Why Might Retail Gasoline Prices Fluctuate?
Economists tend to focus primarily on price as a mechanism to equate supply and demand, and thus to maximize welfare. Under the standard one-shot Bertrand model of duopolistic price competition, where firms have no capacity constraints and sell homogeneous goods, it is predicted prices will be set equal to marginal cost. Of course, most markets are not characterized by these simple assumptions, so prices are often set above marginal cost. As a result, economists are interested in identifying the conditions under which firms can profitably price above marginal cost, as well as the welfare implications of these supra-competitive prices.
Policymakers are also interested in understanding the conditions under which the price mechanism can function more efficiently. For example, competition authorities in countries such as Canada, the United States, and Australia aim to to encourage the development of more competitive market conditions. Consistent with this goal, when a competition authority examines a proposed merger, the key question is likely to be whether the merged firm — and possibly the non-merging firms — will be able to exercise greater market power after the merger, where market power refers to the ability of a firm to raise its price above marginal cost. These authorities also attempt to punish firms that use or extend their market power illegally, either criminally (e.g, price fixing), or under civil law (e.g., abuse of dominance). Thus, competition authorities need to be able to identify the various market conditions which might allow a firm to exercise greater market power, or which might reduce such power.
Retail gasoline appears to be a prime example of a product where a firm might set its price to equal marginal cost. In particular, gasoline seems to be a homogeneous good, and since prices are posted on large billboards at the side of the road, menu costs (i.e., the costs of changing prices) are likely negligible. The high degree of price visibility in this industry also suggests commuters can observe the prices of many stations over a large distance with little to no search costs, and neighbouring competitors can also observe these prices with little effort. Thus, price changes might spread across an entire city within a very short amount of time. For this reason, one might also expect prices will tend to be uniform and stable across markets; a station will not lower its price because it will be “immediately” matched by its rivals, and it will not raise its price because this price increase will not be followed.
Over the coming weeks, your Ride On writers will be writing a lot on retail gasoline markets based on the existing academic literature as well as data we have collected over years. For example, in our next post, we will explain why we are skeptical of the existence of explicit collusion between major-brand gasoline stations. But in the meantime, we want to end this post by summarizing the following reasons why retail gasoline prices might fluctuate or remain rigid:
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