Demand and supply dynamics in market economics

Demand and Supply

There are a number of different factors that Edgar needs to take into consideration with his idea to invest in the gas station business. Let's pretend for a minute that he is not just paying the fair market value for the gas station -- he is -- and simply discuss his theory about the economics of the gas market. If the market for gas stations is even remotely efficient, the price of that gas station will be the present value of expected future cash flows, meaning that all of the knowledge about the determinants of the gas market are already priced into what Edgar is going to pay. His profit comes from the value that he can add to the station through his own management. But let us digress and get Edgar up to speed with what the market has already priced into that gas station.

There are a number of determinants in the gas market. The first is elasticity, because this will affect not only gasoline sales but also the state of the economy as well. He is also relying on sales of other goods, which means we have to talk about cross-price elasticity as well. The paper will also talk about supply, because Edgar has taken the price of gasoline into consideration with his analysis. We don't really need to graph out this stuff -- words are fine -- but we'll give it a go anyway, to illustrate some of the things that Edgar needs to think about. The scenario outlined is rather vague -- I cannot critique Edgar's actual numbers or logic because it was never provided, but I can provide some basic information and analysis that will help him.

Price Elasticity of Demand for Gasoline

Edgar is right in one sense, that $4 gas has been largely accepted. But there are different types of price elasticity of demand with respect to gasoline. First, we have to separate if we can the demand for consumer gasoline vs. For businesses, because we are only selling to consumers at this point. Major commercial users like trucking firms and taxi companies run their own pumps. There is also the fact that demand for gasoline changes over time.

First, the price elasticity of demand for gasoline is larger in the long run than in the short run. One of the most important factors that drives elasticity is the ability of consumers to react to price changes. In the short run, there is limited capacity to react. Consumers can maybe do all their shopping at once or cancel a road trip vacation, but that only produces a small bit of elasticity. In the long-run, they can buy a smaller car, or move to an area where they do not need to drive as much. Note the increasing vibrancy of many American cities -- a lot of millennials don't even own a car now. This is evidence of long-run price elasticity of demand in action. Their parents -- weaned on cheap gas, wanted big houses in the suburbs. That is still in our culture, it is weakening. There might be a short-run acceptance of $4/gallon gas, but in the long-run, consumers are showing some elasticity.

Short-run elasticity has been weakening. Most Americans -- by virtue of living in suburbs and commuting to work or school -- are price inelastic in their gasoline consumption. But note that this is in part because they are often driving smaller cars. Studies in the late 1970s showed higher short-run elasticity than there is today, because cars were huge. So today, consumers are better equipped to handle short run volatility in the price of gas. The current estimate for short-run price elasticity of gasoline nationwide ranges from -0.034 to -0.077, numbers than indicate a relatively inelastic demand (Hughes, Knittel & Sperling, 2008).

It is also worth taking into consideration that the short-run price elasticity of demand is higher when gas prices are more volatile. Consumer are less elastic when volatility is medium or high, and more elastic when volatility is low (Lin & Prince, 2009). If this seems counterintuitive, it might relate to consumer psychology. Consumers feel more in control when price volatility is lower, and that encourages them to be more active in their consumption decision making. When volatility is higher, consumers might become resigned to the fact that they have little control over prices. Remember that in general in the short turn they have a very low level of elasticity anyway, but it definitely seems that consumers are more likely to fuss over gas prices when they think that doing so will actually make a difference.

Long-run price elasticity of demand is higher. There are a number of reasons for this. Consumers might be unable to alter their gasoline consumption much in the short run, but that is because of the way that the structure their lives. Where they live and how much they drive are key variables, and these were trending in the right direction for the gasoline industry for a long time. Lately, however, young people are choosing to live in the city, drive less and when they do drive they are opting for very small cars (Haab, 2008). This general apathy towards car ownership -- they are neutral at best whereas previous generations have been enthusiastic about car ownership -- has affected car ownership and gasoline consumption both (Tuttle, 2013). For Edgar, if his gas station is in an area where everybody is dependent on cars, he can count on persistent inelastic demand for cars, until the population of that area begins to shrink because people feel that the costs associated with driving everywhere are not worth the investment in that part town. This is already happening.

Long run price elasticity of demand for gasoline is around -0.363 (Small & Dender, 2007). This means that there is some give with respect to higher fuel prices. Edgar's position that $4/gallon and going higher is good for business relies on an assumption of very low price elasticity of demand. While this is true in the short run, the evidence suggests that in the long run there is some price elasticity of demand, and that there are good reasons to believe that this is going to only increase. Thus, higher gas prices are just going to push more people past that trigger point where they have to curtail their consumption.

Income Elasticity of Demand

Income elasticity of demand is another interesting issue for Edgar to look at, because it affects some of his other assumptions about why this is a good business to get into. In their study, Hughes, Knittel and Sperling (2008) note that income elasticity of demand for gasoline ranges between 0.21 and 0.75. This means that demand for gasoline increases when income does. There are several explanations for this. The first is that richer people drive more, but it probably is psychological in nature -- richer people don't think about their consumption, and they are more likely to take cars to work. That is a luxury, and those who cannot afford that must find other ways of getting to work . So ultimately, income affects purchasing patterns.

This is important for Edgar, because the one thing he cannot do with his gas station is pick it up and move it. Demand for gas at his station, therefore, is affected by the changes in income in his part of town. As it so happens, incomes are affected to some degree by the health of the economy. The health of the economy is in turn affected at least in part by gas prices, because enterprise use of gasoline tends to have a low price elasticity. So if gas prices are only going to rise, that is going to constraint economic growth. Depending on where Edgar's gas station is, that might not matter much, but in most places, this is going to matter. The demand is not going to get higher of the price rises, and it might not get lower in the short run, but if the price rises, incomes will drop, and that will bring about the observed long-run price elasticity of demand.

Cross-Price Elasticities of Demand

It is pretty vague to talk in general terms about "stuff" but since that's all we know about what Edgar thinks he'll sell, and it is probably a basket of goods anyway, we can only really guess at the cross price elasticities of demand. Since gasoline is what Edgar counts on to bring people to his station, it is assumed that there is a cross-price elasticity of demand for the different goods that he wants to sell. The individual price elasticities will different depending on the characteristics of the good -- we know that liquor and cigarettes have lower price elasticity of demand than other discretionary items, for example. But in general, when fewer people are buying gas, the sale of ancillary "stuff" will also decline as well. Edgar will have to work very hard to offset this effect, by selling things that are destination items and can attract a clientele that does not want gas first and foremost. The other thing Edgar has to think about here is that even people who continue to patronize his gas station will have less money for discretionary items if the price of gas continues to rise. So not only will he have fewer customers, but the remaining customers will spend less as well. The latter trend will be evident in the short-run, too, whereas the former trend is mainly going to be long-run.

All of this means is that an increase in gas prices does not necessarily mean an increase in revenue. It might, in the short run, though customers could just substitute discretionary purchases in the store in favor of the higher gas, which will cannibalize higher-margin goods, but in the long run Edgar might break even or less, depending on the products he stocks, the income characteristics of his neighborhood, the volatility of gasoline prices, the prevailing price elasticity of demand (it fluctuates, as noted above), and Edgar's bargaining power over his customers (so competition, differentiation, etc.).

Profit

So far, some key issues have been raised with Edgar with respect to the revenue side of his income statement. There is also the cost side. There are two factors to be taken into consideration. These are the costs of gasoline and the costs of other goods. There is a difference, in that Edgar needs to understand when he is setting his prices what the profitability of gasoline is -- is it a loss leader or just on a slimmer margin. If gas isn't a loss leader for Edgar in his current business plan, he needs to consider that it is a loss leader for his competitors, and they might be Wal-Mart and Costco. They'll undercut him on both gas and "stuff" (AP, 2008; Tuttle, 2011; Feldman, 2011). This means that Edgar is going to need to understand -- keenly -- his breakeven point, and if one of these companies moves into the area his stop loss point as well.

The Energy Information Administration (2014) outlines the price of gas. Regular gasoline comes in at an average of 12% taxes, 10% distribution and marketing, 14% refining, and 65% is the cost of crude oil. Note that all of the potential profit is in that 10% distribution and marketing, which also includes trucking it to the gas station, and all of the advertising that these companies pay for as well. Thus, Edgar's profit margin on gas is slim, if he has one at all.

We don't know Edgar's costs, so we can't figure out a breakeven point, but we do know that Edgar is going to have slim margins. Let's say he makes 0.1% on a gallon and has $400,000 in fixed costs. That means his breakeven point is 4 million gallons in a year. That is 10,958 gallons per day, or 456 gallons per hour. That's 7.61 gallons per minute just to break even. With ten pumps working that could happen, but Edgar has to know what the volume sales of the station are, because there is only so much he will do to change that.

The profit point on non-gas items is higher, so the breakeven point is lower, which is why Edgar has to realize that it is the ancillaries that will make or break his business. Variable costs are lower relative to revenues -- the margins are better so these are the items that will contribute to covering the fixed costs.

The good news for Edgar is that there is very little marginal cost to his gas station. What is the marginal cost of a gallon of gas, at a station that is already open? Not much. There are marginal costs associated with ancillary goods, however. A small store is much cheaper to run than a comprehensive highway rest stop. Marginal revenue has to be above marginal cost in order to turn a normal profit. Taken together, the ancillary goods and the gasoline must have an average total cost that is above the average variable cost. Taken together, they probably will, even if the gasoline does not on its own. But MR has to be above MC, so if Edgar decides to build a larger service station in order to increase his revenues, he has to increase them at a level that will justify the increased costs. That is why most gas stations do not build giant highway service centers -- only on highways where they have local monopolies do they do this. In competitive markets, gas stations only build to the size of their lot, but understand that ultimately they have to undercut others on gas or their giant attractive station will not generate MR above the MC level, and the station will have to go out of business at that point. Edgar has to know his market well, and tailor his service/product offering in line with the prevailing market conditions.

Market Structure

I want to press home an important point for Edgar, why I keep talking about those ancillary services. The market structure for gasoline is simple. It is perfect competition, more or less. I say less because consumers have very little knowledge about the cost inputs, but otherwise they have a high knowledge of gas prices -- there are apps that make this very easy -- and there is little to nothing that differentiates one company's gasoline from another. In a perfectly competitive market there is no opportunity for profit. That is why hardly anybody even tries to make money on the gas. Edgar might make a razor thin margin every once in a while, but he should count on making basically nothing on gas -- and remember there are competitors will to sell at below marginal cost in order to attract customers.