BP Fines and Gas Prices

Over on Facebook a friend wondered out loud how the fines levied against British Petroleum (BP) would affect gas prices.  It happens that economics has the answer to this question and it’s quite definitive: the fines will have zero impact on the price of gasoline.  Here’s a quick analysis of the non-relationship between BP fines and gas prices.

First, there is competition in the retail gasoline market.  Any attempt by BP to raise prices very far above prices charged by other retailers will cause a large decrease in quantity of gasoline sold. Competitive pressure will therefore prevent BP from increasing price too much.

Some people point to an interesting fact about the retail gasoline market: prices tend to fall slowly but rise rapidly. They allege that this is evidence of anticompetitive markets. But a recent paper by Lewis[1] demonstrates that gasoline consumers behave differently when prices are falling.  During periods when prices are falling consumers devote less time to searching for the best price.  Therefore, there is less effective competition and prices fall slowly.  But when prices are rising, consumers take more time to look for the lowest price.  This increases effective competition so there is less dispersion in prices.

The second argument is more fundamental.  A fine is a one-time fixed cost.  Pricing decisions are short-run decisions.  Profit-maximizing firms will produce the quantity of output and set their price to make marginal revenue equal to marginal cost.  Marginal cost is the cost of producing one more unit of output.  Therefore, marginal cost is not affected by changes in fixed cost.  Fines and other one-time penalties are fixed (sunk) costs.  Since they have no impact on marginal cost they cannot affect price or output.

Sometimes a little economics can take you a long way.