The Broken D.C. Gasoline Market

By:  David Balto
DC Bar

As drivers who have filled up their gas tanks in the District of Columbia are aware, gasoline prices are significantly higher within the District than in nearby Maryland or Virginia. While some of this price gap is due to the higher costs of running an urban service station, most of the blame for the disparity can be placed on the unhealthy state of the District’s retail gas market. Currently, three–quarters or more of the service stations in the District are either owned and operated or supplied by one of the city’s two dominant “jobbers,” the gasoline industry term for distributor.

Forty years ago Justice Thurgood Marshall spoke of the critical role of antitrust laws in the landmark U.S. Supreme Court case United States v. Topco Associates. He declared “[a]ntitrust laws . . . are the Magna Carta of free enterprise. They are as important to the preservation of economic freedom and our free–enterprise system as the Bill of Rights is to the protection of our fundamental personal freedoms.” One needs little knowledge of antitrust policy to recognize that the level of concentration in the D.C. gasoline market is an extraordinary problem.

The antitrust laws, however, do not regulate market structure. That is why state legislation is often necessary to protect consumers from competitive harm. For years, the District attempted to preserve retail gasoline competition by preventing jobbers from owning retail stations through a regulation known as divorcement law. Five years ago the Council of the District of Columbia passed legislation repealing the divorcement law on the hope that the change would result in an increase in competition and ultimately lower costs for consumers. Unfortunately, the opposite has occurred. Since the enactment of the legislation, an amendment to the Retail Service Station Act of 1976, there has been a significant increase in gasoline prices beyond national trends, while the two dominant jobbers have purchased a large proportion of the District’s service stations. Since the repeal of divorcement, the D.C. gasoline market has become a tight duopoly, with the two dominant jobbers’ roughly 75 percent market share higher than that of jobbers in any other U.S. metropolitan market.

This tremendous vertical integration over the past five years has raised serious competition concerns and has undoubtedly led to higher prices for hundreds of thousands of D.C. consumers. Less competition among service stations has resulted in higher prices at the pump. While the national price average for gasoline continues to rise, the District’s premium is increasing as well: The price gap between the District and its suburban neighbors increased by more than 7 cents between 2009 and 2011, according to The Washington Post, and has only continued to grow.
In a D.C. Council session, a bill to reinstate the divorcement policy was considered in detail, with extensive hearings. Ultimately, the effort to reinstate divorcement failed on a 6–6 vote that took place earlier this year. Considering the consistently worsening state of the gasoline market, the D.C. Council should reconsider its vote and pass divorcement legislation as soon as possible.

Vertical Integration

To understand the profoundly unhealthy nature of the D.C. gasoline market, it is worth reviewing vertical integration concerns in the gasoline industry. In many markets, vertical integration among complementary levels can be beneficial. Economic theory teaches that by coordinating the production and distribution of products, vertical integration can promote efficiency and eliminate the need for firms on different levels of the market to secure profits. Moreover, economic theory suggests that with one firm controlling both production and distribution, there is only a single margin to be secured (hence, they will charge less to consumers).

However, economic theory only goes so far. Vertical integration is not always innocuous; it is often quite the opposite. As the early history of the oil industry has demonstrated, vertical integration also can be a very effective tool for stifling competition. For example, Standard Oil Company, one of the first targets of antitrust legislation, acquired key inputs and created distribution bottlenecks that drove rival refiners out of the market. Today’s dominant jobbers in the District have learned lessons from Standard Oil on how vertical integration can stifle competition.

In general, there are three key tendencies of vertical integration that together explain how the elimination of divorcement legislation has harmed competition in the D.C. gasoline market. First, vertical integration can raise entry barriers or foreclose nonintegrated firms from a market. In the case of D.C. gasoline, for example, having two dominant jobbers that control not only the majority of distribution but also a high percentage of the retail market makes it much more difficult for new jobbers to enter the market. Indeed, jobbers from outside the D.C. area have stated that because of the vertical integration of the two dominant jobbers and their service stations, it is exceedingly difficult for a nonintegrated, outside jobber to find enough buyers for their product, and thus make an entry into the market cost-effective and worth the potential risk. Looking at the entrenched duopoly’s control of the retail market, few jobbers see a benefit in approaching the small number of nonintegrated service stations, correctly judging that the opportunities for entry into the current market are too small to gain a reasonable foothold and compete with the duopoly. As the dominant jobbers continue to purchase more retail stations, these barriers to entry will only grow taller, and the problem will become more severe.

Second, vertical integration may enable integrated firms to raise their competitors’ costs in an anticompetitive manner and reduce the incentive for nonintegrated firms to compete. For example, a dominant jobber may diminish the ability of independent service stations to compete on the retail level by limiting supply to these stations or by raising wholesale prices strategically. Positioned at two levels of the market, a vertically integrated jobber/retailer thus relates to service stations as both a horizontal competitor and a supplier, leading to an unfair market advantage at both levels. In its position as supplier, the jobber/retailer has access to competition–sensitive information about its retail buyers. Access to such information often enables a firm to diminish the ability of its rivals to compete. As a competitor, the jobber/retailer enjoys the ability to manipulate the price it charges its retail competitors while setting its own prices, thus using its dual–market position to further hinder its rivals’ ability to compete. Put simply, permitting jobbers to own service stations is essentially putting the fox in charge of guardineliminating divorcement was a suggestion that divorcement laws themselves created barriers to market entry, rather than protected against them. The very limited entry to the D.C. gasoline market over the past five years clearly suggests that this analysis was misguided. Testimony at the time of repeal also missed the mark in assessing the nature of gasoline competition at the retail level, which is significantly more fragile than other markets due to the more general and significant entry barriers for new retailers. Were new service stations relatively easy to open, there would be greater opportunity for new jobbers to enter the D.C. market and challenge the existing firms. Since this is not the case, divorcement repeal simply allowed the two dominant jobbers to dominate the wholesale and retail supply in the District and further inhibit the entry of new jobbers to the market, thereby increasing concentration and stifling competition.

It is true that in some markets these types of acquisitions can create greater efficiencies, especially where an acquisition allows a firm to improve service or lower costs, resulting in lower prices for consumers. In this case, however, the acquisitions have not benefited consumers to any discernible degree. Indeed, many retail operators have continually complained that the two dominant jobbers do not support the same level of quality as previous owners, and that competition based on the level of service has diminished enormously. Drivers seeking to purchase gas in the District must now make do with higher prices and worsening quality of service, demonstrating clearly that there has been little to no consumer benefit resulting from the repeal of divorcement.

Restoring the Market to Health

The current D.C. market structure, in which two jobbers have an immense share of both the wholesale and retail market, clearly has produced significant anticompetition problems. Enactment of new divorcement legislation will eliminate the vertical control that these two dominant jobbers possess. By breaking the ownership bind, independent retailers would have greater freedom to price competitively, and with a broader selection of jobbers from which to choose, independent retailers should be better able to seek the lowest wholesale costs, thus spurring competition at both retail and wholesale levels. Elimination of the ownership bind over retail also should spur greater entry at the wholesale level. With more nonintegrated service stations, there will be an increased ability for new jobbers to enter the D.C. market, leading to further competition, better service, and lower prices for consumers.

Finally, it is worth noting that greater competition, thus lower pricing in the D.C. gasoline market, may, in fact, increase the District’s tax revenue from gasoline sales. While higher prices in theory should bring in more tax revenue, there is a strong chance that the pricing gap between the District and its suburban environs may incentivize consumers to visit Maryland or Virginia to fill up their tanks, a phenomenon that if prevalent enough would actually mean the District is losing revenue because of the price gap. Were gas prices roughly equal in all local jurisdictions, the incentive to leave the city to fill up would be negated, more consumers would purchase gas in the District, and gas tax revenue actually could increase for the District, despite the drop in price.

There is a clear argument for the reinstatement of divorcement in the District, and D.C. Council action on this issue is long overdue. However, there are some important concerns that must be considered in any future legislation to address the divorcement issue. Chief among them, the restoration of divorcement must be a process, not a single step. There is a clear danger that, faced with the need to cease ownership of their service stations, the two dominant jobbers may choose in many cases to remove the properties’ gasoline facilities and sell the property as empty land, which is perpetually in high demand in many areas of the District. Incentives for service station owners to market their property to real estate developers rather than gas station operators are clear: The pool of potential purchasers is much larger, and demand for housing is most likely growing at a greater rate than that for gasoline.

Indeed, evidence from recent sales of service stations demonstrates that the transition from gas station to multistory condominium building is a very attractive path both for station owners and real estate developers alike. If the D.C. Council were to reinstate divorcement without divestiture conditions for existing jobber/retailers, there could be far fewer gas stations in the District in another five years. To a certain extent, this process is already ongoing; the District has half the gas stations it had 25 years ago. Divorcement without specific divestiture guidelines could accelerate the disappearance of service stations from the District, which would itself result in decreased competition and higher prices for consumers.
If the D.C. gasoline market is to return to a healthy state, the D.C. Council must reconsider the issue of divorcement and reinstate a policy that jobbers cannot own and operate service stations to sell the gas that they distribute. Economic theory aside, the past five years of increased price disparities between the District and its suburbs, and the 75 percent market share the two dominant jobbers hold, clearly demonstrate that repealing divorcement was the wrong course to take for D.C. consumers. The D.C. Council should reconsider legislation in its next session. Reinstating divorcement makes sense for retailers, the D.C. government, and most important for consumers. As national gas prices continue to rise, D.C. drivers shouldn’t have to feel even more pain at the pump because of a broken market that could be fixed through smart legislative action.

David Balto is a Washington, D.C., antitrust attorney. He has served at the U.S. Department of Justice, as well as the Federal Trade Commission, where he was a policy director and attorney–adviser to Chair Robert Pitofsky.