Gasoline Price Gouging Is Good

Published July 20, 2007

Gasoline prices have risen sharply in recent weeks. The price increases have come with the predictable complaints of “price gouging” from the politicians, especially Democrats.

The reality is that energy prices generally and gasoline prices in particular are very volatile. From the trading of energy puts and calls, we can calculate the expected volatility in the future. Currently, the one standard deviation of the expected annual price fluctuation for the nearest contract is on the order of +/- 40 percent. Later contracts have lower expected volatility. The economic explanation is that in the wake of a reduction in supply, or a surge in demand, suppliers cannot immediately increase output, nor can motorists easily reduce their consumption. Over time, production and consumption decisions can change. Thus, prices rise almost instantly in the wake of an energy shock and then tend to decline as supply and demand adjustments take place.

In the crucial initial period of an energy shock, some consumers rush out to fill their tanks in an attempt to beat further price increases. If every one of the 243 million passenger vehicles had their tanks topped off with 10 gallons of gasoline, then the demand surge would equal nearly a full week of normal supply. That would cause widespread shortages like those that exist currently in Zimbabwe. One important effect of quickly increasing prices is to discourage such speculative hoarding. Thus, “price gouging” serves a useful function.

Having said this, it should be noted that energy price insurance exists. One can buy futures contracts and call options for gasoline, heating oil (distillate), natural gas and crude oil. These contracts are generally too large to be useful to individual motorists. However, the Nymex MiNY contracts and a new over-the-counter contract may be of use for medium-sized energy consumers or groups of consumers. While hedging is prudent, I would not advise motorists to speculate in the futures and options markets during an energy crisis. Traders act even more quickly than gasoline dealers.

Jim Johnston ([email protected]) is an economist retired from Amoco and a policy advisor to the Heartland Institute.