Fuel for the Fire

John Umbeck on the economics of gas pricing

With prices on a nonstop roller-coaster ride between $3 and $4 per gallon in recent years, it’s never been clearer that the cost of gasoline is influenced as much by local and regional market conditions as it is by international issues.

This summer, for example, pipeline and refinery problems in the Midwest limited production and spurred price hikes of 30 cents per gallon or more in Indiana, Illinois, Michigan, Wisconsin and other nearby states.

“It’s a simple matter of supply and demand,” says Krannert economics professor John Umbeck, who has been studying the petroleum industry for more than two decades. Still, other market conditions and parameters are less apparent.

Gas Pump

“The federal government and most states have laws that impact the way gas stations set prices,” he says. “While the application of those laws is defined in terms of a market, the market itself isn't always clearly defined.”

A field experiment that Umbeck and Jack Barron, Krannert’s Loeb Professor of Economics, conducted in California about 10 years ago illustrates the potential complexities.

With the oil company’s permission, Umbeck and Barron raised and lowered prices daily at 54 company-owned stations in Los Angeles, San Diego and San Francisco over a three-month period to determine why retail gasoline prices were higher in San Francisco than Los Angeles.

The culprit? Different zoning laws within the state allowed some cities to build more stations per square mile, and more quickly, than other cities.

For example, in Los Angeles where more relaxed zoning laws resulted in more gas stations, higher prices decreased sales volume more significantly because consumers only had to drive a short distance to buy a competitor’s gasoline.

However, in markets like San Francisco where there were more zoning restrictions and therefore fewer stations, higher prices had less impact on sales volume because consumers had to drive greater distances between stations. Therefore, gas station owners in LA were less likely to increase their prices than station owners in San Francisco.

“We found that a one- to two-mile radius is where you find most of the reaction to price changes,” Umbeck says. “Consumers have more incentive to drive from one nearby station to another for a price difference of two cents than they have to drive from one town to another for a 20 cent price difference.”