Irwin Kellner Get email alerts

Exceptions to the law of supply and demand

Published: Oct 29, 2007 10:20 p.m. ET


Commentary: Housing, health care illustrate why it doesn't always work


Dr.Irwin Kellner

PORT WASHINGTON, N.Y (MarketWatch) -- Housing and health care are two examples of how the law of supply and demand does not always work the way the textbooks say it should.

Here's how this law is supposed to function: When the demand for a good or service rises, the first thing that happens is that prices go up. This is because, for the moment, at least, demand exceeds supply, putting sellers in a position to raise their prices so they can earn more dollars per unit sold.

However, the more prices rise, the more goods or services will be offered to buyers, since it is obviously more profitable to so do. As a result, not only will sellers' profits per unit of into output will go up - their overall earnings will, too.

As the supply of these goods and services rises in response to these higher prices, it puts downward pressure on prices, since supplies start to exceed demand. Eventually, these prices come down to a level that clears the market at the new higher level of demand and everything is copacetic.

In the case of housing and health care, however, the law of supply and demand does not operate quite as smoothly. As a consequence, there's little to restrain prices from rising in these two key sectors of our economy.

The rate of inflation in both sectors has historically been well above the pace of price hikes of just about everything else in the consumer's market basket because in both cases, higher prices resulting from rising demand has not quickly brought forth more supplies.

This is due to the unusual nature of these industries.

In the case of health care, as you can imagine, it takes years to graduate new doctors, build new hospitals, or develop new drugs. This is true no matter how fast prices rise.

When it comes to housing, it takes a while before builders can put together a parcel of land, secure the necessary building permits, assemble construction crews and purchase needed building supplies.

And this is for new homes, which account for only about one out of every six homes sold in the U.S.

Existing homes take even longer to respond to rising prices, since the decision to sell one's home tends to be based more on such factors as job changes, desires for a new lifestyle, divorce or death.

Simply put, people are not going to put their homes on the market just because it's worth more, since they need a place to live (although, as we all know by now, they have learned to tap this increased value via a home-equity loan).

As a result, prices of both housing and health care tend rise quickly when demand picks up, and they remain high even after supplies eventually expand.

But there's one key difference between housing and health care, when it comes to responding to the law of supply and demand.

As we have been seeing for the past couple of years, it is possible for the supply of housing to overshoot the demand. So far, we have not such a development occur in health care.

That's why housing prices are falling today while health care costs continue to soar.

MarketWatch Partner Center

We Want to Hear from You

Join the conversation