California Gasoline Market

California is somewhat unique amongst other states in the United Sates of America. Aided by the car California developed horizontally rather than vertically, unlike the older East coast cities. As Tom Wolfe notes, the devotion to the car eventually birthed the California Custom, a hot rod culture that in love with power, speed, and style. California’s car culture gave a tremendous amount of power to the oil refiners but by 1943 California experienced its first incidence of Smog, a putrid combination of smoke and fog facilitated by the Los Angeles basin where a large population resides.

The smog incident in the summer of 1943 lead to a flurry of inquiries into the health and safety of the people living in a state obsessed with the car and by 1945 Los Angeles establishes a Bureau of Smoke Control. By 1947, California signs into law the Air Pollution Control Act that establishes Air Pollution Control Districts in an effort to cut down on ambient air pollution. This marks the beginning of California’s intense environmental regulation on factory emissions, a dozen years later California begins to regulate car emissions in an effort to reduce the incidence of photochemical smog. After 1959, California aggressively imposed emissions regulations on both car makers and oil refiners, car manufactures had to implement new anti-pollution measures and oil refiners were forced to create special gasoline blends that reduced pollutants.

As a result of this aggressive environmental posturing by the California state government, California has the most strict pollution controls on both car manufactures and oil refiners in the United States of America. This helps explain some of the premium on gasoline in California, as well as some of the extreme seasonal variation in gasoline prices. Oil refiners that sell in California are forced to sell one of two gasoline blends, a winter blend and a summer blend. The winter blend less expensive to refine but is less pure than the summer blend. The California Smog Board determines when this less expensive fuel can be sold. Refiners have an incentive to run lean on the summer blend and sell as much as possible before switching to the cheaper winter blend. This means that California gas prices experience volatility from both oil supply shocks and the switch from summer to winter blend and vice versa.

Literature Review

Literature pertaining to collusion in the gasoline industry is difficult to find. This is because, except for one clear instance of collusive behavior in 1965 when Texaco ran a gasoline cartel, there has never been a proven case of collusion in the United States’ gasoline market. It is difficult to discern collusive at-the-pump prices and competitive at-the-pump prices. However, the extreme seasonal and regional variation in gas prices have lead some to conclude that there may be overt price setting.

The article by Borenstein and Shepard suggests that this story of overt price setting may be true, but acknowledge that a number of factors make proving collusion difficult. Even when using an empirical model to discern collusive pricing behavior, gas is a highly differentiated product. Stations differentiate product by wholesale or branded gasoline, branded gasoline is differentiated by brand and stations are further differentiated by location and services offered. The number of differentiating factors makes collusive pricing unlikely, but the authors found evidence for collusive pricing in low levels. However, it must be stressed that even a low level of collusive pricing per gallon equates to a tremendous amount of money in the volumes of gasoline consumed within California within a year.

Miller’s article supports this further by acknowledging that even patient collusive firms may engage in the price wars that can be observed in the gasoline market. Indeed, a price war can emerge with a cartel for a variety of strategic reasons that are not consistent with a faltering of the cartel. This means that in the case of gasoline market collusion, the cartel may engage in price wars when the benefits of the price war outweigh the cost of engaging in the price war. For example, the cartel may decide to cull its weaker members in the hopes that the additional premium in gasoline prices after the price war is over outweighs the losses incurred by waging said war. In doing so, remaining members of the cartel can obtain closer to monopoly level pricing as well as other strategic advantages that come from reduced competition.

The Hastings and Gilbert article provides an alternate explanation for the California premium on gasoline. According to their article, as the number of refiner operated gasoline stations increase, so too does the price of gas. Independent gasoline stations seek to purchase gasoline at the lowest price and compete with other stations on price. This is because independent gasoline stations cannot advertise the brand of gasoline sold; whereas company operated gasoline stations can advertise both brand characteristics and price point. This also provides an incentive to increase wholesale price to independent gasoline stations as the number of company owned gasoline stations increases. The reduced price competition from independent sellers may explain the premium in California gas prices to some extent, but it is only in the last fifteen year that there has been an aggressive push to eliminate the independent sellers, which does not explain the longtime price premium for California gas.