Thursday, March 4, 2010

An Explanation Of Why Market Solutions Are Better

Yesterday, a coworker asked me to explain some economic terms, like dead weight loss and consumer surplus. The way these things are explained in economics classes, with graphs and shaded areas, isn't always that accessible. So, I offered this explanation:

Let's say you want to go out for lunch. You look at your wallet and decide that you'd pay up to $10 for lunch. You decide that today what sounds best is Thai food. So, you walk across the street and get a lunch for $8.

Well, you were willing to pay $10. But you only paid $8. So, you have $2 worth of surplus. That's consumer surplus.

Let's say that the lunch cost the restaurant $5 to make, but they sold it to you for $8. So, they have $3 of producer surplus.

So, if you add together consumer and producer surplus, then you have $5 of total surplus.

Now, let's say that the local government decides Thai restaurants need to use a new type of Chili oil in their dishes. Let's also say that this oil costs a $1 more, but doesn't taste any different. The lunch would then cost $6 instead of $5. Total surplus (consumer + producer) drops a dollar. That's dead weight loss.

Depending on how sensitive the restaurant's customers are to price (the price elasticity of demand), either the producer will or won't raise prices to account for this increase in costs. This doesn't affect the overall surplus. It only determines whether the drop in total surplus comes out of the consumer's or the producer's. Either way, total surplus drops.

But this ties easily into why FLG, and many other people, are very much in favor of market-based solutions where possible. At the start of this exercise, you looked in your wallet and said that you would be willing to spend $10 on lunch. You then decided on Thai food.

Well, what if, out of concern for your eating habits, I grabbed your wallet and said I'd buy your lunch? Given that I was concerned for your health, perhaps I wouldn't get you Thai food. Instead, I'd go to a salad place and get the low fat dressing. Moreover, since it's your wallet I might spend more than $10. It's not my money anyway. That in a nutshell is why market-based solutions are better.

You know better how much you want to spend. You know better what you want to eat and how much value that has to you. When somebody else introduces their preferences for yours it oftentimes makes you worse off than if you'd chosen yourself.

In fairness, there are circumstances when the markets fail or market-based solutions are problematic, but too often busybodies label the failure of other people to make decisions that they prefer market failure.

Pretty simple stuff, but somebody asked yesterday.

1 comment:

Anonymous said...

Yah, but you left out the fact that the new chili oil is made by the son of the brother of the head of the health department. This is called 'nephew surplus'. dave.s.

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