Center for the Study of Energy Markets

It has been documented that retail gasoline prices respond more quickly to increases in wholesale price than to decreases. However, there is very little theoretical or empirical evidence identifying the market characteristics responsible for this behavior. This paper presents a new theoretical model of asymmetric adjustment that empirically matches observed retail gasoline price behavior better than previously suggested explanations. I develop a "reference price" consumer search model that assumes consumers' expectations of prices are based on prices observed during previous purchases. The model predicts that consumers search less when prices are falling. This reduced search results in higher profit margins and therefore causes a slower price response to cost decreases than to cost increases. I then develop testable implications that distinguish my model from two alternative explanations of asymmetric adjustment. The first is a model in which firms temporarily collude using past prices as a focal price. The second theory suggests that increases in wholesale cost volatility reduce consumer search behavior. Using a panel of gas station prices, I estimate the response pattern of prices to a change in costs. Estimates are consistent with the predictions of the reference price search model and contradict the previously suggested explanations of asymmetric price adjustment.