The Power and Necessity of Consumer Surplus

Peter Smith’s October essay (“The Free Market—Efficient, Amoral, and Ready to Go”) is a masterpiece of clarity and simplicity about the essential flaw of Keynesianism and “aggregate demand”.

Schumpeter used a term, “capitalism in fetters”, to sum up what Peter Smith is describing:

in spite of profligate governments, discriminatory and burdensome taxation, ever-increasing regulation, and arbitrarily-imposed “redistributive justice”, efficient and amoral free-market economic forces have always found ways through to make us all richer.

 Peter Smith concisely states the Keynesian assumption about aggregate demand in times of economic slowdown:

 If only those pesky consumers still in jobs would lift their spending—presumably on existing products produced by existing industries and businesses—which they clearly don’t want to do. In the wings, the IMF wrings its hands about too much government austerity reducing demand; but less austerity putting the system at risk.

It is no wonder that the situation looks conflicted and hopeless and that despondency hovers. Focusing on demand is focusing on the cart when the focus should be on the horse. The horse in this case is production and those who drive production to new heights and how they do it …

It is silly to think that the IMF or anybody in the economics profession does not understand the role of business investment and production in contributing to economic growth. Of course they do; that isn’t the point. It’s the emphasis they give to the demand side of the economy in driving growth, courtesy of Keynesianism, that creates a policy dilemma and which, in turn, generates an air of despondency. Economic salvation lies on the supply side; on the Adam Smith side. The key is to give business the scope and freedom to invest by cutting the government’s claim on resources and by reducing regulatory obstacles to hiring labour, developing and using resources, and to exploiting opportunities.

All this fits in with conclusions I have been drawing recently about “consumer surplus” and “economic rent”. Put simply, “consumer surplus” is like the difference between the price that people might have been prepared to pay for something, and the lower price they actually do pay for it in competitive markets. Take modern electronic consumer goods—once upon a time it would have cost hundreds of thousands of dollars to obtain the equipment to create your own videos and audio recordings of as good a quality as can now be done at a fraction of the cost. The people who are walking into the chain store and buying recorders and editing programs, are doing so because massive “consumer surplus” has been created by ingenious and entrepreneurial people.

But there is “consumer surplus” in nearly everything “demanded” today in free markets, including, fortuitously, necessities like food and clothing. People don’t just buy bread and milk now; they buy cakes and pastries, exotic cheeses and ice-cream. David Horowitz, in “The Road to Nowhere”, makes the following astute observation about the queues on the opening of the first McDonald’s in Moscow in 1989:

Here, the capitalist genius for catering to the ordinary desires of ordinary people was spectacularly displayed, along with socialism’s relentless unconcern for the needs of common humanity. McDonald’s executives even found it necessary to purchase and manage their own special farm in Russia, because Soviet potatoes—the very staple of the people’s diet—were too poor in quality and unreliable in supply. On the other hand, the wages of the Soviet customers were so depressed that a hamburger and fries was equivalent in rubles to half a day’s pay. And yet this most ordinary of pleasures—the bottom of the food chain in the capitalist West—was still such a luxury for Soviet consumers that to them it was worth a four-hour wait and a four-hour wage.

Of all the symbols of the epoch-making year, this was perhaps the most resonant for leftists of our generation. Impervious to the way the unobstructed market democratises wealth, the New Left had focused its social scorn precisely on those plebeian achievements of consumer capitalism that brought services and goods efficiently and cheaply to ordinary people. Perhaps the main theoretical contribution of our generation of New Left Marxists was an elaborate literature of cultural criticism made up of sneering commentaries on the “commodity fetishism” of bourgeois cultures and the “one-dimensional” humanity that commerce produced. The function of such critiques was to make its authors superior to the ordinary liberations of societies governed by the principles of consumer sovereignty and market economy. For New Leftists, the leviathans of post-industrial alienation and oppression were precisely these “consumption-oriented” industries, like McDonald’s, that offered inexpensive services and goods to the working masses—some, like the Sizzler restaurants, in the form of “all you can eat” menus that embraced a variety of meats, vegetables, fruits and pastries virtually unknown in the Soviet bloc.

These mundane symbols of consumer capitalism revealed the real secret of the era that was now ending, the reason why the Iron Curtain was necessary, why the Cold War itself was an inevitable by-product of socialist rule: in 1989, for two hours labour at the minimum wage, an American worker could obtain, at a corner Sizzler, a feast more opulent, more nutritionally rich and gastronomically diverse than anything available to almost all the citizens of the socialist world (including the elite) at almost any price.

Not just “more nutritionally rich and gastronomically diverse than anything available” to contemporary socialist elites, but to almost all of humanity preceding them.

Here is a general rule. I do not know whether it has been stated before: increased aggregate demand is the result of increased “consumer surplus”. As Peter Smith quotes Irving Fisher: “In economics it is difficult to prove originality; for the germ of every new idea will surely be found over and over again in earlier writers.” But it is surely very strange if large numbers of “experts” concerned with “aggregate demand” do not see the vital role played by consumer surplus.

“Economic rent”, on the other hand, is the opposite of “consumer surplus”. It is people being forced to pay “what they can stand” for something they either cannot do without or have no option about. Obviously many transfers via government come into this category. The corollary to this is that the person on the receiving end of the transfer is exploiting a position of power vis-à-vis the people who are being forced to pay.

These theoretical questions were far more central to discussions of economics in the late 1800s than they are today, probably because “economic rent” was far more extant and “consumer surplus” was rare. The role of land ownership was central to these discussions of economic rent.

Once upon a time, there was a fixed link between the price of a loaf of bread, and the price of the land on which wheat was grown. Ricardian land rent theory holds that the price of land is derived from the value of what is produced on it, and the value of what is produced on it depends on the ability of people to pay for that product. Land will be switched between uses according to consumers’ greater or lesser valuation of what is produced on it. But the total supply of land is fixed, and hence only “demand” for each product mattered for the value of land. Land will be allocated by the market, first to the highest value use, and what is left over will be allocated to the next valuable use, and so on until very low-value uses are unable to obtain land at all.

There is an important relationship between this theory, which is still erroneously applied by many economists who should know better, and improvements in transport. Improvements in transport, and reductions in the cost of transport, bring more land into the “local” economy. Gradually, the amount of land that can be devoted to lower-value uses is increased. This shifts the whole “supply” curve for land outwards, so that each type of use of land can obtain land at a lower price than what applied before the improvements in transport.

At some stage of economic development, the price of many goods ceases to be set by “what people can stand” within their incomes, because the whole system has come to enable competition. The whole modern global economy works like this for most products. The price of a personal computer or a car is not set by “what people are prepared to pay” within a system where land in their local economy is scarce and the cost of transport of many resources prohibits their use at locations distant from the site of the resource. For example, there would have been a time when it would not have been worth buying rubber from Malaya. Most economies would have to do without altogether if they had no rubber of their own located nearby.

The world economy was at one time heavily based on coasts and waterways because it was completely uneconomical to transport many resources far inland, and waterborne transport had a major cost advantage over other modes; hence the great explorers’ devotion to finding routes by sea to replace major overland trading routes. But you still could not expect to find bulk cotton, for example, available for sale far inland at prices anyone could afford to pay. The manufacturers of garments were located at ports, and finished garments could be transported inland at prices that made those garments competitive in price to those woven locally inland from locally produced wool.

But we are in a situation today where there is actually a competitive supply of most resources everywhere in the world—the real cost of global transport has become that low. This means that manufacturers of goods secure market share by more efficient methods of production, hence forcing their competitors also to become more efficient. Not only this, but entirely new things are invented for people to spend their money on. So the price of a personal computer, for example, is far cheaper now than it would be if all prices were derived from a supply of resources that was limited to a small area near the consumers in each local economy. In fact there would be no personal computers at all without a globally connected economy. Everyone’s budgets would still be taken up with food and housing and clothing. Remember, the price of land for housing, and land for the production of food and the materials for clothing, would rise to whatever point at which the consumers of the end product could stand to pay at their current income levels. There would never be consumer surplus—or even discretionary income, for most people.

This occupied the attention of many economists in the 1800s. It seemed self-evident that it was “unfair” that as the economy developed, the only people who were going to get richer were those who owned the land. The prices of the product of the land, and especially the price of accommodation, would rise as fast as the incomes of the non-land-owning workforces, leaving them no further ahead. Marx’s advocacy of the nationalisation of land was made in this context. So was Henry George’s advocacy of land taxes.

But Alfred Marshall and other economic thinkers predicted that transport improvements would ameliorate this “monopoly land rent” effect, and they were correct. They were also very influential. Many politicians and social reformers regarded investment in railways and better roads (initially for horse-drawn transport and then bicycles) as serving this social end as well as economic ones.

Ebenezer Howard, the “father of urban planning”, was early on a supporter of nationalisation, but having been persuaded otherwise by the Marshall argument, was a lifelong advocate of “new towns”, with the price of land remaining as low as the initial “rural land” purchase price, plus the cost of development and a modest profit. He never succeeded in obtaining the necessary finance to achieve his dream in the UK. But in the USA, and increasingly in other Western nations, competitive automobile-based development from the 1930s onwards had the effect of ending “economic rent” in housing and creating “consumer surplus” instead—hence the trend to larger and better homes on larger properties, for a lower proportion of household income.

I hold that the “aggregate demand” problem today is a problem of the return of economic rent and the defeat of consumer surplus, in housing first and foremost. The more governments “spend to stimulate” without regard to consumer surplus or indeed to any measure of value, the worse the problem gets. The recipients of the spending are capturing a form of economic rent.

The return of economic rent in housing and indeed all urban land, is because the old classical theoretical condition of land being allocated by the market to the highest value uses has been violated by modern urban planning. The low cost and flexibility of the transport system which has eliminated economic rent and created consumer surplus, in housing and other necessities and consumer goods, has been nullified by urban growth boundaries and zoning.

I hold that this is where the single greatest systemic distortion is to be found in the modern economy. Fred Foldvary and other experts in “the land price cycle” have been puzzled by the decades of low volatility in most countries following the boom and bust of the 1920s and 1930s. The role of land price “bubble and bust” in the Great Depression has never received adequate attention from scholars of this era; the focus on stock markets has led to valuable lessons being missed, which may need to be learned painfully this time around.

In addition to the price volatility or stability that are present in urban land markets due to the conditions of land “supply”, there is a vast difference in the underlying level of prices around which the cyclical fluctuations occur. The UK had only one significant phase of abundant spatial growth in residential areas: in the 1930s, before the 1947 Town and Country Planning Act intervened. Professor Nicholas Crafts of the University of Warwick has written a discussion paper regarding the way this boom in the building of “high value for money” housing helped the UK “escape the liquidity trap” that stymied fiscal and monetary policy in the USA at the time.

But by 1984, after several decades of the Town and Country Planning Act, Paul Cheshire and colleagues from the London School of Economics found that the price of land per square foot in the centres of comparable UK and US towns differed by a factor of 325. At that time it was hard to find a US city with restrictions on the conversion of rural land to urban use of the kind that applied in the UK.

This difference in land prices between supply-limited and supply-unlimited urban land markets probably worsens the longer the supply limitations persist. The response of housing markets partly conceals the extent of the difference, because the difference in “the price of housing” is often “only” 100 per cent—however, the systemically more expensive housing is very much smaller, on even smaller still plots of land per dwelling, average age of the housing stock is older, its condition worse, and the quality of new buildings lower.

I believe we can make the following claim, based on long-standing urban economics principles. All this was far better understood a century ago before the economics profession dropped the ball.

As long as the supply of land is rationed, the cost of housing relative to incomes will remain “as high as people can possibly stand” and with a significant proportion of people priced out of the market altogether. All cost variables that occur in “the housing market” between people’s incomes and the land rentiers will be merely a “share of the housing cost that the people can possibly stand”. Any reductions in these costs will merely result in greater gains to the land rentiers, and “housing costs” will remain fixed as a (high) proportion of people’s incomes. This is really a form of “monopoly rent” but the profession needs a better terminology. Alan W. Evans of the University of Reading discusses this in his excellent 2004 textbooks.

Abolition of infrastructure levies; regulating the cost of building materials; reducing the amount of space per person; reducing the size and quality of homes; mass manufacturing processes—none of these measures will bring house price median multiples below a trend point of about six. The example of the UK’s cities shows that the price per square foot of urban land can and does increase by whatever factor is necessary to keep the “median multiple” up to around six and higher, regardless of what trade-offs are made in other “costs of housing”.

Yes, there are other areas of concern regarding the emergence of a “rentier economy” in our time. But for decades, most of the examples of successful rent-seeking already existed without tipping our economies into crisis. It is urban planning, as mavericks like Randal O’Toole of the Cato Institute have insisted all along, that is responsible for a new level of crisis. Other academics and experts have been coming to similar conclusions, but this conclusion seems to carry a guarantee of mainstream obscurity.

It is a question of how much growth in aggregate demand can be expected, even if entrepreneurs continue to create consumer surplus, when a “monopoly rent” paradigm in urban land has been re-imposed. Every dollar of aggregate household discretionary income is going to be spent in a fight for survival from the land-rent black hole. Equity withdrawal spending on the part of those who do own their own property can conceal the systemic problem for only so long, increasing the downside risk at the same time.