Commentary

Ready for Higher Gas Prices?

By Bart J. Wilson and Thomas A. Firey
This article appeared in The Hartford Courant on May 28, 2006.

Connecticut drivers who are struggling with high gas prices should keep their eyes on their state legislators over the next few weeks. Good intentions may mislead the General Assembly into making matters worse.

The lawmakers are considering outlawing “zone pricing” — fuel wholesalers offering gasoline at different prices to different geographic areas of the state. Connecticut lawmakers considered similar legislation during the spring session, only to have the bill die. Now there is talk of calling a special session so lawmakers can approve the bill.

On its face, a zone-pricing prohibition may sound appealing to consumers. But if Connecticut does pass a zone-pricing prohibition, the law will force many consumers to pay more than they should for gasoline.

To understand this, we must first understand gasoline retail pricing. Two factors really affect gasoline prices: how far the station lies from its nearest competitors and the number of potential customers in the area. Station owners will always set their prices as high as they can, limited only by the fear of losing customers to competitors. Motorists know this, and avoid the high-priced gas station in the middle of nowhere.

Many years ago, fuel wholesalers noticed the enormous profits made by low-competition stations, and the wholesalers decided they wanted a cut. They set “zone prices,” charging the low-competition stations more for gasoline.

Interestingly, this didn’t raise gasoline prices to the consumer. Zone pricing simply shifted some of the profits from the retailer to the wholesaler. That’s why gas retailers want a zone pricing prohibition — they want the low-competition profits for themselves. If zone pricing has no effect on consumers, why would a Connecticut zone-pricing prohibition hurt motorists?

One of us recently used experimental economics to test this scenario. When forced to set a statewide price, wholesalers (with a hungry eye on the high profits of the low-competition retailers) set the price higher than the price they had given to high-competition retailers. The high-competition retailers were forced to raise their prices to consumers.

Neither the wholesalers nor the retailers in this experiment acted illegally or malevolently when doing this. They simply responded to the incentives set by the zone-pricing regulation. When zone pricing was allowed, the wholesalers fought intensely on price in the high-competition areas while extracting some of the excess profits in the low-competition areas. With the zone-pricing prohibition in place, wholesalers set high statewide prices to keep extracting some of the excess profits.

The same would happen in Connecticut if a zone-pricing prohibition were enacted: Gas prices at low-competition stations would stay the same, but prices at competitive stations would rise.

Fortunately, lawmakers can give motorists some relief — if not right away, then in the long term. For many years now, Connecticut has been one of the few states to have a “divorcement” law, requiring all motor fuels to pass through independent retailers on their way from refiners to consumers. Proponents claimed the law was necessary to keep Big Oil from pushing all mom-and-pop franchisees out of business. But this has been proven a canard: Most states do not have divorcement laws, yet most gas stations are owned by franchisees. The law only created a situation where every gallon of gas sold in Connecticut undergoes a double-markup — one by the refiner, and the other by the retailer.

If Connecticut lawmakers really care about consumers, they will retract the divorcement law. It won’t make retailers happy, but it will give Nutmeg State motorists a welcome break.

Bart J. Wilson is associate professor of economics at George Mason University in Virginia. Thomas Firey is managing editor of the Cato Institute’s Regulation Magazine.