gas_station

A cap on the price of gasoline is a bad idea…

And the Nintendo Wii can tell us why.

First, let’s back up a bit and describe how the market for gasoline works. Gasoline is a commodity (gasoline from Shell is effectively the same as gasoline from Exxon), and everyone knows the price (due to those giant signs on the side of the road). This means that we can model the gasoline market using basic economics and we should be able to draw some reasonable conclusions. Ready?

Supply and Demand Curves

Supply Curve

Let’s talk about supply and demand. We all know that the “law of supply and demand” somehow determines prices apparently – but what exactly is happening? Well, let’s start with a “demand curve”.

This describes how much consumers would want (demand) for a certain price. A typical gasoline demand curve can be seen on the right – if the price is really high (Point A), we’ll only use a car for essential trips (low demand). If the price goes down (Point B), we’ll use more and more until we’re driving everywhere. Sound reasonable?

Demand Curve

Now let’s look at supply curves. These curves describe the behaviour of the other side – the guys that produce gasoline. If the price of gasoline is really low (Point C), you’ll only sell it if you can cover your costs (generally). As the price of gasoline increases (Point D), more and more supply is available. This is a result of higher prices allowing higher cost methods to be effective. If a new extraction method costs 50 bucks a barrel, you better be able to sell it for more than 50 bucks or else there’s no point. An example supply curve is on the left.

Market Price

Supply and Demand Equilibrium
So we have a supply curve, and a demand curve – so what? Well, now we know what the price of gas is! How exactly? Well, let’s put the supply curve and the demand curve overtop of each other. We can see this on the right – any ideas of what the price of gas is?

If you guessed where the two curves cross, good work! Where the two curves cross gives us:

  1. the price of gas
  2. the amount of gas sold

It’s the single point where consumers demand the exact same amount that producers want to provide. If the price was lower, consumers would want too much and producers wouldn’t produce enough (scarcity). If it was higher, consumers wouldn’t want as much gas and producers would produce too much (surplus).

Now we know how to determine market price. Now ask yourself – what happens if someone (perhaps the government creates a law) says “Nope! That price is wrong! Change it!”.

Price Ceilings

There are a few different terms for this, but we’ll limit ourselves to an enforced maximum price – called a price ceiling. There are two different ways a price ceiling can be implemented.

The first is rather boring – called a nonbinding price ceiling. For example, if gas was currently selling at 3$ and a law was made saying the maximum price is 4$, what do you think would happen? Well, not much is right. It would really only come into effect if prices continued to rise.

So what’s the other type? It’s called a binding price ceiling. Suppose gas was currently selling at 3$ and a law was made saying the maximum price is 2$ – clearly something is going to happen. From our previous discussion about supply and demand curves we know two things happen when price decreases:

  1. consumers can afford more, so demand goes up
  2. producers make less money, so supply goes down

Wait a second… that doesn’t seem to make sense. We have more demand, and less supply? That seems to mean that prices would go up. But they can’t because the law says they can’t. So what happens?

Excess Demand

Excess Supply
Well, not much can happen. It’s the law after all. Prices will stay at the price ceiling, but look at the graph on the right. The quantity demanded by consumers used to be the same as that provided by producers – but now consumers want far more and consumers provide far less. This difference is called “excess demand”.

So what happens if you have excess demand in a market? Well, let’s ask the Nintendo Wii.

Nintendo Wii

Wii Equilibrium
First off, the situation with the Nintendo Wii isn’t purely a result of a price ceiling. It’s very similar however (limited production capacity combined with a price ceiling). Let’s create the supply curve for Nintendo Wiis. Assume we sell at a constant price (suggested retail price), and the factory can produce up to a certain number of units – but no more.

Now let’s put a consumer demand curve over that (right) – we can see that the curves cross and an equilibrium price is produced. Consumer demand at equilibrium is less than the factory capacity, the suggested retail price is appropriate and everything works out wonderfully.

Wii Excess Demand
Now suppose that your executives completely underestimated consumer demand, and are now so far behind that they cannot possibly build a factory in time to satisfy this demand. The demand curve shifts to the right significantly (for a given price there is now much more demand). The Nintendo Wii factory can only produce so much however, and we can see excess demand in the graph on the left. Now we have a problem – if you’re going to make something cheap, there better be a lot of it!

Why you don’t want the gasoline market to act like the Wii market

Both situations involve excess demand. And the problems that occur are effectively identical. For instance:

  • If you’re first in line, you’re golden! No problems, you get your (Wii/gasoline) for a cheap price. Unfortunately, if you’re at the end of the line, no (Wii/gasoline) for you! The market chooses based not on willingness to pay, but on willingness to screw around and hunt for a scarce item.
  • People try to play the system. If they’re at the front of the line, people will buy (a Wii/gasoline), and then try to sell it for a higher price to those at the end of the line.
  • The excess demand still hasn’t gone away. Everyone still wants (a Wii/gasoline). Now it’s just a huge pain to find.

For instance, you could be working a 9-5 job, which requires gas to drive to. You don’t have time to figure out what stations have gas – so you end up buying gas on the black market at a ridiculous price from a seedy guy who spends his entire day wandering around finding gas stations that actually have gas. Not exactly a shining example of capitalism.

So what has the Nintendo Wii taught us in regards to gasoline pricing?

Lessons

Price caps on markets like gasoline don’t solve a damn thing. They sound like a good idea at the start – but the very act of regulation changes the way the market works, and causes an unintended result, shortages. These shortages then tend to reward speculation instead of real investment and progress.

In short, gasoline is expensive because we can’t live without it, and continue to pay whatever price is demanded. Real solutions for transportation and infrastructure aren’t as simple as saying “gas should be cheap, always!”.

“Those who cannot remember the past are condemned to repeat it.” -George Santayana

19 thoughts on “A cap on the price of gasoline is a bad idea…”

  1. Your argument is sound in theory, but in not effective in practice. It does not account for the greediness of gas and oil companies who control the supply AND price and merely CHOOSE to under produce thus driving up prices.

    It’s Hard NOT to support the capping of prices when gas & oil companies are reporting record profits:

    http://www.thestar.com/article/419706

  2. Well, ain’t you smart!

    Now explain how:
    Iraq and other oil producing countries are making record profits from oil and gas
    Exxon has been making $10Bn+/quarter since 2005
    All Gas companies have been making record profits.
    How Exxon sales in 2007 has been more than those of GM and Ford Motors combined.

    See my friend, Economics is simply theory, but practice which is Accounting shows you a whole different picture: Price Manipulation or Greed.

    You may not want to try to explain the record profits but let me put it in a small equation for you:
    Profit= Revenue-Expenses (Fixed+Variable)

    Almost all the expenses involved in Oild and Gas production are fixed. They are investments that have been made decades ago. So for profit to go up you have to manipulate revenues and do that you have to play with prices and Wall Street Speculators take care of that very well. That’s why every bad news from an OPEC country is good news for Wall Street and the Oil companies. Demand doesn’t affect it any brother, at least in theory.

    Economists are acting as if babies everywhere start driving instead of crawling these days. Give me a break!

  3. In recent news it had been told that a few gas refineries were in excess gas and had to shut down. Does that mean there is more demand than what could be produced? I would search u a reference to a link, but I am at work now.

    Look out guys, I have an impression that he could be working for the oil companies to spread propaganda.
    I guess the oil companies are striking back, lol.

    JC

  4. I enjoyed reading this article, its good to know someone out there knows how supply and demand works.

    To those who are obsessed with how much an oil company makes:
    Does it matter? Sure, they might be richer than you are, but then again, there are many industries that make billions, yet its only “big oil” that is under the spotlight.
    The oil companies make pennies on the gallon with gasoline, they cannot afford to “cut prices” any lower than they are now. It is ignorant of someone to believe that any company is simply raising prices because they can get away with it. Because of supply and demand, reacting to competition, the prices will always be as low as they can afford to be. (Obviously an exception occurs in the case of a monopoly, but this does not apply now).

    If oil companies were to put prices above the equilibrium of supply and demand, you would see a large drop in demand and an increase of supply. So far neither of these have been observed, so i believe it is safe to say that the oil companies are doing their best to get us the gas at the lowest prices available with the current laws/taxes.

  5. “Economists are acting as if babies everywhere start driving instead of crawling these days. Give me a break!”

    No, Economists are acting as if India and China are developing and requiring more oil because of it, thus driving up demand because more people are consuming a global commodity.

    The profit arguments presented do not refute anything that has been written in this blog post.

  6. I agree with your views on supply and demand and the part played by speculators affecting the price of gasoline. One should also note that my generation (the Baby Boomers ) have already retired or are close to retirement. We have an advantage over those who must drive to work daily and therefore add to the demand for gasoline. We DO NOT have to drive anywhere unless we choose to do so and I for one have decided not to drive unless it is absolutely necessary and plan carefully so that I can do the greater part of my shopping in three or four trips per month. I’m sure many others in my position are doing likewise. The result is a reduced demand for gasoline which should continue more into the next decade.
    I also foresee a reduced workforce in most industries further reducing the demand for gasoline. It would be interesting to see a study on the effect of the Baby Boomer retirement looming on the horizon vs. the number of “new” people entering the workforce.

  7. “The oil companies make pennies on the gallon with gasoline, they cannot afford to “cut prices” any lower than they are now. It is ignorant of someone to believe that any company is simply raising prices because they can get away with it.”

    So you’re saying that it’s by accident that record profit is accidental even though the correlation between record prices and record profit is so apparent?

    Well think about this, if Exxon were to cut prices by 50%, what do you think would happen? They would still post record profits of over $5 billion every quarter. they would still earn a larger profit/quarter than any company in any other industry.

    The difference between the oil industry and other industries when it comes to profit is that all other industries have fluctuating cost that oil companies don’t have, thus oil companies are able to keep larger portion of their revenue in profits. other industries invest in r&d, they don’t and they should…

  8. The supply curve for the Wii should be vertical, the quantity is set regardless of price. This would show that there is an equilibrium point for supply constrained markets.

  9. Grapher, I’d agree for the “total” market, but this is meant to be a reflection of purely Nintendo’s manufacturing capabilities. They can produce up to a certain amount, at a constant price.

    For the entire market with people arbing it, you’re definitely correct.

  10. Your supply/demand theory is correct except that you left out some important factors.
    Conservation and development of alternative fuels will skew the demand curve.
    How much depends on the desire of people (and governments) to free themselves from the
    corporate oil oligarchy and the willingness to expend non-monetary costs such as human casualties in oil wars such as those we are seeing in Iraq. For instance, what if everyone starts carpooling? Demand drops.
    Your model fails to consider these aspects that will effect supply and demand.

  11. Re: Not doing R & D – What a load of crap… All major oil producing companies do R&D. They do it is several areas including renewable energy (do you really think they plan to be left out when the world finally shifts) and refinery efficiency. In 1976 we were approaching 100% refinery capacity, so we built a new one (the last one to be built in the US). Demand has grown considerably over that time, but we are able to shut down refineries mainly due to technology that takes us from 60-80% of a barrel of oil going to usable product to about 97% going to usable product. They also have this little thing they do called oil exploration… This is the equivalent of R&D spending. It is an investment that is constantly being made in future capacity. Finally, they do a tremendous amount of research in the areas of material sciences… The materials and technology used in oil recovery today are not the ones that will be used tomorrow. It is increasingly difficult to tap oil with today’s materials and technology, so new ones are continually being developed. The idea of directional drilling was not even feasible 20 years ago, today the Canadian tar sands could not be developed without it.

    In response to being able to cut prices by 50% and still generate monster profits, that is fundamentally true if they were able to control the market price of oil. 80% of the worlds supply is controlled by state run entitities. 20% is in private hands (most of that oil is found in the US and Canada). Those nations that produce oil sell to the highest bidder and if you don’t like it, they will take it elsewhere. (See Hugo Chavez and Venezuela). Exxon, Marathon, BP, etc… only control the price of oil that they explicitly own. So what does the cost of a barrel of oil become. The marginal cost of the last barrel produced in order to satisfy world demand. So if the last barrel of oil sucked out of the ground to meed world demand costs $135, then they all do. This is a fundamental of commodity pricing. Now it is true that the actual production cost is currently lower than $135 per barrel for every barrel produced. This is due to the risk of supply disruption, which is priced into a barrel of oil. Let’s say that the last barrel out of the ground cost roughly $85 to produce… The rest of it is some type of risk premium or expectation of demand spike in the near future and other issues too numerous to explain (like a falling US dollar). I acknowldge that some of that premium is currently pretend and some of it is real (This is what is known as a bubble folks…) Eventually, the pretend premium will be driven out of the market.

    Now here is the fun part. Let’s get back to the argument that Exxon, Marathon, etc… could cut prices by half. Let’s say that they did that… They could only do it for the oil that they control explicitly which is roughly 40% of the US’s supply. The rest they have to buy at the market price. It certainly would give the American consumer some breathing room at the pump. But wait… There’s more. If they did that, you can bet that within hours high priced lawyer would file a class action lawsuit against the oil companies for failing in their fiduciary duties to their investors by dumping gasoline at less than its full market value. How much would they be liable for do you ask? The answer is the full amount that they just manipulated the price below what the market dictates. This would then have to be built right back in to the price of gas in expected lawsuit payouts that big oil would end up having to pay in lost shareholder value. If you want proof of this, why do you think that the government is always bringing in the oil execs about high prices and nothing ever happens. It’s because at the end of the day there is nothing the oil companies can or should be forced to do. They are earning appropriate profits on a product that they sell. Even if they go ahead and enact legislation criminilizing the manipulation of oil prices, no one will ever go to jail over it. Why??? Because it is already illegal. If people could be prosecuted for it, they would have been already by the SEC.

  12. @Gov

    Oil companies may be posting record profits, but how much of the increase in those profits is eaten by the decreasing value of the dollar? How much is eaten away by inflation? What is the distribution of profits amongst the various divisions of the company?

    “So you’re saying that it’s by accident that record profit is accidental even though the correlation between record prices and record profit is so apparent?”

    Not necessarily by accident, but even if there is a direct correlation between the record oil prices and the record profits (which you’ve not shown, or given any indication about availability of data, you’ve simply stated it) how much of that is driven by factors I’ve mentioned above, or others than don’t immediately come to mind without actually having to think about the question?

    Also, while capex for oil production is high, don’t ignore costs such as transport of product, which may not be low at all.

    Profits in isolation also don’t necessarily mean much. What is the actual change in cash in the company? They may be making record profits, but how much is going back into the company? The balance sheet would show how much cash is floating around. Yes, this is subject to manipulation, but that sort of thing can be investigated and checked. If their cash in hand is simply growing with those profits then they’re just hoarding money. On the other hand, that cash could be spread between r&d and dividends or used for acquisitions. A statement of the magnitude of profit also says nothing about what the profit margin is. From the information you’ve given I get the impression that oil company profit margins must be at least 50%. A look at their 2007 financial results shows that their margin is actual just over 10%, hardly a huge margin. It also shows an r&d spend of 2% of net income.

    Yes, the oil companies make large profits, but off huge revenues. Could oil be cheaper? Perhaps it could, but these profits don’t necessarily make a case for it. There are all sorts of reasons to dislike companies like Exxon – they’re hardly friends of the environment – but huge profits isn’t necessarily one of them.

    Finally, all your ranting ignores what the post is actually about, which is the bad effects of binding price ceilings.

  13. What is the result the vast majority of the american population is looking for? doing nothing? just letting the gas prices soar until the economy totally collapses? do you really beleive supply and demand is driving the devastating high gas prices, and the huge record profits in the oil/gas industry is just nature of the free enterprise system? really? afraid not, there is minipulation, specualtion, deception, exporting/importing tactics, gaming the system in many ways, all with the goal of raising record revenues. On the surface people are fooled thinking this is just business. Problem is this naive beleif will wreck the economy again, most people are suffering badly as the behaviors continue striving for more record profits. It is unsustainable to just do nothing. All for capitolism, but not at the expense of destuction to our the country. Soaring gas prices will do it, it must be stopped before it’s too late. There has to be a limit to prices and profits and the sky is not it! Nothing wrong with a modest profit, but there are limits to everything, even gas. If ever the government should regulate something, would think it would be gas long before healthcare. There is no checks and balances in the oil/gas industry, that has to change. Status quo is unsustainable.

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