Wyandanch Library

Overview

George Stigler's The Theory of Price is a cornerstone text of the Chicago School of economics and one of the most rigorous treatments of price theory ever written. Stigler walks the reader through the mechanics of how prices are determined in competitive and non-competitive markets, covering supply and demand, production costs, factor pricing, and the behavior of firms under different market structures. His writing is precise, analytical, and refreshingly free of unnecessary abstraction.

What sets Stigler apart is his insistence on applying theory to real-world phenomena. Every concept -- from the elasticity of demand to the theory of the firm -- is grounded in observable market behavior. He treats economics as an empirical science, not a branch of mathematics, and his emphasis on information costs and search theory (for which he later won the Nobel Prize) anticipated entire fields of modern financial economics.

Price Theory: The Core of Economics

Stigler opens with a simple but powerful claim: price theory is the core of economics. Not macroeconomics, not monetary policy, not game theory -- price theory. Everything else is built on top of understanding how prices form in markets.

Why? Because prices are the mechanism through which decentralized economies allocate resources. No central planner decides how much wheat to grow, how many cars to build, or how many software engineers to train. Prices do it. When the price of oil rises, producers drill more wells and consumers drive less. When the price of a software engineer rises, universities expand their computer science programs and firms substitute automation for labor. Prices coordinate the decisions of millions of independent actors without anyone being in charge.

For Stigler, price theory isn't a subfield of economics -- it is economics. And for investors, this is the right starting point. Every investment decision is ultimately a bet about prices: the future price of a company's products, the future cost of its inputs, and the price the market will eventually assign to its equity.

Supply, Demand, and Market Equilibrium

Stigler's treatment of supply and demand goes far beyond the introductory X-shaped graph. He builds both curves from their microeconomic foundations.

Demand reflects the aggregated choices of consumers, each making decisions at the margin. The demand curve slopes downward because of diminishing marginal utility (the Menger insight) and the substitution effect -- as a good becomes more expensive relative to alternatives, consumers switch. Stigler emphasizes that demand is not a number; it is a schedule of quantities demanded at every possible price. The demand curve encodes the subjective valuations of every participant in the market.

Supply reflects the aggregated decisions of producers, each facing their own cost structure. Firms produce additional output as long as the marginal revenue from the next unit exceeds the marginal cost of producing it. The supply curve slopes upward because, in most industries, marginal costs rise as production expands -- you use your best resources first, and each additional unit requires tapping into less efficient capacity.

Equilibrium is the price at which quantity supplied equals quantity demanded. Stigler is careful to emphasize that this is not a static concept. Markets are constantly being shocked by new information, changing tastes, technological shifts, and policy changes. The equilibrium price is always moving, and the speed of adjustment depends on how quickly information spreads and how flexible prices are. This is directly relevant to understanding market microstructure and price discovery in financial markets.

Elasticity: Measuring Responsiveness

Elasticity is one of the most practically useful concepts in all of economics, and Stigler gives it a thorough treatment.

Price elasticity of demand measures how much the quantity demanded changes in response to a change in price. If a 10% price increase leads to a 20% drop in quantity demanded, demand is elastic (elasticity > 1). If the same price increase leads to only a 3% drop, demand is inelastic (elasticity < 1).

Why does this matter for investors? Because elasticity determines pricing power:

Inelastic demand (necessities, addictive products, products with no close substitutes) means the firm can raise prices without losing much volume. Revenue rises. This is the economic foundation of a pricing moat.
Elastic demand (commodities, products with many substitutes) means price increases drive customers away. Firms are price-takers, not price-setters.

Stigler also covers income elasticity (how demand responds to changes in consumer income -- luxury goods are income-elastic, staples are not) and cross-price elasticity (how demand for one good responds to price changes in another -- the formal definition of substitutes and complements). These concepts are essential tools for industry analysis and competitive positioning.

The Theory of Costs

Stigler's treatment of cost theory is where the book becomes indispensable for business analysis. He distinguishes several cost concepts:

Fixed vs. Variable Costs

Fixed costs do not change with output in the short run -- rent, insurance, executive salaries, depreciation on existing equipment. Variable costs change directly with output -- raw materials, hourly labor, energy, shipping.

The critical insight: fixed costs are irrelevant for short-run production decisions. A firm should continue producing as long as revenue covers variable costs, even if it is not covering fixed costs. Shutting down would lose all revenue while still incurring fixed costs. This explains why airlines fly half-empty planes, why hotels slash rates in the off-season, and why money-losing companies continue operating for years.

Marginal Cost and Average Cost

Marginal cost is the cost of producing one additional unit. Average total cost is total cost divided by total output. The relationship between these two is crucial:

When marginal cost is below average cost, average cost is falling (each new unit is pulling the average down).
When marginal cost is above average cost, average cost is rising.
The profit-maximizing output is where marginal cost equals marginal revenue.

For investors analyzing operating leverage, this framework explains why high-fixed-cost businesses (software, pharmaceuticals, media) have explosive profit growth once they cross the breakeven point -- marginal costs are near zero, so each incremental dollar of revenue drops almost entirely to the bottom line.

Returns to Scale

Stigler carefully distinguishes short-run diminishing returns (adding more workers to a fixed factory eventually produces less per worker) from long-run returns to scale:

Increasing returns to scale: doubling all inputs more than doubles output. Common in industries with high fixed costs, network effects, or learning curves.
Constant returns to scale: doubling inputs doubles output.
Decreasing returns to scale: doubling inputs less than doubles output. Common in industries where coordination costs grow with size.

Understanding returns to scale tells you whether an industry naturally tends toward consolidation (increasing returns favor large firms) or fragmentation (decreasing returns favor small ones). This is one of the most important structural questions in any industry analysis.

Market Structure: Competition and Monopoly

Perfect Competition

In Stigler's framework, perfect competition is the benchmark -- not because it exists perfectly in reality, but because it reveals the logical implications of competitive forces. In a perfectly competitive market: many firms sell identical products, no single firm can influence the price, entry and exit are free, and information is perfect.

The key result: in long-run competitive equilibrium, economic profit is zero. Price equals minimum average total cost. Firms earn just enough to cover their cost of capital -- nothing more. Any excess profit attracts new entrants who compete it away.

This is not a theoretical curiosity. It is the default prediction for any industry without structural barriers to entry. When Buffett talks about "commodity businesses" that earn poor returns on capital, he is describing industries that approximate perfect competition.

Monopoly and Market Power

A monopolist faces the entire market demand curve and can choose both price and quantity. The result is output restriction (produce less than the competitive quantity) and higher prices. The monopolist's profit-maximizing point is where marginal revenue equals marginal cost -- and marginal revenue is always below price for a monopolist because selling an additional unit requires lowering the price on all units.

Stigler's key contribution here is not the textbook monopoly model -- it is his analysis of what creates and sustains market power in practice. Barriers to entry, patents, control of essential resources, economies of scale, regulatory capture, and information advantages all contribute. His later work on regulatory economics showed that many monopolies are sustained not by natural advantages but by political barriers -- an insight directly relevant to analyzing regulated industries and government-granted franchises.

Price as Information Signal

Perhaps Stigler's most enduring contribution is his emphasis on price as an information signal. In his seminal 1961 paper "The Economics of Information," Stigler showed that acquiring information is costly, and that price dispersion in markets persists because of these search costs.

This insight reshaped economics. If information were free, there would be one price for every good. In reality, prices vary across sellers because buyers don't have time to check every option. Stigler formalized the optimal search strategy: keep searching as long as the expected gain from finding a lower price exceeds the cost of searching.

For financial markets, this framework explains:

Bid-ask spreads as compensation for market makers' information costs
Price momentum and mean reversion as the market gradually incorporates information
Active management fees as the cost investors pay to have someone else do the information search
Market efficiency as a function of how cheaply information can be gathered and processed

Why This Matters

Price theory is the bedrock of investment analysis. Understanding how prices form, how costs influence supply decisions, and how market structure affects competition gives investors a rigorous framework for evaluating businesses and industries. Stigler's work is particularly valuable for fundamental analysts who need to think clearly about competitive dynamics, pricing power, and the economic forces that drive margins and profitability over time.

When you analyze a company's competitive position, you are doing applied price theory. When you ask whether a company has pricing power, you are estimating demand elasticity. When you model operating leverage, you are working through Stigler's cost curves. When you assess barriers to entry, you are analyzing market structure. This is the analytical engine behind sound business and investment analysis -- it is Nick's favorite economics book for a reason.

Key Takeaways

Supply and demand are not just curves on a graph -- they represent the aggregated decisions of real economic actors responding to incentives.
Elasticity determines pricing power: inelastic demand is the economic foundation of a business moat.
The theory of the firm explains how production costs, returns to scale, and factor prices determine market supply -- and whether an industry naturally consolidates or fragments.
Fixed costs are irrelevant for short-run decisions; marginal cost drives production choices.
In competitive equilibrium, economic profits are zero -- sustained profits require structural advantages.
Market structure (perfect competition, monopoly, oligopoly) materially affects pricing, output, and long-run profitability.
Information is costly: search costs, imperfect information, and transaction costs shape real market outcomes in ways idealized models miss.
Price theory is the analytical engine behind sound business and investment analysis.