Econ 101 Revisited

I hate to do this again, since it has already been addressed on this site here, here,and here, but I keep hearing politicians, people in the media, and folks in the general public who don't have a clue, so here goes...

People, let's put down the tinfoil hats and get off the soap boxes, here. Ignorance is bliss, they say, but it is also THE driving force behind the politicians' and the media's insistence in "doing something about 'price gouging' at the pump". RELAX. Take a DEEP breath.

Once again, an understanding of how the marketplace works is sorely lacking -- they don't teach economics at "Ed Co." (public school), so it shouldn't be a real shock so many don't "get it". Add to that certain well-meaning (but economically illiterate) politicians who are looking to score points with the consumer for "coming to the rescue" against the "greedy, price-gouging oil companies", and you have a recipe for misinformation and misplaced anger.

Let's try to understand a bit more about this commodity called gasoline. Most of this is understood, but let's review, anyway: First of all, it begins as crude oil, which is located deep below the ground in places like Utah, Colorado, the Gulf of Mexico, Alaska, the East and West Coasts of the US, Venezuela, Saudi Arabia, and on and on... It must be tapped by drilling, then pumped or shipped to a refinery where it can be separated into useable products, like gasoline or diesel fuel, heating oil (same as diesel fuel for the most part) and various other items. Secondly, it does not belong to you, YET. You don't have a right to gasoline at the price YOU think is "fair". The price of gasoline, like any other product, is set in the marketplace by the interaction of two forces: the availability of a product and the desire to acquire the product by those who want or need it. Supply and demand. Let's look at each factor, shall we?

As for supply... after it's acquired as crude, shipped to the refinery and processed, the gasoline (or other product) has to be shipped or pumped via a pipeline to a distributor who then pumps or delivers it to a wholesaler or retailer, who finally sells it to the consumer. That's a fair number of steps in the process. Any interruption at any point will cause the wholesale or retail supply to drop. When the supply drops, the price must rise.

Why is that, you say? Well, because the demand for the product is still unchanged. In simple terms, we still want the same amount, but the available product has suddenly become relatively scarce.

Why do you think diamonds cost so much? It's not because they're rare. In reality there is plenty of raw material to be mined. But because the Diamond mines and the supply chain up to the wholesaler and retailer are owned by the Diamond Cartel, it controls not only the available supply but the price for the most part. The supply of the "bling" in the marketplace is intentionally kept very limited by the Cartel, thereby making it artificially scarce and therefore, expensive.

Because diamonds are kept in short supply, the price of those that are available will be as high as: a) the seller can set, yet still be able to sell enough to maximize his profits, but b) not so high the consumer will not buy any. That same equation works anytime any particular product is in short supply. Like gasoline, recently.

Most politicians, in essence, are making the mistake of equating the current supply fluctuations in gasoline with an artificially manipulated supply -- such as is the case with diamonds. Understandibly, they're making an incorrect conclusion. It's not really a matter of "price gouging" at all, but rather one of gasoline's relative scarcity. We're talking apples and oranges, here.

Let's look at the effect of changing demand on price. Back in the Summer even before Katrina, the price of gas was going up. Not because of any hanky-panky by BIG OIL, but because it ALWAYS goes up in the Summer. Why? There are two big factors. The first is people want to go more places and do more things, and they want more gasoline so they can do it. Quite simply, the demand increases. Secondly, the refiners have a limited capacity -- there are not any refineries sitting idle that can be brought on line -- yet the EPA reqires a laundry list of different "blends" of fuel for different areas, which are aimed at reducing (somewhat) Summertime pollution. In this case, there is the same quantity coming out of the refineries, but more different products are being made. That means the amount of product going to any given place is constrained.

It's easy to see how the demand for some of the blends may become disproportionately high. For example, let's say the demand in California goes up significantly more than is anticipated by the refiners and retailers. In the winter (when there are far fewer different blends reqired), additional supplies of finished product may be re-routed to the west coast -- which could help satisfy the additional demand. But in the Summer, the distributor cannot send North Dakota gas out to the west coast because the North Dakota blend is different. The additional demand cannot be met easily, so the available supply becomes relatively scarce, and the price goes up.

Don't forget the fact the price of crude oil has almost doubled over the past year. That means regardless of other factors, the price of the finished product would be more now than it was in the past.

There's one more contributing factor this year -- the weather. Add in the fact Katrina caused a significant, although temporary (thankfully), disruption in the distribution of gasoline from the Gulf of Mexico region of the US. It also shut down a significant portion of production, temporarily. So what do you think that should mean? Good for you, if you said "the price would be expected to go up significantly".

Gasoline (in any blend) became relatively scarce three weeks ago (some Governors were even warning that their states "could run out of gas" in the aftermath of Katrina). With a scarce product, the price HAS to go up. If not, 1) the supplier will run out of the product and won't be able to meet any demand, and 2) people will want to "stock up" to weather the coming "shortage".

One good thing about higher prices is that they discourage stockpiling. That means some supply should be available at some price. Rising prices also encourage conservation. Because people know they only have so much money to spend on gasoline, they understand they need to make what they do have go farther. This is the marketplace at work.

Once the pipelines were back up and refineries moved production back on line, the prices DID start to come back down, didn't they? That's because the supply increased relative to the demand for it. People wanted x amount, but there was now more than x quantity available. In order to sell the supply on hand, a retailer or wholesaler had to lower the price to encourage consumers to buy from him (or her).

New development: Hurricane Rita is in the Gulf of Mexico, so guess what? The distinct possibility exists that supplies will be disrupted again, and in anticipation of that, the price has stopped going down -- temporarily. Wholesalers and retailers realize they'll probably have to pay more next week to get the needed supply since it could very well be limited. You should expect the price you pay will be going up because of that.

BOTTOM LINE: There may be SOME "price gouging" going on in limited instances, but the reality is the marketplace works to match demand with the available supply through price. If a particular retailer is truly "gouging" his customers, chances are they'll soon find out the guy down the street is selling gas for much less, and go there. In that case, if the "gouger" wants to sell anywhere near the normal amount of his gas, he'll have to lower the price. Remember, a full supply of $4 a gallon gas you can't sell is not worth having. What to do? Lower the price to the point people WILL buy it. End of "gouging", pure and simple -- and without Gov Co's interference.

STILL DON'T BELIEVE ME? Check out this, and this by Thomas Sowell, or this, and this by Walter E. Williams, or this by Jeff Jacoby, which leads into:

WHAT TO DO ABOUT THOSE HIGH PRICES: Not much, except conserve where you can and shop around for the best price available. In the long run, though, tell your politicians to put pressure on the EPA to limit the number of different summer blends they require. Also, push your legislators to make it less difficult to increase refining capacity. No new refineries have been built in the US in the past 25 years, due to government environmental restrictions and such. In essence, it has been easier to expand an existing refinery than build a new one. But many plants have reached the limit they can expand on their existing property, so expansion is not necessarily an option. Finally, tell them it needs to be easier to extract oil domestically (far too many people have pushed the politicians to keep oil wells away from places where crude oil is obatainable. There has been significant opposition to new drilling based on misplaced environmental concerns, as well. The oil is there, but compromises must be made to get it. That would go a long way toward neutralizing OPEC's grip on us.

So don't buy into this notion of "price gouging". What you're seeing is the marketplace in action. You may not like it, but that's what it is. If you think retailer A is selling gas for too much, shop around. Find a better price. Go there, instead. It's called "making a choice with your feet". And tell your Congressman or Congresswoman to work on the REAL problems, rather than the perceived ones.