Gas Station Profits

"Dan" posted this question in a comment to the blog - Tufte's Economics Classes Blog - my upper division students have to post to and comment upon for credit:

I would like to know: If gross profit on consumer purchases of gasoline when the retail price was 1.50 was 20 cents, when gas prices are 3.00 per gal is the gross profit increased proprtionatly to 40 cents? That is, does the percentage profit remain the same? If it does, I'd like to know how it can be justified, since aside from the slightly inreased carrying charges on the price the dealer pays for the gas, his fixed expenses remain the same regardles of the price he pays for the fuel. Rent, insurance, labor electric etc remain constant and are not affected by the price he pays for gas. It cost him X to store and pump the stuff no matter what he pays for the product.

I hadn't really thought about this before, so here are my thoughts about this:

I think this is a very good question for which I don't have a decent answer.

I think there are three ideas that need to go into an answer though.

1) Pricing of undifferentiated products (like gasoline) is a prisoner's dilemna: every seller has both the ability and incentive to undercut their competitors. This would tend to keep profits per gallon at the same level.

2) Rate of return arbitrage would say that investors tend to prefer firms with a higher rate of profit as a percentage of revenue. In this case, if gas station owners profit per gallon remained the same as prices rose, then gas stations would be an undesirable asset to own, and their price would drop. Any gain that you made by buying a station cheaply would add to your profit per gallon. This would continue until the profit rate on gas stations equalled that on other assets.

3) Don't forget that gas station owners incur a lot of risks that may be difficult to recognize if they do not come to fruition. But ... they must still be compensated for those risks that might (or might not) happen. So, I think it is pretty reasonable for station owners to be making more profits right now. The reason is that they are bearing the risk of some form of government regulation that might take away their ability to earn profits in the future. I'll bet you that gas wholesalers in Hawaii are mighty glad they made those profits while they could - now that the state has capped their ability to even cover their costs (much less make a profit).

SHAMELESS PLUG: I didn't require any classes to blog this summer, so  Tufte's Economics Classes Blog has been pretty quite for 4 months. But, I will have junior and senior business majors from my Managerial Economics class writing this fall, so stay tuned. They should be starting up in 1-3 weeks.

Comments

[gary lammert]

Gasoline prices are a fragment of one of the six piece of the economic puzzlle:

A Completed Fibbonocci Third Growth Sequence on Friday 26 August 2005

The fractal evolution since October 2002 strongly suggests that there are very real and very simple quantum number fractal laws that underlie the macroeconomy. This discovery will be little consolation to the turmoil that is about to unfold over the next decade.

August 24 (Wednesday's) and August 25 (Thursday's) trading days once again demonstrated on a 5 minute unit fractal level, the recurrent precise fractal theme of x/2.5x/2x-2.5x - that pervades the economic universe.

For the Wilshire 5000 the base was about 17 five minute units. The three sequential growth fractals were 17/42/34 of 34 before the fall on Friday morning. The lateral 'skeletonized' evolution of this fractal sequence suggests the final lower (very lower) high is close at hand. Friday August 26 is the Fibonacci 85th day of a 52/130/85 daily sequence dating since August 2004.

1.62 times 52 equals 84.24 days.... If growth sequences follow idealized
Fibonacci related fractals, Monday 29 August 2005 will break lower in
a nonlinear manner. A deluge is coming.

Gary Lammert The Economic Fractalist http://www.economicfractalist.com/

[NOTR]

Hopefully as your students look at the economics of the gas business, they also get dipped in the hidden cost of doing business, state and federal regulations, all which interfere with the free market mechanisms.

[Keith]

This image (http://www.mjervin.com/image6.gif) is a pretty good indication of how retail gasoline prices are built up. Crude producers sell it to refiners, who turn crude into gasoline (and other things). Gasoline is sold by refiners to marketing companies, whose job it is to distribute it out to gas stations. You can think of this layer as the wholesale business. Then taxes are a percentage (over 100% in most places, over 1000% in Europe) of the wholesale price paid by the gas station. Add a margin of about 10-20 cents a gallon to get the gas station's final retail price.

Most gas stations make more money on beer and cigarettes (and *cough* porn) than on the gas itself, which is why they all turned into convenience stores (big, nice pretty ones) at about the same time about 10 years ago. The gas is just a way to get you in the door in most cases.

[Keith]

This reminds me of another piece of good advice for price sensitive gas shoppers out there. Never buy midgrade or "Plus" gas. That gas in the middle pump is where the gas station makes almost double margins because of how they charge for it. The industry in general calls it "yuppie gas" because of who buys it. Poor people buy regular. Rich people in rich cars buy premium. Yuppies think premium is too fancy and overkill but they still want their car to have "the good stuff" so they buy the midgrade.

Midgrade gas is nothing more than a 60-40 mixture of regular and premium, usually mixed in the actual nozzle you are spraying into your car.

Typically you will see that regular will be $2.50/gal and premium will be $2.70/gal or so. Midgrade will fall somewhere around $2.65 or so, implying that it is closer to premium. If you look at the octane ratings on the pumps though, you will see that regular is 87 octane, premium is 92 octane (93 in some states), and midgrade is 89 octane.

If you feel you *have* to have midgrade gas, pump 10 gal of regular gas into your car in 1 transaction, pay for it, then pump 5 gal of premium into your car and pay for it separately. You'll get the same 2/3rds-1/3rd mixture and pay about $2.57 instead of $2.65 for it.

[James Stephenson]

I had heard that Gas Stations, earn less than 10 cents a gallon profit from the gas. Heck, if you lease a shop from say Shell, you get 2 cents per gallon sold. 20 cents profit per gallon, if that were true there would be more gas stations, so many that eventually the price would fall.

Anyway, I am not sure if this is true or not, but where is this guy pulling 20 cents from?

James

[Dave Tufte]

I loved Keith's comment about midprice gas. I've just learned a new trick.

After reading all these I'm inclined to think that the correct answer is that arbitrage forces the rate of return on gas stations to stay at the same level as the price of gas rises. The result is the convenience store phenomenon (noted by Keith), and also the disappearance of most family owned gas stations in the 1970s (when they became lousy businesses relative to other sorts of shops).