Tuesday, 1 May 2018

The shocking truth about retail fuel pricing has been revealed!

Thanks to some outstanding investigative reporting (read: a leaked email), the shocking truth about fuel pricing was revealed yesterday:
A leaked email has exposed the pricing strategy underpinning the petrol industry.
In the email obtained by Stuff, BP pricing manager Suzanne Lucas outlined a plan to counter dwindling sales in Ōtaki, where the price of fuel was 20 cents more expensive than in nearby town Levin.
Instead of reducing the price in Ōtaki to make the station more competitive, Lucas proposed an increase of the fuel price across the entire region, with the expectation that competitors would match the new price.
"We have already increased all three sites mentioned by 5cpl [cents per litre] and have found that the Z [Energy station] in Paraparaumu has already matched our pricing," Lucas wrote.
Imagine that! Fuel pricing is not just based on costs of production, but competition makes a difference! Yawn. Anyone with a modicum of economic literacy could have pointed this out, but politicians and the media are not well known for their understanding of basic economics. And so we end up with stories like this:
A National Party MP and the Automobile Association (AA) are calling for the fuel industry to be more transparent about its pricing after a leaked email from BP lifted the lid on the company's petrol pricing strategy...
Jonathan Young, National's energy spokesman said the BP email was very concerning.
"I think the Commerce Commission would be very concerned about this as well."...
It's time for a reality check. The Commerce Commission has better things to do than follow up on this. To save them some time and effort, I can summarise BP's pricing strategy (not to mention the pricing strategy of every other fuel retailer in the world) in two bullet points:
  • If costs of supply go up, put prices up, and if costs of supply go down, put prices down; and
  • When there is less competition, put prices up, and when there is more competition, put prices down.
In every principles of economics course, students learn that the profit-maximising price for a firm with market power occurs at the quantity where the marginal revenue curve meets the marginal cost curve. In other words, costs are not the only thing that matters in pricing - revenue matters too. If there is less competition in the market, then consumers will have relatively less elastic demand for the good - they will react less if prices are increased. So, when there is relatively less elastic demand, firms can add a higher mark-up over their costs (and so the market price will be higher).

So, it is incredibly naive to believe that only costs matter in pricing decisions. Given that, this should come as no surprise:
Motorists are right to feel they are being unfairly treated after revelations about how BP sets its petrol prices, Prime Minister Jacinda Ardern says.
"Certainly what's been revealed today probably wouldn't surprise some motorists," Ardern said at her weekly press conference on Monday.
"But to hear so blatantly that pricing decisions are being made that sit outside of the price of crude oil, that sit outside the exchange rate, or that sit outside operating costs will no doubt be raising eyebrows with consumers."
Ardern is at least right about the fairness aspect though. Research by Nobel Prize winner Daniel Kahneman (and described in his book Thinking, Fast and Slow as well as Richard Thaler's Misbehaving: The Making of Behavioral Economics, which I reviewed here) shows that consumers are willing to pay higher prices when sellers face higher costs (consumers are willing to share the burden), but consumers are unwilling to pay higher prices when they result from higher demand - they see those price increases as unfair. The latter point almost certainly extends to consumers' views of the unfairness of higher prices that would result from less robust competition between firms.

So, we should not be surprised by the behaviour of fuel retailers and their pricing decisions. From the BP email, it doesn't seem that there was any overt cartel behaviour (or collusion between 'competing' retailers), so there was no illegal behaviour that the Commerce Commission would be interested in. However, we might rightly question the fairness of BP's pricing behaviour (especially if you live in Ōtaki!), and BP will probably face negative consequences (if only in terms of adverse publicity) for doing something that it is almost certain every fuel retailer would do in the same circumstances.

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