Thursday, June 19, 2008

Puzzle: Credit Card Merchant Fees

Why do credit card companies charge merchants a percentage of sales, rather than a flat fee?

I saw these two articles today discussing the effect of gas prices on retail gas stations. Both suggest that gasoline merchants are feeling a squeeze. Their margins on gasoline are razor-thin--just cents on the gallon. As the price rises, the fees they must pay to the credit card companies rise, turning their small profit to zero or even negative profit. The puzzle to me is, why do they charge a percentage? Does it really cost more to process the transaction for someone who filled up a 15 gallon tank than it does for someone who filled up a 10 gallon tank? The only explanation I can come up with is that there is a greater risk of fraud with larger purchases (the $1,000 TV purchase might be more likely to be fraud than the $30 gasoline purchase), but it seems to me that this at best explains a sort of tiered fee structure with a series of flat fees (or possibly a flat fees at some levels and percentages at others).

A naive answer would be "they do it because they can and gasoline station owners have no choice". But if they have no choice, why not charge even higher fees? Or why not charge a very large lump sum? Why this particular fee structure? Also, there is more than one credit card company; if some other structure is obviously superior, why doesn't one of them offer it, and see all the gas stations switch over to using them exclusively? Some stations are apparently refusing to accept credit cards; will this lead the credit card companies to change the terms?

Now, in any case, gas stations use gasoline as a loss leader to bring customers into the actual store to buy expensive sodas and bags of chips (much like the famous movie theater popcorn story; search the page for the word "popcorn"). There's no iron law that says they must make a positive accounting profit on their gasoline sales to stay in business. What matters is that their overall economic profit is zero or positive.

I'm guessing that someone has solved this problem already, so link me to it!

Monday, June 16, 2008

The Prius and Gas Prices

My wife drives a 2005 Prius (I drive a 2004 Mazda 3s) . She usually bicycles to work, but when we drive somewhere we usually take the Prius to save on gas. Last weekend we drove out to "The Farm", which is some land her parents own about an hour south of Nashville in a rural area. We averaged 50.6 miles per gallon on the drive back from The Farm (it's mostly highway driving). We usually get around 45 to 48 miles per gallon in the Prius. I think this is pretty darn good.

The Prius has insulated us somewhat from the rise in gas prices. A trip to the farm uses about 1.5 gallons. While this costs us $6 now, as opposed to $3 just a few years ago, and while this is a doubling of our gasoline bill, it's still very small. If we were to drive my car it would use about 2.5 gallons, and cost $10, versus $5 a few years ago. If we road with Liz's parents in their land yacht, it would cost $14 to get to the farm. So the two way trip costs $12, $20, and $28. Gas prices would have to rise to $8 per gallon before we would start feeling the pain that Liz's parents feel. This is unlikely to happen soon.

In addition to the wonderful fuel economy, the Prius has other nifty features. It has an LCD screen that controls all the electronics (stereo, climate control, etc.) and gives great feedback on how one's driving affects fuel economy. It is also spacious (and a hatchback), holding five people and lots of stuff quite comfortably. It is not fun to drive in the way my Mazda is, but it is competent and confident on the road. The Prius fits handily into small parking spaces and turns very tightly. I can actually parallel park it with ease, something I normally find difficult. Buying a Prius on purely financial grounds probably doesn't make sense for most people at current gas prices. As protection against higher prices, and as a really nice car all-around, the Prius makes a lot of sense. Oh, and Consumer Reports rates it very highly for reliability.

I have seen some confusion and concern about the life of the batteries. While the batteries are not terribly environmentally friendly, they do have a fairly long life. They are warranted for eight years or 100,000 miles (whichever comes first), and should be expected to last a good deal longer than that (in California the warranty is 15 years/150,000 miles). When last I checked on this, Toyota claimed they had never replaced a Prius battery due to use (as opposed to damage in an accident). Priuses have been used as taxis for a while now, surely racking up lots of miles. A google search for "how long will the Prius battery last?" seems to suggest that it should last at least 200,000 miles.

This brings me to the long-term effects of gas prices. There is a standard list of effects that could occur when gas prices go up:
-People buy more fuel-efficient cars (some are just smaller, some use new technology).
-People combine trips.
-People carpool.
-People bicycle or take alternative (possibly public) transportation.
-People move closer to work.
-People move to cities where everything is closer, and away from rural areas with their longer driving distances.
-Developers build more integrated communities (e.g., a condo tower with a grocery store on the bottom floor).
-Automobile manufacturers invest in improving old engine technologies and developing new ones

I'll leave out discussion of what oil extractors and refiners might do (basically, they try to extract and refine more oil). In some sense, we should expect the U.S. to look more European, in terms of how people travel and where they live. Some of these changes will take more time than others; cities do not change their layouts quickly.

This brings me back to the Prius. To the extent that cars like the Prius shield consumers from higher gas prices, they will slow the other forms of transition. If automotive technology gets good enough, fast enough (or if people all shift to really small cars) then the other more structural changes may occur very slowly, or not at all. People may keep living out in the country, but all drive small hybrid cars instead of pickup trucks (or maybe someone will come up with a small hybrid pickup truck to allow a rural citizen to maintain his or her country credibility). It's difficult to forecast exactly what will happen, since it depends greatly on peoples' preferences--their willingness to substitute between different ways of dealing with higher gas prices.

Monday, June 09, 2008

Arbitrage, Gasoline, Diesel, and Mexico

A story was on the local news last night about people in the southwestern U.S. crossing into Mexico to buy gasoline and diesel. Apparently it is significantly cheaper there. The story did not go into why it might be cheaper, although I had some guesses.

My first thought was that gas would not stay cheaper in Mexico for long. This was clearly a kind of abritrage. With people buying less gasoline in the U.S., and more in Mexico, the price of gasoline in Mexico should rise, and the price in the southwestern U.S. should fall. If there were no transportation costs and no differences between the products, then the price should, in equilibrium, be the same in both countries.

Of course, as this article explains, the products are not the same, and clearly there are costs to driving to Mexico to get gasoline and diesel (including waiting in long lines). Also, Mexican gasoline and diesel do not have meet the same regulatory standards as U.S. gasoline and diesel, and there is apparently a possibility that they may be bad for American engines designed to run on cleaner fuels. We therefore should not expect the price to be the same in both countries; the price of Mexican fuel may go up, but it should remain cheaper than U.S. fuel, due to the costs of getting it and the poorer quality.

Mexico also subsidizes its gasoline and diesel to make it more affordable for consumers, but that should not prevent prices from rising if Americans drive over to buy a lot of fuel.

A similar phenomenon is going on in the U.S. between diesel and gasoline. Diesel fuel provides better fuel efficiency than gasoline. For a long time it was cheaper than gasoline, too, but people didn't use it because of the stigma of the poor diesel engines of the 1980s, and because gasoline was cheap enough. Diesel engines were also dirtier than gasoline engines until recently (new regulatory standards were imposed, and automakers have come up with several ways to reduce diesel emissions). As a result of these engine improvements and expensive gasoline, more people began switching to diesel. The price of diesel, of course, started to rise.

What should we expect in equilibrium? We should expect the price of diesel to rise just enough that the marginal consumer is indifferent between buying a car with a diesel engine and a car with a gasoline engine. There should be no significant savings in going with either route. (This could still vary for some drivers, depending on their driving habits.)