CSEM WP 120 Asymmetric Price Adjustment and Consumer Search: An Examination of the Retail Gasoline Market

It has been documented that retail gasoline prices respond more quickly to increases in wholesale price than to decreases. However, there is very little theoretical or empirical evidence identifying the market characteristics responsible for this behavior. This paper presents a new theoretical model of asymmetric adjustment that empirically matches observed retail gasoline price behavior better than previously suggested explanations. I develop a “reference price” consumer search model that assumes consumers’ expectations of prices are based on prices observed during previous purchases. The model predicts that consumers search less when prices are falling. This reduced search results in higher proÞt margins and therefore causes a slower price response to cost decreases than to cost increases. I then develop testable implications that distinguish my model from two alternative explanations of asymmetric adjustment. The Þrst is a model in which Þrms temporarily collude using past prices as a focal price. The second theory suggests that increases in wholesale cost volatility reduce consumer search behavior. Using a panel of gas station prices, I estimate the response pattern of prices to a change in costs. Estimates are consistent with the predictions of the reference price search model and contradict the previously suggested explanations of asymmetric price adjustment. ∗E-mail: [email protected]. I would like to thank my advisor Severin Borenstein, as well as Richard Gilbert, Stephen Holland, Aviv Nevo, Carl Shapiro, Celeste Saravia, Catherine Wolfram and everyone at the University of California Energy Institute for advice and Þnancial support. I would also like to thank Charles Langley (UCAN) for collecting and providing the data used in this paper.