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More on the Pattern of Changes in Prices at the Pump

AEI’s Ben Zycher, in response to my recent post on the pattern of gasoline-price changes, wrote the following to me by e-mail, which I share here with Ben’s kind permission. My e-mailed reply to Ben is reproduced beneath his note to me.

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Hi Don; I hope that all is well.  I don’t quite understand your argument about the unilateral direction of intertemporal supply shifts for such resources as crude oil the consumption of which is substitutable over time.  In a standard Hoteling  model of such intertemporal allocation and price dynamics, an increase in the expected future price (actually, the return to holding stocks, for which price is a good proxy) for any given market rate of interest reduces current output in favor of increased future output, such that the expected price rises at the market rate of interest. So far, so good; output/consumption has been shifted forward, as you  point out.  Suppose now that the expected future price falls in the absence of a change in the market rate of interest.  Production will increase in the current time period, and expected output falls in the future time period, again such that the expected prices rises at the market rate of interest.  Accordingly, I think that your argument that future production cannot be shifted back in time is not correct; the intertemporal substitutability works in both directions.

There is a literature on consumer search dynamics in the gasoline market, and the central empirical finding in this context is that consumers devote more resources (time, etc.) to searching for lower gasoline prices when the latter are rising than when they are falling.  This might explain why such prices fall more slowly than they rise.

Best, BenBenjamin ZycherSenior FellowAmerican Enterprise Institute

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Ben,

Thanks.

You might be correct. You’re more expert in energy economics than I am, so ultimately I’ll defer to you. But the Alchian-Allen argument to me makes sense.

Here’s how I reason through it (implicitly holding the rate of interest constant throughout). When future crude-oil prices rise, it’s easy (as Alchian and Allen note) to store present supplies, of both gasoline and crude oil, for sale in the future. Present prices rise immediately. So far, so good. I think there’s no disagreement here.

When future crude-oil prices fall, refining will indeed, as a result, ramp up in the present period. But turning crude oil into refined gasoline takes time. Specifically, it takes more time (I suppose!) to refine a barrel of crude into gasoline than it does to withdraw already-refined gasoline – as well as barrels of crude – from the present market. At any rate, the foregoing is what I take Alchian and Allen to say.

I confess to giving Alchian and Allen a huge benefit of the doubt. I believe that Alchian is history’s most underrated economist, even more underrated than is the terribly underrated Julian Simon. So every instinct in my body is to trust him – instincts that, judging from what I’ve learned, from those who knew him, of Alchian’s personality, he would hold in contempt.

Obviously, Alchian and Allen wrote what they did decades ago, so petroleum-refining technology differed then from what it is today (again, I suppose). Perhaps today the time required to turn a barrel of crude into gasoline is much less than it was in A-A’s day, thus making (what I take to be) their explanation either weak or simply wrong.

Or perhaps they were simply, if uncharacteristically, mistaken on this matter and that I then – in searching for the key that makes their explanation valid – slipped into error. It wouldn’t be the first time!

Don