question:
Over the past few decades, inflation-adjusted medical prices have increased. Based on this information alone, can we infer the cause of the price increase: a decrease in supply or an increase in demand? If not, what additional data is needed to determine whether the increase in price is due to a change in supply and demand?
Solved:
I use this question in my Principles of Microeconomics class to highlight the central lesson. That means you should never make inferences from price changes alone. As Scott Sumner has repeatedly emphasized, price increases can be caused by increased demand, decreased supply, or a combination of both. Therefore, simply observing price changes is not enough to identify the root cause. To determine why the price changed, we also need to look at what happened to the quantity.
Before moving on to the analysis, it is helpful to clarify the framework. Below, we treat health care as a complex good. Although this adds some complexity to the measurement, it is a standard and appropriate simplification for principle-level analysis. Similarly, the quality of health care has improved significantly over time. This does not undermine the supply and demand approach. Improving quality affects production costs and consumers’ willingness to pay, so it works through changes in supply, demand, or both. As a result, changes in quality can be incorporated within the same price and quantity framework used here.
For example, suppose you observe that both the price of health care and the amount of health care consumed are increasing over time. In this case, the data shows that the price increase is primarily driven by increased demand. Importantly, this conclusion does not require that supply remain constant. Rather, it reflects the fact that the supply-side change was dominated by a sufficiently large outward shift in demand, resulting in an increase in equilibrium price and quantity.
In contrast, if we observe that the price of health care is increasing even though consumption is decreasing over time, we can conclude that the price increase is primarily caused by a contraction in supply.
This inference follows directly from the logic of supply and demand, which treats each observed price and quantity pair as the outcome of an equilibrium. At any given time, market price and quantity reflect the intersection of the general supply and demand curves. Therefore, when you compare results over time, you are comparing different equilibria produced by changes in supply, demand, or both. By observing how price and quantity move together beyond equilibrium, we can infer which change was dominant without directly observing the underlying curve itself. This is why changes in price must be interpreted in parallel with changes in quantity. Together, these reveal the direction of the forces reshaping the market.
Note that it is not necessary to identify specific underlying factors, such as demographics, regulations, preferences, or technology, before drawing conclusions about whether supply and demand have changed. These factors are important for explaining why supply and demand change, but they are not necessary for determining which side of the market has changed. In supply and demand analysis, such factors only become important if they shift the supply curve, the demand curve, or both. By observing how the equilibrium price and quantity change, we can infer whether demand or supply was the dominant force, even if we do not know the exact cause of the change. In other words, price and quantity data identify the direction of change, and information about the underlying determinants explains its causes.
It is also important to emphasize that total spending on health care (price and quantity) does not tell us whether price increases are due to changes in demand or supply. When demand increases, total spending increases because both price and quantity increase. However, if demand is relatively inelastic, a reduction in medical supply may also increase aggregate spending, since prices may rise more than the quantity decreases. Therefore, the root causes of high prices cannot be determined from total spending on health care.
In other words, inflation-adjusted increases in health care prices alone do not tell us whether demand or supply is the cause. To identify the dominant forces, we need to look at how quantity has changed with price.
