Cutsinger’s Solution: Inflation and Healthcare

Over the past several decades, the inflation-adjusted price of healthcare has increased. Based on this information alone, can you infer the source of the higher price–lower supply or higher demand? If not, what additional data would you need to determine whether higher prices are being driven by changes in supply or demand?

Solution:

I use this question, and others like it, in my principles of microeconomics class to emphasize a central lesson: you should never reason from a price change alone. As Scott Sumner has emphasized repeatedly, higher prices can result from an increase in demand, a decrease in supply, or some combination of the two. Observing a price change by itself is therefore not enough to identify the underlying cause. To determine why prices have changed, we must also examine what happened to quantity.

Before turning to the analysis, it is useful to clarify the framework. In what follows, healthcare is treated as a composite good. While this introduces some measurement complications, it is a standard and appropriate simplification for a principles-level analysis. Likewise, the quality of healthcare has improved substantially over time. This does not undermine the supply-and-demand approach. Improvements in quality affect production costs and consumers’ willingness to pay, and therefore operate through shifts in supply, demand, or both. As a result, changes in quality can be incorporated within the same price-quantity framework used here.

Suppose, for example, that we observe both the price of healthcare and the quantity of healthcare consumed rising over time. In this case, the data indicate that higher prices are driven primarily by an increase in demand. Importantly, this conclusion does not require that supply has remained constant. Rather, it reflects the fact that any supply-side changes were dominated by a sufficiently large outward shift in demand, resulting in a higher equilibrium price and quantity.

By contrast, if we observed that the price of healthcare was rising while the quantity consumed was falling over time, we could conclude that higher prices were driven primarily by a contraction in supply.

This reasoning follows directly from the logic of supply and demand, which treats each observed price-quantity pair as an equilibrium outcome. At any point in time, the market price and quantity reflect the intersection of the prevailing supply and demand curves. When we compare outcomes across time, we are therefore comparing different equilibria generated by shifts in supply, demand, or both. Observing how price and quantity move together across equilibria allows us to infer which shift was dominant, even though we do not directly observe the underlying curves themselves. This is why changes in prices must be interpreted alongside changes in quantities: together, they reveal the direction of the forces reshaping the market.

Note that we do not need to identify the specific underlying factors—such as demographics, regulation, preferences, or technology—before drawing conclusions about whether supply or demand has changed. While these factors are important for explaining why supply or demand shifts, they are not necessary for identifying which side of the market shifted. In supply-and-demand analysis, such factors matter only insofar as they shift the supply curve, the demand curve, or both. By observing how equilibrium price and quantity change, we can infer whether demand or supply was the dominant force, even without knowing the precise source of the shift. In short, price and quantity data identify the direction of the change, while information about underlying determinants explains its cause.

It is also important to emphasize that total spending—price times quantity—on healthcare cannot tell us whether higher prices are due to changes in supply or demand. An increase in demand would raise total spending, since both price and quantity increase. However, a decrease in the supply of healthcare could also raise total spending if demand is relatively inelastic, because price may rise by more than quantity falls. For this reason, total spending on healthcare does not allow us to identify the underlying source of higher prices.

In short, a rise in the inflation-adjusted price of healthcare, by itself, does not tell us whether demand or supply is responsible. To identify the dominant force, we must examine how quantity changed alongside price.