Almost every report on the gasoline situation following Katrina has focused on supply, or consumer frustration. But in markets, consumers have an enormous influence on price, a fact that is poorly understood or appreciated. Right now, consumer demand is helping to lead the way as we return from the disaster of hurricane Katrina. Just as panic and fear of rising gasoline prices fueled their ever-faster ascent, today’s reticence to buy is helping to hasten a decline in the price of gas.
As most of us have noticed, the price of gasoline has backed off what some feared would be an endless upward spiral. There are a couple of good reasons for recent reductions in gas prices. One is the fact that our storm-damaged petroleum distribution system is regaining capacity every day. Significantly, we know this because our information systems are so efficient that news barely has time to be created before it is disseminated throughout the electronic media. Market reaction from consumers incorporates this information at the speed of acquisition.
The availability of current information is particularly relevant in tumultuous times, as recent events have demonstrated. When it became evident that a Category 5 storm hitting New Orleans would cause serious disruption, markets reacted. Scarcer oil and gas, and reduced refining and delivery capacity were anticipated. Suppliers correctly priced retail gallons according to replacement cost, rather than at production cost. In volatile markets, they may not (or may not be allowed to) raise price fast enough to avoid some losses in the lag period.
It takes an event like hurricane Katrina to remind us that expected future prices are one of the five major influences on consumer demand for any product. The others are: income or wealth, tastes and preferences, the number of consumers seeking the same good in a market, and prices of related goods—either complementary or substitute goods.
It’s also typical in markets for cost changes to lead price changes on the supply side, but real-time news means changes in expected future prices on the demand side just as quickly. Consumers can form and act upon their expectations about future price almost immediately. This is what they did.
Consumers saw prices climbing daily, and expected that prices in the near future would be higher still. No one wanted to wait to buy, if that meant a higher per gallon price. Gas hoarding, filling up from 15/16ths of a full tank, buying huge quantities to store; all evidence of expected higher prices in the future, and a potential cost of waiting.
What most buyers didn’t understand was that a feeding frenzy at the gas pump helped insure that expected higher prices became a self-fulfilling prophecy.
As demand rises, given supply at a particular moment, price rises. If we picture an auction market with furious bidding over the last one or two gallons of gas, we get an idea of how fast anxious bidders can drive up price. But note—it’s the bidding and the self-propelled price increases that eventually calm the fury. As price rises, some people reassess their immediate desire for the product, decide to wait, or find alternatives. By the time gas reached about $3.29/gallon in the recent episode, many people reconsidered their demand for gas. That’s a good thing—it helped quell panic at the pump, and halt a lot of the demand-driven increases in price. Notably, price regulations hinder instead of help the problem.
This also works in reverse, and we are beginning to see it. If expected future prices drive today’s demand up when we think they will be higher tomorrow, they drive today’s demand down when we think tomorrow’s prices will be lower. Why buy gasoline on the way home from work Tuesday, if you expect that by Wednesday the price will have fallen a few cents per gallon? I reduced my demand on Tuesday, waiting one more day. I’m sure I’m not unique.
Will suppliers try to keep prices from falling to generate profits? Some may be recovering from earlier losses, and will delay decreasing the price. Recovery in the Gulf, will speed downward price adjustments, and there will be ups and downs. But evidence from market behavior suggests that if anything, the tendency among suppliers is to drive price as low as possible, even to the point of gas price wars. There, consumers win every time.