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Thursday, October 1, 2015

Never Reason from a Price Change

dollar up or down

The title is one of the favorite and oft-repeated sayings of Prof. Scott Sumner of The Money Illusion and EconLog. Yet, it bears repeating for many financial journalists and even economists too often ignore it with predictably confused results.

All the events which may occur in the market for any good or services fall into one of four categories. Each of these categories affect price, quantity, and volume of trade in (usually) predictable ways which can be summarized in this handy chart:

Category Effect on Price Effect on Quantity Effect on Volume
Increase in Supply ↓ ↑
Decrease in Supply ↓ ↑
Increase in Demand
Decrease in Demand

The most important fact about this table is not that the effect of supply changes on volume of trade is in general unpredictable (though that is worth remembering), but that the direction of the price and quantity arrows are in general completely unrelated. In other words, an increase (decrease) in price is equally compatible with an increase and a decrease in quantity (and vice versa). How these two arrows relate depends purely on the nature of the underlying event.

So when a commentator points to the strange fact that, for example, oil consumption went up even as prices increased, he exposes nothing dysfunctional about the market, but only his ignorance of the underlying causes, basic microeconomics, or both.