Gas Prices

I asked my friend David (who worked at the Federal Reserve and is studying economics, so he must know these things), "David, why do gas company profits go up when gas prices go up?"

David had a ready answer: profits are made against average prices (the average cost to produce), but what you pay at the pump is determined by marginal prices (the price of the last barrel). Usually we're used to prices going down in quantity due to economies of scale. With markets like oil, this is only the case until you run out of oil. Then, oil gets more expensive, fast.

David made a somewhat thorough explanation on a blog here (the anonymous ones in the middle), which explains this idea, and which links to an explanation of marginal cost and some neato charts and graphs.

My lay-person's summary:

Imagine you (an oil maker) could fulfill 90% of the world's demand for gas at $2.00 a gallon. But what if the remaining 10% cost you $3.50 a gallon to produce? You had to use some extra-expensive technology to get it out.

If people needed that 10% (i.e. the demand was inelastic), they would end up paying $3.50 for all gas, not just the last 10%. This is because gas isn't sold in bulk, on average costs - it's sold as a commodity, which means every barrel has to be profitable to produce. And once people are paying $3.50, nobody's going to want to sell for $2.00/gallon.

So now you're paying the oil company $3.50 for $2.00 gas 90% of the time, and $3.50 for $3.50 gas 10% of the time.

So, they make huge profits on 90% of the gas, and then people get upset about the record profits.

The right thing is for the market to correct this in another way: either for someone to invest the profits in a way that makes the marginal price lower again, or for consumers to reduce demand thorugh the use of alternate fuels, which takes some time to happen.

Anyway, I knew what inelastic demand meant in terms of pricing from high school econ, but I don't think I had thought through why that would make profits higher right now.

(David's obviously a good tutor.)