Retail gas prices in the Midwest have been very high in the summer of 2000. In Chicago and Milwaukee, for example, the price of gasoline rose to $2.50 a gallon in June. This prompted Congress and the Clinton Administration to pressure the Federal Trade Commission (FTC) to conduct an investigation. The FTC subpoenaed at least seven oil companies, and owners and operators of pipelines, terminals, and blend plants, asking for details about the supply, refining, marketing, transportation and pricing of gasoline. It is now reviewing boxes of documents.

The issue at stake, according to the FTC, is "whether there was any illegal contact, communication, or signaling among competitors". The FTC told Congress that it realizes that the Organization of Petroleum Exporting Countries reduced production, causing the price of crude oil to rise to $33 a barrel, and that reformulated gas (which is harder to produce) was required in Chicago and Milwaukee after May 30, but that these factors were insufficient to account for the extent to which gasoline prices rose. However, an industry spokesperson stated that the idea of price-fixing was ludicrous.

Prices in the Midwest have fallen since the investigation began. At $1.45 a gallon, they are the cheapest in the nation.

(Updated October 1, 2000)

1. Suppose that the market for gasoline is in fact competitive.
a) Draw diagrams of the equilibrium of the industry and a representative firm, showing the firm making a profit.
b) Now show the effect on both diagrams of the higher cost of crude oil and the greater cost of producing reformulated gas. What happens to the equilibrium price in the industry and the firm? Can these factors account for the higher price of gasoline?

2. Suppose that, in addition, the firms in the industry colluded in some manner and fixed prices.
a) Draw another set of diagrams showing the industry in competitive equilibrium and making profits.
b) This time add a marginal revenue curve to the industry diagram. Mark the joint-profit-maximizing output and price levels in the industry and the implications for price, output and profit in the representative firm. Can price-fixing account for the higher price of gasoline?

3. Why is price-fixing problematic? Refer to your diagram.

4. Why might the temptation to fix prices through collusion be relatively great in the gasoline industry? (Think about the elasticity of demand for gasoline.)