Jul

4

Petrol 101

July 4, 2006 | Comments Off | Joshua Gans

OK, here is an exam question: demand stays the same but a key cost component rises. What happens to profits? This is about as basic as it gets, they go down. Why? Because the supply curve has shifted to the left. While price might be higher there is less producer surplus or profits.

So how do we reconcile this prediction with today’s news that Caltex’s Australian profits have soared? Not only here but everywhere (see my earlier post)?

There is a theory in economics regardling how competition amongst firms may be soft during slumps but intense during booms. The idea is that competing firms worry that when they drop their prices to grab market share this might trigger a price war. That means any gain they get would be temporary. Thus, when margins are low (during slumps) the grab for profits is not worthwhile but when margins are high (during booms) they are. So perversely, demand may be high but prices and profits may be lower.

Flip that theory around to think about cost shocks. When costs are low, margins are high and so there is more reason to be competitive. On the other hand, high costs bring low margins if a firm decides to compete for market share and so they don’t. The end result is higher profits associated with higher prices and demand and supply seemingly not delivering the results one would expect on profits.

This outcome does not require any explicit collusion and so does not violate price fixing laws. It is caused by oligopoly and in petrol refining and distribution in Australia, that is not going to change anytime soon.

[Update: 5th July, 2006: crikey.com.au liked this post and included it in their bulletin today. This might become a more regular thing.]


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