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Gas Prices Fact or Fiction: A Primer on Supply and Demand

Mises Daily: Tuesday, October 18, 2005 by


The recent upward spike in gasoline prices (particularly those following natural disasters) has unleashed a torrent of theories attempting to explain the pricing behavior in gasoline markets. From the Internet to television media pundits to the local newspaper editorial pages, and from political ideologues both left and right, it seems everyone has their pet theory about the rising price of petrol.

In an attempt to clear up some of the most erroneous ideas and to bring sound economic analysis to bear on the issue, it seems only appropriate to play a bit of "gasoline price fact or fiction" with our old friends, supply and demand.

(1) Gas prices are controlled entirely by wholesalers and big refinery oligopolists who illegally collude and profiteer at consumer expense. Fiction.

One of the leading and most widespread theories about gasoline markets is that prices are controlled entirely by oligopolists and monopolists in the oil and gasoline industry, and that suppliers may charge whatever high price they prefer with impunity due to collusion and cartel agreements. The evidence offered to support this theory is that prices between gas stations tend to move up (and down) in a synchronized pattern, with the inference being that price collusion must be occurring between suppliers. How else to explain the tight co-movements in gasoline prices?

While gasoline wholesalers and refiners certainly possess modest "market power," suppliers do not "control" prices. Instead, prices are controlled by the interplay between supply and demand; the collusion theory tends to ignore the demand side of the market. That gasoline refiners and wholesalers have any market power at all is due solely to the fact that consumer demand for petrol tends to be less sensitive to price changes. The demand for gasoline is said to be "price inelastic," meaning that when prices change, consumers' buying habits change proportionately less than the accompanying change in price.

The demand for gasoline tends to be price inelastic for several reasons. First, gasoline, broadly defined, has very few close substitutes. With fewer alternatives from which to choose, consumers tend to be less price conscious.

Second, gasoline is viewed (subjectively) as a "necessity" by most people. Most people are willing to sacrifice other goods and services in order to spend more of their income on gasoline, at least in the short run.

Third, in the short run, consumers do not have as much time to alter their buying behavior in response to price spikes. That is, in the short run, they do not typically adjust to higher gas prices by purchasing fuel-efficient hybrid vehicles or by riding their bicycles or walking to destinations. These adjustments in buying and lifestyle patterns take time. In the long run, however, consumers adjust by seeking alternatives, and the demand for gasoline becomes more price elastic.

Finally, at present, gasoline expenditures are still a relatively small portion of most household budgets. According to the latest Bureau of Labor Statistics' Consumer Expenditure Survey, consumers spent only 3.3% of their annual income on gasoline in 2003. As a result, households tend to be less sensitive to price changes. As the price of gasoline rises and becomes a larger percentage of the typical household budget, consumers may become more sensitive to prices changes, making demand for gasoline more elastic over time.

So, gasoline is a price-inelastic good, at least in the short run. But, to assert that consumers will pay the same amount for a gallon of gasoline at any price, and that suppliers can sell equal quantities at all prices, is simply wrong. This notion defies the basic law of demand, which states that at lower prices, consumers will purchase more of a good. When prices fall, gasoline consumers eagerly buy more gas; demand is not perfectly inelastic.

As a final thought experiment, think about it this way: If the demand for gasoline is perfectly price inelastic, and if refineries and wholesale oligopolists have complete control over prices, why do prices ever stop rising? In other words, why don't we pay five or ten times more for gasoline than we presently do? Surely the self-interested suppliers of petrol are going to charge as high a price as they can obtain. Why would they ever stop short of infinity in their price hikes if consumers will pay any amount?

According to the US Department of Energy, gasoline prices averaged $2.61 per gallon the week before Hurricane Katrina made landfall. During and after the hurricane, prices jumped to an average of $3.07 per gallon. Then, in the subsequent two weeks, prices dropped to an average of $2.78 per gallon. If prices are controlled entirely by colluding gasoline oligopolists, how can this be? Why would prices ever stop rising, let alone decline, if they are controlled entirely by suppliers?

Moreover, why has it taken so long for prices to rise to the levels we currently observe? Again, according to the US Department of Energy, gasoline prices averaged just $1.53 per gallon the week after September 11, 2001, and dropped to $1.10 per gallon by the end of December that same year. This was over four years ago, following a terrorist attack on US soil. Why has it taken self-interested suppliers of petrol four years to "exploit" consumers with $3.00-per-gallon gasoline, and why do we fail to observe $20.00 — or even $30.00-per-gallon gasoline prices right now? Answer: something else must be going on, something for which the conspiracy theory of gasoline prices fails to account. Assigning blame to those "villainous" gasoline wholesalers just won't do.

(2) There is a loose connection between the world price of crude oil and the price of gasoline, and the rising price of crude oil in recent years can partially explain the rise in gasoline prices. Fact.

We must be careful, here. The cost of inputs in the production of any good or service does not determine the price of the output it helps to produce. That is, prices of outputs cannot be "justified" by their costs of production. If this were true, no business firm would ever take a loss, since the prices at which it sells its output would always cover the costs of production, including the entrepreneur's profits. Instead, prices are a function of relative supply and demand conditions. Input costs can influence, however modestly, the supply of outputs. And, changes in the supply of outputs can alter output prices.

Most people recognize that crude oil is the key input in the production of gasoline products, and that the price of crude oil in international markets has been rising consistently for several years. The US Department of Energy, Energy Information Administration estimates that 56% of the price of an average gallon of gasoline was comprised of crude oil costs in August 2005.

As such, the price of crude oil can and does influence the supply and price of gasoline. When the price of oil rises as it has, the (opportunity) cost of supplying gasoline increases for petrol suppliers, reducing the quantity of crude oil demanded in gasoline production and potentially reducing the supply of gasoline. All else equal, we would expect a rise in the price of crude oil to lead to a rise in the price of gasoline, and this is certainly consistent with the facts.

According to the US Department of Energy, the futures price of crude oil in the first week of August, 2000, was $27.79 per barrel. By the final week of August, 2005, the futures price of crude had risen to $68.94 per barrel, an average annual increase of 20%. During this same five-year span, the price of petrol in the United States rose from $1.46 to $2.61 per gallon, an average annual increase of just over 12%. During the year from September 2004 through September 2005, the futures price of crude oil rose at an average monthly pace of 2.4%, while the price of gasoline in the same period rose at an average monthly rate of 3.2%. The following chart, based upon data from the Department of Energy, shows the close connection between the price of crude oil on the futures market and the retail price of gasoline from August of 2004 through September of 2005:

While there is not a perfect mirror reflection in the price changes between crude oil and gasoline, and correlation does not equal causation, the similarities in movement suggest that rising oil prices are at least loosely connected with rising gasoline prices.

(3) Markets work fine under normal circumstances, but fail under crisis situations. Government must regulate prices and impose price controls during a crisis (such as after a hurricane) to stabilize markets. Fiction.

This is an argument that we hear frequently (and not surprisingly) from state governors and their pit-bull attorneys general, ever poised to put a legal stranglehold on retail gasoline stations thought to be engaged in "price gouging," however that practice is to be defined.

What the argument states is that the pricing system works well under "normal" circumstances, when supply and demand are relatively stable. But, when crisis situations occur, and when supply and demand conditions are significantly altered because of a national disaster or other emergency situation, prices become too volatile and thus require "stabilizing" through government price controls and other regulatory measures. That is, prices are said to "behave" properly prior to a crisis, but improperly during and after a crisis.

This is certainly wrong when one stops to think about it. Prices are coordinating information; signals to suppliers and demanders, a reflection of the market conditions of supply and demand. It is inconsistent and illogical to assert that prices perform their proper signaling and coordinating function in non-emergency situations, but then, somehow, for no apparent reason, simply stop performing their signaling and coordinating role during and after a crisis.

In fact, if anything, it's just the opposite. The pricing signals that emerge from a free market during and after a natural disaster (such as a hurricane) are even more important for us to rely upon. It is precisely during emergency situations, when supply and demand experience their greatest volatility, that we are most in need of the coordinating information that prices convey. It is during a natural disaster, such as a hurricane, when pricing signals will be most valuable in conveying to suppliers and demanders the relevant information about the use of scarce resources. And, it is precisely during such crisis situations where the artificial manipulation of pricing signals by the government (through explicit or implicit price ceilings) will do the greatest damage and lead to the greatest shortages.

We saw this clearly in the shortages of gasoline in and around the Houston and Gulf areas prior to Hurricane Rita. Government officials were looking for any opportunity to file law suits against "price gouging" retailers in the aftermath of Hurricane Katrina. As a result, some gas stations in the Gulf region were understandably reluctant to raise their prices in the face of escalating demand during the Hurricane Rita evacuation. When prices remain too low relative to supply and demand conditions, a shortage must result. This is in fact what happened. Gasoline shortages in the Gulf Coast region stranded numerous people along the Texas and Louisiana freeways in the baking sun, directly in the path of an oncoming hurricane.

So, why does this argument so frequently come up? It stems from the following fact: Those who make this argument tend to generally agree with and accept the outcomes of the pricing system and the market under "normal" circumstances. That is, they will tolerate the prices they pay for goods and services under conditions they believe are routine. However, when an emergency situation arises, these same people strongly dislike and view as unacceptable the (higher) prices that emerge from the very same pricing system they rely on under normal circumstances.

Thus, they claim that the market is not functioning properly and needs regulating because they dislike (for moral and emotional reasons) the outcomes they observe during a crisis. This is surely inconsistent. In fact, the price movements we tend to observe during and after a hurricane in the Gulf reveal that the market is working precisely the way any good economist would predict: a spike in demand for gasoline, accompanied by a reduction in the supply of gasoline refining capacity, will cause prices to rise. Just because some consumers dislike this outcome does not mean that markets have failed.

(4) There is no rational reason why retail gas prices at the local pump should skyrocket before a hurricane or immediately after a natural disaster, since the retail gasoline at the pump was purchased in a previous period and at a lower wholesale cost. That retail gas prices do rise during such events is merely more evidence of price gouging and exploitation. Fiction.

Here is another common misconception about gasoline prices that desperately needs dispelling. As before, our good friends supply and demand may be able to help, along with an understanding of how expectations influence markets.

First, the supply-side component. As mentioned above, cost does not justify prices, and the retail price of gasoline is not determined by the price of wholesale gasoline at the time it was purchased and pumped into the tanks at the local gas station. Instead, the retail price of gasoline at the pump is based upon expected replacement costs relative to current demand. In technical terms, the cost of the wholesale gasoline already in the reservoir at the local pump is a "sunk cost" (literally and figuratively), while parting with it by selling it to retail gasoline consumers is an "opportunity cost." In economics and in business, opportunity costs matter more than sunk costs.

Gasoline companies, knowing that Gulf Coast hurricanes can destroy oil rigs, damage underwater pipelines, and disrupt oil refining capacity, will expect that a hurricane-induced oil and gasoline shortage will push up the wholesale cost of gasoline. Expecting an increase in the future price of gasoline, local gas stations will logically pass some of that anticipated increase on to current retail petrol consumers. And, the opportunity cost of selling that gasoline will be reflected in the demand and willingness to pay for it among competing buyers, along with the anticipated cost of replacing it with higher-priced wholesale supplies.

Think about it this way: If you are a homeowner looking to relocate, would you sell your current home for the exact amount of money you paid for it, plus repair and improvement expenses incurred during the time of ownership? If the cost of something in one market determines the price at which it is sold in another market, then yes, you would. But, that is not the case, as the example should make clear.

The price you paid for your home does not typically even enter into the resale price decision because it is a sunk cost; it is historical, in the past, based upon market conditions that were different at the time of purchase. The price you ask for it when you want to sell it is based upon new market conditions, new developments, changes in supply and demand in the housing market that have occurred since you purchased the home, meaning that you might sell the home for much more or for much less than you paid at the time you bought it.

The same goes for the petrol in the tanks at gas stations, and the analogy to home sales is appropriate even when we recognize that the time duration between the purchase and resale of a home is usually much longer than between the purchase and resale of gasoline. Market price is based upon the (opportunity) cost of replacing that wholesale gasoline, plus the changes in the demand conditions that have occurred since the wholesale gasoline was pumped into the retailer's tanks. If that opportunity cost is expected to rise, the retail price will rise immediately to reflect that expectation.

Additionally, there is a demand-side component that is even more important. It, too, is related to expectations. Consumers, knowing that Gulf Coast hurricanes can retard oil and gas production and restrict supplies by knocking out refining capacity, will also expect prices to rise. On the basis of these expectations, and even before a hurricane makes landfall, consumers will increase their demand for gasoline immediately, hoping to buy some gasoline and top off their tanks before prices rise.

However, when all consumers act in tandem based upon similar expectations of rising prices, overall market demand will increase. And, because the supply of gasoline at the retail pump is fixed, at least momentarily, the increase in market demand based upon expectations of a future price hike leads to a self-fulfilling prophecy: prices rise immediately, even before the hurricane has had a chance to damage the supply chain, simply because demanders are more intensely bidding for the scarce supply of petrol at the local gas pump. This rise in price is an unmitigated good from the perspective of the market as a whole. It is precisely this rise in price that forestalls or prevents a shortage of gasoline and forces consumers to economize on its consumption, ensuring that there is enough gasoline to go around.

So, there certainly are rational reasons why the price at the pump jumps immediately when some change occurs in the global oil and gas markets, and the laws of supply and demand do a good job of explaining this connection. Now, admittedly, we may not like this fact, and we may complain loudly about the higher gasoline prices that result. But, we should at least take some comfort in understanding why.

(5) Fuel conservation and calls for less driving by a jawboning president are unnecessary and unwelcome. Fact.

President George Bush's recent call for reduced driving and increased conservation is just as wrongheaded as President Carter's conservation pleas back in the 1970s. First, the hike in gas prices alone will be sufficient to encourage conservation. As prices rise, fuel users will cut back and seek alternatives and substitutes. Not a lot, mind you, since the demand for gasoline tends to be price inelastic in the short run, as explained above. But, as gas prices rise, consumers become more price conscious and will conserve in their own interest, without being jawboned by grandstanding politicians. Often, this will mean switching to a higher-mileage vehicle and away from low-mileage SUVs and minivans. Evidence indicates that this is, indeed, occurring.[1]

Second, higher prices will give innovators, entrepreneurs, and investors motivation to introduce substitutes and alternative fuel vehicles that are more fuel efficient. These alternative fuel sources and technologies may not have been economically viable when gas was $1.50 per gallon, but become potentially viable and profitable as gas edges higher in price toward $4.00 or $5.00 per gallon. Even now, as reported by the Wall Street Journal,[2] auto producers are developing new technologies that conserve on the use of gasoline in response to rising consumer demand for fuel efficiency.[3] The beauty of this process is that pricing signals encourage anonymous cooperation between millions of dispersed suppliers and demanders, leading to an efficient use of resources without the browbeating and handwringing of politicians.

(6) Reducing or temporarily suspending gasoline taxes will help to "stabilize" gas prices. Fiction.

According to the US Department of Energy, federal and state excise taxes made up approximately 18% of the average price of a gallon of gasoline in August 2005. This is a significant amount. But, while lower gasoline taxes are a welcome proposal under most any circumstance, their temporary reduction or repeal will do nothing to "stabilize" gasoline prices. In fact, temporarily toying with gasoline excise taxes is likely to make gas prices more volatile, as it will breed expectations and speculative behavior into supply and demand.

  Super sale: $16

While a tax reduction or repeal would certainly lower the price of gasoline in the short run, there is nothing to guarantee that the price remains low simply because the tax has been reduced. Changes in underlying supply and demand conditions could very quickly push prices back upward and wipe out any price reductions resulting from gasoline tax cuts. If this happens, the politicians who have promised that they can deliver lower priced gasoline by cutting gasoline excise taxes now face angry consumers with misplaced expectations. In the worst-case scenario, these politicians may feel pressure to go further and impose price caps on gasoline, leading to inevitable shortages. And, in the long run, those taxes will be re-imposed, pushing gasoline prices up from whatever level they have settled at the time.

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The best solution would be to permanently eliminate federal and state gasoline excise taxes and pay for interstate highway repairs and expansions strictly through tolls paid directly by roadway users. While this is politically unpopular, toll pricing is a much more economically rational means of allocating scarce roadway use, and may have the added benefit of encouraging greater fuel conservation and reduced traffic congestion on US highways.

In summary, the fact is that gasoline price movements are a direct result of the daily, voluntary choices made by buyers and sellers of gasoline in response to market supply and demand conditions. Once we understand supply and demand, we can understand why and how these price movements occur. The greatest fiction of all is that, when we dislike the outcomes of this market process and the prices that result, we can point the finger at some villainous entity and then employ the force of government to "do something" to correct it. Such thinking is an economic prescription for disaster, and further endangers economic liberty.

Tom Lehman [mail] is Associate Professor of Economics at Indiana Wesleyan University. Comment on the blog.

[1] Chon, G. (2005, October 4). Sales of SUVs fall sharply. The Wall Street Journal, p. D1; Lundegaard, K. (2005, October 4). Car buyers seem to favor economy over power. The Wall Street Journal, p. D5.

[2] Sapsford, J. (2005, October 5). Mazda concept car will run on three fuels. The Wall Street Journal, p. D5.