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Gasoline Price Gauging

Gasoline Price Gauging
In 1981, a Boston-based gas station owner set the highest gasoline prices in the nation.8 During that summer, he charged $1.69 per gallon for unleaded gas during the daytime and $2.59 per gallon at night, when other downtown gas stations were closed. (His all-time high price was $3.99.) Even at these extreme prices, however, the station owner sold an average of 3,000 gallons per week, half of this at night. Despite catcalls, pickets, and even vandalism from angry motorists during the gasoline crisis, the owner "stuck by his pumps"; he even charged $1 for air. As he put it, "People think of gas stations as public mammary glands, but they're wrong. This is a business and it's important to generate profits from every part of it. If I can use a resource, like air, to pay for the electric bill, so much the better. If you allow capitalism in its true form, it works beautifully."

The station owner was an avowed profit maximizer, albeit not a very attractive one. How did he profit by his dual-price policy? The answer is price discrimination. Although his costs varied little day and night, the elasticity of demand varied greatly. He maximized his profit by charging a higher price at night, when demand is much more inelastic than during the day. In fact, we could go so far as to say that he operated under different market structures, day and night. At night, he appeared to have a pure local monopoly. Motorists desperate for gas had to drive miles to find another station open during those hours. Thus, the owner sold gas even at gouging prices. (Of course, at those prices the motorist may have preferred to buy five gallons rather than a full tank.) During the day, he faced a number of competitors within blocks and numerous stations in neighboring Cambridge. That is, the market resembled monopolistic competition. There was some product differentiation due to locational convenience and brand allegiance. Nonetheless, in normal times excess profits are limited by relatively free entry of new firms. (The gasoline crisis and accompanying supply shortage afforded sellers short-run, excess profits.)

Question
a. Suppose that, during the day, the station owner's demand is given by PD = 2.06 - .00025QD. The marginal cost of selling gasoline is $1.31 per gallon. At his current $1.69 price, he sells 1,500 gallons per week. Is this price-output combination optimal? Explain.
b. The station owner sells an equal number of gallons at night, setting PN = $2.59. Suppose elasticity of demand is EP = -3. According to the optimal markup rule (in Chapter 3), is this price profit maximizing?
c. The station owner is able to sell gasoline day and night at high prices. Why aren't there more gas stations in downtown locations in major cities? Explain.

Solution Preview

a) The price is maximized when MC=MR
TR = P*Q = (2.06-0.00025Q)*Q
MR=dTR/dQ = 2.06 - 0.0005Q
MC=1.31
Equating the two we get 2.06 - 0.0005Q = 1.31
Q = 1500 gallons
P = 2.06-0.00025*1500=$1.685
Thus, the price output combination is optimal.

b) Optimal mark up = M=Ep/(1+Ep)-1 = (-3/(1-3)-1=50%
Optimal mark up price = 1.31*(1+50%)=1.965
The price is not profit maximizing. The price should ...

Solution Summary

Gasoline Price Gauging is emphasized.

$2.19