Surplus: Inefficiency

Having a surplus is essential to creativity. Without a surplus there would be no new products or new processes of production, some of which can lead to lower costs and prices.

Typically when we think of “efficiency” we imagine that the product was made in the simplest, most direct, least expensive way — avoiding any waste. Certainly, new products and processes of production can be more efficient than the old ones.

However, that is part just of what we, as economists, mean when we talk about efficiency. When we call a society efficient there is a second and very important component: that the society produces the mix of goods and services that the people want most at a price that just covers the cost of production.

While the existence of a surplus makes that possible, it also creates circumstances that make it less likely. Surplus puts money into the hands of the innovators — both the companies and those at the upper-end of the income distribution. They can use that extra surplus to reinforce a company’s market position and promote the recipients political agenda. When the innovation is widely adopted the significant addition to surplus makes that outcome more likely. It reminds me of the old adage ‘Money talks’.
Let’s take a closer look at how the increased surplus can lead to greater inefficiency.

Initially there is strong incentive to inform potential customers about the new product and to get it to market as soon as possible. Other considerations fall by the wayside. The Boeing 737 Max is an example. Effectively the company took over the government’s role and responsibility for ensuring plane’s safety.

Sometimes the company promotes the product without disclosing the actual or potential hazards that are associated with its use. Opioids, and tobacco products are typical examples.

Since initially the company is the single producer of the product with few rivals, there is little significant pressure, and no guarantee or incentive for them to produce the product using the lowest-cost techniques. Their primary objective is increasing sales.The bottom line is that under these conditions there is little incentive for the producer to be efficient in the traditional sense of the term.

The initial circumstances also contribute to inefficiency in the second sense of the term as well. Innovations provide the opportunity for consumers to get products that were not previously available. Their preferences change. When consumer’s income remains the same, they can no longer purchase the same products as they did previously. Society’s optimal product mix changes. The producers of the previously desired products have a lower surplus and are made worse off.

Moreover, as we showed in the prior blog post entitled, “The Winners and the Losers”, when the innovators charge prices greater than the cost of production and marketing — and as a result they get “excess profits” — that takes money out of consumer’s pockets. With that money they would have been able to buy additional goods and services. Furthermore, those high prices prevent those consumers who would have purchased the product at lower prices from getting the products they want and perhaps need

In addition, the suppliers of the products that were displaced as a result of the innovation, and their employees, are made worse off. They have less surplus and are pushed towards the lower-end of the income distribution. The net effect is that the process is inefficient because it makes it less likely that consumers will get the product mix they want at a cost that just covers the cost of production.

There is another factor that contributes to inefficiency. When the companies that produce the innovation make excess profits, the company and the executives, managers and owners have greater surplus and are pushed further towards the upper-end of the income distribution. That additional surplus allows them to engage in activities that protect and enhance their market position. The additional surplus also makes it possible for them to lobby for and promote their private agendas, including their political preferences. That makes it even less likely that the goods and services the society produces is the product mix that the population as a whole would prefer.

Furthermore, those at the upper-end do everything they can to minimize their tax burden. To accomplish that some have even move their corporate headquarters. Others have lobbied for and gotten legislation passed that promotes their private interest. The net effect is that those at the upper-end do not pay a proportional share of taxes. The unpaid balance falls on the rest of the population.

Moreover, those at the upper-end of the income distribution frequently advocate for a smaller role for government. That along with a reduced government budget makes it less likely that government agencies will be able to restrict inappropriate corporate behavior and the actions by those at the upper-end of the income distribution that are not in the public interest. For more about the current shift see this New York Times article which discusses the gap between the haves and have-nots of the tech industry.

In summary, a large surplus and the unequal distribution of it leads to inefficiency, in regard to both aspects of the concept. It makes it less likely that the goods and services will be produced in the least costly fashion and sold at a price that just covers the cost of production. Furthermore, the product mix is less likely to be the one that consumers  would prefer. Instead, the mix reflects the preferences of those at the upper-end of the income distribution and does not help those who have been harmed by the changes that have occurred.