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ECONOMIC ANALYSIS: A primer on understanding the mystery of gas prices

May 8, 2006

You usually don't get a lot of space when you write a letter to the editor of your local newspaper. So when I've read those despairing cries of outrage and mystification at the behavior of gas prices recently, I have managed to resist the urge to respond in kind. Explaining energy prices-or any price, for that matter-isn't quite as hard as hitting a curve ball in baseball, but both explanations take more than the 3 or 4 inches of column space most readers, and most newspaper editors, have the patience to read.

To an economist, there's not much mystery at all. World demand for oil has risen substantially, especially in countries like China and India, where consumption of crude oil doubles every 10 years. Low prices in the past have kept exploration and investments in costly new technologies for extracting oil low. And a new refinery hasn't been built in this country in more than two decades.

That adds up to rising demand in the face of sluggishly responding supply, and every economics textbook ever written says prices should adjust upward. In fact, the mystery to us is why they took so long to start heading up in the first place.

That's not going to satisfy those who seize on every daily gyration of gasoline prices on every street corner with fury as proof of conspiracy, especially when those prominently displayed numbers spike higher. Why, some of us ask, are prices lower in New Castle, higher on the freeways, lower in the mornings, or appear to all move at once?

That's a lot of questions. And even though the editors give me a little more space in this column, it's still not enough to hold the half dozen or so classes needed to really address them all.

But you can go a long way in unraveling these mysteries by looking at how prices of other products behave. None of the comparisons are perfect, but they reveal a lot.

Gallons of gasoline are a little like shares of stock in a company, at least in this sense: Both are heavily traded-billions of both are bought and sold every day. And both are commodities, in the sense that they are uniform. The gas in my tank is the same as the gas in your tank, just as the shares of Eli Lilly stock I own are the same as yours.

And we all know that commodity prices are subject to rapid fluctuation. That's because as new information about the future is received, how people assess the value of their holdings changes as well.

But there's another important aspect of gasoline prices that has more in common with an entirely different type of product, namely, housing. That may surprise you. But gas prices and home prices have at least two aspects in common that can help us understand their behavior.

For one thing, location matters. The station sitting in front of you when your needle is on empty is much more valuable to you than the one 20 miles down the road, just as the 1,600-square-foot brick home in Indianapolis that sells for $110,000 can go for 10 times that amount on a mountainside in southern California.

Because geography is involved, information on prices tends to be imperfect. We're not always sure how to price our homes when we sell, particularly in a turbulent market, because it is difficult or costly to assess what other sellers are asking. Some buyers will make the effort to price all the alternatives, but some will not. The upshot is that price differences-whether for identical homes or gallons of gasoline-can sometimes stick, even when one deal is clearly the best.

The comparison to home sales also offers this final insight on energy prices: How many of you apply a fixed markup to the price you paid for your home when it comes time to sell? It doesn't work. The market will tell you what your home is worth, just as it tells us every day what to spend on the gas we pump.



Barkey is an economist and director of economic and policy study at the College of Business, Ball State University. His column appears weekly. He can be reached by e-mail at pbarkey@ibj.com.
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