When gasoline prices rise, consumers certainly notice. But many people have very little idea why prices at the pump rise and fall. Take a look at the factors that determine the price consumers pay from day to day.

Oil Prices: The Crude Reality

Logically enough, the price of gasoline is determined in part by the price of oil. But a whole host of other factors impact the average retail price of gas.

Key Takeaways

  • The law of supply and demand rules gasoline prices, as it rules all commodities.
  • Both supply and demand are changing in our time.
  • The supply of high-quality oil is dwindling while global demand is increasing.

According to the U.S. Energy Information Administration, the price of crude oil actually comprised only 54% of the average retail cost of gasoline in 2019. Federal and state taxes were the next highest cost factor, averaging 18%, followed by distribution and marketing costs, refining costs, and profits.

Those figures varied between 2010 and 2019 but, overall, the price of crude oil comprised 59% of the average retail cost of gasoline.

To understand how gas prices are set, consider the core factors of supply, demand, inflation, and taxes. While supply and demand get the most focus (and the most blame), inflation and taxes also play a part in increases in the cost to consumers.

Supply

The law of supply and demand has a predictable impact on the price of gas. Less predictably, both are changing substantially in our era.

Oil does not come out of the ground in the same form everywhere. It is graded by its viscosity (light to heavy) and by the degree of impurities it contains (sweet to sour).

The price for oil that is widely quoted is for light/sweet crude. This type of oil is in high demand because it contains fewer impurities and takes less time for refineries to process into gasoline. As oil gets thicker, or "heavier," it contains more impurities and requires more processing to refine into gasoline.

Light/sweet crude is simply becoming scarcer and harder to obtain. As the supply of this preferred oil becomes constrained, the price climbs.

On the other hand, heavy/sour crude is widely available throughout the world. The price of heavy/sour crude is lower, sometimes substantially lower, than light/sweet crude to compensate for the higher cost to process it.

Demand

The growth in the number of people driving cars and trucks, particularly in parts of the developing world, has expanded dramatically over the last few years. China and India, each with populations in excess of one billion, are experiencing expanding middle classes that will likely drive more cars and use more gasoline over time.

China alone had built more than 80,000 miles of interprovincial highway by late 2020, and it is continuing to add more than 6,000 miles a year, according to a Chinese government site.

By comparison, the U.S. has a total of about 47,000 miles of interstate highway, according to the Federal Highway Administration.

Many countries subsidize the retail price of gasoline to encourage industrial development and gain popular support, creating an artificially higher demand for gasoline.

Creating Balance

Prices help allocate scarce goods. That is, consumers respond to higher prices for any commodity by using less of it. Although demand for gasoline is elastic in the long term, small disparities in supply and demand in either direction will not have a significant impact on prices in the short run. This inelasticity of demand means if prices go up, demand goes down, but not by very much.

The reason is that people are locked into their lifestyles for the near term. While they may change their fuel consumption by buying more fuel-efficient vehicles, moving closer to work, or taking public transportation, they can't or won't do so in response to a temporary hike in prices.

The price will balance the supply of gasoline with the demand for it. The global nature of the market for gasoline assures that balance.

That leaves inflation and taxes to account for the biggest relative increases in the price of gasoline.

Inflation

Inflation is the general rate at which the prices of products and services are rising (and, conversely, the rate at which purchasing power is falling). In the U.S., an item that cost $1 in January 1950 would cost about $10.98 in January 2020.

In 1950, gas cost about 27 cents per gallon. Adjusting for inflation, a gallon of gas should cost about $2.98 in January 2020, assuming taxes, supply, and demand stayed the same.

Taxes

The tax on a gallon of gas in 1950 was 1.5 cents. In July 2019, the combined federal, state, and local taxes on a gallon of gasoline averaged 18% of the total price. Federal tax made up 18.4 cents, while state tax made up 29.66 cents.

Other countries have vastly different tax policies for gasoline, some of which can make taxes the largest price component.