Monday, July 31, 2017

Generalizations in Interpreting Supply and Demand Diagrams

In a recent post Hidden Benefits of Taxes we argued that while a tax wedge reduced allocative efficiency, it increased productive efficiency.  With a tax wedge,  a portion of the remaining Social Surplus was allocated to the government, the Harberger Triangle in the diagram being discarded since it was no longer being (inefficiently) produced.  Inefficient production is a waste of resources, often irreplaceable ones.  For a very nice post on this issue, see this book review of:  "Capitalism 3.0 A Guide To Reclaiming The Commons" (2006) book by Peter Barnes,over at Portrait of the Dumbass

So.  Consider the situation where the source of a product, the factory or the mine, is far from the consumer, and the cost of transport is significant.
The shipper must cover the cost of transport, so the price the consumer is going to have to pay will be much higher than the shipper pays the producer.  We also observe that the quantity bought from the producer will ordinarily be the same as the quantity sold to the consumer.  And we see that if we draw a diagram of the entire process, including the cost of transport, we have an identical diagram as if we had a tax wedge:  The wedge now going to cover the costs of transport, instead of going to government coffers.

Now the wedge covers all transport costs T so we can consider it as the resources consumed to include those that are necessary to support the capital involved in the transport.  This would as well include any retained surplus. What was actually surplus and what was cost to the shipper is not yet defined by the diagram.  Where the infrastructure costs are zero,  the wedge is merely the costs incurred by the shipper.

We note that high transport costs imply that the productive costs must be low, since only the most eager and wealthy of consumers are willing to pay the high prices for the product. Productive efficiency, per se, must be high.  There is thus a large Allocative loss, but also correspondingly large deferred costs.

Now, where transport costs are low, we see that there is still a market for those goods which are produced at a higher cost, with less efficient processes, among those with a lower inclination to pay.  With a lowering of transport costs, there is an increase in allocative efficiency, a reduction in allocative loss, and a reduction of productive efficiency

However, there is another way of looking at low transport costs.  We can say that lower amount of resources given over to transportation support a smaller infrastructure.

So we can consider a rectangular wedge in any situation where there is a cost between supplier and consumer, and the quantity supplied does not change.

Now we will define a community to consist of consumers and the local businesses to support them. The supplier will input into this community.
The supplier will sell to the local businesses, who sell the input to the consumers.  The difference between the price the businesses pay and the price the consumers pay the businesses, times the quantity supplied by the businesses, is seen to support the businesses.

The interesting thing is that the size of this wedge, that is, the size of the business sector in the community, depends on the inefficiencies involved in the conveyance of the input from the suppliers to the consumers.   A totally efficient conveyance between supplier and consumer would eliminate any business sector in the community.

The point is, while from one point of view this wedge is wasted resources, from another point of view it supports the business sector of the community. And from that point of view it is not wasted at all.  Indeed, let us look at the worst possible alternative to the community:  Suppose a more efficient supplier is able to provide inputs directly to the consumer, at just below the price community business would have been able to supply them.  We see that the consumer is marginally better off, but the business sector of the community has essentially been destroyed.  Virtually the entire surplus has been absorbed by the supplier, and the surplus which would have gone into the community to support the business sector is denied the community..

Where the transport costs become low, it may become in the interests of the society to increase the tax wedge, in order to maintain productive efficiency.  And see the previous discussion at

1 comment:

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