OK, I've heard enough.
"Those damn oil companies are gouging us again!"
"Why should they be able to raise the price on gas they already have in their tanks?"
"It's not fair! They're just using the hurricanes to make more money, those greedy bastards!"
"There oughtta be a law!"
We've all heard it or said it ourselves, either after Katrina or before, during, and after Rita. Listening to the radio, I've heard DJs on two separate stations talking about how the "oil companies are gouging the consumers, period, end of discussion, and don't bother to give me any facts because it just might confuse me, and I'm not that big on math anyway."
Well, for those of you who aren't willfully avoiding reality, but still don't understand how a gas company can raise prices on gas they already have in their tanks without gouging, read on and I'll take you through it. And as a bonus, the only math you'll need is basic addition, subtraction, multiplication, and division, and what the heck, for the DJs, I'll even give throw in the answers.
For now, let's take gas out of the equation since it has some unique properties that complicate things. We'll start our tour of pricing with a loaf of bread.
Now, the store owner, we'll call him Bob, decides he wants to sell bread to his customers so he goes to his supplier, Fred, who will sell him 10 loaves of bread a day for $1.00 a loaf on credit.
Now, Bob needs to price the bread so that he makes enough to get his $10 back, plus a small profit, so he prices the bread at $1.10 per loaf. (At this point, we're ignoring other costs, like payroll, maintenance, utilities, etc.) Once Bob sells the 10 loaves he bought, he makes $11.00. Counting the $10.00 he was in the hole for the initial purchase, he is now up $1.00.
Bob is happy, until he goes back to his supplier, who informs him that because of inflation, bread will now cost $1.10 per loaf. In order to restock, Bob will have to give Fred $11.00, leaving Bob once again $10.00 in the hole. He hasn't advanced his condition at all; he's still in debt the same amount as when he started.
This simple example demonstrates why a seller cannot price his goods based on what he paid, but on what he will have to pay to replace them. The former method leads to bankruptcy as you never earn enough to repay your initial debt.
Being a good business man, Bob realizes that he must pass the increased cost on to his customers, otherwise he will lose money and go out of business, so he adds 10 cents to the cost of bread, and sells 10 loaves at $1.20 each for a total of $12.00. Subtract the $10.00 he was in the hole, and Bob now has $2.00. He's made $1.00 each cycle.
When Bob goes back to Fred, he finds that prices are stable and he can still buy bread at $1.10 per loaf. He decides to buy 15 loaves this time to try and expand his business. He gives Fred $16.50 for 15 loaves and heads off to his shop. He keeps his prices the same and sells all 15 loaves for $18.00, yielding a record $3.50 profit on the transaction. Bob is well on his way to paying back the initial $10.00 investment and getting his business into the black. He achieved record profits not by raising his prices but by increasing the number of loaves of bread sold while maintaining the same profit margin. He's still making $1.00 for every 10 loaves of bread he sells.
This time around, Bob expands again and buys 20 loaves of bread at $1.10 each, costing him $22.00 and putting him $18.50 in the hole. Fred tells him that this is the maximum amount of credit he will grant. Bob isn't worried because if he sells it all at $1.20, he will wind up ahead $5.50, meaning the next 20 loaves will leave him down only $16.50, easily within his credit limit and still moving towrds a positive balance.
But as he opens, he hears that a drought in the farm belt has caused wheat prices to soar, meaning that the supplier's cost of a loaf of bread will double in the near term. Now Bob is in a very tough position. He knows that the next time he goes to Fred for bread, it's going to cost him at least $2.20 per loaf, or $44.00 for a full supply. Since he only expects to have $5.50 at current prices, he won't be able to fully restock without going over Fred's credit limit. In order to stay in business and keep serving his customers, he must raise the prices on the current stock of bread, which he paid $1.10 for, in order to be able to buy the next supply.
Bob raises his prices to $2.30 per loaf, sells them all, and makes $46.00 on the sales, netting $29.50 after paying off his credit line with Fred, truly a record profit. But, if he wants to stay in business, he has to buy more bread, and even if prices stay stable, he'll pay $44.00 for the next 20 loaves, putting him $14.50 in the hole yet again.
Now Bob is truly unhappy, because not only is he climbing out of debt very slowly, customers are complaining that he's price gouging, threatening lawsuits and demanding price controls on bread, even though his profit margin has stayed at $1.00 for every 10 loaves of bread sold.
So now, hopefully everyone understands how prices can go up even before the hurricane hits, or even when the gas is already purchased. Remember though, that this has been a very basic discussion and has left out about a zillion factors (If you want loads more detail, ask Uncle, he's the accountant in the family) that affect the actual margins, but it does illustrate the principles involved.
Posted by Rich at September 24, 2005 4:14 PM | TrackBack