Why Gas Prices Spike

One thing I hear over and over whenever gasoline prices go up is the following question (often rhetorical) from callers to various talk radio programs.

If the oil was purchased before there was a spike in oil prices, and the gasoline was refined before there was a spike in prices, why is the price going up almost instantly when there is news of a supply disruption in far off countries? Somebody is getting gouged!

The answer is quite simple. The actors in markets are basically forward looking. Being sentient creatures human have the ability to think about things like tomorrow and the day after that and even thirty years into the future (this is why many people have things like 401ks when they are 35). I know this seems terribly, terribly obvious, but apparently to most people who subscribe to the above view point this observation has gone right past them.

What does the above have to do with the price of gasoline? Well it is simple. Suppose we have a market for cookies and typically the market clears with 10 cookies being bought (sold) each day. Now, there is a big explosion at a cookie making plant and tomorrow there will only be 2 cookies. You own a cookie retail store so what do you do? Keep prices the same and then close up shop and sell nothing tomorrow because the 2 cookies went to your competitor? Further, your competitor having the only two cookies on the market is now a monopolist and will set the price of cookies quite high. Or do you raise your price now, knowing that some of our cookies won’t be sold today and you can sell them tomorrow at the higher price?

At the same time consumers are also forward looking. What are they likely to do? If the price doesn’t go up, people might buy more cookies today than they normally would. The idea here is that consumers are trying to insulate themselves from the supply shock as well. So tomorrow’s shortage can appear today. Thus, today cookies become relatively more valuable.

What the above is basically saying is that markets are dynamic and forward looking. As things change, prices change to smoothe out consumption, production and so forth over time. This is all accomplished via the price. Distort the price and you distort how the various actors in the market will react. We saw precisely this problem in California during the electricity crisis. State law mandated that the retail rate–i.e. the rate the final consumer sees–be fixed. The wholesale price on the other hand was allowed to go up and down. Further, State law held that the investor owned utilities had to provide electricity to meet the demand of their customers. The customer sees a price of $0.11/kWh, the whole price on the other hand goes up to $0.50/kWh. Demand is totally unresponsive to the price because the price the final consumer sees is artificially set too low. Final result: a complete disaster.

Mandating that a gas station cannot raise the price on the gasoline in the tanks right now even though they bought the gasoline prior to the supply disruption would only ensure that we have shortages. The ability to raise prices is what keeps market economies from not having shortages. When a good becomes more scarce the relative price increases to keep demand and supply in balance. Legislation that tries to circumvent this us about as successful as legislation that tries to suspend the law of gravity.

FILED UNDER: General, , , ,
Steve Verdon
About Steve Verdon
Steve has a B.A. in Economics from the University of California, Los Angeles and attended graduate school at The George Washington University, leaving school shortly before staring work on his dissertation when his first child was born. He works in the energy industry and prior to that worked at the Bureau of Labor Statistics in the Division of Price Index and Number Research. He joined the staff at OTB in November 2004.

Comments

  1. BigFire says:

    Nah, that’s too logical of an explaination. People will blame it on the EVIL OIL company and BUSH because that takes far less brain cell to compute.

  2. jwb says:

    There’s no point in explaining this stuff. The public must invent some fiction that makes them out to be a victim, so they will not have to face the idea that their economic situation is changing, and that they might actually want to adapt their behavior.

    After all, you can say that people are sentient and forward-looking, but the people driving around in GMC Yukons and bitching about gas prices prove you wrong.

  3. Herb says:

    I am looking forward, into the future, 10, 15, 20 and even 25 years into the future. The availability of oil is abundant and the demand for oil is low because of alternative fuels.

    With your theory, the price of gasoline should be about .98 cents a gallon or less.

    What happened?

    Or, do you have another theory or excuse for this also.

  4. James Joyner says:

    Herb: If demand for oil is indeed low, that’s what would happen. Or it would become a boutique commodity and be artificially scarce because it would not be worth drilling, processing, and distributing at such a low price.

  5. Herb says:

    James:

    I think you missed the point. Steve inferred that the price of oil was high because the speculators are looking “into the future” and betting that oil would be scarce thereby causing higher prices as we are seeing now.

    My point was that oil would be at a lower price “into the future” because of less demand due to alternative fuel availability.

    So, If the price of oil is high now due to this “Future Speculation” then where are lower prices now because of “future speculation” ya know, lower demand in the future.

    It is very interesting that the stock market is now reacting to high oil prices causing a big drop in the past two days. I have always noticed that when a commodity or product starts taking a toll on the big money on Wall Street and the pockets of big money people are being fleeced, then Wall Street has always “put the screws” to those who effect their money

  6. slickdpdx says:

    Steve: I think you are a great addition to this blog!