Simple theory says gas prices will drop

As consumers in the marketplace, most of us think we have little power. The seller makes the product, sets the price, and we take it or leave it. Even bargaining – especially in our society – is shunned.

So it's no surprise that most people think gas prices will just continue to rise. In fact, when I do personal presentations around the state, the typical question I get about gas prices is, “how high will they go,” not “will they ever fall?”

This is understandable because most of us operate on a “straight line” method of predicting the future. This way of forecasting simply says to expect the future to be like the past. So if gas prices have increased in the past, they will increase in the future.

While straight line forecasting is appealing, it often isn't correct. Trends do change. The housing market is a great example. From 2003 to 2007 housing prices skyrocketed. Now, in many markets, they're falling.

Indeed, a large part of the training professional economists receive is devoted to more complicated (and hopefully, more accurate) forecasting methods than the straight line theory. And the good news – for consumers – when these methods are used is that there's reason to expect gas prices to soon fall.

Here's why. The twin pillars of economics are demand and supply. Demand tells us how much of a product consumers want to purchase at any price, and supply gives us the corresponding amount of the product sellers will offer. The price of the product is stable when demand and supply are equal.

But when demand is greater than supply, or, in dynamic sense, when demand is increasing faster than supply is increasing, there will be upward pressure on the price. This is exactly what has happened to oil – and by extension, gas – prices this decade. The worldwide demand for oil (and gas) has been increasing faster than the worldwide supply. Most of the increased demand has come from developing economies in China, India, the Middle East, and Eastern Europe.

Now, straight-line forecasting would assume demand would continue to outstrip supply and oil and gas prices would continue to surge. Economic forecasting doesn't. Economic forecasting says that, rather than being pawns in the price game, consumers are active participants. The biggest way consumers can impact the price is by taking their business elsewhere. That is, if in response to higher prices, consumers purchase less of the product, prices will eventually fall.

This year's rapid rise in gas prices (up over 30 percent), combined with the slow economy and stagnating incomes, have motivated drivers to make big changes. They're driving less, carpooling and using mass transit more and buying fewer gallons of gas. These actions can turn a situation of “demand greater than supply” into “supply greater than demand” – which, in turn, switches the trend from rising prices to falling prices.

It's the potential for this kind of switch that has caused many energy forecasters to predict a pattern of falling gas prices in the near future, for several years! While the price pullback won't last forever, it will give consumers a welcome respite.

So we may very well have an upcoming test of two competing forecasting techniques – between the “straight line” and the economic. Soon we can all decide if economic forecasting is foolish or foresighted.

Mike Walden is a William Neal Reynolds Distinguished Professor and Extension Economist in the Department of Agricultural and Resource Economics at N.C. State University who teaches and writes on personal finance, economic outlook and public policy.