When gasoline is expensive, people grumble that big oil companies like Chevron and ExxonMobil are colluding to keep prices high. They’re wrong. The best way to understand why businesses aren’t collectively fleecing consumers can be found in the economics tradition of price theory.
The man-on-the street viewpoint seems reasonable at first. Few substitutes are available for oil and oil products, such as gasoline. Drivers can’t scale back much when prices at the pump rise. Oil giants know this, seemingly giving them the power to line their pockets at the public’s expense.
But while firms might be tempted to collude to underproduce and overcharge, markets constrain them from doing so. Ultimately, collusion is an unsustainable strategy, since a single defector can cut its own prices, gain market share, and boost its profits. Competition is a hardy weed. Though old-fashioned supply and demand may drive prices higher than we want, competition works to consumers’ advantage, keeping them in check.
Consistent with the Chicago, UCLA, and Vienna schools, we define price theory as “the study of how the price system coordinates the disparate plans of producers and consumers.” Because markets are connected by prices, we must understand how prices work in order to understand how markets work. What makes price theory unique in economics is its parsimonious balance between theory and empirical fact.
In the gasoline example, price-theory reasoning helps us see that the pursuit of profit cuts against the temptation of collusion. Using price theory to reason through a problem like this was once common in economics; it isn’t anymore. Policymakers and the public aren’t getting the advice they need from economists. That’s a major hindrance to public discourse—and it has serious policy implications, too.
To revive this tradition, we recently organized and ran a boot camp for economics graduate students and early career professors that emphasized how price theory can address important questions. After several days of seminars, discussion, and problem solving, we’re more convinced than ever that economists need to return to their roots to explain how the world works.
Unlike other approaches that influence young economists, price theory does not devote major effort to hyper-mathematical modeling; nor does it make heroic assumptions about rationality. Instead, it takes a few workhorse models and uses them to study an astonishing range of circumstances. Why might corn farmers prefer the government to subsidize ethanol instead of corn in general? Which firms are most supportive of minimum-wage hikes? What are the probable effects of corporate tax cuts on workers’ take-home pay? These are merely a few examples of perennial questions that price theory can help us answer.
Other approaches to economics claim to offer better answers, but they are limited by their inflexibility. Elegant theoretical models often add complexity without adding explanatory power. Statistical approaches purport to “let the data speak for itself,” but they rarely yield generalizable results. Price theory strikes the right balance. It uses theory, but as a guide to measurement rather than as an end in itself. It lends itself well to empirical analysis because it teaches us what to measure and, more importantly, what not to measure. If an economist’s first instinct in researching the effects of minimum-wage laws is to gather data on unemployment and the number of jobs, he needs a price theory refresher.
We are not the first to notice the scarcity of economic reasoning among today’s economists. The University of Chicago has run a price theory summer camp for years. Leading price theorists such as Kevin Murphy and Casey Mulligan are working hard to spread the message, co-authoring with two other scholars a helpful textbook and making their recorded lectures widely available. Mulligan was also the plenary speaker on the final night of the boot camp.
A price theory revival would have implications reaching far beyond the academy. Though economists rarely enjoy the celebrity status of Milton Friedman nowadays, there remains a strong demand for economic expertise, both in addressing policy questions and staffing key government positions. Economists cannot fulfill their public calling if they lack basic training and know only esoterica. In the current policy landscape, we need to understand, for example, how raising tariffs will affect domestic output and employment, what the costs and benefits are of income inequality, and how large-scale immigration affects markets and politics.
More than any other economic approach, price theory can generate convincing and useful answers to the questions that arise time and again in our public discourse. It’s due for a revival.
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