Every time gas prices take a jump, we hear many people around us railing at the big oil companies. Rapacious monsters that they are, they're surely  responsible for the high price of gasoline and are raping consumers to reap unfair and excessive profits.

Below you'll see a recent chain email that blames big oil for high gas prices. But if we take the principles of free market economics into account, it becomes clear that the author of this email suffers from a woeful lack of understanding when it comes to basic economics. If you slept through Economics 101, it's time to wake up and understand the factors that are really driving prices at the gas pump.   (To learn more, be sure to check out our Economics Basics tutorial.)

Gas Prices and Oil Companies

Chain-Email Excerpt:
WE CAN GET GAS BACK DOWN TO $1 PER GALLON!
Now that the oil companies and the OPEC nations have conditioned us to think that any drop in the cost of a gallon of gas is a DEAL, we need to take aggressive action to teach them that BUYERS control the marketplace, not sellers.
We can do that WITHOUT hurting ourselves. How? Because we all rely on our cars, we can\'t just stop buying gas, but we CAN have an impact on gas prices if we all act together to force a PRICE WAR.
Here\'s the idea: For the rest of this year, DON\'T purchase ANY gasoline from the two biggest companies. If they are not selling any gas, they will be inclined to reduce their prices. If they reduce their prices, the other companies will have to follow suit. But to have an impact, we need to reach literally millions of gas buyers. It\'s really simple to do.
Join the resistance!

Why This Email Fails Econ 101

The author of this email text asserts and implies several things; we'll analyze each of them in an economic context in the next section. First, let's identify the email's assumptions:

  1. Buyers control a marketplace, not sellers (in other words, buyers alone can control the price of a good or at least buyers have more control over prices than sellers).
  2. Consumers can boycott one oil company without creating increased demand at other oil companies.
  3. There is no wholesale level pricing and distribution in gasoline markets.
  4. Integrated oil companies are all in league with OPEC (the Organization of Petroleum Exporting Countries).
  5. A "price war" is not something that does not continuously happen between competitors in a free-market economy.
  6. It's unfair that oil companies should make so much money.

(Feeling overwhelmed by rising oil prices? Save a bit of money by following the tips presented in Getting A Grip On The Cost Of Gas.)

Back to the Basics of Economics

Now let's analyze each of the author's propositions taking the basics of economics into account.

1. Buyers have more control over prices than sellers: False.

The price of gasoline is not and cannot be determined by buyers alone. The price of gasoline (like any good) is a function of both supply and demand. (For more insight, read Economics Basics: Demand and Supply.)

This fundamental economic principle is worth a quick review. Figure 1 demonstrates how both supply and demand determine the equilibrium price for a good. Note the following:

  1. The graph's axes are Price and Quantity. The slope of the supply and demand lines (curves) show the amount of a good that will be supplied and demanded at a certain price. The intersection of the lines establishes a market clearing equilibrium price (Equilibrium 1 on the graph).
  2. If the demand for a good increases (the demand curve shifts to the right, D1 to D2), and supply remains the same, the price of the good will rise (P1).
  3. When the price of a good increases, suppliers have incentive to produce more of that good, and the supply curve shifts to the right (S1 to S2). This increase in supply establishes a new equilibrium price at an overall higher quantity of goods sold (Q1 to Q2)

In the context of the gas price email, buyers do not control the price of gasoline any more than sellers do. The market will always find an equilibrium price established by the levels of both supply and demand.

 

Figure 1: Supply and demand equilibrium

2. Consumers can boycott one oil company without creating increased demand (and prices) at other oil companies. False.

The email proposes nothing more than shifting demand from one oil company to another. In the short term, this may very well decreases prices at the larger companies, but it will also increase prices at the other oil companies as the demand for their products increases. The economic laws of supply and demand and equilibrium pricing apply to individual companies and gas stations as well as to the entire market. Therefore, regardless of whether the big oil gas  station across the street lowers its prices as result of lower demand, Station X will not decrease its prices as the email postulates because the demand for Station X's products has just increased.

3. There is no wholesale level pricing and distribution in gasoline markets. False.

The proposition in the email does not change the aggregate level of demand in the marketplace, it simply shifts demand from one company to the next. In the long run, the larger company would sell its surplus supply (as a result of the decline in demand for its products) in wholesale crude oil and crude oil products markets. The companies experiencing the increase in demand would buy that supply, and compete among themselves to establish an equilibrium price.

There are very well-established and liquid markets for crude oil and oil products, including gasoline. Crude oil and refined products are traded constantly in both physical and futures markets world wide. The proposition in the email fails to recognize that aggregate demand and supply have not changed and, in the long run, the price of gasoline would end up close to where it started. In the short run, consumers boycotting the large companies would simply hurt themselves by creating higher prices at competing gas stations. (Find out how crude oil affects gas prices in What Determines Oil Prices?)

4. Integrated oil companies are all in league with Organization of Petroleum Exporting Countries (OPEC). False.

Many people believe that oil companies have influence over the decision process at OPEC, the organization that attempts to control the supply of oil, and therefore the price, in order to maximize its members' profits.

Within OPEC, each member nation is allocated a production quota. International oil companies operate independently of OPEC, but because OPEC controls a larger percentage of world crude oil exports (supply not consumed by the producing nation), OPEC's policies impact the price of oil worldwide. As demonstrated in the illustration above, if the demand for a good increases while supply remains constant, the price of that good will rise (Equilibrium 1 to P1). While oil companies might benefit from OPEC's supply constraints, they do not participate in OPEC's decision-making process, and could just as easily be hurt by OPEC's policies if OPEC (assuming its member nations were able) decided to attempt to increase the supply of oil worldwide. (Learn more about this organization in Meet OPEC, Manager Of Oil Wealth.)

5. A "price war" does not continuously happen between competitors in a free market economy. False.

The email proposes that buyers should start a price war between competitors. In free market economies, price wars continuously take place between competitors as companies try to maximize profits and drive competitors out of business. Competitive pricing and striving for efficiencies is the grease that lubricates a free market economy. If one company believes it can maximize total profits by lowering its price - which in turn will increase sales, and thereby increase total profits - the strong motivation for profits causes it to do so.

It goes against the laws of human nature and economics to suppose that companies are not constantly trying to outperform their competitors.

6. It's unfair that oil companies should make so much money. False.

The incentive to earn a profit is what makes a free market economy work. If you take away that incentive, you take away market innovation and efficiency. Without the incentive of making a profit, capital is not put at risk. As such, a "windfall profits tax" on oil companies could lead to a reduction in the amount of gasoline that companies supply, meaning possible shortages for consumers.

If you take away an oil company's motivation to make large profits, you take away its incentive to make risky investments such as exploring for new crude oil fields and building new refineries. In addition, these large oil companies are publicly traded companies and they operate for the benefit of their shareholder. Anyone is free to buy shares in these public companies - and these investors expect to get a return on their investment.

The Bottom Line

In a free market, supply and demand determine the price of a good. There are really only two options to bring down the price of gasoline: Increase aggregate supply or decrease aggregate demand. If you decide to boycott a large gas company, you'll only hurt yourself in the short run by paying even higher prices at a competitor's pump. In the long run, prices will find an equilibrium through demand and supply adjustments at the wholesale level.

To learn more about the forces at play, read Peak Oil: Problems And Possibilities.

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