The spring issue of Regulation magazine is full of good articles, including the Adelman article to which I referred yesterday. Another article worthy of careful reading is “Economics at the Pump” by my colleague Bart Wilson and Cary Deck. They report on a set of experiments that they ran to explore the effects of different types of price and industry regulation on retail gasoline prices. What they found was that pricing practices that policymakers think harm consumers may actually be better for consumers than a more uniform regulatory approach.
Deck and Wilson explore three different policy issues that frequently arise when retail gasoline prices fluctuate. The first is zone pricing, under which refiners sell to their affiliated retailers at wholesale prices that differ across geographic areas. Sometimes policymakers look at this practice as “gouging” because it implies the ability to charge higher wholesale prices in zones where their retailers do not have nearby retail competitors. Of course, being a “glass is half full” kind of gal, I look at zone pricing and see the refiners having to charge a lower price in areas with robust retail competition.
The second practice is a regulatory one, not an industry one, called divorcement. Divorcement is a law under which refiners cannot have affiliated retailers; in other words, in a divorcement state refiners and retailers cannot be vertically integrated. Maryland is one such state, as Deck and Wilson point out (and now I have a good explanation for why gasoline at my in-laws costs more!). Many policymakers perceive vertical integration as being antithetical to robust competition, for reasons that I’ve never been able to fathom. Vertical integration can actually enable more robust competition because it reduces the likelihood of pancaked markups from wholesale to retail to customer. In the case of retail gasoline, where the markets are pretty competitive but the typical demand is inelastic, vertical integration can thus remove some of the surplus losses that arise from double marginalization, or from having layers of producers along the supply chain pricing above marginal cost.
The third issue that arises in retail gasoline policy is the asymmetry of price fluctuations, or, the question of why price increases flow through to retail customers quickly, but price decreases take longer to be reflected fully in retail prices. Many scholars have explored this question, and the research is well summarized in a research paper by Dallas Fed economists Nathan Balke, Stephen Brown and Mine Yucel, and a policy paper by Stephen Brown and Mine Yucel.
Deck and Wilson designed a set of experiments to explore these three issues. In their experiments they constructed an urban 7×7 street grid. There were four different brands of gasoline at retail, and gas stations were arranged in this grid to approximate different competitive conditions. The subjects in the experiments were split, with half being refiners selling their branded gasoline and choosing wholesale prices, and half being retailers operating two gas stations and setting retail prices. The retail prices at each station were common knowledge to all retailers and refiners.
The retail customers were automated robots who were randomly assorted within the grid. They had full information about prices, and their preferences incorporated travel costs from their current location to each gas station. To get at the price change asymmetry question, they also programmed world crude oil price fluctuations into refiner costs. The article does a nice job of explaining how Deck and Wilson established the costs and preferences of the refiners, retailers and customers.
Using this stylized environment, Deck and Wilson then implemented different rules that approximated each of the issues described above. They did three different “treatments”: zone pricing, uniform pricing (in which it is illegal to use zone pricing), and company pricing (in which all gas stations were vertically integrated).
The big-picture result of their experiments was that “uniform … pricing and divorcement harm consumers.” In other words, mandating uniform wholesale pricing and making zone pricing illegal resulted in refiners charging higher prices in areas with several competing gas stations, whereas under zone pricing they acted on their incentives to charge lower prices in those areas: “when zone pricing is banned, consumers in the clustered, center area pay 10.9 percent higher prices than when zone pricing is permitted.” For divorcement, they found that customers paid lower prices (on the order of 10-15 percent lower) in the company-owned treatment than under the divorcement rules when vertical integration is illegal.
Deck and Wilson also found evidence of price change asymmetry that is consistent with the empirical results of other studies.
I particularly like the way they phrase their conclusion:
Policies like divorcement and uniform pricing actually harm consumers rather than help them. The reason is simple: The well-meaning interventions are designed to manipulate market allocations, but they backfire because they cannot account for the complex incentives in an intricate industry.
This article comes out of research that Deck and Wilson have performed for the Federal Trade Commission on the effects of gasoline pricing regulation on consumer well-being, including this working paper.