Why is Gas Priced by Fractions of a Cent?
I was speaking with a former foreign policy colleague at an event when conversation turned to gas prices. Knowing my current work in pricing strategy, he asked why gas is priced in fractions of a cent in the United States. While I could hazard some educated guesses, I realized I didn’t know the full story.
So I decided to learn that story, hopefully figuring out what is unique about gas that manifests this pricing strategy. Here is what I learned.
Although there is room for debate, the most commonly accepted origin of the 9/10 cents practice dates to 1940, when Congress modified an existing tax to $0.015 per gallon of gasoline. While that may sound like a small amount, keep in mind that gas prices hovered around $0.20 at the time. Retailers, looking to share this roughly 7% new tax, began pricing in fractions of cents. The marketing benefit of prices ending in 9 had been known since the mid-1800s, so that method made its way into pricing gas by fractional cents, giving us gas prices ending in 9/10 cents.
While the tax was supposed to be temporary, it not only stuck around but grew over time. Today the tax still maintains the fractional cent, and the fractional cent retail pricing of gas similarly persists. And those pieces of pennies add up: the gas industry in the U.S. earns close to $1.5B a year more than they would rounding down to the nearest cent.
(And the marketing aspect of those 9’s adds up as well. The profit margin of gasoline at the retail level is small, only about 2%. Gas stations count on higher margins on consumer packaged goods and other products in their convenience stores, while very competitive prices for gas get customers to stop in the first place.
Of course, as consumers, we are never left with a bill that includes a fractional penny. Those fractions are rounded up or down to the nearest cent when it comes time to pay. And it’s an effect pretty much only seen at the retail level.
So, that gives a good idea of the history of the practice and why it has continued. But what about gas in particular makes fractional cent pricing acceptable to consumers?
Nature of the Product
The fact that consumers buy gas on a continuum rather than in discrete gallons (unless you’re a wizard with the gas nozzle handle) likely makes it easier for both sides to live with the current arrangement. The pump price and volume numbers go along until the tank is full or you release the handle, and there perhaps isn’t much analytical thought put into the final ratio that appears.
A store could try pricing a gallon of milk at $3.679 instead of $3.67, but consumers purchasing one discrete unit at a time would likely feel the effect of that extra fraction more directly. It would only take a couple scanner swipes to notice that $3.679 always comes up $3.68, and that may be enough to irk the consumer more than the $0.009 is worth to the retailer.
On the other hand, an item price of $3.679 in a long shopping list of other items with fractional cent prices may get buried psychologically to the consumer while adding up to something meaningful to the grocery retailer. Supermarkets, like gas stations, face very small margins, so the effect of even an additional penny per item could become substantial for revenue. It would depend, of course, on the costs associated with such a pricing regimen.
I can’t find good evidence of a grocery store trying this strategy. My suspicion is that, like many business practices, it comes down to tradition and customer expectation. Groceries haven’t routinely priced with fractional cents in the past, which makes it less likely for them to do so in the future. Customers also may balk at a pricing scheme that varies from their expectations, especially if it appears to them to be a mercenary attempt to wring out additional revenue unrelated to any value claim about the product.
Invisible to the Consumer?
The value of a penny has changed substantially since the gas tax was created. Does increased inflation make fractional cent pricing more or less likely? On the one hand, gas stations in the 1930s were asking their consumers to give up more proportionally than they are now. Pennies are practically worthless in 2016.
Conversely the value of a fractional penny today is low for the retailer as well. Gas stations had a real reason to make the price change in 1934: to offset some of the increased cost due to the new gas tax. Consumers understood that. A company trying to charge an extra $0.009 for a product today may come across as mercenary, with bad PR swamping any small revenue increase.
Fractional cent pricing clearly works well for gas stations. How much of that comes down to inertia, unique to the industry, is an open question. Companies in industries with similar purchasing patterns and product characteristics (i.e. non-discrete, relatively large volume) may want to take a second look. Tradition is usually a bad excuse for not experimenting.
Originally posted at: http://www.wiglafjournal.com/pricing/2016/04/why-is-gas-priced-by-fractions-of-a-cent/