Question:
In recent decades, the inflation-adjusted cost of healthcare has risen significantly. Given this information, can we deduce whether the increase is due to lower supply or higher demand? If not, what further data would be necessary to establish the driving force behind these elevated prices?
Solution:
This question, among others, serves as a valuable tool in my principles of microeconomics class, aiming to convey a crucial lesson: never base conclusions on price changes alone. As Scott Sumner has frequently pointed out, rising prices can be a result of increased demand, decreased supply, or some combination of both. Thus, merely observing a change in price is insufficient for pinpointing its underlying cause. To truly understand why prices have shifted, we must also analyze changes in quantity.
Before delving into analysis, it’s helpful to establish some context. For the purposes of this discussion, we view healthcare as a composite good. Although this could complicate measurement, it remains a widely accepted simplification appropriate for introductory analyses. Additionally, the quality of healthcare has significantly improved over time; this enhancement does not detract from the supply-and-demand framework. Better quality influences both production costs and consumer willingness to pay, thereby affecting shifts in supply, demand, or both. Consequently, quality changes can be represented within the same price-quantity framework employed here.
If we observe that both the price and the quantity of healthcare consumed are rising, this suggests that the increase in prices is primarily driven by heightened demand. Crucially, this does not imply that supply has remained unchanged; rather, it indicates that any shifts in supply were overshadowed by a substantial increase in demand, resulting in elevated equilibrium price and quantity.
Conversely, if we see that while the price of healthcare is rising, the quantity consumed is declining, we can conclude that the higher prices are primarily a result of a decrease in supply.
This reasoning directly follows from the principles of supply and demand, which consider each observed price-quantity pair as an equilibrium outcome. At any given moment, the market price and quantity reflect the intersection of the respective supply and demand curves. Comparing outcomes over time allows us to assess different equilibria influenced by shifts in either supply, demand, or both. Examining how price and quantity interact across equilibria helps to identify which factor was more influential, despite us not observing the underlying curves directly. This highlights why changes in prices must be evaluated alongside changes in quantities: together, they illuminate the forces reshaping the market.
It’s worth noting that we do not need to pinpoint specific underlying factors—such as demographics, regulation, preferences, or technology—before concluding whether supply or demand has shifted. While these elements are crucial for understanding why the shifts occur, they are not necessary for identifying which side of the market has changed. In supply-and-demand analysis, these factors are relevant only to the extent that they shift the supply curve, the demand curve, or both. By analyzing changes in equilibrium price and quantity, we can deduce whether demand or supply was the predominant influence, even without determining the exact sources of those shifts. In essence, price and quantity data indicate the direction of change, while details about the underlying determinants help explain the cause.
Finally, it is essential to stress that total spending—calculated as price multiplied by quantity—does not clarify whether rising prices stem from supply or demand shifts. A demand increase raises total spending, as both price and quantity rise. Conversely, a decrease in healthcare supply could also elevate total spending if demand is relatively inelastic since price increases might outpace quantity decreases. Therefore, total spending in healthcare does not enable us to discern the specific source of the rising prices.
In summary, the rise in the inflation-adjusted price of healthcare alone does not reveal whether demand or supply is the culprit. To ascertain the dominant force, we need to analyze how quantity has varied in relation to price.
