Experimental Gasoline Markets

Cary A. DeckUniversity of Arkansas

Bart J. WilsonGeorge Mason

University

Evidence-Based Public Policy Conference Fall, 2005

Motivation

Few industries evoke such strong sentiments by consumers, retailers, wholesalers, and policy makers as gasoline.

Why? Consumer and business demand for

gasoline is inelastic. Modern economies depend on a large

volume of gasoline. Retail prices are posted nearly everywhere

we drive.

Motivation

The practice of zone pricing has been a particularly contentious topic in the public policy debate. Zone pricing is the industry term to describe the

practice of refiners setting different wholesale prices for retail gasoline stations that operate in different geographic areas or zones.

Chevron contends that they “price our wholesale gasoline to our dealers at prices that will allow them to be competitive in relation to their nearby competition.”

Connecticut Attorney General Richard Blumenthal proposed legislation to ban zone pricing claiming that it “only benefits the oil industry, to the detriment of consumers.”

Motivation

Another issue is divorcement, the legal restriction that refiners and retailers cannot be vertically integrated. Maryland was the first state to pass such

legislation in 1974 with a handful of other states following suit.

Bill Lockyer, California Attorney General, in a task force report states that “the key to enhancing competition at the retail level is to eliminate vertical integration by petroleum companies.”

However, this runs counter to basic economic theory and evidence from field studies [Barron and Umbeck (1984) and Vita (2000)].

Motivation

Yet another topic that has led to much public debate is a “rockets and feathers” phenomenon in retail prices. This is the perception that retail gasoline prices

rise faster than they fall in response to cost shocks. Beyond gasoline, Peltzman (2000) finds the

phenomenon in 2/3 of industries he tested. Using monthly national prices, he finds that “rockets and

feathers” is uncorrelated with concentration. For gasoline, Borenstein et al. (1997) presents a

collusive theory based upon trigger strategies. Other explanations posited include inventory costs,

menu costs, and consumer search costs (e.g., Johnson 2002, Castanias and Johnson, 1993).

Industry Background

World Market Price

Oil Field

Refiners

Wholesalers

Unbranded Rack Price Branded Rack Price

Wholesalers

Unbranded Stations

Company Operated Stations (Branded)

Lessee Stations(Branded)

Dealer Owned Stations (Branded)

Transfer Price Dealer Tank Wagon

Retail Customers

Environment and Institution

Consumers Each buyer has a value v for one unit of gasoline. A fractioni of buyers have a preference for brand bi,

i.e., these buyers gain additional utility if they consume brand bi.

Each buyer has an initial location on a “city grid” and incurs a quadratic travel cost to reach a station.

All retail prices are public information. Consumers purchase one unit from the station

offering the greatest net utility, assuming it is positive.

Robot buyers operate in the market.

Environment and Institution

Refiners Only refiner i can sell its branded gasoline bi at a cost

per unit of ci. Refiner i sets wholesale per unit prices (DTW)

for K units of gasoline.

Retailers A retailer j is contractually obligated to carry a

particular brand and only observes the DTW for that refiner.

Each retailer has an exogenously determined location in the “city grid.”

Retailer j sets the retail price pj for a unit of gasoline and its costs include DTWj and an operating cost of ej.

Treatments

Zone Pricing (4 Refiners and 4 Lessee Dealers)

Refiners set DTW prices for each retail location carrying its brand.

Each retailer observes two location specific DTW prices but cannot shift inventory between locations.

Uniform Pricing (4 Refiners and 4 Lessee Dealers)

Refiners must set one price for both retail outlets carrying its brand.

Company Operated (4 Retailers) Retailers and refiners merged so that DTW for brand i

outlets is ci.

Experimental Design and Procedures

Experimental Design and Procedures

Store 6P=?

Experimental Design and Procedures

Twelve laboratory sessions, four in each treatment. Each session lasted no longer than 90 minutes.

- a period lasted about 2 seconds. Subjects were undergraduate students. The average payoff was $18.25, including $5 for

showing up on time. World oil prices

First 600 periods ci constant. Last 600 periods ci followed a random walk with

changes occurring every 34 to 60 seconds.

Results: Zone (Wholesale) Pricing

0

400

800

1200

1600

110 120 130 140 150 160 170 180 190 200 210 220 230 240 250 260 More

Price Bins

Fre

quen

cy

Center Stations

Corner Stations

90

110

130

150

170

190

301 326 351 376 401 426 451 476 501 526 551 576

Period

Pri

ce

Wholesale CostCenter StationsCorner Stations

Wholesale Prices

Posted Retail Prices

Results: Uniform Wholesale Pricing

0200400600800

10001200140016001800

110 130 150 170 190 210 230 250 More

Price Bins

Fre

quen

cy

0200400600800

10001200140016001800

110 130 150 170 190 210 230 250 More

Price Bins

Fre

quen

cy

0

200400

600

8001000

1200

14001600

1800

110 130 150 170 190 210 230 250 More

Price Bins

Fre

quen

cy

0

200

400600

800

1000

12001400

1600

1800

110 130 150 170 190 210 230 250 More

Price Bins

Fre

quen

cy

Corner Retail Prices

Center Retail PricesZone Treatment Zone Treatment

Uniform Treatment Uniform Treatment

Why is Zone Pricing not Harmful?

90

110

130

150

170

190

210

1 26 51 76 101 126 151 176 201 226 251 276

Period

Pri

ce

Corner Station PriceWholesale Price to Corner StationsCenter Station PriceWholesale Price to Center Stations

Who Benefits from Uniform Wholesale Prices?

0

1000

2000

3000

4000

5000

6000

7000

0 1000 2000 3000 4000 5000 6000 7000

Station Profits

Ref

iner

Pro

fits

Zone, Session 1Zone, Session 2Zone, Session 3Zone, Session 4Uniform, Session 1Uniform, Session 2Uniform, Session 3Uniform, Session 4

The stations.

Who Benefits from Uniform Pricing?

Consumers56%

Station Owners

9%

Refiners35%

Consumers44%

Station Owners

26%

Refiners30%

Zone Pricing Uniform Pricing

Which Buyers are Harmed?

16.9% reduction in utility 17.8% reduction in utility

Results: Company-Operated

0200400600800

10001200140016001800

110 130 150 170 190 210 230 250 More

Price Bins

Fre

quen

cy

0200400600800

10001200140016001800

110 130 150 170 190 210 230 250 More

Price Bins

Fre

quen

cy

0

200

400

600

800

1000

1200

1400

1600

1800

110 130 150 170 190 210 230 250 More

Price Bins

Fre

qu

ency

0

200

400

600

800

1000

1200

1400

1600

1800

110 130 150 170 190 210 230 250 More

Price Bins

Fre

quen

cy

Corner Retail Prices

Center Retail PricesZone Treatment Zone Treatment

Company-Operated Treatment

Company-Operated Treatment

Which Buyers Benefit?

20.1% increase in utility 24.4% increase in utility

50.6% increase in utility

Who Benefits from Vertical Integration?

Consumers56%

Station Owners

9%

Refiners35%

Zone Pricing Company-Owned

Consumers74%

Refiners/ Station Owners

26%

Price Dynamics: Center Stations

50

100

150

200

250

601 651 701 751 801 851 901 951 1001 1051 1101 1151

Period

Pri

ce

Wholesale CostPricesCosts

50

100

150

200

250

601 651 701 751 801 851 901 951 1001 1051 1101 1151

Period

Pri

ce

Wholesale CostPricesCosts

Zone Pricing: Prices and Costs are Cointegrated

Uniform Pricing: Prices and Costs are Not Cointegrated

Price Dynamics: Corner Stations

50

100

150

200

250

601 651 701 751 801 851 901 951 1001 1051 1101 1151

Period

Pri

ce

Wholesale CostPricesCosts

50

100

150

200

250

601 651 701 751 801 851 901 951 1001 1051 1101 1151

Period

Pri

ce

Wholesale CostPricesCosts

Zone Pricing: Prices and Costs are Cointegrated

Uniform Pricing: Prices and Costs are Not Cointegrated

Price Dynamics: Company-ops

50

100

150

200

250

601 651 701 751 801 851 901 951 1001 1051 1101 1151

Period

Pri

ce

Wholesale CostPricesCosts

50

100

150

200

250

601 651 701 751 801 851 901 951 1001 1051 1101 1151

Period

Pri

ce

Wholesale CostPricesCosts

Corner Stations: Prices and Costs are Cointegrated

Center Stations : Prices and Costs are Cointegrated

“Rockets and Feathers”: Experiment Level

-11-9-7-5-3-113579

11

1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39 41 43 45 47 49Periods

Ad

just

men

t of

Pri

ces

Zone: CenterZone: CornerCompany-ops: CenterCompany-ops: Corner

Policy Conclusions

Banning Zone Pricing When zone pricing is banned, consumers in the

clustered area pay 11% higher prices than when zone pricing is permitted.

Consumers in isolated areas pay the same prices with zone pricing as they do when it is prohibited.

Banning zone pricing nearly triples average station owner profits, but has no effect on refiner profits.

Divorcement Consumers in the clustered area and isolated

areas respectively pay 13% and 17% lower prices with vertical integration than with divorcement.

Rockets and Feathers Conclusions

Station prices in the clustered area adjust quickly with zone pricing, but still rise faster than they fall.

Station prices in the isolated areas adjust more slowly than in the clustered area, but rise as fast as they fall.

With company-owned stations, station prices adjust symmetrically to changes in station costs, but this response is much slower than with vertical separation.

With uniform wholesale pricing, station prices and costs are not cointegrated.

The End.