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BOHANON & STYRING: Market ultimately keeps gas prices in check

January 30, 2016

Economic AnalysisIndiana motorists are enjoying gas prices below $1.50 a gallon. It wasn’t long ago we cheered them dropping below $2 a gallon. What accounts for this bounty? When gasoline prices rise, newspaper and TV commentators regularly hammer Big Oil’s conspiratorial “greed.” Have oil companies, refineries and gas station owners suddenly become generous and beneficent towards consumers? Well, not really.

Consider the following conceptual exercise. Let’s say, a few weeks back, all the gas station owners in Indiana got together in an Internet chat room and said: “OK, guys. We know our wholesale prices are going to fall soon by about 50 cents a gallon; let’s all agree to keep our gas prices fixed at $2 a gallon. This will give us $500 a day in extra profit for every thousand gallons sold.”

The father of economics, Adam Smith, predicted this is exactly what they would like to do. “People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices.” But he went on to tell us that, as long as the conspirators did not have among themselves a “bye-law with proper penalties,” the price-fixing scheme would not last. No need to call in the antitrust cops. Why? The same greedy motive that causes merchants (or oil companies) to set up a price fix will undermine it.

Suppose the $2-a-gallon rule is in place and being followed. Bohanon’s station is making an extra $500 a day on the thousand gallons he sells—but then his twin competitor Styring down the street gets an idea. “If I drop my price by a nickel a gallon, I can sell 2,000 gallons a day, make 45 cents a gallon, and pull in $900 in extra profits a day!” Of course, once Styring starts this, we are off to the races. Bohanon’s sales drop, so he must retaliate by dropping his price 10 cents a gallon to get those customers back. Add in other competitors within driving distance, and you get the point. As long as the price-fixing scheme cannot be enforced by law or mafia contract, we consumers have little to fear.

With no legal standing to enforce cartel rules, cartels harbor a built-in incentive to cheat. They don’t last long. The cheaters are our public benefactors and protectors.•

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Bohanon is a professor of economics at Ball State University. Styring is an economist and independent researcher. Both also blog at INforefront.com. Send comments to ibjedit@ibj.com.
 

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