Discuss possible reasons for ‘sticky’ petrol prices despite a decrease in crude oil prices.

Petrol prices are often found to be relatively rigid even when crude oil prices plunge, leading consumers to refer to petrol prices as “sticky”. 

Discuss possible reasons for ‘sticky’ petrol prices despite a decrease in crude oil prices.                                                   [25]

Introduction

We would expect movements in petrol prices to closely mirror movements in crude oil prices considering that crude oil is used as an input in the production of petrol. However, there are other factors which can also affect prices petrol, and we will have to take these other factors into consideration when looking at price movements for petrol.

Crude oil affecting petrol prices

Crude oil is a factor input used in the process of refining petrol

1.      Lower Prices of crude oil èLower Cost of Production for petrol

2.      Firms should in theory pass lower costs to consumers èIncrease in supply èLower Prices for petrol.

Crude oil not affecting petrol prices           

Petrol Industry – Oligopolistic Market Structure

Figure 4a: Market for Petrol, Kinked Demand Curve Model

When price of crude oil falls àMC of petrol fall. Assuming producers pass on cost savings to consumers, the price of oil would decrease.

However, if we assume that oil producers follow the kinked demand curve model of oligopoly, prices are likely to be rigid. 

If a firm increases prices, other firms would not change their prices and there would be a more than proportionate fall in quantity demanded, resulting in the price elastic demand above the kink.

If a firm decreases price, other firms would follow suit and there would be a less than proportionate increase in quantity demanded, resulting in the price inelastic demand below the kink.

With reference to Figure 4a which shows the market for petrol,

Prices are likely to remain rigid at P, where the kink in the demand curve is. Even though marginal cost (MC) may fall from MC0 to MC1, petrol producers are unlikely to decrease price as this can be misconstrued by competitors as under-pricing and set off a price war. This is assuming the change in MC is not large enough that MC still cuts the vertical portion of marginal revenue.

Other factors affecting cost of production for petrol

(RWA) Crude oil is not the sole factor input; there are other costs such as wage and rental costs. Lower prices of crude oil but higher rental costs (e.g. as in the case of frequent increases in property price) àdecrease in total cost of production is moderated àsmaller increase on Supply

Rising affluence levels causing significant increase in demand for petrol

Rise in incomes globally àincrease in demand for vehicles àderived demand for petrol àRelatively increase in demand due to huge large scale economic growth in the world, especially in China and India.

Combined effects of a moderated increase in supply and increase in demand 

Figure 4b: Market for Petrol       

With reference to figure 4b, which shows the market for petrol,

·      As mentioned, increase in demand is likely to be greater than the increase in supply

·      Supply curve shifts from SS0 to SS1

·      Demand shifts from DD0 to DD1

·      Price of petrol is likely to rise from P0 to P1

·      Quantity of petrol will increase from Q0 to Q1

Conclusion

A wide variety of factors would have caused the change in crude oil prices to not significantly change the prices of petrol. It could also be the case that petrol prices do mirror crude oil prices, but there is a lag time for petrol prices to catch up with changes in crude oil prices.