Will Rising Prices Choke Off Demand? A Basic Economic Lesson

I'm gnashing my teeth and wailing in disgust over newspaper headlines like this: "Oil Prices May Choke Off Recovery."  Or "Forecast of Rising Interest Rates Threatens Economic Growth."  Or even "High Lumber Prices Threaten Housing."  These headline writers flunked Econ 1.  For those of you who need a review, take a look at a basic Supply and Demand chart.  Let's say we're talking about widgets.


Initially, the price is at the level that brings Supply into equality with Demand (Original).  Find where these lines intersect and then move over to the left axis to find the price.  The quantity sold can be found by starting at the intersection of supply and demand and then moving down.

Now suppose that the demand for widgets increases.  The demand curve shifts to the right, meaning buyers want to buy more widgets at any given price.  The new equilibrium (where Supply intersects  Demand, New) is at a higher price, but also a higher quantity of widgets sold.  It doesn't make sense to worry about a higher price stifling sales when the higher price is a result of higher demand.

There's a sense in which the bad headline writers are correct.  Start with the old equilibrium (that intersection of Supply and Demand, Original).  Move horizontally to the right until you hit the Demand, New line.  That's the increase in quantity that would have occurred if the price had not risen.  From there, move up and the left along the demand curve (new) until you hit the new intersection point.  That leftward move up the demand curve is how much of the increase in demand was lowered by rising price.  But the quantity of goods bought will always be higher when demand has increased.

Let's go to the real world.  Oil prices will rise as the global economy increases.  But rising oil prices will not derail global recovery–rising oil prices are a result of rising demand.  It would be a different story if the rising oil prices were due to an exogenous factor, such as a disruption of oil production due to Middle East war.

Interest rates will rise as the economy strengthens.  Long-term rates will rise due to market forces; short-term rates will rise because the Fed pushes them up.  But in both cases, the rise will be a result of increasing demand for credit, so it will not stifle that demand.

Lumber prices are up because of some small rebound in construction.  As such, it cannot prevent a housing recovery.  (I'm not expecting much of a housing recovery, but if one comes, lumber prices will rise a little without choking off the recovery.)

Business planning implications: when you see rising prices in your sector, figure out whether they are due to rising demand, or a supply restriction.  Expect quantities to rise if demand triggered the price hike.