Why petrol prices move in cycles and why you should care

Anyone who owns a car will know the feeling. You pull into a petrol station to fill up, only to find that prices have jumped by 30 cents overnight. Worse still, the station across the road has raised their prices at the same time. Over the following weeks, prices drift down until the cycle repeats itself. 

Why do petrol prices cycle in this way?  

One explanation we can rule out is changes in underlying costs. While movements in wholesale costs drive long-term trends in prices, these costs don’t cycle. Price cycles also differ across cities, suggesting they are largely driven by local market dynamics. 

If costs aren’t cycling, but prices are, the cycle must reflect a deliberate pricing strategy by petrol stations. There are a couple of explanations for why stations might want to use this strategy: 

1. Price discrimination. Cycles may allow firms to target price sensitive consumers when prices are low and sell at higher prices to less sensitive consumers at other times. 

2. ‘Muddying the waters’. When prices are constantly changing, consumers may find it harder to identify cheaper stations, reducing how much they search for better deals and allowing stations to charge higher prices. 

However, these explanations have a missing piece: prices are an equilibrium outcome, they depend on both supply and demand. Firms may want to use price cycles to soften competition and raise margins, but how do they get away with it with consumers? 

The first thing to note is that it’s not because consumers lack options. 

While empirical evidence from Perth, Melbourne and Sydney suggests that the ability of stations to coordinate (tacitly collude) plays an important role in driving price cycles, a sizable minority of petrol stations keep their prices consistently low. And prices at individual stations vary substantially over time. 

This means that consumers could save large sums of money by shopping around. We estimate that in Sydney, the average driver could save around $16 when filling up their tank by purchasing at the low point of the cycle rather than the peak, and roughly $12 by purchasing at the cheapest station in a 3km radius rather than the most expensive.  

Over a year, these savings add up. The ACCC estimates that motorists could save over $400 a year in Sydney and over $740 in Perth by shopping around in this way. 

In an idealised world, where consumers always purchased from the cheapest station, and always timed their purchase right at the bottom of the cycle, price cycles would not exist. Stations would have no incentive to cycle their prices if no one purchased when prices were high, and no station would charge a higher price than their competitor if it meant no one would purchase from them. 

So why don’t consumers shop around more? 

There are a few sensible reasons why in the real world many motorists don’t seek out the best deal. Economists refer to these reasons – why all demand does not flow to the cheapest price – as ‘demand frictions’. Broadly speaking, they come in two forms:  

1. Non-price factors. Some motorists might prefer the more conveniently located station, or to fill up on a Friday night. 

2. Information frictions. It is costly to track frequently changing prices, and so some motorists might not know that they could get a better deal at another station, or that prices are about to jump. 

These demand frictions give firms ‘market power’. In petrol markets, they allow firms to use price cycles to soften competition and increase their margins. 

What role can policy play?  

Australian jurisdictions have experimented with two forms of intervention to help reduce demand frictions. 

The first intervention is to provide consumers with more information. Prominent examples include FuelWatch and FuelCheck in WA and NSW respectively. These ‘information platforms’ allow consumers to see real-time prices for every petrol station in the state. 

In theory, these information platforms aim to reduce information frictions by making it easier for consumers to find cheap petrol and plan their purchases. In practice, take up can be limited and slow. 

More information also goes both ways. Evidence suggests that greater price transparency can allow petrol stations to better monitor their competitors, leading to higher prices. Whether these platforms improve outcomes for consumers is thus dependent on whether the effect of reducing information frictions outweighs the effect of allowing firms to monitor their competitors. 

The second intervention is to restrict the frequency with which firms can change their prices. In WA, stations can only change their prices once a day, and similar rules have been proposed in Victoria. Such restrictions may help ‘unmuddy’ the water, making it easier for consumers to identify cheaper stations, and incentivising firms to set lower prices to attract customers.  

But once again there is a trade-off as forcing firms to lock in their prices for longer periods of time may mean they are unable to respond to large shocks to supply or demand. 

The trade-offs involved with both these interventions highlights an important point: it is very difficult to design policy to address demand frictions without first having a strong understanding of what consumer demand looks like. 

In ongoing joint e61 and University of Melbourne research we’re aiming to advance our understanding of exactly this. Using de-identified, consented and aggregated bank transaction data, we’re exploring how, when and where Australians buy petrol. This research will help us understand whether and how policy makers can intervene to improve outcomes in these markets. 

Why should we care? 

If you’ve read this far, you may be tempted to ask, why do we care so much about petrol markets? Won’t they become a problem of the past as electric vehicles take hold? 

The issue is that as the economy evolves, we’re getting more and more markets with the same fundamental features as petrol markets. Technological advancements mean that eCommerce, consumer finance and energy markets are now all settings where consumers face prices that change frequently, there are significant information frictions, and where there are choices over subtly different products. 

As digital markets continue to spread, understanding how consumers behave in these environments will only become more important. In this way understanding petrol markets isn’t just about fuel – it is also a way to carefully think through these issues of the future.