Never Preach from a Price Change

What if high prices are good?

For those that missed it, I’m excited to announce that, starting this summer, I (Brian) will be joining the International Center for Law and Economics. You can read ICLE’s announcement or my Twitter announcement here. I will be working on competition and antitrust and general law and economics topics. Those are key topics that come up repeatedly in this newsletter; they are important to me. I will also continue to do academic research. I’m beyond thrilled for the chance to join such a tremendous intellectual group.

People have asked what this means for the newsletter. Absolutely nothing! We will keep doing our weird thing here at Economic Forces, writing on the topics that interest us. The money is just too lucrative to leave. As always, if you have a question you’d like us to discuss, drop it in the comments or reply to the email. 

Now on with this week’s topic.

---

Every few months, a chart from Mark Perry makes the round of online economics discussions.

For those sharing it, the presumption seems to be that higher prices are bad. That’s Perry’s takeaway:

1. Blue lines = prices subject to free market forces. Red lines = prices subject to regulatory capture by government. Food and drink is debatable either way. Conclusion: remind me why socialism is so great again.

I’m not so sure. Wages are in red too. Surely, it’s a good thing that wages rise. As usual, the story is more complicated.

First, note that these lines aren’t independent. After all, the spending on healthcare has to show up as income for someone. If healthcare is like most industries, most of the increases in prices will show up as wages. Pushing up the cost of healthcare goes along with pushing up wages. When wages are there, we can’t talk about each line entirely independently.

For this post, let’s ignore the wage line and look at the other lines that we can think of as independent. Further, I’m going to be thinking about relative price changes. I won’t worry about inflation which further complicates this picture. We are interested in how these lines differ from the overall inflation line in black.

High Prices are Good for Sellers, Bad for Buyers

People often assert that high prices are bad. It’s so painfully obvious as not to warrant an elaboration. Look at healthcare! It’s up! That’s bad!

An obvious but ignored in the “high price=bad” assertion is that high prices are good for sellers and bad for buyers. I love that the price of economic lectures has gone up over the years. Thanks, KSU students and parents! My dad, a long-time dairy farmer, cheered with the price of milk went up. Looking at healthcare again, all of that rise in price goes to someone either in wages, rents, profits, or something else.

There’s an asymmetry in how we think about price rises. Most of us sell one good (our labor) but buy a bazillion things. Picking a good a random, we are more likely to buy that good than a sell. Maybe that is why we instinctively seem to have this aversion to any price rises. We assume it is for something we buy, not something we sell. When inflation occurs, people don’t think their wages will rise.

Also, a 10% increase in the price of economics lectures is a much bigger deal to me than a 30% increase in healthcare. I spend little of my income on healthcare as a young-ish healthy person. Gas is even less, yet we all worry about gas price rises.

We should pause for a second and not assume that high prices are bad. It has winners and losers.

High and Low Prices Can Both Be Efficient

Putting aside the exact winners and losers, can we say something about the overall effect of higher prices?

Remember that prices are signals of underlying conditions. When there is a hurricane, and the price of generators goes up, the storm was the real problem, the real destruction. The prices reflect that reality. When Russia starts a war (imagine) and the price of gas goes up, the war and the breakdown of trade destroy value. The prices reflect that. Conditional on the underlying conditions, the price rise doesn’t change the efficiency. Everything is efficient.

We can see this in the case of supply and demand. With no externalities, the price is Pareto efficient, and market participants maximize the total gains from trade, called the total surplus. Now suppose something changes in the market, such as an increase in the cost of producing gasoline. The market outcome is still efficient. Up, down, or constant, it doesn’t matter what happens to price.

Remember that price rises are good for sellers and bad for buyers. In the simplest case of supply and demand, those gains and losses directly offset each other on the margin. People have still exploited all gains from trade.

Previously, Josh touched on this point in schools and housing prices.

When it comes to schools, economics tells us that bad schools are sort of like pollution. Some people will be willing to pay higher rent to live in an area with better schools. Other people are willing to bear the cost of a lower-quality school in exchange for cheaper rent.

Neither the high rent nor low rent bundle is better. They involve different trade-offs.

There’s nothing special about supply and demand for this qualitative point. The same is true if we complicate the model to include market power. The market power existed before and after the shift. The change in price doesn’t change that. There’s no general rule that says price rises in markets with market power are bad. Again, we need to know the source of the price change.

Never Preach from a Price Change

With these preliminary complications out of the way, we can not move to the real point of the post. If we want to know if the total surplus increased (what I’ll call “good”), we cannot look at the price; we need to look at the source of the price change. Scott Sumner popularized that you should not reason from a price change. As Scott summarizes the point:

I have a series of posts exposing the common fallacy of “reasoning from a price change.” (Trademark) This occurs when people assume that consumers will buy less oil when the price is high, or there will be less investment when interest rates are high, or there will be fewer exports when exchange rates are high. In fact, the effect of price changes on equilibrium quantities depends entirely on the cause of the price change. When prices rise due to less supply, quantity falls, when they rise due to more demand, quantity rises.

Sumner stresses that we need to know the cause of the price change to determine what will happen to the quantity.

A direct implication of “never reason from a price change” is that I’m calling “never preach from a price change.” (HT: Nick Whitaker)

We need to know the cause of the price change to determine what will happen to the total gains from trade.

Let’s think about the highest price rises in the chart above: healthcare and education. One takeaway is that prices are rising because the government is wasteful and can’t control costs. This is in contrast to private companies that are subject to profit and loss. I’m sympathetic to that argument but must resist simply confirming my priors.

Let me put forward another possibility: prices rose because the value created in healthcare and education rose. The most significant change in these markets is the demand side, not the cost side.

Let’s start with education. In the first newsletter ever at Economic Forces, I argued that the simple supply and demand story is that technological change increased the college premium, which drives up the demand for college. Students today perceive that the value-added by going to college is higher than in 1997, regardless of whether it is from skills acquired in college or pure signaling. The students bid up the price of college. If that’s the story, then college is generating more value than in the past, and higher prices reflect a good thing in terms of total surplus.

Another possibility is that the government has gotten more involved with higher education, primarily through loans. Because of government involvement, education is dominated by waste and rent-seeking. This increase in costs drives up the cost of education. Higher costs reflect a bad thing in terms of total surplus.

Luckily, basic supply and demand tells us how to differentiate these two stories.

If it is a demand-side story about the value-added of college increasing, we would expect the quantity demanded to go up along with prices. If it were about costs rising, we would expect the quantity demanded to go down. In reality, both could be happening, but it is at least plausible, given that quantity of students attending college has increased over the past decades, that the “this is a good change” story dominates.

One way to account for these sorts of demand-side increases is to adjust the price by some measure of quality. The data used in the chart above already tries to account for quality. If done perfectly, we should rule out one source of demand increases from the picture.

We can see this when we look at the television line at the bottom of the chart. It’s not that the nominal price of today’s 60-inch 5k flatscreen is so much lower than a massive CRT in 1997 but that the “price per unit of TV quality” has dropped. The price of TV services has fallen.

Quality isn’t only relevant for TVs. I’ll argue that controlling for quality is vital to understanding the healthcare market. If quality increases faster than the statistical agencies can account for, price rises will reflect demand increases because the product is better. A paper by Dunn, Hall, and Dauda (forthcoming in Econometrica) is the latest in a long line of papers that argue that once we account for quality, many healthcare costs are rising less than commonly measured, if not falling. The idea of healthcare costs as falling goes against the popular narrative, but it’s plausible.

A paper by Murphy and Topel from 2006 estimates that the gains to life expectancy since 1900 (partially from medical innovation) were worth over $1.2 million to the representative American in 2000. If people pay more today for healthcare because the quality has risen, that is a net gain for society.

My point is not to get into the weeds about healthcare or education. There are many problems in those markets, and I’m not a health or education economist.

I’m simply making the point that, just as we cannot reason from a price change, we cannot preach from a price change. We do not know whether a rising price reflects demand or supply-side changes without more details. If the value to consumers for the product rises, a price rise reflects an increase in the value to society.

We need to know the cause. Price theory is about uncovering those causes and then tracing out the implications.