Penny-Deep, Inelastic Demand, & Sticky Prices

Penny-Deep, Inelastic Demand, & Sticky Prices

December 20th, 2018

If you want to succeed in business, you strive to be the best, or the biggest, or carve out something unique your competitors fail to do. Think about that the next time you’re standing at a fuel station pump. If the place has been around long, it likely falls into one of those three categories.

Is it the best run place in town? Is it a big, branded chain outlet? Or does it offer you something unique‒perhaps convenience, clean restrooms, and/or unleaded 88 and flex fuels? Even if the station hits one or all of these, you can bet its owner understands that in the fuel business, customer loyalty is penny-deep. Generally, motor fuel demand is inelastic, meaning whether prices rise or fall, you and I pretty much buy the same amount because we need to commute to work and get the kids to hockey practice.

Sure, we all complain about gas prices. It doesn’t help that unlike most businesses, gas stations post prices on the street for us to watch and compare as we zip by. But maybe we ought to cut the fuel retailer some slack. After all, pricing for them is more complicated than simply changing the big numbers on those marquee signs.

As wholesale costs rise, fuel retailers must anticipate what their replacement costs will be when they call in that next delivery from the tanker truck. In other words, they are gauging what it will take to refill those 10,000-gallon tanks buried under the parking lot, and adjusting accordingly in a business based on pennies per gallon. If they miss by a few, they risk erasing all profit margin. It is particularly noticeable when unforeseen world events or natural disasters disrupt supply and wholesale prices spike.

When prices do fall, you may have noticed sticky prices‒when it seems prices just aren’t dropping as quickly as they rose. But if we recall that a station’s storage tanks already contain tens of thousands of gallons of the higher priced fuel…well, maybe we can appreciate why retailers are in no hurry to immediately follow the market down.

Some states, like Wisconsin, have predatory pricing laws that attempt to prevent larger operators from selling fuel below cost and, ultimately, knocking out small stations. In other markets, retailers may use a “loss leader” strategy in which regular gasoline is priced at their wholesale cost in order to draw in more motorists. The logic is that overall traffic increases and all those customers will buy other, higher profit stuff inside the store.

Pricing isn’t necessarily easier for a big branded chain of stations. At any given moment, large chains have huge volumes of fuel “in play.” Given their large inventory, they typically need to lead local prices up. When that happens, it can cause demand destruction at their outlets as customers shift to nearby competitors with a lower price.

Next time fuel prices spike (and you know they will), let’s resist that urge to unload on the person working behind the counter. They’ve heard it all before, and they dislike rising prices as much as we do. And if you want to save a few pennies per gallon, you can try using 88 octane, which is almost always 5-7 cents per gallon less than your regular unleaded.

NOTE: 88 octane gasoline is for use in 2001 and newer gasoline vehicles