Adventures in Smarshland

May 10, 2009

Lightbulb Moment (The New Capitalism)

Filed under: Uncategorized — smarsh @ 3:55 pm

There has been this persistent nagging problem that has frustrated me about economic science, the measurement of human welfare. It started in college when a skeptic in our class asked why the value of domestic production (for instance child raising, home made crafts kept as family heirlooms) are not valued in the measurement of GDP. The answer given was that the measurement implicitly quantified the opportunity cost associated with the tradeoff between household production and production of societal wealth. Furthermore, it was suggested by the professor that if raising children is done well than the children will be more productive members of society in the future, so it can be viewed as an investment in which the stay at home parent is giving up present income for increase value of future income by their offspring. But I was still not convinced.  It is maybe well to pause to understand explicitly what GDP is supposed to represent: the market value of all final goods and services produced within the borders of a nation.  So part of the problem is the transactions I am describing don’t take place in a market, but still have value.

I continued to think it through, what else do we miss in this less than perfect measure.  Well, we certainly miss transactions based on barter or favors done for family and friends, such as when my family helped my uncle put a new roof on his house.  Certainly in that case value was created but its measure was not recorded.  However, is that just a case of the reverse broken window fallacy.  Presumably, as a result my uncle had more disposible income because he did not have to pay a roofing contractor to do the labor and could use that money to purchase other goods and services.  So in that context I think the indirect benefits are still recorded as wealth is created or preserved and can be used to finance cash flows.  So maybe a similar analogy holds for the case of a stay at home parent.  The family would otherwise have to pay for child care, whose quality is probably significantly worse than a parent’s own care because who cares more about the own child’s welfare more a parent or an employee, in other words a classic principle agent problem is avoided.  So maybe GDP is still measuring what it is supposed to, just indirectly.

But, I still felt something was amiss.  Two different examples finally struck me hard enough to get me to think about the problem from a different perspective.  I think the problem can be best summarized by the quote by the famed pioneer of “value investing” Benjamin Graham, “price is what you pay, value is what you get”.  The problem with netbooks is that companies, namely Intel and laptop manufactures who use their low power cheap CPUs, get much less revenue and profit from these laptop than their more full fledged counterparts.  But, when 95% of what people want to do with a computer is browse the interwebs and maybe write a word document and do their quicken, then you get just as much value at a lower price.  But this makes a significant dent in GDP, lower prices mean lower recorded “market value of final goods”.  So in some sense Moore’s law has led to significant cost deflation and value creation.  GDP does not record value it records price.  Similar to an infomercial, “But Wait, there’s more”.  Isn’t this just like the reverse broken window fallacy I desribed above.  Doesn’t the lower price mean that the consumer is left with more money in their pocket which means they can either save the difference or use it to buy more goods and services they could not have puchased otherwise.

Hurumph, I thought I finally I figured out what had troubled me all these years.  It wasn’t until I was watching a youtube video that it finally dawned on me, the Benjamin Graham quote was still right, the reverse broken window fallacy didn’t explain it all.  You see the youtube clip was costless to me, perhaps you could argue it was add supported, but nonetheless very little “value of final goods and services” would be recorded in GDP, but I enjoyed it tremendously.  Furthermore, if someone had asked me at what price would you be indifferent between paying to watch the video and not watch the video, I probably would say ~$10.  So the economy had produced $10 of value, but recorded only maybe a nickle of advertising revenue.  I think a similar arguement could be made for the netbook case, the vast major of people are getting the 95% of the value of an expensive laptop ~$1,200 for the price of $350 plus they can spend difference on other goods and services which has a multiplier effect.  What I trying to illustrate here is not a shocking revelation to economics, it has long been understood that the triangle area to the left of the equilibrium price on a supply and demand diagram between the demand curve and the supply curve is known as consumer and producer welfare, but this is not how we quantify the success of our economy.  The case of “micronutrients” such as iodine enfused salt is a classic example of something that cost almost nothing but has enormous welfare consequences, prevent goiters and raising IQ in developing children.  Another market that has been receiving a lot of attention lately, the auto industry, the commentary is also about GDP based analysis of success rather than consumer welfare based measures.  One of the criticisms of the move toward a fleet of vehicles which are smaller and lighter than behemoth SUVs is they garner a substancial lower price tag also with lower margins.  But the welfare to society is much the same.  So I’m sure as the industry retools to produce smaller cars GDP will be lower as a result, but I not convinced we will be worse for the change in terms of welfare.

Since I don’t have time to finish my thoughts I will like many college texts, “leave it to the reader” to show what the effect of a theoretical mass transit system in ever major U.S. city perhaps along the lines of the system found in cities such as New York or London, would have on the automotive industry, GDP, and welfare.


  1. This is one of the reasons why Austrians typically don’t trust aggregate measurements.

    Comment by nordsieck — May 10, 2009 @ 4:33 pm

  2. An interesting post — thanks for writing it

    I have always mistrusted macroeconomics, ever since I learned about it in my first econ class back at BYU. Microeconomics was so elegant, and to me at least, so clearly correct, that it was not hard for me to buy into it. But macro seemed like a bunch of assumptions that were wrong or impossible to verify that led to a lot of suggestions (often wrong, in my view) about how things ought to be. It never felt right. I’m somewhat pleased, I’m realizing, that GDP (which I understand to be a macroeconomic measure) sits a little wrong with you. Maybe I’m just trying to justify my own misgivings, or maybe I was always a little bit right?

    I have never really thought about GDP as deeply as you obviously have, but I think you are certainly right in bringing up the Graham quote. From Wikipedia: Gross domestic product (GDP) is defined as the “value of all final goods and services produced in a country in one year.” But really, as you present here, all that GDP measures is the price, the value, and these are two very different things.

    Sometimes I make a bad choice and buy crappy products. These things have very little value compared to the price. But most of the time, I get more — and sometimes much more — value out of a product than I paid. Essentially what I’m saying is that trading is a positive-sum game most of the time (if it were not so, the economy simply would not work — total value would quickly drive to zero). Yet all of this consumer excess is simply not measured anywhere. How big a of a piece of the economic pie is this? Could it be a significant amount, or perhaps be even larger than measured GDP? I think this is quite possible!

    When are you getting your Nobel Prize for discovering this?

    Comment by Ryan — May 10, 2009 @ 6:13 pm

  3. As for your readers’ exercise on transportation, it is an interesting question that I will try to think about some. My initial thoughts are this: the NYC system started privately, became public, and now consumes large amounts of local, state, and federal money. There is probably some local consumer excess, but at the price of coerced transfer payments from everywhere else. I can’t imagine that NYC’s subways make me better off, except for when I happen to be visiting NYC — but certainly the subway subsidies make me worse off the rest of the time.

    Comment by Ryan — May 10, 2009 @ 6:18 pm

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