prices, such as the first station located off of a high traffic freeway exit. Nevertheless, the explanation that I prefer is that gasoline consumers do not have all of the information regarding prices of gasoline in surrounding areas. Websites like Gas Buddy help alleviate this informational deficiency in a nearly costless way thanks to its gas price maps and price lists. As more people use the site, the local gasoline markets covered should theoretically approach a perfectly competitive equilibrium.

Where does the website get its price information? People who are interested in either winning gas cards or making the gas market more efficient have accounts on the site and post gas prices there. Although there are obvious benefits to the information provided by Gas Buddy, there may also be drawbacks to the site. Besides the obvious damage to the profits of gas station companies, there are likely to be people who misuse the information. For example, imagine the user who drives several miles out of his way to fill-up on gas that is only 5 cents cheaper per gallon than the nearest station. This person may save $.75 or so, but environmental costs of the extra driving distance, the cost of the additional gasoline used and vehicle wear, and the value of the person’s extra driving time are likely to sum to significantly more than $.75. So, while getting the cheapest gas is great, remember that there are more to costs than just retail prices.

Author’s note 10/19/09: During her review of this post, Kasie Jean mentioned the possibility that consumers may have gasoline brand loyalties. The author found this unlikely but later received advice from a trusted mechanic regarding the benefits of Chevron with Techron gasoline. The author owns no securities issued by the Chevron corporation.


Discussion Questions

1. Now that you are aware of a gasoline price website, would you use one to locate the cheapest nearby gas prices? Why or why not?

2. Think about the characteristics of perfectly competitive markets. Do you believe that gasoline markets are perfectly competitive? If not, what are some aspects, besides those described above, that keep them from perfect competition?

3. In 2007, a study concluded that the optimal tax on gasoline was $2.10 per gallon. What is your opinion of this conclusion? Do you think that gas price websites would be viewed more if gasoline taxes were significantly higher?

4. In what other ways has the internet made markets more efficient or perhaps less efficient?

The Peculiar Economics of Ratings

Recently, Michelin released a new Red Guide for San Francisco. For those who are not foodies, Red Guides are Michelin’s ratings for restaurants and hotels. Their hotel ratings tend to be ignored, while the restaurant ratings are the subject of a great deal of interest and speculation, particularly in France, where the addition (or worse yet, removal) of a “star” can make or break a restaurant. The Michelin guide also raises some interesting economic questions. The peculiar economics of ratings systems has two sides—the consumer side and the supplier side.

Consumers use published ratings as an information-gathering mechanism, a way of economizing on the costly actions associated with determining the quality of a product that they wish to purchase and consume. This is especially true for goods characterized as experience goods--that is, goods for which the consumer cannot easily ascertain the product’s quality prior to purchase. It's also true for durable goods like cars, or for goods that can only be purchased once, like a college education.

The more expensive a good is, the more incentive a buyer has to invest in information gathering. A meal at the local diner may not warrant the time, money, and effort needed to determine the restaurant’s rating. For a trip out of town or a visit to an upscale restaurant, such an investment may be useful, especially because it can help to reduce the risk of a disappointing experience.

Consumers want clear, objective information from a ratings guide. Advertising cannot convey the same kind of information, since it is (appropriately) perceived to be self-serving. Yet, how much faith can we place in the (presumed) objective information from ratings services, like Michelin or the Zagat’s? Is there a potential problem with these ratings guides that can affect the quality of the information they produce?

Sellers clearly can benefit from a favorable rating in these guides--for many restaurants, it can mean a significant boost to their revenues and provide an avenue to other revenue sources (a great rating could pave the way for the chef to write a cookbook, or these days, have their own TV show). Such a system may create perverse incentives for restaurateurs. A restaurant could alter its menu offerings, change the décor, or upgrade the wine and beverages list to improve their rating, but these changes may change the qualities that originally contributed to the restaurant’s popularity among consumers. Further, this can contribute to a restaurant version of an “arms race” to be the top-rated restaurant in a given city. This may be trivial, but the same logic applies to all sellers who compete for ratings rather than consumers. It is not as trivial, for example, in the case of colleges and universities who expend resources to boost their US News rank, or in the case of schools and teachers who “teach to the test” as opposed to teaching valuable academic skills.

1. What determines how much consumers are willing to spend on a restaurant guide for a city? Would this differ between local residents and visitors?

2. How do consumer ratings differ from advertising? When could advertising provide more useful information than a ratings guide?

3. Some people decry products that are supposedly shaped to win the favor of critics; a great example of this is that many people argue that winemakers produce wines to appeal to the tastes of the powerful wine critic Robert Parker. What’s the flaw in this logic?

4. Whose ratings are more valuable—those of expert reviewers like Michelin or the accumulation of opinions from regular diners?

5. When the Michelin ratings were published, many in San Francisco objected to the rankings. Some commentators argued that the taste of the Michelin writers was different than the taste of Californians. Since not everyone's preferences are the same, does it make sense for there to be one "accepted" ranking system? Would your answer be different if the good in question were surgeons rather than restaurants? Why?

Harold Elder is a Professor of Economics at the University of Alabama. His research and teaching focuses on applied microeconomics, including law and economics, public sector economics, and a range of public policy topics. He regularly teaches Principles of Microeconomics in the College of Commerce and Business Administration and is the advisor for his university's Masters and Ph.D. programs.