Professional Documents
Culture Documents
Access to this document was granted through an Emerald subscription provided by emerald-srm:318550 []
For Authors
If you would like to write for this, or any other Emerald publication, then please use our Emerald for Authors service
information about how to choose which publication to write for and submission guidelines are available for all. Please visit
www.emeraldinsight.com/authors for more information.
About Emerald www.emeraldinsight.com
Emerald is a global publisher linking research and practice to the benefit of society. The company manages a portfolio of
more than 290 journals and over 2,350 books and book series volumes, as well as providing an extensive range of online
products and additional customer resources and services.
Emerald is both COUNTER 4 and TRANSFER compliant. The organization is a partner of the Committee on Publication Ethics
(COPE) and also works with Portico and the LOCKSS initiative for digital archive preservation.
Introduction
Although the petrol market exhibits many of the textbook principles of price
competition, it does possess some specific characteristics and mechanisms
which cause it to behave in a distinctive manner. In this article, we expose
some of these major points of difference and consider the consequences that
arise from them.
While petrol has been the subject of a number of articles, these papers have
been preoccupied with non-price initiatives such as Ang and Tan (1990),
Treadgold and Lennox (1994) and Cohen (1998a). Pricing in the petrol
market has received less attention. We could only find Slade (1989, 1992),
who uses gasoline prices in the USA to uncover underlying strategies during
price wars. We differ from Slade (1989, 1992) in that while we look at the
strategies adopted by oil companies our focus is on the underlying
infrastructure and mechanisms of the market. We suggest that it is these
characteristics that are important and that cause interesting deviations from a
classical exposition of the subject.
e set the scene by considering the attitude of motorists to petrol and in
particular to the price of petrol. We then explore the distinctive features of
this market the price adjustment processes (both upward and downward),
the local nature of competition, and finally the presence of a leverage effect.
JOURNAL OF PRODUCT & BRAND MANAGEMENT, VOL. 8 NO. 2 1999, pp. 153-162, # MCB UNIVERSITY PRESS, 1061-0421 153
price is so important to petrol purchasers they have little else on which to
base their purchasing decisions. In keeping with this motivation, the price of
petrol was originally freely (but now subject to regulations) posted outside
petrol stations on pole signs which in itself further sensitises petrol
purchasers to the importance of price.
Seeking cheapest petrol A curious phenomenon about petrol purchasers is that they sometimes go
considerably out of their way to hunt for the cheapest petrol, sometimes
forfeiting much of the benefit that a cheaper price might provide by the
petrol consumption in seeking it. Few industries exhibit so much obsession
among consumers about prices. The dispersion of prices the spread of
prices among alternative brands is not very large with a measure of less
than 1 per cent (Cohen, 1998b), so that even if a motorist persistently bought
the most expensive, the impact on his/her annual petrol bill would be
insignificant when compared to other car-related purchases such as servicing
and repairs. Why then are consumers so intent on finding a petrol price
bargain? We suggest that the very nature of petrol as a necessary purchase,
vital to everyday life, causes a certain degree of resentment and a feeling of
obligation and restriction of freedom among petrol purchasers. Too often in
the past, oil companies have exploited this characteristic, specifically when
Downloaded by HACETTEPE UNIVERSITY At 09:16 22 January 2017 (PT)
there have been petrol shortages, and more generally showing a lack of
appreciation for the motorist's custom. It is this attitude that causes petrol
purchasers to retaliate when the opportunity presents itself by behaving
(almost) irrationally when purchasing petrol. Consumers see ``price hunting''
as an opportunity to hit back at oil companies.
and fleet cards) are sometimes bought by oil companies for the purpose of
estimating fundamental parameters such as elasticity.
Such analyses show that the cross-price elasticity of demand for a typical
major brand is ten implying that a 10 per cent change in volume could
result from a 1 per cent movement in price relative to competitors. This
figure is clearly extremely high when compared to other industries and
reflects the consumer attitudes towards petrol that were described earlier.
This cross-price elasticity varies quite markedly from one brand to another
for example, we estimate the cross-price elasticity for a minor petrol brand
such as Jet is of the order of 30, reflecting their extremely heavy dependence
on price. The cross-elasticity can also vary quite markedly between
individual petrol stations of the same brand. In general, the better quality
(recently developed or prime location) stations show a low cross-elasticity
while poorer quality stations (poor facilities and poor location) show a very
high elasticity, even if they carry the same premium brand. Finally, some
geographical differences are also evident. In some regions of the country,
some northern localities in particular portray higher cross-elasticities than
some southern parts. Indeed, there are even variations between different
trading areas within the same locality.
Price adjustment
Unit gross margins are Oil company profits depend on selling high volumes of petrol at low unit
critical profit margins (see Monopolies and Mergers Commission) rather than high
unit margins on low volumes. Unit gross margins, therefore, are critical to
profitability. They are measured against a cost of product, which is based on
the spot price for petrol on the Rotterdam market. While only a small volume
of petrol is actually bought or sold through Rotterdam, many deals are struck
on the basis of this market price and most integrated UK oil companies use it
as the basis of the transfer price between their refining operation and their
marketing operation. The important feature to note is that the Rotterdam
price is extremely volatile because it is sensitive to world balances in supply
and demand, which themselves are sensitive to political as well as economic
factors. In addition, the cost of product which mirrors it has to be measured
in pounds for UK oil companies and since the Rotterdam market is quoted in
US dollars then a further source of volatility arises from the sterling/dollar
(2) Esso,
(3) BP,
(4) Texaco, and
(5) Mobil (even prior to its merger with BP).
Anyone outside these ``big five'' is unlikely to be followed when it increases
price. Even from among the big five leading a price increase is always a
gamble that may lead to humiliation if others do not follow. This is in fact
what happened to BP in the 1980s when it announced a price increase but
none of the big five followed. It was in effect denied the position of leader
and was forced to humbly cancel its price increase plans. So there is a natural
reluctance about leading prices up and sometimes some delays may occur,
with the consequent sacrifice of profits. Eventually, sheer necessity forces
competitors to overcome any reluctance in increasing prices to the point that
on occasions they have been accused of responding rapidly to cost of product
increases but only slowly to decreases (as described below).
Erosion of prices Because the motorist cross-price sensitivity is high, most oil companies have
an incentive to undercut others, which leads to a gradual erosion of prices.
Rarely, if ever, is a price decrease announced in the way price increases are
announced. The downward adjustment of prices is usually achieved by
gradual price erosion. This price erosion can take some time, and when unit
profit margins have been large, oil companies have been accused of
``dragging their heels'' during the downward adjustment of prices in contrast
to rapid responses during upward adjustment of prices. While this
mechanism, making profits during the transition from one equilibrium state
to the next, is an ingenious one, no evidence was found to support this
accusation as reported by Bacon (1986) and more recently by Manning
(1991).
In contrast to price increases, which can only be led by a few, price erosion
can be instigated by any one of the competitors or even by a single petrol
station. The speed of response in a locality depends on the number and
identity of competitors concerned and the price sensitivity of the local
market. It follows that each local trading area has a characteristic rate of
Customer Response
Low High
Leverage
Price undercutting In the early 1980s, oil companies were on a course of head-on collision
because each competitor was trying to undercut the price of others. To be the
cheapest became almost an obsession as if it were a sign of ``virility'' rather
than an admission of marketing failure. As reported in the national press of
the day, the climax of this activity was the well publicised event when a Jet
petrol station and a nearby Shell petrol station vowed to undercut each other,
which resulted in petrol being sold well below cost. The (one mile) queue of
consumers wishing to take advantage of the prices on offer caused traffic
congestion, which had to be controlled by the police. While this example is
Downloaded by HACETTEPE UNIVERSITY At 09:16 22 January 2017 (PT)
extreme, it does show the thrust of the oil company strategies of the time and
allows us to speculate that retailing divisions of oil companies managed to
accumulate sizeable losses. Clearly an alternative pricing strategy had to be
developed.
Trade-off between volume In early 1983, the majors of the market, led by Shell, appeared to ignore the
and margin taunts of the ``price-cutters'' of the time and maintained their price levels at
the expense of reduced market shares. This approach is in fact no more than
the classical trade-off between volume and margin. What the majors were
effectively doing was to trade-off some of their market share (i.e. volume) in
return for higher margins on the market share that they did manage to retain.
Since the majors tended to have a much larger number of petrol stations than
the minors, purely geographical strength ensured that they did manage to
retain some significant market share. An important determinant of their
success was the fact that they have a very low profit volume (PV) ratio. Put
another way, their unit gross profit margins are a tiny proportion of their
selling price mainly because of the large duty component in petrol prices.
This meant that a ``leverage effect'' came into play as discussed by Monroe
(1990) whereby any increase in relative price causes a disproportionate
increase to their unit gross profit margins. For example, assuming that the
unit gross margin is of the order of 5 per cent of the selling price, then an
increase in relative price of 1 per cent causes an increase in unit gross profit
margin of 20 per cent. So the classical volume-margin trade-off is not evenly
weighted the volume loss is governed by the 1 per cent price increase but
the margin gain is governed by the 20 per cent unit gross profit margin
increase. Put another way, a 1 per cent increase in price enhances
profitability for volume losses of up to 16.7 per cent, at which point
profitability returns to levels prior to the contemplated increase in price. In
contrast, a 1 per cent decrease in price requires at least a 25 per cent increase
in volume to offset the lower profit margin. These break-even volume
changes to maintain profitability in fact imply price elasticities of 16.7 and
25 and it is interesting to compare these values with the price elasticities
stated earlier of 10 for the major oil companies such as Shell and Esso
and around 30 for the ``price-cutters'' such as Jet and Elf. Indeed, this
comparison explains why the ``price-cutters'' live up to their name.
option to choose depended on which option would lead to the least damage
to Esso's profits. Ignoring second order effects, this decision simply boils
down to whether margin changes are more important to profits in this market
than volume changes. In most markets volume is extremely important to
profitability, which is why it is common for incumbent firms to cut prices
when faced with the prospect of new entrants into their market. For the
hypermarket entry into the petrol market there were two important
differences. First, because petrol has a small PV ratio, the leverage effect
discussed earlier favours the protection of profit margins at the expense of
losses in volume. Second, the volumes lost by oil companies due to the
hypermarket entry initially were relatively small. It was only in the mid-
1990s that the volumes at stake became significant. We therefore claim that
the natural response of an incumbent firm to the threat of new entrants might
be to cut prices. In the case of petrol, because of specific peculiarities, the
leverage effect and the slow entry of hypermarkets, a period of restraint was
in fact in the interest of major oil companies such as Esso. However, while
this period of restraint was rational in the short term in the quest for profits, it
did give the hypermarkets an opportunity to gain a foothold in the market,
with disastrous long-term consequences.
Counter-intuitive behaviour We claim that the leverage effect helps to explain some of the counter-
intuitive behaviour in the petrol market such as why petrol companies find
it beneficial to increase prices despite customers being highly sensitive to
price and also why Esso's price cutting response to the entry of hypermarkets
was delayed by some ten years. While the leverage effect is important in
many markets, its effects are most felt when price movements that are
contemplated are significant when compared to the PV ratio and hence it is
particularly important to the petrol market, which is characterised by a PV
ratio which is extremely low. The characteristic of a low PV ratio itself stems
from the heavy burden of duty that each litre of petrol has to carry. It is
interesting to consider what would happen if the level of duty was lower, as
it is the USA, or if duty was not collected through the price of petrol but
instead through other means such as road tax or a tax on tyres but this is
left as a matter for further research.
local trading level has led us to define some generic pricing policies margin
maximisation, volume maximisation, competitor matching and price wars.
The chosen policy for a trading area will depend on its specific
characteristics and the overall success or failure of an oil company is simply
the cumulative effect of its success or failure over all the local trading areas
in which it competes.
The fact that profit margins account for only a tiny proportion of the price of
petrol makes the leverage effect extremely important in the petrol market and
sometimes leads to action which appears counter-intuitive. In particular, we
suggest that the leverage effect permits oil companies to increase prices,
despite motorists being very price sensitive, and also we attribute the (ten-
year) delay in Esso's price cutting response to the entry of hypermarkets to
be partly due to the leverage effect.
Impact on profitability The petrol retailing market then broadly adheres to classical theory of price
competition but it does have some special characteristics which cause
interesting deviations. In addition, real-world issues such as the price
adjustment process and the local nature of competition present practical
difficulties which can have a material impact on profitability.
The peculiarities of the petrol market may well be present, although in a
lesser form, in other markets. It would be interesting to find out and to
consider the implications. This, however, must be the subject of further
research.
References
Ang, B. and Tan, K.C. (1990), ``Forecasting of diesel and petrol sales: an evaluation of various
marketing strategies'', Energy Policy, Vol. 18 No. 3, pp. 246-54.
Anon (1996), ``Petrol selling: pump action'', The Economist, Vol. 338, 27 January,
p. 58.
Bacon, R. (1986), ``UK gasoline prices: how fast are changes in crude prices transmitted to the
pump?'', Working Paper EE2, Oxford Institute of Energy Studies, Oxford.
Cohen, M. (1998a), ``The problem of competition in the UK petrol market'', Strategic Change,
Vol. 7 No. 4.
Cohen, M. (1998b), ``Price dispersion when products are differentiated: incorporating customer
involvement'', Applied Economics, Vol. 30 No. 6, pp. 829-35.
Dwek, R. (1992) ``Can Shell strike oil as a retailer?'', Marketing, 6 February, pp. 22-3.
Appendix
Consider a competitor whose volume V varies linearly with its price P according to the
following equation
PP
V Vo L Vo where
P
Downloaded by HACETTEPE UNIVERSITY At 09:16 22 January 2017 (PT)
The total profit p is simply unit margin m 6 volume V. Differentiating p with respect to P,
we get
d dV dm mLVo PP
m V Vo L Vo
dP dP dP P P
&
1. Johan Hagberg, Hans Kjellberg. 2015. How much is it? Price representation practices in retail markets. Marketing Theory 15:2,
179-199. [CrossRef]
2. David McCaffrey, Tom Liptrot, Barbara Jenkins. 2011. Retail gasoline pricing: A Bayesian hierarchical approach to modeling the
effect of brand on elasticity. Journal of Revenue and Pricing Management 10:6, 514-527. [CrossRef]
Downloaded by HACETTEPE UNIVERSITY At 09:16 22 January 2017 (PT)