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 Ethanol Bubble?

The New York Times reports that in less than one year, ethanol prices have plummeted over 30%. As a result, there is even talk of a government bailout for ethanol producers in case the price of ethanol falls too low!

So, why did price spikes in last year's ethanol market give way to falling prices this year? To understand the price fluctuations, we need to know how the short-run behavior of firms in competitive industries (such as ethanol) differs from their long-run behavior. In the textbook model of perfectly competitive industries, an increase in demand causes the equilibrium price of ethanol to increase in the short run—from P1 to P2 in the diagram below. In the short run, higher ethanol prices lead to higher profits for ethanol producers.

In the long run, the lure of profits attracts new ethanol producers. The long-run entry of additional ethanol producers expands the supply of ethanol, causing the price to fall back to its initial level:

Notice that economic profits converge to zero in the long run. As explained by most textbooks, zero economic profit does not mean that ethanol producers barely have enough to eat. Zero economic profit means that ethanol producers are earning incomes that compensate them for the next best salary they had to give up to go into producing ethanol.

Ultimately, in competitive environments, a surge in demand causes an initial spike in prices, but the equilibrium price gradually falls back toward initial levels. In the end, the long-run price of ethanol may not even change, but more ethanol will be produced than before.

Discussion Questions

1. Referring to the diagram on the left above, why does it take only a short period for prices to spike, but a long period for prices to fall again?

2. Referring to the diagram on the right above, why is the quantity of ethanol fixed for a period in the very short run?

3. Corn is a key ingredient to the production of ethanol. The New York Times article points out that corn prices have remained high over the past year even as the price of ethanol has declined. How might developments in the ethanol market have contributed to the rising price of corn?

Fueling Protests and Cars

Tortillas—a central component of the Mexican diet—have been a source of recent uproar in Mexico. Rising tortilla prices fueled protests in Mexico City two weeks ago. Many people in Mexico earn only $5 per day, and with the price of tortillas approaching $0.45 per pound, protests were inevitable.

Tortilla prices may be fueling the protests, but it's the growing demand for corn among American ethanol producers that's fueling the rise in tortilla prices. As more and more ethanol plants come online in the U.S., the number of buyers in the corn market increases, putting upward pressure on corn prices. Rising corn prices mean rising input prices for tortilla makers and rising tortilla prices for consumers. So does fueling your Honda Accord with ethanol-laced gasoline take tortillas off the plates of Mexicans? The answer depends on the time horizon: the short run or the long run.

Three characteristics in the market for corn make it highly competitive. First, there are many corn producers in the United States, Mexico, and the rest of the world. Second, corn tastes about the same no matter which farmer sells you the corn. Third, there are few barriers to new corn producers entering the market in the long run.

In the short run, however, firms cannot exit or enter the market. Rising ethanol production in the U.S. creates a higher demand for corn. The market demand for corn shifts to the right from D1 to D2, increasing the price of corn from P1 to P2. Corn producers react to the higher price by producing more corn (moving from q1 to q2). The higher demand for corn also causes corn producers to earn an economic profit.

How does this affect the tortilla market in Mexico? Corn is a major input for tortillas—as corn prices rise, the cost of tortilla production rises. The supply of tortillas shifts to the left from S* to S**. The price of tortillas increases and the quantity of tortillas consumed decreases. The reduction in tortilla supply causes the price of tortillas to rise sharply in Mexico because tortillas are essential to the Mexican diet (the demand for tortillas is fairly inelastic). As a result, the financial burden of higher corn prices falls on tortilla consumers more so than the producers.

Fortunately, as the Los Angeles Times reports, help is on the way for the people of Mexico. In the long run, firms may exit or enter the market. Unusually high short-run profits in the corn market will undoubtedly cause more farmers to plant corn in the long run. As they do, the supply of corn will shift to the right from S1 to S2. As more farmers plant corn in the long run, profits return to normal and the price of corn falls. In the long run, as the diagrams suggest, it's possible that the higher demand for ethanol will have no effect on corn and tortilla prices.


Click here for another Aplia perspective on food prices and ethanol.

Discussion Questions

1. How would a price ceiling at P* affect the Mexican tortilla market?

2. Should the Mexican government subsidize tortilla producers until corn prices fall back to previous levels? How would a subsidy—or voucher—for tortilla consumers affect the tortilla market in the short-run?

3. Are Mexicans worse off or better off due to the increase in U.S. ethanol production?