Asymmetric price adjustments under ever - increasing costs Evidence from the Retail Gasoline Market in Colombia Marc Hofstetter Jorge Tovar Economics Department Universidad de Los Andes

Motivation There is abundant empirical evidence that prices rise faster than they fall given a change in costs. Peltzman (2000), working with 77 consumer and 165 producer goods, finds evidence of asymmetric price adjustments in most markets. Meyer et al. (2004) surveys the literature noting that, for agricultural products, interest rates and gasoline markets, such findings tend to be robust.

Asymmetry under ever – increasing costs? Asymmetric price adjustments have been empirically tested for a great variety of markets (Survey in Meyer et alter, 2004). Always tested under increasing and decreasing costs. Is there asymmetric price adjustments under ever – increasing costs? The Colombian gasoline market offers a unique scenario to test this issue.

The Colombian Gasoline Market REFINERIES Gas stations are owned by wholesalers or by independent owners using one of the wholesaler’s brands. State Controlled Monopoly (Ecopetrol) IMPORTS STORAGE CENTERS Regulated Prices Reference Prices (Major cities only) WHOLESALERS (Supply Centres) GAS STATIONS CONSUMERS Transport Services

Asymmetry under ever-increasing costs: Definition Under the assumption that consumers do not observe costs: If costs increase above the reference price, the retailer will have the incentive not to increase the price above the reference price, or at least to delay the increase. If a rise in costs is smaller than the increment of the reference price, the retailer can increase prices up to the reference price.

Hypothesis Consumers’ expectations about the retail price of gasoline are anchored to the reference price and determine the adjustment speed of retail prices following a cost change. Asymmetry, therefore, arises.

Data (I) Monthly retail gasoline prices collected during the first week of each month in ten major cities. Provided by UPME (Ministry of Mining & Energy). Monthly wholesale prices based on the monthly price regulation. Data used is on regular gasoline as it represents in 2005 93% of current consumption.

Data (II) Data available from July 2003 – December 2006. Methodology changed in mid 2004. Therefore, econometric estimations used information from July 2004 – December 2006. Unbalanced panel of over 200 gas stations in 10 cities.

Data (III)

Similarly small cost changes would imply a fast price adjustment. Our hypothesis states that large cost changes should be followed by a slow reaction of prices Similarly small cost changes would imply a fast price adjustment. As a consequence, large cost changes imply low margins, while small cost should be related to higher margins. Simple averages of margins P-C Margins (%) ΔSmallC* ΔLargeC* ΔTOTALC mean N 10,90% 10,70% 10,80% 2411 2712 5123 * Mean averages are statistically different (p-value = 0.02). Source: UPME. Own calculations

Estimation strategy How do we econometrically estimate asymmetric price adjustments? Meyer et alter (2004) discuss what they call the pre-cointegration approach and the cointegration approach. The former divides input prices into increasing and decreasing phases by interacting them with the appropriate dummy variables. The cointegration approach, establishes a long-run relationship between prices and costs and estimates an error correction models track adjustments of prices to (negative and positive) cost shocks.

First stage of our empirical model Pools the data by cities and estimates the first step of the error correction model where it is theoretically expected that prices and costs should be related in the long-run

Price-cost long-run relation. First stage results Price-cost long-run relation. Source: UPME. Own calculations

Second stage The change in prices depends on lagged (2) price and cost changes. It includes the error correction term estimated in stage 1. In order to further allow for asymmetric adjustment, is also allowed to affect price changes in a different way depending on whether costs are large or small ( ). This distinction makes explicit the asymmetrical adjustment of prices and allows the speed by which prices reach their long-run relation with costs to be different.

Second stage results

Potential Explanations for Asymmetric Price Adjustments “The results suggest a gap in an essential part of economic theory”. Peltzman (2000) Borenstein et alter (1997): Collusion. It might be that prices exhibit downward stickiness following a drop in costs. Only when demand conditions trigger a price change, output prices start to adjust. This would explain the slow downward reaction to cost reductions.

Potential Explanations for Asymmetric Price Adjustments Inventories. Given a (sudden and potential) excess of demand the effect on prices is transmitted faster due to the existence of inventories and production lags. On the contrary, given a (sudden and potential) excess of supply, prices would not fall as fast due to the existence of inventories. Search. During periods of high volatility, consumers might search less when they observe a price change assuming it reflects a change in costs rather than a change in margins. This might allow retailers to pass quickly any cost increase to prices while delaying the transmission of cost decreases.

Potential Explanations for Asymmetric Price Adjustments The search story extended (Lewis, 2005): If observed Pt <Pt-i,i>0 → consumer will not search due to the small probability of finding an even lower price: Less consumers search, retailers face a (temporary) inelastic demand and margins grow. Implications: When costs rise (well) above expectations, firms will increase prices (though not margins) and consumers will search. when costs fall firms will lower their prices but only enough to prevent consumers from searching. This implies that when costs fall, margins will be higher.

Potential Explanations for Asymmetric Price Adjustments Eckert (2002): Maskin and Tirole’s (1988) alternating-move price setting duopoly model. Price cycle equilibrium, with retail prices determined by two alternating regimes. A price war is set in the undercutting regime up to the point where it is profitable for a firm to raise prices above the monopoly level. Then, another undercutting regime starts.

Potential Explanations for Asymmetric Price Adjustments Rotemberg’s (2005) state dependent model: Firms choose the timing to adjust prices so that it corresponds with times when consumers would find price changes palatable A large increase in reference prices (relative to costs) would be the signal of palatable times and trigger faster price adjustments.

Robustness Tests: Single Error correction term

Robustness Tests: Lag structure (4 lags)

Robustness Tests:

Conclusions The reference price seems to play a key role in determining the existence of asymmetric pricing under ever increasing costs The main conclusion is that, even under ever-increasing costs, asymmetric pricing does exists even in the case of a heavily regulated market. Search seems the most plausible reason that explains asymmetric pricing in Colombia´s retail gasoline market.