Explaining prices, part I

A reader e-mailed me,

Not long ago when gas pump prices were below $2/g there was a differential of $.10/g for each higher octane. I know not why, but, can assume it is a fee for refining. Currently in the Va. area the differentials have been more like $.20-.25/g. No way did refining costs double. Please help me understand this.

My reply:

Hi Mike,

Apart from government mandates (which Austrian economists like me consider "interference" with prices), it's a matter of supply and demand. The cost of producing something is a baseline, because in general, sellers must charge more than the marginal cost of production, else it's simply not profitable to stay in business. After that, though, sellers will charge what the markets will bear, i.e. what price people are willing and able to pay. A major-brand station may charge 1 or even 5 cents per gallon more for the same octane level than a major-brand station across the street, when both likely get their gasoline from the same wholesale supplier. The two stations down the road from me will charge the same price, except one is pure self-serve and the other is pure full-serve. They're not even a quarter-mile apart, but the full-serve just happens to be beyond an intersection few people travel on. BTW, the difference between adjacent octane grades at both of those stations is 10 cents.

I presume you found my old post on oil prices versus gas prices. I've been meaning to revisit it but haven't had the opportunity to do analytical blogging. But in the meantime, if you follow the two links I had supplied and look at the data since, you'll see nearly the same relationship as when oil and gas prices were at these levels. Right now we're back to pre-Hurricane Katrina days, where prices depended more on the limits of U.S. refineries (refineries get expanded, but because of environmentalist lobbying, there hasn't been a new one built in 33 years).

When crude prices got so high, that influenced the price baseline far more than refinery capacity limits. The reason we saw crude near $150 per barrel was because we hit the very limit of global crude production. Everybody was pumping what they could, what rigs were physically capable of pumping and/or limits that governments set. Prices are set at the margin, so the price doesn't depend on the average price of every barrel of oil: the price for all units is the price paid for the very next unit. And remember it isn't only what you're willing to pay, but also what the next guy is willing to pay. Demand so far outstripped supply like never seen before, so though one oil trader's clients were willing to pay $70, another trader's clients might be willing to pay $75. And up and up. The same goes for wholesale gasoline.

I don't have any data on this, but I wonder how much of the demand for higher octane is because people are holding onto their cars longer, and using slightly higher octane is a way to prevent knocks and pinging. There certainly is no disincentive now that prices have come down.