High profits and cost shocks in the fuel market : the role of demand adjustment costs

This paper shows that, with demand-adjustment frictions, firms can increase short-run profits in the presence of cost shocks. Firms exploit short-term price inelasticity by balancing current markups against future demand. We further examine the incidence of temporary profit taxes and find that, due to dynamic price-setting, the classic neutrality result no longer holds: firms temporarily lower prices to shift profits across tax periods, thereby increasing consumer welfare. We use this model to compare a profit tax, a price cap, and a fuel discount to the case of no policy intervention.