The Economics of Gasoline RetailingPetroleum Distribution and Retailing Issues in the U.S.

Andrew N. Kleit, P.h.D.Professor of Energy and

Environmental EconomicsThe Pennsylvania State University

December 2003

Cover Photo Credits

Background photo courtesy of BP p.l.c.

Photo 2: Photo courtesy of

ConocoPhillips.

Photo 4: Photo courtesy ofExxon Mobil Corporation.

Photo 3: Photo by Corbis

Photo 1: Photo courtesy ofConocoPhillips.

The Economics of Gasoline Retailing:Petroleum Distribution and Retailing Issues in the U.S.

Andrew N. Kleit, P.h.D.Professor of Energy and

Environmental EconomicsThe Pennsylvania State UniversityANK1@psu.edu814-865-0711

December 2003

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Abstract

The U.S. gasoline marketing sector is marked by ahigh degree of competition. Refiners use a varietyof distribution methods and channels to bringgasoline to consumers in order to compete in thismarketplace. They can, for example, own andoperate the retail outlets themselves (company-operated outlets), or they can franchise the outletto an independent dealer and directly supply itwith gasoline, or they can use a “jobber,” a personor firm who gains the right to franchise the brandin a particular area.

These marketing strategies, with their differentlevels of control and investment by refiners andassociated pricing practices, can come into conflictwith each other when they coexist in the samemarketplace. As a consequence, critics periodical-ly call for the elimination of some of these market-ing strategies and practices. Among them, criticsclaim refiner restrictions on where jobbers can sellbranded gasoline (referred to as “non-price verticalrestraints”) reduces competition. Refiners havealso been criticized for zone pricing. This is thepractice whereby refiners set uniform wholesaleprices and supply branded gasoline directly totheir company-operated and franchised dealer sta-tions within a small but distinct geographic areacalled a “price zone.”

The analysis done in this paper by Professor Kleit,however, shows that these criticisms are not valid.His review of the available theoretical and appliedresearch shows that the elimination of zone pric-ing would result in higher average prices for con-sumers. Similarly, Kleit finds that eliminating theability of refiners to restrict where their brand canbe distributed would likely reduce their invest-ments in distribution outlets and harm consumers.

Thus, from a competitive viewpoint and a con-sumer perspective, Kleit finds that calls for theelimination of non-price vertical restraints andzone pricing in the gasoline marketing sector aremisplaced. These strategies are the result of com-petition between various forms of distribution ingasoline marketing. This competition promotesefficiency, which benefits consumers by bringingproduct to market for less.

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About the Author

Andrew N. Kleit is Professor of Energy andEnvironmental Economics and MICASU FacultyFellow at the Pennsylvania State University. Hehas published over 40 articles on antitrust and reg-ulatory issues in a wide variety of academic andpopular outlets. Previously he had been SeniorEconomic Adviser to the Director for Investigationand Research, (The chief antitrust official inCanada); Economic Advisor to the Director,Bureau of Competition, Federal TradeCommission; and Associate Professor ofEconomics at Louisiana State University. ProfessorKleit has been named as one of the top competi-tion economists in the world three times by GlobalCompetition Review magazine of London. He hasa PH.D. in Economics from Yale University. Thisresearch was supported by a grant from theAmerican Petroleum Institute. The viewsexpressed herein are solely those of the author, andnot necessarily those of API, its member firms, orthe Pennsylvania State University.

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Table of Contents

Executive Summary 7

I. Introduction 10

II. The Integrated Refiner’s Problem 1 1The Refiner’s Point of View 11

Managing the Brand 13

III. Types of Branded Retail Outlets 15Company Operated Outlets 16

Franchised Dealer Outlets 17

Jobber Operated or Jobber Franchised Outlets 18

IV. The Rise of Hypermarkets 20

V. Issues Surrounding Zone Pricing 2 1

VI. Issues Surrounding Non-Price Vertical Restraints 24The Motivation for Non-Price Vertical Restraints 24

Antitrust and Non-Price Vertical Restraints 24

VII. Whose Interests Are Being Served? 26

VIII. Gross Gasoline Marketing Margins 27

Conclusions 28

References 3 1

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Figure List

Figure 1: U.S. Refineries, 1947-2002; page 11

Figure 2: Number of Gasoline Service Stations; page 12

Figure 3: Gasoline Distribution System; page 15

Figure 4: Motor Gasoline Sales by Outlet Type; page 16

Figure 5: Theoretical Competitive Zone Development; page 21

Figure 6: Gross Gasoline Marketing Margins, 1983-2002; page 27

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Executive Summary

Introduction The U. S. petroleum retailing industry is one of themost competitive in the world. Despite this, indus-try practices in gasoline retailing continue to becontroversial. In part, this controversy occursbecause integrated refining companies use a varietyof distribution methods to maximize their efficien-cies while moving gasoline from the refiner to theconsumer. These different distribution methodscan come into conflict with each other. The goal ofthis study is to examine why integrated refiners usedifferent distribution methods, how those methodsare manifested in retailing and pricing of petroleumproducts, and the important policy issues that sur-round those distribution and retailing choices.

The Integrated Refiner’s ProblemAn integrated refiner both owns a refinery, and hasa branded presence in the retail gasoline market.In 2002, integrated refiners accounted for about78 percent of all refineries in the United States,down from 79.3 percent in 1992.

A refinery is an expensive investment and is com-plex to operate. It is doubtful that any new refin-ery could be built in the U.S. at present for a vari-ety of economic and political reasons. While therehas been a dramatic decrease in the number ofrefineries, the capacity at U.S. refineries hasgrown, as the remaining refineries have expanded.

Along with the drop in the number of refineries,there has also been a large decrease in the number ofretail gasoline outlets. The number of retail outletshas declined from over 203,000 in 1994 to about168,000 in 2003.

Refiners have clear incentives to improve productdistribution and those incentives work to the ben-efit of the consumer. Simply put, the more effi-cient the distribution system, the lower the cost ofgasoline distribution. Lower distribution costshelp drive retail prices lower, all else being equal.The price of gasoline at the pump, however, willultimately depend upon the marketplace forces ofsupply and demand and competition. The lower

the retail price of gasoline to consumers, the moreconsumers are likely to drive and the higher thedemand for gasoline.

Types of Branded Retail OutletsCompanies have three different basic types of out-let options and may employ any or all in theirmarketing strategies to compete in the market-place. First, integrated refiners can own and oper-ate the retail outlets themselves (company ownedoutlets). The second option is to franchise theoutlet to an independent dealer and directly sup-ply it with gasoline. The third option is to utilizea “jobber,” a person or firm who gains the right tofranchise the brand in a particular area.

The basic advantage of a company operated outletis that the company can manage the entire cus-tomer offering, including the retail price of gaso-line to the consumer, and thus protect its brandagainst “free-riding” that could occur with anindependent dealer or distributor. Comparatively,the chief advantage of a franchised dealer outlet isthat the operator has incentives to engage in entre-preneurship. The disadvantages of this methodinclude that the refiner gives up a degree of con-trol of the outlet's ability to meet consumer needs.Finally, the major advantage of the jobber form ofdistribution is reduced refiner involvement. Thejobber is responsible for siting and building facili-ties and creating local promotion. The jobber alsohas incentives for entrepreneurship, which mayresult in more efficient stations than would occurthrough company operations. The major disad-vantage of this form of retailing is that it is difficultfor the refiner to manage the brand it has licensedto the jobber, thus leading to potential “free riding”on the refiner’s brand name.

Jobbers constitute the largest fraction of sales, withabout 44 percent of the market. Lessee and opendealers contribute about 27 percent of the market,while company-owned operations constitute about12 percent of the market. The remaining sites areindependently operated and unbranded, andinclude the new retailing concept of hypermarkets.

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The Rise of HypermarketsHypermarkets and “super convenience stores” arenon-traditional retail outlets that specialize in sell-ing high volumes of gasoline at prices near thewholesale price of gasoline. In general, the retail-ing strategy for hypermarkets is to attract cus-tomers to their stores through a low price of gaso-line and a large number of gasoline pumps, andthen induce those customers to come inside theirstores and buy other products. Not surprisingly,the existence of hypermarkets has generated ten-sion in the relationship between integrated refin-ers, who supply hypermarkets with at least part oftheir gasoline, and the refiner’s traditional outlets,franchised dealers and jobbers. Refiners seek tosupport their direct service operators and jobbers,to keep them in business, by maintaining andimproving their competitiveness. Refiners also,however, implicitly support hypermarketers, whoseaggressive pricing increases the demand for refinedgasoline, and whose stations can be an importantdistribution channel for refiners.

Zone PricingThe FTC has described zone pricing as “the prac-tice whereby refiners set uniform wholesale pricesand supply branded gasoline directly to their com-pany-operated and franchised dealer stations withina small but distinct geographic area called a 'pricezone'.” Differences in wholesale prices among pricezones in a particular region can reach up to severalcents per gallon, though most price differences aremuch smaller, and typically, the price differencebetween neighboring stations is minimal. Eachrefiner determines the nature of its price zones, andthe wholesale price to be charged in that zone,based on a variety of factors. These include thecompetitive conditions in a station’s trading area, aswell as the physical nature of the zone based onnatural and artificial impediments to consumers’purchases. Firms look at competitors’ prices in thearea when setting up their own zones.

It should be noted that price zones are the conse-quences of different levels of competition in differ-ent areas. With the introduction of more non-tra-ditional retailers, such as hypermarkets, zone pric-ing becomes a mechanism designed to help dealerscompete and respond to new marketing challenges.Price zones are not the cause of the competitive-ness of such locations. Thus, eliminating pricezones could result in some retailers being unable tocompete. This, in turn, could result in failure ofsome sites, and thus affect the overall level of com-petition in the gasoline retailing sector. Indeed,the available empirical evidence indicates that theabolition of zone pricing would raise the averageconsumer price of gasoline.

Non-price Vertical RestraintsNon-price vertical restraints in gasoline retailing,in the form of restrictions on where jobbers cansell branded gasoline, have recently drawn scrutiny.Since the 1977 Sylvania decision, under theantitrust laws, non-price vertical restraints havebeen evaluated under the standard of “rule of rea-son.” This rule implies that for a plaintiff to suc-ceed in such a case, it must show a logical theoryof consumer injury, and that the balance of theevidence supports that theory, and that any anti-competitive resulting behavior must outweigh anyefficiency.

Non-price vertical restraints can have important,pro-consumer, efficiency rationales. Refiners investin a variety of promotional and other activities forfranchised dealers. They recoup these investmentsthrough wholesale margins. In particular, refinersgenerally make more investments in franchiseddealer outlets than they do in jobber stations. Thiscreates competitive tensions between these twotypes of outlets. The jobber trade group, thePetroleum Marketers Association of America, how-ever, asserts that non-price vertical restraintsshould be eliminated to enhance what is referredto as “intrabrand competition.” However, the

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choice of whether or not to allow “intrabrand”competition should be left solely to the refiner.The refiner has the same incentive as the con-sumer of gasoline – to minimize the distributioncosts of the product.

These and other charges against the retail gasolinedistribution network often come from competitorsof refiner affiliated stations. These economic actorsoften have interests that are contrary to both therefiners and the final consumer. However, the pur-pose of the antitrust laws, and public policy in gen-eral, is to protect the interests of the consumingpublic. It is not to increase the profits of any levelor type of distribution.

Gross Gasoline Marketing Margins The best way of analyzing the gasoline marketingsector is by the extent of margins in the sector. Thelower the margins, the lower prices are to con-sumers. The gross marketing margins for gasolinein the U.S. from 1983, in constant 2003 dollars,have declined 8 cents per gallon, from $0.277 pergallon in 1983 to $0.197 per gallon in 2002, a dropof 29 percent. It appears, however, that marginsfluctuate when measured on a yearly basis. Giventhis, it may be more accurate to examine marketingmargins by using three year moving averages.Employing this metric, we observe that margins fellan average of 5 cents per gallon, from $0.252 in1985 to $0.203 in 2002, a decline of 19 percent.These figures are indications that competition inthis area has acted to serve consumers alike.

ConclusionsCritics of the retail gasoline sector have called forthe abolishment of non-price vertical restraintsand zone pricing in this industry. From a compet-itive viewpoint, however, these calls are misguided.The strategies at issue are the result of competitionbetween various forms of distribution in gasolinemarketing. To eliminate these practices would beharmful to the consuming public.

The retail gasoline marketplace is subject to a widevariety of competitive forces. In response to theirneeds in the marketplace, different firms willadopt one or more of several different types of dis-tribution systems. Tensions can arise, however,between these distribution systems, with their dif-ferent levels of control and investment by refiners,when they coexist in the same marketplace. Toalleviate these tensions, and generate incentives forthe proper level of investment, refiners use non-price vertical restraints with their downstreamaffiliates. Refiners also use zone pricing to meetcompetitive threats in different markets.

Several parties have criticized the use of non-pricevertical restraints and zone pricing, claiming thatthey reduce competition in various markets. Theanalysis of this paper, however, shows that thesecritiques are not valid. No coherent anticompeti-tive theory of the relevant non-price verticalrestraints exists. Indeed, opponents of suchrestraints admit that these restraints are unlikely toviolate the antitrust laws. Eliminating the abilityof refiners to use such restraints would likelyreduce their investments in distribution outletsand harm consumers. Similarly, research hasshown that the elimination of zone pricing wouldresult in higher average prices for consumers. Itwould also force many refiners to exit from morecompetitive retail markets.

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Introduction

The U. S. petroleum retailing industry is one ofthe most competitive in the world. Despite a clearrecord of performance, industry practices in gaso-line retailing continue to be controversial. In part,this controversy occurs because integrated refiningcompanies use a variety of distribution methods tomaximize their efficiencies while moving theirgasoline from the refiner to the consumer. Thesedifferent distribution methods can come into con-flict with each other. The goal of this study is toexamine why integrated refiners use different dis-tribution methods, how those methods are mani-fested in retailing and pricing of petroleum prod-ucts and the important policy issues that surroundthose distribution and retailing choices.

Section II of this report suggests that events in thissector are best examined from the view of the inte-grated refiner. Like consumers, the integratedrefiner wants to lower the costs of distributinggasoline. The refiner also wants to manage itsbrands so that they can provide benefits to con-sumers.

Section III reviews the three basic methods bywhich integrated refiners distribute gasoline:through company operated stations, franchiseddealer stations, and jobbers. Section IV examinesthe rise of a new “non-traditional” component ofthis distribution mechanism, hypermarkets.

The most controversial practices in gasoline retail-ing, price zones and non-price vertical restraints,such as territorial restrictions, are examined inSections V and VI. The evidence is clear thatthese practices do not harm consumers. In largepart, the practices of zone pricing and non-pricevertical restraints are ways for companies to becompetitive in the marketplace while minimizingtensions between distribution channels. As long asdifferent types of distribution systems exist, inte-grated refiners will act to optimize their distribu-tion networks and activities like zone pricing andnon-price vertical restraints are part of that opti-mization. Section VII reviews the economicincentives that may cause the opposition to non-price vertical restraints.

The best way to evaluate the performance of theretail gasoline distribution system is to look atwhat retailing costs consumers. Section VIIIexamines marketing margins, the measure of thecosts of marketing to consumers. Since 1983,gross marketing margins have fallen significantly,implying this is an innovative dynamic sector,inconsistent with widespread anticompetitivebehavior. Section IX contains some concludingthoughts.

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II. The Integrated Refiner’s Problem

A. The Refiner’s Point of ViewThe best way to examine the retail distribution ofgasoline is from the integrated refiner’s point of view.An integrated refiner both owns a refinery, and has abranded presence in the retail gasoline market. Suchfirms as ExxonMobil, Shell, Marathon Ashland, BP,Sun Oil (Sunoco) and ChevronTexaco are integratedrefiners. Of course, there are refiners without a retailpresence, as well as independent gasoline stationsand chains that do not own refineries. In 2002, inte-grated refiners accounted for about 78 percent of allrefineries in the United States, down from 79.3 per-cent in 1992.1

In this context, an integrated refiner operates bothrefineries and retail distribution systems. A refin-

ery is an expensive investment and is complex tooperate. In addition, it is very difficult to enter intothe refining business. The last new refineries in theUnited States went onstream in the late-1970’s.Indeed, many observers state that it is impossible tobuild a new refinery in the United States.

From an economic point of view, it also representsa “sunk” or “asset specific” investment. (See Klein,Crawford, and Alchian, 1978.) Sunk investmentsare considered risky by economists, since they donot have valuable alternative uses. Thus, refineryinvestments cannot be switched into another sec-tor should the refinery prove non-remunerative.Thus, refiners need to take actions to protect theirsunk investments.

1 Data derived from National Petroleum News Factbooks and U.S. Energy Information Administration, Petroleum Supply Annuals.

Figure 1U.S. Refineries, 1947–2002

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Over time in the U.S., there has been a dramaticdecrease in the number of refineries. However, theamount of capacity at U.S. refineries has grown, asthe remaining refineries have expanded theircapacities. (See Figure 1.) Since 1947, the num-ber of refineries has declined from 399 to 149. Atthe same time, the refinery average capacity hasgrown significantly, resulting in a tripling of totalrefining capacity from 5 million barrels per day toover 16 million barrels per day.

There has also been a substantial decrease in thenumber of retail gasoline outlets. As Figure 2indicates, the number of outlets has declined fromover 203,000 in 1994 to about 168,000 in 2003.(Unfortunately, breakdowns by type are not avail-able.) This decline in the number of stations hasbeen the result of a number of factors, including

the cost of compliance with environmental regula-tions, population dynamics, and changes in thenature of ancillary business, such as automotiverepair work. Also, retail margins have compressedover the years. Lower margins require higher vol-umes and some stations have simply been inca-pable of producing the throughputs necessary toremain viable due to small properties, aging facili-ties and other physical constraints.

The gasoline retailing sector is entirely differentthan the refining sector with respect to asset-specif-ic investments. Gasoline retailing requires invest-ments primarily in land and storefronts. Suchassets are relatively easy to obtain, and relativelyeasy to move to alternative uses. There is, there-fore, a great deal of entry and exit in this sector.

Figure 2Number of Gasoline Service Stations

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It is thus the refining sector where investment ismost at risk. The refining of oil is of little value ifthere is not an efficient method to market theproduct. Thus, a refiner desires to get its productto market – from the refinery, through a pipelineor other method of transportation, to a terminal,or “rack,” via truck to a station, and then sold to acustomer. A refiner also desires a more certainmarket for its product than would be availablesimply by using gasoline “spot markets.” Thistask, however, is extremely complex.

It is very important to understand that the refinerhas clear incentives to improve product distribu-tion and that those incentives work to the benefitof the consumer. Simply put, the more efficientthe distribution system, the lower the cost of gaso-line distribution. Lower distribution costs helpdrive retail prices lower, all else being equal. Theprice of gasoline at the pump, however, will ulti-mately depend upon the marketplace forces of sup-ply and demand and competition. The lower theretail price of gasoline to consumers, the moreconsumers are likely to drive and the higher thedemand for gasoline.

At the refinery, the higher the demand for gaso-line, the higher the wholesale price (at the refinery)of gasoline. The higher refinery prices, all otherthings being equal, the higher refinery profits.Thus, in general, both integrated and nonintegrat-ed refiners desire low distribution costs for gaso-line, as it increases their refining profit potential.2

In large part, this paper is about the retail distribu-tion choices integrated refiners must make if theyare to remain viable, and the conflicts between theresulting distribution channels. As the discussionabove indicates, refiners will seek the most efficientand lowest cost set of distribution methods, all elsebeing equal. In that sense, refiners have exactly thesame desires as consumers, who desire low costs ofretail distribution to create low retail gasoline pricesfor consumers across all types of retail outlets.

B. Managing the BrandIn addition to seeking out the lowest cost methodsof distribution, the refiner often has an importantname brand reputation to both employ and pro-tect. The utility of branding is often unclear tocasual observers. Economists, however, have con-ducted important work in this area showing howbranding serves to protect product quality for con-sumers. (See, for example, Klein and Leffler,1981, and Shapiro, 1983.)

In economic terms, the value of a brand is repre-sented by the amount consumers are willing to payproducers for an implicit promise of value. Thepromise of value deals with goods whose quality isnot obvious upon inspection. The branding of aproduct also implies product consistency – that theproduct will have the same quality each and everytime it is purchased by the consumer.

A natural candidate for the use of branding is gaso-line, whose attributes are not clear to the eye of theconsuming public. Today, most refineries produce“base gasoline” that meet Federal standards. At the“rack,” firms add in their own package of additives.Each firm’s package has different attributes, and thequality of these packages is one measure uponwhich retail gasoline stations compete.

A perhaps less obvious candidate for branding, butstill quite important, is the quality of other goodsand services at gasoline outlets. The quality ofthese services is by no means apparent when a con-sumer chooses a particular station. A station’sbrand logo signals to the consumer the quality ofthese goods and services.

The basic theory of establishing a brand reputationis clear. The first input into establishing a brand isselling quality products and services for a substan-tial period of time, building up a positive expecta-tion in the minds of consumers about quality.That expectation is reinforced by advertising, whichserves to signal that the high quality products willcontinue to be supplied. In the case of integrated

2 Naturally, refiners also seek to earn an adequate return on their marketing and distribution assets as well. But their investment in refining is generally far greater, and more at risk, than the investment in other marketing and distribution assets.

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refiners, their brands are the result of decades ofproviding high quality service, backed up by largenational advertising campaigns. Today, however,established brands face new challenges from “super-convenience stores” and hypermarkets, as discussedbelow in Section IV.

Once a refiner has established a brand name reputa-tion, it must take active measures to manage thatreputation. In the gasoline sector, the refinerdepends in large part on independent dealers topresent its brand image to the consuming public.(See, for example, Hart and Murphy, 1998,Lafontaine and Shaw, 1999, Bai and Tao, 2000.)The integrated refiner must take active steps to stopits franchisees from “free-riding” on its reputation.

For example, when a potential consumer is drivingdown the road looking for a gasoline station, shewill see a distinctive sign with a particular refiner’sbrand name on it. The quality that brand signalswill help the consumer decide whether or not togo to that station. But that brand quality is sharedamong the brand’s outlets. In such circumstances,it could be profitable for the owner of a particularoutlet to “shirk” on product quality – not offer theproduct or service quality implied by its brandname. This may increase the outlet’s profits byreducing its costs. However, this action harms thebrand name value of the entire chain, resulting inreduced profits for other outlets, as well as theintegrated refiner. Klein (1995 at 12-13) describesthe problem this way:

In general, when franchisees use a commonbrand name, each franchisee can reduce itscosts by reducing the quality of the productit supplies without bearing the full conse-quences of doing so. Because a reduction inquality has the effect of reducing thedemand facing all franchisees using thecommon name, not just the future demandfacing the individual franchisee who hasreduced quality, the incentive for individualfranchisees to supply the desired level ofquality is reduced.

It is this type of shirking that brand managementseeks to stop.

In the retail gasoline sector, there are two impor-tant aspects to brand name. The first is the qualityof the brand’s gasoline. Each integrated refiner hasa special package of additives that it adds to itsgasoline at the “rack,” the end of the pipeline orsupply line from the refinery. The perception ofthis quality varies from firm to firm. For example,one integrated refiner makes the quality of itsbranded gasoline a centerpiece of its marketingcampaign, and claims that its gasoline is signifi-cantly superior to other brands of gasoline. Otherfirms assert that, while quality of gas is important,the differential in quality between their own gasand other brands is quite small.3

This aspect of brand quality, the attributes of thegasoline sold, is relatively straightforward to pro-tect. Outlets are required to sell only gasolinefrom a specific brand. Outlets are monitored close-ly for the quantities of gasoline they order fromthe refinery. In addition, the refiners hire testingservices to determine if the gasoline at an outlet’spump is actually that brand’s gasoline. Failure tosell only the specified brand of gasoline is cause forfranchise termination.

Another aspect of brand quality is the nature ofthe other, non-gasoline services, offered at retailoutlets. Especially important in this category isthe cleanliness of station facilities. Other items ofconcern involve station hours, quality of otherproducts sold at the station, and whether or notthe retail fuel price is above competitive levels.High price levels at one outlet harm the refiner’sbrand name identity, so the refiner seeks to keepstation prices at competitive levels. (See also thediscussion below in Section III-B.) Integratedrefiners spend substantial resources in hiring moni-toring services to evaluate stations on these criteria.

3 Of course, this type of disagreement among competing firms in the industry is to be expected.

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III. Types of Branded Retail Outlets

Integrated refiners sell gasoline through their owncompany operated outlets, as well as to independ-ent gasoline retailers, called dealers, and distribu-tors, often referred to as jobbers. A diagramdepicting the different types of retail outlets isshown as Figure 3.

Companies have three different basic types of out-let options and may employ any or all in theirmarketing strategies to maximize efficiencies andcompete in the marketplace. First, they can ownand operate the retail outlets themselves (companyowned and operated outlets). The second optionis to franchise the outlet to an independent dealerand directly supply it with gasoline. This optionmay have three different forms of property owner-ship. This operator can lease from the refiner,lease from a third party, or own the outlet out-right. The third option is to utilize a “jobber,”who gains the right to franchise the brand in aparticular area.4 Jobbers may choose to operate

some of their outlets with their own employeesand franchise other outlets to dealers. In addi-tion, as depicted in Figure 3, some integratedrefiners also supply some of the gasoline soldthrough hypermarkets. The mix of distributionmethods varies widely across firms. Differentrefiners, depending on which type is perceived asmost efficient, use different types of outlets.

In this section I will review the advantages anddisadvantages of each type of outlet from therefiner’s point of view. Figure 4 gives the break-down of sales by type of outlet since 1995. In2001, jobbers constituted the largest fraction ofsales, with about 44 percent of the market. Lesseeand open dealers contribute a little over 27 per-cent of the market, while company-owned opera-tions constitute about 12 percent of the market.The remaining sites are independently operatedand unbranded and include the new retailing con-cept of hypermarkets.

4 The definition of some of these terms can vary across companies.

Figure 3Gasoline Distribution System

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A. Company Operated OutletsMost integrated refiners directly own and operate,with their own employees, (often, between 10 and20 percent) some of their own gasoline outlets. Inthese locations, company employees generallymanage the outlet, taking retailing and pricingdirection from the refiner.

The basic advantage of a company-operated outletis that the company can manage the entire cus-tomer offering, including the retail price of gaso-line to the consumer. The refiner, for instance,can select the outlet’s level of service and offeringsto best match its perception of local demand. Itcan make sure that only its gasoline is sold at theoutlet.5 It can also ensure that the outlet takespart in the company’s promotional activities. Forexample, if a refiner wishes to have a company-wide campaign of discounted soft drinks at itsoutlets, it is much easier to implement that cam-

paign at company-owned operations than at inde-pendent dealer and jobber outlets.

Further, a company-operated station also allowsthe refiner to engage in controlled product or serv-ice experimentation. For example, a refiner mightbe interested in investigating a new method ofprocessing transactions. To determine (at mini-mum cost) whether or not the method is feasible,the refiner could easily try it out at its own sta-tions. Company-operated stations also providethe refiner with immediate and direct access toinformation about consumer needs and othertrends in the marketplace.

At least one integrated refiner is revitalizing anolder “hybrid” method of managing companyowned operations by using contract managers atsome of its outlets. Under this governance struc-ture, the refiner owns the station, but gives anindependent contract manager the opportunity to

5 These theories imply that the stronger the value of a refiner’s brand name, the more the company owned operations will choose it. Lafontaine and Shaw(2001), in a study of franchising across products, found this to be the case.

Figure 4Motor Gasoline Sales by Outlet Type

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actually operate the outlet. The refiner establishesthe retail price of the gasoline and other products,as well as sets service standards. The contractmanager is responsible for managing the outletand is paid by commissions on sales. Such anarrangement can provide control of the productand service offerings, while employing the entre-preneurial skills and community affiliation of thecontract manager for the integrated refiner.

B. Franchised Dealer OutletsWhile refiners operate some of their own brandedoutlets, most outlets are operated by others. Asecond form of gasoline outlet is referred to as afranchise dealer. In such operations the dealereither owns a site outright, or, more commonly,leases it from the refiner. The franchised dealeragrees to buy its gasoline entirely (or almost entire-ly) from the refiner, and the refiner arranges forthe gasoline to be delivered to the outlet. If therefiner develops a new outlet, it has often investedtwo or more million dollars in the site. If thedealer owns the outlet, the refiner may also haveinvested in the site, either by paying for improve-ments in the outlet, or loaning money to the deal-er, often at favorable terms or amortized over theterm of the contract. In addition, some refinersmay also be responsible for securing the site andarranging for promotion of the brand name in therelevant area, as well as for delivering the productto the station.

Finally, if refiners own or lease the station proper-ty, they also take the responsibility for environ-mental liability and major equipment and buildingmaintenance for the site, which is generally a sig-nificant obligation. The cost of these activities bythe refiner is reflected, at least to some degree, inthe wholesale price of gasoline charged to the fran-chised dealer.

The chief advantage of a franchised dealer outlet isthat the operator has incentives to engage in entre-preneurship. The disadvantages of this methodinclude that the refiner gives up a degree of con-

trol of the outlet's ability to meet consumer needs,either in the form of the quality of the servicesoffered or the competitiveness of the retail pricedisplayed at the pump.

Refiners who use franchised dealer operations striveto increase the quantity of gasoline sold at fran-chised dealer outlets. They have two importantreasons for doing so. First, inducing gasoline salesgenerates a more certain market for their refinedproduct, which is, in large part, the purpose of ver-tical integration in this area. Second, refiners donot want direct service outlets to price uncompeti-tively, as that harms the refiner’s brand name, aswell as other franchised dealers in the chain.

Volume related contractual provisions differ fromcompany to company. An example of a portion ofa “synthesized” contract is presented here. A refin-er may agree to supply an outlet with 100,000 gal-lons of gasoline per month at the “standard” dealertankwagon price. Further, in areas where competi-tive market conditions dictate, the refiner mayprovide the retailer with an incentive to sell moregasoline through rebates designed to reduce thefranchised dealer's cost of product. For example,if the outlet purchased between 100,000 and125,000 gallons, the refiner will reduce the priceby 2 cents below standard price. For all gasolinesales above 125,000 gallons per month, the refinerwill reduce the price by 4 cents below standardprice. In this manner, the franchised dealer is ableto be more competitive and is encouraged to sellmore gasoline.

Indeed, refiners may have several other methodsthey can use to induce dealers to lower prices toconsumers. Senator Carl Levin of Michigan, elab-orating on a 2002 U.S. Senate staff report,described one alleged incident:

... the Majority Staff was told by severaldealers that if they don’t charge their retailcustomers the recommended price, the nextdelivery of gas from the oil company willreflect any increase instituted by the dealer.These dealers are saying that if they decide

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to price their gas at 1.40/gallon when the oilcompany recommend $1.35, the next deliv-ery of gasoline to the station ..will have a 5cent/gallon increase in the price to the retail-er.6

Whether true or false, these allegations present aninteresting example of how a refiner could act inthe consumer interest by encouraging lower retailprices from station operators, even when thoseoperators seek to maximize their margins and prof-it by charging higher prices. Clearly, the refiner’sinterest is in getting a lower price to consumers“on the street.”

While there are advantages to operating throughfranchised dealers, a potentially significant disad-vantage is that certain franchised dealers may havelimited access to financial resources and workingcapital. As the marketing margins continue todecrease (see Section VIII below), smaller fran-chised dealer operations may be prone to try toincrease their unit margins at the expense of vol-ume. This is often a self-defeating strategy.

Consider a franchised dealer who suffers some typeof financial setback. This operator may not havethe financial and operating capacity to compete inthe marketplace. Instead, in an attempt to over-come the setback, such an operator may raise itsprice of gasoline above the market level, to increaseprofit, at least on a per unit basis.

Such a strategy may work in the very short run.However, consumers will quickly determine thatthey can purchase gasoline elsewhere at a lowerprice. The result: station profits will dwindle. Thestation operator may then raise prices again. Thepattern repeats itself until the point at which thestation operator has very high prices, and low vol-ume and low profits. The station operator may goout of business.

This scenario, referred to in the industry as the“death spiral,” is very adverse to the interests of theintegrated refiner. First, it reduces the amount ofgasoline sold by the refiner through this particularlocation, reducing refiner profits. Second, it harmsthe refiner’s general reputation for competitiveness.Third, it puts the refiner’s investment in the fran-chised dealer’s outlet at risk.

To try to solve such problems some refiners willplace volume requirements on their dealers, or useother contractual mechanisms discussed above toencourage lower prices. Minimum volume clausesin the franchised dealers contract require the dealerto sell a certain quality of gasoline per unit of time,or face loss of the franchise. However, the refinermay waive these provisions in periods where mar-ket demand has decreased for other reasons.

c. Jobber Operated or JobberFranchised Outlets

A third type of retail outlet is referred to as a “job-ber” or a “distributor.” A jobber or distributor isan independent operator who owns and operates anumber of retail outlets, or sometimes has its ownfranchisees operating a portion of those outlets.The jobber enters into an agreement with therefiner to sell that refiner’s gasoline and displaythat refiner’s brand at particular stations.

The jobber is responsible for siting and buildingfacilities and creating local promotion. Often thejobber has knowledge of local conditions and thusis better able to perform these tasks. The jobberalso has incentives for entrepreneurship, whichmay result in more efficient stations than wouldoccur through company operations.

The refiner expects jobbers to develop markets forthe refiner’s brand. Developing markets includeslearning about the relevant area, investigatingpotential outlet sites, and finding outlet operators

6 Statement of Senator Carl Levin, Hearings on “Gas Prices: How Are They Really Set?,” Permanent Subcommittee of Investigations of the Committee on Governmental Affairs, U.S. Senate, April 30, 2002 at 9.

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who can succeed in the relevant area. Especially inrural areas, these are tasks that a jobber may findeasier to perform than a refiner’s employees.

The major disadvantage of the jobber form ofretailing is that it is difficult for the refiner tomonitor the jobber’s marketing tactics, thus lead-ing to the potential for “free riding” on the refin-er’s brand name. For example, jobbers often havecontractual agreements with more than one brand-ed refiner. Such jobbers could switch the brand ofa portion of their chain with relative ease. A job-ber can also abandon a territory, leaving a brandedrefiner without distribution in an area. This prob-lem may be especially acute in or near a congestedurban area, where escalating real estate prices maygive a jobber the chance to profit by selling its realestate properties to a non-gasoline related firm.

Because of the additional services the jobber per-forms, including arranging the delivery of productto its own stations, it typically receives gasoline ata lower (wholesale) price than franchised dealers.This creates the potential for the jobber to resellthe gasoline to the refiner’s franchised dealers prof-itably. Both jobbers and franchised dealers couldgain from this “arbitrage” opportunity, at least inthe short run. However, if refiners allowed thisactivity to occur, it could eliminate much of thecompensation they receive for developing and pro-moting franchised dealer operations. To stop thistype of economic arbitrage, refiners use non-pricevertical restraints, as discussed below.

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IV. The Rise of Hypermarkets

Hypermarkets and “super convenience stores”7 arenon-traditional retail outlets that specialize in sell-ing high volumes of gasoline at prices near thewholesale price of gasoline. In general, the retail-ing strategy for hypermarkets is to attract cus-tomers to their stores through a low price of gaso-line and a large number of gasoline pumps, andthen induce those customers to come inside theirstores and buy other products. Firms in this cate-gory across the country include Wa-Wa and Sheetz(super-convenience stores) in the Northeast,Costco and Albertson’s in the West, and Wal-Mart(the last three all hypermarkets) in various loca-tions across the country. One industry sourceforecasts that hypermarkets will grow from their2002 level of 13 percent of the industry to 16 per-cent in 2005.

The rise of hypermarkets appears to have begun inthe mid-1990s, as hypermarketers advanced theone-step shopping concept. At around that sametime, federal regulations required refiners tochange the environmental specifications of their“base” gasoline to a relatively uniform standard.This made the “base” gasoline sold by unbrandedfirms more competitive, and such firms were betterable to provide product comparable to that sold inbranded outlets. This, in turn, increased the abilityof unbranded retail outlets to sell gasoline to con-sumers. (It should be noted, however, that inte-grated refiners still engage in important competi-tion in gasoline product quality.)8

Hypermarkets obtain at least some of their gaso-line product from integrated refiners who also havetheir own distribution networks. This is not sur-prising. Hypermarkets often serve to enhancerefiner interests. In the short run, hypermarketscan serve as remunerative outlets for gasoline arefiner cannot use in its distribution channels. Inthe longer term, refiners may choose to sell gaso-line to hypermarkets on a continuous basis, ifrefiners believe this is more profitable than main-taining or adding to its distribution chain. Inaddition, in the long run, it is a goal of refiners toincrease the demand and price for their wholesaleproduct. These extremely competitive marketersdrive down (gross) retail margins, increasing thedemand for gasoline and, therefore, increasingrefiners’ profit potential.

8 Statement of James Carter, Regional Director, ExxonMobile Fuels Marketing Director, Hearings on “Gas Prices: How Are They Really Set?,” Permanent Subcommittee of Investigations of the Committee on Governmental Affairs, U.S. Senate, April 30, 2002 at 21.

7 For ease of exposition, these stories together will be referred to as “hypermarkets” from now on.

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V. Issues Surrounding Zone Pricing

The FTC has described zone pricing as “the prac-tice whereby refiners set uniform wholesale pricesand supply branded gasoline directly to their com-pany-operated and franchised dealer stations with-in a small but distinct geographic area called a'price zone'.” 9 Zone pricing is a reflection of therefiner’s recognition that there are different com-petitive conditions in different geographic areas.For example, stations in areas with gasoline hyper-markets need lower wholesale prices in order toremain competitive. Differences in wholesaleprices among price zones in a particular region canreach up to several cents per gallon, though mostprice differences appear much smaller (MarylandTask Force, 2001, at 5) and typically, the price dif-ference between neighboring stations is minimal.Nonetheless, despite the limited differentialbetween competing stations, various legislativeproposals have been put forward by franchiseddealers, jobbers and their organizations to requirerefiners to offer the same prices on product to allcustomers in a geographic area.

Each refiner determines the nature of its pricezones, and the price to be charged in that zone,based on a variety of competitive factors. Theseinclude the competitive conditions in a station’strading area, as well as the physical nature of thezone based on natural and artificial impedimentsto consumers’ purchases. Such impediments caninclude a river or a set of hills, congested bridgesand highways, and flows of traffic between work-ing centers and residential areas. A graphic depict-ing a typical zone-pricing situation is shown asFigure 5. This figure shows how the path of aninterstate highway determines the boundary of theprice zone. Other factors in zone identificationcould be differences in local taxes and differentgovernment gasoline specifications.

The price level in an area is based primarily oncompetitive issues. Firms look at competitors’prices in the area when setting up their own zones.The size and configuration of a price in a zonemay, in large part, be a function of whether or not

9 See http://www.ftc.gov/opa/2001/05/westerngas.htm.

Figure 5Theoretical Competitive Zone Development

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there is a hypermarketer in the area. Low pricezones are thought of by refiners as “help to thedealer” – they keep the franchised dealer in busi-ness while meeting competition in low price areas.10

One industry executive has explained zone pricingin a more intuitive fashion:11

It’s the dynamics of meeting competition, andthat’s our basic philosophy. Zone pricing isjust that. It is figuring out what’s the relevantarea of competition, and who do you want tocompete against and why and figuring outwhere to set your price relative to those, sothat you can get the volume that you needand the balance between volume and priceand margin is what generates the cash to runthe business. And it sounds mysterious, and itsounds complicated, but it is actually as sim-ple as meeting local competition.

In recent years refiners have been using sophisticat-ed decision support systems to help define and setprices in price zones. These systems will estimate astation’s gasoline volume as a function of the factorsdiscussed above, and changes in the station’s retailprice. Given this, the systems will estimate whichwholesale price will maximize the refiner’s profits,while allowing the franchised dealer to remaincompetitive, optimizing his profits as well. (SeeMaryland Task Force, 2001, at 6.)

The precise nature of price zones differs from com-pany to company, as well as from region to region.One refiner has a price zone for almost every sta-tion. Another has over half of its price zones con-sisting of only one station. Other companies willgenerally have several stations in most price zones.

It should be noted that price zones are the conse-quences of different levels of competition in differ-

ent areas. With the introduction of more non-tra-ditional retailers like super convenience stores andhypermarkets, zone pricing has become a mecha-nism designed to help dealers compete and respondto the new marketing challenges. Price zones arenot the cause of the competitiveness of such loca-tions. Thus, eliminating price zones could result insome retailers being unable to compete and couldresult in failure of some sites and thus affect theoverall level of competition in this sector.

The existence of different price zones has beenused by some franchised dealers and their tradeassociations in their attempt to show the existenceof economic price discrimination. Price discrimi-nation is offering a product that costs the same atat least two different prices to competing cus-tomers.12 In certain circumstances price discrimi-nation is illegal under the Robinson-Patman Act.The legal rules of this law are extremely complicat-ed, to say the least, and will not be discussed atlength here.13

Eliminating zone pricing, as sought by some fran-chised dealers and their associations, would havetwo negative consequences for consumers andrefiners alike. First, requiring equal prices wouldraise prices to some dealers of a particular supplier,and reduce them to others. Recent economicresearch (see, for example Shaffer and Zhang,1995), however, indicates that prices are more like-ly to rise on average than to fall. The reason isthat eliminating zone pricing would change thefocus of competition from many retail outlets toonly a few terminal locations. The resulting “soft-ening” of competition will likely generate, on net,higher prices for consumers.

10 See the discussion along these lines in Majority Staff of the Permanent Subcommittee on Investigations, U.S. Senate, “Gas Prices: How Are They Really Set?,” (2002 at 302).

11 David C. Reeves, President, North American Products, Chevron Texaco Corporation, Hearings on “Gas Prices: How Are They Really Set?,” Permanent Subcommittee of Investigations of the Committee on Governmental Affairs, U.S. Senate, April 30 at 21.

12 It should be noted that economic definitions of price discrimination can vary.13 For an economic discussion of the Robinson-Patman Act, see Viscusi, Vernon and Harrington (1992, 278-286). The Robinson-Patman

Act is routinely criticized by scholars for many of the reasons presented here.

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Consistent with this, Comanor and Riddle (2003)found that requiring uniform pricing in Californiawould, on net, increase average prices to con-sumers by reducing the level of competitionbetween stations. �is study indicates that, hadzone pricing been eliminated in California in 1997and 1998, retail gasoline prices would have beenbetween 1.8 and 4.6 cents per gallon higher onaverage. �is would have cost Californiamotorists between $419 million and $625 milliondollars per year in higher gasoline prices, depend-ing upon the time period studied and interpreta-tion chosen of the proposed statute.

Similar results are found in a recent working paperby Deck and Wilson (2003). Deck and Wilson“simulate” gasoline markets through the use ofexperimental economics. Experimental economicsis a relatively new field of economics that tests eco-nomic hypotheses under laboratory conditions.14

Deck and Wilson find that, in the laboratory, theelimination of zone pricing raises prices in morecompetitive markets by approximately 11 percent.�e elimination of zone pricing has no effect onprices in less competitive markets. �e elimina-tion of zone pricing also serves to redistributeprofits away from refiners toward the owners ofstations in less competitive markets.

Two other economists speaking before a U.S.Senate subcommittee in 2002 made similar argu-ments. According to Professor Justine Hastings ofDartmouth University:15

If refiners are forced to charge one wholesaleprice, it actually could be the case that aver-age wholesale prices would rise. In addition,they certainly would rise in low-incomeneighborhoods, currently the most price sen-sitive neighborhoods. Zone price elimina-tion could be a very regressive policy.

Professor R. Preston McAfee of the University ofTexas made a similar statement:16

Elimination of zone pricing by statute willnot tend to reduce average gasoline prices.Instead, as Dr. Hastings emphasized, it willtend to increase prices in the most competi-tive and also the poorest areas. Zone pricingis essentially the same phenomenon as thesenior citizen discount at the movie theater.�at is, companies give a lower price to themore price sensitive consumers, like studentsand senior citizens.

Second, without the tool of zone pricing, refinersand retailers would likely be forced to withdrawfrom low-priced zones, reducing competition inthose areas, as well as the value of their brands.Under uniform pricing, a refiner facing competi-tion from a hypermarket, could not reduce thewholesale price at that location without doing so inthe entire terminal tributary area or, under someproposals, an entire state. In such a circumstance,a refiner would be reluctant to lose margin in alarge area in order to remain competitive in asmaller one. �us, it might have little choice butto withdraw from the low-priced area, reducingcompetition further. In the long run, brand main-tenance would suffer, and the value of the brand torefiners and consumers would decline.

It is also quite common for jobbers to use zonepricing when they supply their own franchisedoutlets. (See Maryland Task Force, 2001 at 9.) Inaddition, some refiners are experimenting usingzone pricing with jobbers, charging them a differ-ent price for gasoline at the rack, depending onthe destination of that gasoline.

14 �e founder of experimental economics, Vernon Smith, received the Nobel Prize for Economics in 2002 for his contributions in th is area.

15 Testimony of Justine Hastings, Assistant Professor of Economics, Dartmouth University, Hearings on “Gas Prices: How Are �ey Really Set?,” Permanent Subcommittee of Investigations of the Committee on Governmental Affairs, U.S. Senate, April 30, 2002 at 114.

16 Testimony of R. Preston McAfee, Professor of Economics, University of Texas, Hearings on “Gas Prices: How Are �ey Really Set?,” Permanent Subcommittee of Investigations of the Committee on Governmental Affairs, U.S. Senate, April 30, 2002 at 117.

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VI. Issues Surrounding Non-Price Vertical RestraintsA. The Motivation for Non-Price

Vertical RestraintsAs discussed above, refiners often allow independ-ent operators known as “jobbers” to sell theirbranded gasoline in certain areas. The territorythese jobbers can operate in, using that brandedname and selling the refiner’s gasoline, is, however,often highly restricted. Thus, refiners engage in aseries of non-price vertical restraints with their job-bers that preclude them from selling gasoline out-side their assigned territories.

These jobbers have asked their elected officials toenact legislation to end such restrictions, whichthey refer to as “redlining.” (Of course, it shouldbe noted that the term “redlining” is a pejorativethat does not accurately represent the practices inquestion.) According to the FTC,17

“[t]here are two general types of redlining:1) territorial, in which the contract betweenthe refiner and the jobber gives the refinerthe right to refuse to approve the jobber'srequest to supply branded gasoline to inde-pendent stations or supply its own stationsin specific price zones; and 2) site-specific,in which the contract includes financial dis-incentives for the jobber to sell in locationsdirectly supplied by the refiner and preventsa jobber from shipping low-priced gasolineto stations located in high-priced zones.”

These restraints are useful to refiners because theprice differential that causes them is required forrefiners to recoup their investments in dealer oper-ated stations. These investments include develop-ing distribution systems, siting costs, financial sup-port, and responsibility for environmental con-cerns. Thus, non-price vertical restraints are clear-ly useful tools for brand support. They allow boththe refiner and the franchised dealer to engage inbrand investment without the threat of “free-rid-

ing” on those brand investments by a jobber.Should these territorial restrictions be prohibited,refiners can be expected to act in at least one oftwo different ways. First, they may restrict invest-ments in their brands. Second, they may reducethe number of jobbers they use, or choose not touse jobbers when expanding their distributionchannels, replacing them with less efficient formsof distribution. Neither outcome would serve theconsumer interest, as the number of branded siteswould be reduced.

B. Antitrust and Non-Price VerticalRestraints

Since the 1977 Sylvania 18 decision, under theantitrust laws, non-price vertical restraints havebeen evaluated under the standard of “rule of rea-son.” This rule implies that for a plaintiff to suc-ceed in such a case, it must show a logical theoryof consumer injury, and that the balance of theevidence supports that theory. It cannot bestressed enough that the focus of antitrust enforce-ment is the protection of consumers, rather thanthe protection of individual competitors.

A theory of anticompetitive behavior has severalelements. First, the firms using the practice atissue must be competing in a relevant product andgeographic market. Second, the firms using thepractice at issue must, together, have market powerin the relevant market. Third, the use of the prac-tice must in some logical manner encourage supra-competitive pricing, generally through enhancingtacit collusion. Fourth, any anticompetitive result-ing behavior must outweigh the impact of any effi-ciencies from these practices.

Each of these factors may be important in thedetermination of the outcome of an antitrust case.For example, if the two firms being sued for collu-

17 See http://www.ftc.gov/os/2001/05/wgspiswindle.htm.

18 Continental T.V. Inc. v. GTE Sylvania Inc (1977) 433 U.S. 36.

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sive behavior in a matter compete in separatecities, but not head to head, that is likely to be afatal flaw in a case. If the firms at issue constituteonly a small portion of a market, say 10 percent,then that also is a fatal flaw in a case.

The third condition, the necessity of an anticom-petitive theory, can also be problematic. Forexample, assume that the firm using the practiceat issue is dominant in the market, and no otherfirms use the practice. In this case the dominantfirm is unlikely to be colluding with any of itsrivals, so the relevant restraint is unlikely to beharming consumers.

The fourth point is important to remember. Non-price vertical restraints can have important, pro-consumer, efficiency rationales. Refiners invest in avariety of promotional and other activities for fran-chised dealers. They recoup these investmentsthrough higher wholesale margins. If the directservice operator can obtain its gasoline from anoth-er source able to lawfully supply the same brand ofgasoline, says a local jobber, then it will be “free rid-ing” on the refiner’s investment. Thus, non-pricevertical restraints serve to protect the refiner’sinvestment in the franchised dealer’s location.19

Franchisees who take exception to a refiner’sactions have recourse in the courts, under theantitrust laws. However, it is clear that under theantitrust laws the chances of successful litigationare extremely limited. Indeed, according to theposition paper prepared for the jobber trade groupthe Petroleum Marketers Association of America(Bassman, Mitchell and Alfano, 2003) “Withrespect to the antitrust laws, the landmark deci-sion of the United State Supreme Court inContinental T.V., Inc. v. GTE Sylvania Inc., [433U.S. 36 (1977)] all but dooms jobber hopes offinding a basis in the antitrust laws to attackredlining.” The reason for this is clear: non-pricevertical restraints in this industry are unlikely toharm consumer welfare.

The PMAA, however asserts that non-price verti-cal restraints should be eliminated to enhancewhat is referred to as “intrabrand competition.”Intrabrand competition occurs when a firm usestwo or more distribution networks in the samearea. For example, outside of the gasoline busi-ness, it is useful to examine AT&T’s sales of cellu-lar phones. In many areas AT&T sells cellulartelephones through both its own corporate storesand through independent franchises. The compe-tition between the two is referred to as “intra-brand competition.” Such “competition” wouldbe reduced were AT&T to eliminate its independ-ent franchises. But there is no reason to concludethat consumers would be injured.20

If AT&T has market power in the relevant area, ithas that power whether or not it uses independentfranchises as well as company owned stores. Ineither circumstance, AT&T can control (throughsetting retail and/or wholesale prices) the quantityof cellular telephones sold. Therefore, there is nopurely “competitive” implications that arise from anAT&T decision to allow, or to end, “intrabrandcompetition” in its own product. The same analy-sis holds true for a gasoline refiner deciding how itshould distribute its own product.

Given this, one must ask why AT&T wouldchoose to allow intrabrand competition? Theanswer comes from AT&T incentives as an“upstream producer.” AT&T seeks to deliver itsproduct at the lowest cost, all other things beingequal. If it finds that using franchisees lowers itstotal cost, it will use them. This is similar to theincentives of an integrated refiner to lower itscosts for distributing its gasoline.

Thus, the choice of whether or not to allow“intrabrand” competition should be left solely tothe refiner. The refiner has the same incentives asthe consumer of gasoline – to minimize the distri-bution costs of the product.

19 For a broader discussion of these issues, see Klein and Murphy (1988).20 For a fuller discussion of these issues, see Liebelier (1982).

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VII. Whose Interests Are Being Served?

Charges against refiners’ administration of theirretail gasoline distribution network often comefrom jobbers and other competitors of refiner affil-iated stations, as well as from franchised dealersand their trade associations. As Baumol andOrdover (1984) point out, however, these actorsoften have economic interests that are contrary toboth the refiners and the final consumer. Thisneeds to be understood in order to evaluate theclaims made against the retail gasoline system.

The purpose of the antitrust laws, and public poli-cy in general, is to protect the interests of the con-suming public. It is not to increase the profits ofany level or type of distribution. Thus, as the oldsaying goes, “there is a difference between protect-ing competition and protecting competitors.”Protecting competition means moving to providecustomers with the lowest sustainable prices, notprotecting the profits of any level of production orany individual firm.

Market participants, therefore, are not alwaysfriends of the antitrust laws or the general publicinterests. Being economic agents, they preferhigher profits to lower profits for their segment ofthe network. They can gain higher profits throughtheir marketplace actions. They may also be ableto gain profits through political activity.

Jobbers have worked with their political represen-tatives in attempts to end vertical restraints. Thereason for this is simple: these vertical restraintslimit jobber profit opportunities. They restrictjobber profits by restricting the places they can sellgasoline. Dealers have reasons to desire the end ofzone pricing, if, as the results of Deck and Wilson(2003) indicate, eliminating zone pricing, whileraising prices to consumers, shifts profits awayfrom refiners and toward station owners.

One should remember that refiners, although theyclearly prefer higher profit to low, have the properincentives to choose their own distribution meth-ods. Refiners prefer low cost distribution methodsto high cost methods, everything else being equal.The reason for this is simple: Lower distributioncosts increase the profit potential of refiners, and,at the same time, lower prices to consumers. Ifrefiners choose not to use jobbers in particularareas, that decision can be expected to be generat-ed by the refiners’ belief that jobbers do not repre-sent the lowest cost method of distribution inthose areas.

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VIII. Gross Gasoline Marketing Margins

In the end, the best way of analyzing the gasolinemarketing sector is by the extent of margins in thesector. The lower the margins, the lower prices areto consumers.

Figure 6 graphs out the gross marketing marginsfor gasoline in the U.S. from 1983, in constant2003 dollars.21 It is clear that since 1983 therehas been an important decline in retail gasolinemargins.

Gross marketing margins for gasoline in the U.S.from 1983, in constant 2003 dollars, havedeclined about 8 cents per gallon, from $0.277per gallon in 1983 to $0.197 per gallon in 2002, adrop of 29 percent. It appears, however, that mar-gins fluctuate when measured on a yearly basis.

Given this, it may be more accurate to examinemarketing margins by using three year movingaverages. Employing this metric, we observe thatmargins fell an average of 5 cents per gallon, from$0.252 in 1985 to $0.203 in 2002, a decline of19 percent. These figures are indications thatcompetition in this area has acted to serve com-petitors and consumers alike.

Thus, the bottom line is clear. Margins have beendecreasing in the gasoline marketing segment.This is an indication that competition in this areahas acted to serve integrated refiners and con-sumers alike.

21 Gross gasoline marketing margins are calculated as the difference between the average retail price of all types of gasolines (excluding federal and state taxes) and the weighted average sales for resale price from the dealer tank wagon, rack, and bulk for all grades of gasoline as reported by the Energy Information Administration, Petroleum Marketing Annuals, Table 31.

Figure 6Gross Gasoline Marketing Margins, 1983-2002

2003

cen

ts p

er g

allo

n

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IX. Conclusions

Critics of the retail gasoline sector have called forthe abolishment of non-price vertical restraints andzone pricing in this industry. From a competitiveviewpoint, however, these calls are misguided. Thestrategies at issue are the result of competitionbetween various forms of distribution in gasolinemarketing. To eliminate these practices would beharmful to the consuming public.

The retail gasoline marketplace is subject to a widevariety of competitive forces. In response to theirneeds in the marketplace, different firms willadopt one or more of several different types of dis-tribution systems. Tensions can arise, however,between these distribution systems, with their dif-ferent levels of control and investment by refiners,when they coexist in the same marketplace. Toalleviate these tensions, and generate incentives forthe proper level of investment, refiners use non-price vertical restraints with their downstream affil-

iates. Refiners also use zone pricing to meet com-petitive threats in different markets.

Several parties have criticized the use of non-pricevertical restraints and zone pricing, claiming thatthey reduce competition in various markets. Theanalysis of this paper, however, shows that thesecritiques are not valid. No coherent anticompeti-tive theory of the relevant non-price verticalrestraints exists. Indeed, opponents of suchrestraints admit that these restraints are unlikely toviolate the antitrust laws. Eliminating the abilityof refiners to use such restraints would likelyreduce their investments in distribution outletsand harm consumers. Similarly, research hasshown that the elimination of zone pricing wouldresult in higher average prices for consumers. Itwould also force many refiners to exit from morecompetitive retail markets.

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34

Andrew N. Kleit, P.h.D.Professor of Energy and

Environmental EconomicsThe Pennsylvania State University

ANK1@psu.edu814-865-0711

December 2003