Here
is an exam question: demand stays the same but a key cost component
rises. What happens to profits? This is about as basic as it gets, they
go down. Why? Because the supply curve has shifted to the left. While
price might be higher there is less producer surplus or profits.

So how do we reconcile this prediction with the news that Caltex’s Australian profits have soared?

There
is a theory in economics regarding how competition amongst firms may
be soft during slumps but intense during booms. The idea is that
competing firms worry that when they drop their prices to grab market
share this might trigger a price war. That means any gain they get
would be temporary. Thus, when margins are low (during slumps) the grab
for profits is not worthwhile but when margins are high (during booms)
they are. So perversely, demand may be high but prices and profits may
be lower.

Flip that theory around to think about cost shocks.
When costs are low, margins are high and so there is more reason to be
competitive. On the other hand, high costs bring low margins if a firm
decides to compete for market share and so they don’t. The end result
is higher profits associated with higher prices and demand and supply
seemingly not delivering the results one would expect on profits.

This
outcome does not require any explicit collusion and so does not violate
price fixing laws. It is caused by oligopoly and in petrol refining and
distribution in Australia, that is not going to change any time soon.

Peter Fray

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