Economic principle: There’s no such thing as “bad” when talking about prices.

Just because the price of something is rising is not necessarily bad. For example, when the food prices go up it may be “bad” for consumers but it’s “good” for farmers. Also when the price for a particular good goes up, consumers will search for substitutes. Chicken for beef, etc.

Economic principle: Markets are self-regulating

The fact is that rising prices at the pump will cause consumers to seek more fuel-efficient cars and manufacturers to find ways to deliver them. It will eventually lead to big developments in energy to the point where there will no longer be a need for gasoline. Instead we’ll be using some other fuel. In short, necessity is the mother of invention. It’s a self-regulating mechanism.

There’s a reason why all those SUVs were sold in America during the 90s and early 2000s despite the fact that the government was mandating higher fuel efficiency from manufacturer fleets: gas was cheap for 20 years. Now you hear all the complaining about the price of gas but nobody forced anyone to buy that Escalade or Suburban. Consumer demands are much more powerful than government regulation and taxation, that’s why you are seeing much more emphasis on smaller more efficient models and the manufacturers are scrambling to meet the new needs. The companies that do so will be the winners.

Oil companies are making record profits on our backs. Wrong.

Every quarter, we hear about the billions of dollars that the “big oil” companies make as if they were stealing from us. But consider this: if you sold a product that the entire world needed in ever-increasing quantities wouldn’t you also be recording record profits each quarter? If you sold popcorn and made 10 cents per pound sold, but each quarter you sold 20% more popcorn you’d be bringing in ever more profit. The thing here is to focus on the profit margin. The 10% is still 10% but the amount you brought in was 20% greater than the previous quarter. All you did was sell more product. Well, as it turns out the “big oil” companies all pretty much make about a 10% margin. That’s a healthy profit but far from highway robbery. The shareholders of those companies are entitled to a return on their investment. By the way nobody is keeping you from becoming one of them and deriving some benefit from the “windfall”.

Economic Principle: Excess profits invite competition

So here we have 3 or 4 major oil companies making about 10% profit on ever increasing amounts of oil they are refining and selling. Why not 15% or 20% if they really have to power to gouge consumers? The answer is that they have to compete with each other and they all compete with potential entrants to the industry. Getting into the popcorn industry is probably a lot cheaper than getting into the energy business and thus we can expect profit margins in an industry with such a high cost of entry to be higher than others.

How is it possible that the oil companies only make 10% if the price of gas is going up so much?

The answer is that the oil companies take an input (crude oil) and add value to it by refining it. They tack their costs of refining on to the cost of the crude and re-sell it to retailers. Think of a baker. When the price of flour goes up, he raises the price of bread to his customers so that he can continue to make the profit margin he’s accustomed to. As long as the demand for bread is constant the baker is insulated from risk. However the demand for bread is “elastic” which is a fancy way of saying variable. People can substitute other things for bread but you can’t (in the short term) substitute the gas in your tank so the demand for gas is relatively inelastic.

Now what would be “bad” is if the oil companies colluded (or got together and decided) that they would agree on a pre-set price. Instead of competing with each other they would be in cahoots to make more profit than the market would normally yield them. Two things here. First, if they did engage in such a behavior they would still face the potential of new entrants to the industry. Secondly they would run afoul of anti-trust law. Congress has investigated these companies time and again and never discovered any collusion. The truth is that they don’t need to collude. They sell a product with a healthy profit margin and a demand that won’t be decreasing anytime soon.

Now it’s illegal for oil companies to collude but it’s not illegal for countries to collude. Remember the oil companies don’t usually own the oil fields, countries do. And that’s why we have organizations like OPEC that try to rig the price of crude oil. Their objective is to try to get top dollar for their finite oil resources. Who can blame them? They play with the flow or supply of oil to maximize their price. The oil companies have about as much control of this as the baker has over the cost of flour.

Competition in the retail gasoline market.

Unlike oil refining, gasoline retailing has very low barriers for entry. Most gasoline stations are owned by independent businessmen, kind of like franchisees. Anyone that has the prerequisite funds can buy the land, get the permits and obtain the equipment to sell gas. Not surprisingly, gasoline retailers make very little profit per gallon of gas. In most cases consumers don’t have perfect pricing information. For example nobody could possibly know the prices of every item in a drug store. Consequently one drug store might have some items cheaper than a competitor and other items that are more expensive. Assuming the two drug stores are right next to each other, a consumer might be tempted to shop both stores and buy the lower priced items at each. What would eventually happen is that the stores would end up with the same prices on all the items because the owners would change prices to react to consumer behavior. If I have alka seltzer priced at $2.00 and don’t sell a single box, I will lower the price until they start to sell. And my neighbor who also owns a drug store will raise the price from $1.60 at which the product is flying off the shelf. Eventually we will both end up at $1.80 without ever even walking into the competitor’s store. Even if we colluded to fix the price of alka seltzer at $2.00 (well above the market price) consumers would go somewhere else to get their alka seltzer. Often we shop at stores where we generally know the prices are lower than other stores even though another store might have specific items on sale for cheaper. We factor in time, transportation costs, customer experience, etc.

But the retail gasoline industry is as close to a “perfect market” as there is in the real world. Gas stations are forced to advertise their prices on big lit signs. Gasoline is virtually indistinguishable between retailers. And competitors are often located in close proximity. That limits the gas station owner’s ability to set the price at any old level he wants. If he’s a penny more expensive a gallon than the station across the street, he may still be able to sell gas due to consumer brand loyalty, or because the penny isn’t worth it to a drivers coming in the “wrong” direction to make u-turn, etc. But he can’t charge 10 cents more or he’ll lose a good chunk of his sales.

Now, in some areas of the same city gas is more expensive than in other areas. For example in Miami Beach gas can be 50 or 60 cents more per gallon on the mainland. Why is that? Well, those gas station owners charge more because they can. They are in an isolated area with less competition. Consumers are willing to pay a premium for gas in order to save the effort of having to drive to the mainland to get gas. But there’s a limit to how much these retailers can charge too. When I worked in Miami Beach and found my tank on empty, I would pump $3 worth and fill up closer to home. The retailer made a handsome profit on the gallon I bought but he didn’t sell me more because I (the consumer) felt the price was too high.

There’s no such thing as “price gouging”

If you believe in free markets then there can be no such thing as price gouging. The market sets the price. Regardless of how high that might be, it’s can’t be perceived as a “bad” thing only as a reflection of short supply vs. high demand. Let’s look at an example. When the hurricanes shut down all the gas stations a couple of years ago the price gouging regulations went into effect and the retailers were prevented from raising their prices beyond a certain percentage of the pre-storm price. What resulted were long lines and shortages. This always happens when you implement price controls. If the price of gas had gone up to $10 a gallon in the aftermath of the storm, the only people that would have purchased it would have been those who were literally running on fumes and those that needed the gas most. Instead you had people rushing out to top off. Many gas stations ended up restricting the amount they would sell each consumer. The self-regulating nature of the market was sabotaged by artificial price ceilings. Remember the real price of any good is what consumers are willing to pay. If consumers are willing to pay $10 a gallon for gas then the seller should be allowed to charge it. In the short term these types of price controls don’t mean much (beyond the short-term inconvenience of the lines and the shortages) but the same sentiment that creates these types of situations is used by governments in other countries (Cuba, for example) with the same predictable results. If you take away the profit from an industry the products of that industry will be scarce. It’s easy to be swayed by the emotional arguments of “price gouging” and consumer abuse but applying any degree of logic to the situation will prove that the “cure” often is worse than the “disease”.

Why Ana Menendez should just STFU.

In her dumbass column she talks about a “living wage.” Just like price ceilings, price floors have unintended consequences. Arbitrarily raising wages above the market price for labor is essentially a price floor in the labor market. Higher wages mean higher prices for consumers. And aren’t the people whose wages we just arbitrarily raised also consumers? So you make more money but everything you buy is more expensive? Sounds like a recipe for inflation to me. And it is. Thank God that bitch isn’t in government and thank God nobody takes her seriously.

If you are dork like me and love learning about all this stuff, then I recommend this free online book about basic economic principles in layman's terms from Oklahoma University.