Curbing the Trend:
Consumer Petrol vs. the Alchian-Allen Effect
The Alchian–Allen effect was described in University Economics, first published in 1964 by Armen Alchian and William Allen. The effect outlines a very peculiar phenomenon within consumer behavior: when there are two substitute goods of differing prices that are subjected to the same fixed-cost increase, consumers will opt for the more expensive good. To think of it another way: when there are two versions of a product, one of which is more expensive, any increase in the fixed cost of the products will lead consumers to purchase the most expensive option. This is because the added per-unit amount decreases the relative price of the more expensive good.
A clear example of this phenomenon can be found with coffee: if two different kinds of Costa Rican coffee, the cheaper Robusta and the slightly-more-expensive Arabica, are being imported to the United States, and thus are subjected to the same import tax, consumers in the US will more often opt for the Arabica variety. This effect can permeate into all sorts of price-differencing situations, whether it be urban vs. rural prices, import vs. domestic, varying quality levels, consumer preference, and so on.
The model holds water across a variety of situations, especially when looking at cities; urban centers with higher fixed costs have a tendency to import the more valuable version of whatever good is being brought in. You can get sushi anywhere, but Nobu only exists in such high cost areas. Most American towns have some sort of auto dealership (or five), yet only in select cities could you drive a Bentley off the lot. This “fixed per-unit amount” is a key part of the effect, since it’s the mechanism that decreases the relative price of the pricier product. This can come in the form of flat-rate premiums, tariffs, import costs, transportation costs, incidental costs (such as a high-spoilage or high-damage potential), or taxes.
David Henderson, writing for The Library of Economics and Liberty, outlines the initial basis for the Alchian-Allen effect, or what was previously identified as the “oranges principle”— They gave no name to their insight and so we graduate students at UCLA, where Alchian and Allen taught, called it the “oranges principle.” The idea is that the cost of shipping low-quality oranges is the same as the cost of shipping high-quality oranges. Say the price of a high-quality orange in Florida is PH and the cost of a low-quality orange in Florida is PL. Obviously, PH > PL. But let the cost of shipping to Minnesota be X. Then the price of a high-quality orange in Minnesota is PH + X. The price of a low-quality orange in Minnesota is PL + X. PH/PL > (PH +X)/(PL + X). Therefore the relative price of a high-quality orange in Minnesota, relative, that is, to the price of the low-quality orange in Minnesota, is lower than the relative price of a high-quality orange in Florida relative to the price of a low-quality orange in Florida. That’s why a disproportionately high percentage of oranges tend to be shipped out.
While not a driving force of all consumer behavior, the effect allows us to explore a different rationale for consumption, especially if it seems initially unsound. The Alchian-Allen effect is said to extend across any pair of goods (or even intangibles) that meet the requirements (substitute consumer goods, fixed tax), and this in turn is used to direct price-modeling efforts. However, I believe there’s a good that not only meets these requirements, but bucks the trend entirely and is something most people buy every day, week, or month in some capacity. I’m talking about good ol’ gasoline.
Consumer-access gasoline is a unique commodity in that it is subjected to a flat tax, and exists (typically) in three tiers— regular (the lowest octane fuel–generally 87), mid-grade (the middle range octane fuel–generally 89–90), and premium (the highest octane fuel–generally 91–94). These octane tiers are a measure of a fuel's ability to resist "knocking" or "pinging" during combustion, caused by the air/fuel mixture detonating prematurely in the engine. In luxury or high-performance cars, it’s typically understood that they require a higher octane, while the average consumer vehicle can exist solely on a diet of 87. Higher octane fuels are often required or recommended for engines that use a higher compression ratio and/or use supercharging or turbocharging to force more air into the engine.
While using a non-recommended octane level for your vehicle can cause increased engine wear over time, no single tank of regular or mid-grade or premium will affect the health of a vehicle (note that we will not be touching on diesel fuel).
To the point of the “flat tax” requirement for the Alchian-Allen effect to take place, gasoline in America is subjected to a federal excise tax (18.4 cents per gallon); the last time the tax was raised was in 1993, and the tax itself is not indexed to inflation (which increased 77 percent from 1993 through 2019). With this, the price fluctuations in gasoline can be used as a proxy for a flat-tax increase since it typically affects all octane levels the same, and all local producers are subjected to the same taxation. While each (and area) will experience its own fluctuations, the overall trends remain the same due to the number of exogenous factors that affect gas price. Below is the historical price breakdown for regular, mid-grade, and premium fuel through 2020 (dollars per gallon, excise tax included):
Robert Lawson and Lauren Raymer touched heavily on this in their 2006 report for Economics Bulletin, titled “Testing the Alchian-Allen Theorem: A Study of Consumer Behavior in the Gasoline Market”. With this, they measured consumer metrics from a single, rural, independently-owned gasoline station in West Virginia for the years from 1992-1999. For each day, the total amount of gasoline sold at each pump in each of the three grades was obtained, as well as the prices for that day.
The logic of the Alchian-Allen Effect in this study would persist as market shares of higher quality gasoline should increase at the expense of regular grade gasoline when overall gasoline prices increase. However, both in the Lawson-Raymer study and in the subsequent data, we can see that the effect fails to affect the market for gasoline. From Lawson-Raymer: “The empirical results do not conform to this expectation [of the Alchain-Allen effect]. We find instead that the consumers in this sample responded to higher gasoline prices by switching to mid grade gasoline from premium grade gasoline leaving the market share of regular gasoline unchanged.” To summarize the empirical findings of the study: Price fluctuations of the three grades of gasoline were highly correlated with each other over time. The median difference in price between premium and regular grade was $0.17 and between mid grade and regular was $0.08 with very little variation... It is a fair description of the data to say that the price differentials were essentially constant between the three grades.
While absolute price differences among the three grades were relatively constant, the relative price of one grade to another was not nearly as constant. As the mean price of gasoline increased the relatively fixed price differential between the prices of each grade caused the price of premium and mid grade gasoline to decline in relation to regular grade gasoline. For every $0.10 increase in the average price of gasoline there is a 2.3% decrease in the price ratio of premium to regular grade gasoline and a 1.6% decrease in the price ratio of mid to regular grade gasoline. As the mean price increases, the premium and mid grades of gasoline become cheaper relative to the regular grade. The relatively fixed gap in absolute prices between the three grades acts in a similar manner as a fixed per-unit tax... If consumers are responding to relative prices, we should expect to see an increase in the market share of mid and premium grade gasoline as the mean price increases.
The results show that the market share of regular grade gasoline was essentially unchanged as the price of gasoline changed. The market share of mid grade gasoline increased as the average price of gasoline increased. A ten cent increase in the average price resulted in a 1.2% increase in the market share for mid grade gasoline. The market share for premium grade gasoline, however, fell in response to higher overall gasoline prices, indicating a 1.4% decrease in the market share for premium grade gasoline in response to a ten cent increase in average gasoline prices. These results do not conform to the expectations of the Alchian-Allen [theory]. Instead of seeing consumers moving from regular grade to mid and premium grade gasoline as overall prices rise, we observe a pattern where regular grade market share is unchanged while premium grade consumers switch to mid grade.
For this analysis, it may be relevant to have historical gas prices at hand, as well as understanding the market share of each octane level as purchased by consumers. Remember— if the Alchian-Allen effect holds true, we should see mid-grade and premium gasoline market shares increase (even marginally) as the prices of all three octane levels begins to increase. Broken out by octane level, below are the average dollar per gallon prices for gasoline from 1996 - 2021, as well as the market share for each octane level in terms of sales of thousands of gallons per day:
