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Gasoline Price Gauging

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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.

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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
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Operations Management: Purchase vs Make Case Study

Hurst Corporation CASE STUDY

Mike Mathers was purchasing manager for the mid-west division of the Hurst Corporation. Shortly before his company was to install an exhaust system in a new construction project, Mike was asked to compare fabricating the pipe with purchasing the pipe from an outside source.

Hurst Corporation, a mechanical and sheet metal contract, was founded over 50 years ago. Although it had a number of branches in North America, the majority of its metal fabrication work was performed in its Midwest facility. The company mission stressed quality workmanship, competitive pricing, and timely performance.

A LABORATORY EXHAUST SYSTEM

Hurst recently was awarded the bid to provide the HVAC system in a corporate headquarters building that housed a research laboratory. This was a complex project with many nonstandard features due to the specialized use of the building.

The system included a need for over 6500 feet of 10-inch diameter, 16-gauge stainless steel pipe. This piping would be used for venting the laboratory exhaust. When the cost estimation department at Hurst prepared the original bid, they had planned to fabricate this pipe at their Midwest facility.

A REQUEST FOR COST REDUCTION

As the project got underway, the VP of Operations asked Mike Mathers "if it would be possible to provide the stainless steel pipe at a lower cost than the original estimate." Mike knew, of course, that any reduction in cost must not come at a sacrifice of quality. Because of toxins that would be present in the laboratory exhaust, it was critical that his system be absolutely leak proof. Every pipe run would be individually tested to insure integrity. If leaks were uncovered in the welds, it would require a time-consuming effort to reweld the joints on-site.

Mike realized that there were two approaches to providing the pipe. Hurst could proceed as planned and fabricate the pipe in-house, using the lowest-cost, acceptable quality steel available on the market. The second possibility would be to find a supplier who could provide the pipe already formed at a better cost.

THE PURCHASE OPTION

Mike first explored the purchase option. He did a thorough search of the market, and found that most suppliers were asking from 23 to 28 dollars per linear foot (delivered) for 10-inch-diameter, 16-gauge stainless steel pipe. He was pleasantly surprised, however, to find a supplier who would provide the pipe for $18.10 per linear foot. These suppliers provided the pipe in 20-foot sections and guaranteed the pipe to be sound (no leaks). In addition, their pipe was "perfectly" true (round), a trait that Hurst's current equipment could not always provide. This feature would reduce the time needed to make connections between sections of pipe and reduce the likelihood of bad weld joints.

Although this option sounded very attractive, Mike, a veteran in the purchasing area with 14 years of experience, knew he would have to subject his options to a thorough analysis to ensure a wise decision.

THE MAKE OPTION

Mike had access to the data necessary for manufacturing cost estimating. He knew that the process of making pipe required two steps. First, a flat sheet of steel is formed into a cylinder through the process of "rolling." Then the seam is joined in a welding process. For a 10-inch-diameter pipe of 16-gauge steel, it takes about six minutes per piece to roll, including loading and unloading the part. The equipment Hurst had available for this process could roll lengths up to eight feet. The welding process was estimated to take ten minutes for an eight-foot section. The figure the company used for cost estimating purposes for hourly labor rate was $32.60 per hour. An overhead charge of 40 percent was added to the variable costs.

Stainless steel sheets were available in 36-inch, 48-inch, and 60-inch widths at any length up to 10 feet, with the best price being $1.80 per pound. A square foot of 16-gauge steel weighs two and one-half pounds. The welding process required welding wire and welding gas. Welding wire cost around $5.20 per pound and .03 pounds were needed per foot of weld. Welding gas cost around 25 cents per eight-foot seam.

Many of the lengths of pipe needed in the project were longer than eight feet. Thus, Mike thought it necessary to include the cost of an extra joint (which, for example, would make two eight-foot lengths into one sixteen-foot length) in the "make in-house" alternative. Such a joint required welding around the diameter of the pipe, a process that, with setup, would take around 18 minutes per joint.

THE DECISION? Mike wondered which option would be best. Should Mike recommend purchasing the pipe or making it?

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