Philanthrocapitalism or Paternalism in New Guise?

Some Economics Background

There are two concepts that are key to understanding how we economists view and interpret the world. One is consumer surplus (and it's production-side counterpart, producer surplus). The other is consumer sovereignty. I'm not saying that these are all there is to economic thought and theory, but if you want to understand what approximates the moral underpinnings of economics as currently practiced, these are the two I think you should start with.

First, consumer surplus. This is our welfare measure. We believe it captures how much better off you are made by competitive markets. "How so?" you ask. Well, batten down the hatches and I'll try to explain it.

Start with the idea that there are things that make you better off by some metric that you and you alone possess. If you have more of these things, you are happier, more satisfied, "better off" you might say. If you have less, you aren't as happy, satisfied, or well off. And you have only a certain amount of income with which to acquire that combination of goods and services that will make you happier, more satisfied, better off. You must go into the marketplace, with that income serving as a constraint, and choose the right mix and amounts of goods and services that make you as well off as you can possibly be (in your own estimation) without exceeding your income. (We're going to assume away borrowing in this discussion and we're going to ignore how you come by the income you take to market.)

Let's say that you have determined that what will make you best off today is the acquisition of six pieces of apple pie. Let's also assume for a moment that you have to buy them one at a time, negotiating a price for each slice that you acquire. Let's also assume that you are hungry and intend to eat the first piece of pie right away. That first piece provides a very high amount of happiness, satisfaction, and well-being. The amount you are willing to pay for it is also high, reflecting the amount of happiness, satisfaction, and well-being you expect to derive from consuming it. The second slice, yields a bit less happiness, satisfaction, etc. After all you already have one. For this reason, you negotiate a slightly lower price, one that reflects the lower benefit you expect to receive from it. The third piece is even less beneficial and so you are willing to pay even less for it. And so it goes until you reach the 6th piece of pie or the 3rd piece of pie or whichever piece it is that costs more than the benefit you expect to derive from it (the seller is bargaining, too, and there's some price below which he cannot sell you the slice of apple pie and still at least cover the cost of its production).

This yields the classically downward sloping individual demand curve seen in economics text books.

The beauty of the market is that you don't have to negotiate the price of each unit of a good you purchase. You arrive there to find that all slices of pie are sold at the same price. You were willing to pay more for slices 1, 2, and 3, but you find you can acquire them for the same price you were willing to pay for slice 4! The difference between what you were willing to pay for the 4 slices and what you actually pay is what we call consumer surplus. It measures how much better off you are made by a well-functioning competitive market that provides you all the pieces of pie at the price that equals the cost of producing the very last unit of pie. (Producer's surplus measures the gains to the producer who gets to sell all the units produced at a price that reflects the cost of the last unit produced, that is, it costs him less to produce the next to the last and even less to produce the next to the next to the last and....you get the idea...so he makes profit on all but the last unit produced.) Consumer surplus is denoted by the triangle bounded by $6, $2, and where the line from 4 units intersects the green demand curve in the diagram below.

If the market is competitive, the $2 price will be very close to the actual costs of producing pie slice #4. Market forces will foster competition among firms to produce pie slices at the lowest cost possible while maintaining quality. (Of course, if ingredients are not labeled, consumers may be hoodwinked on quality. If you doubt me, spend some time reading about why we had to have food regulation in the US.)

The larger is consumer surplus, the better off are we. Why? Well, one reason is that our total satisfaction exceeds the value of the money we had to part with to achieve it. Another is that because we didn't have to pay the amount we actually value each pie slice at, we retain that money to spend on other things that will also make us happier.

One of the best ways to make consumer surplus large is to live in a world where price is a low as it can be (subject to the constraint that the product actually delivers those qualities which the consumer values). Think "truth in advertising" and "consumer financial protection" and food and nutrition labels. A well-functioning competitive market with no information asymmetries, no agency problems, no monopolies, no externalities would (at least in theory) deliver this most utopian of results.

The other key concept that emerges from this simplified overview of welfare economics is consumer sovereignty. This is the "liberty" that is (as far as I can tell) the primary moral byproduct of a well-functioning free market. It means that we get to decide what makes us happiest, what is best for us. We vote with our dollars in markets, signalling that which we value most. It transmits to producers who, if they are alert and desire to make a profit, supply us with that which we desire in the right amounts and mix (subject to technology constraints). And we all live happily ever after. No standing in line at the store because central planners decided we needed more shoes while we wanted more bread. No empty shelves because someone in Washington guessed wrong about that which we desired. A perfect match between what we want and what we get, every time (of course, subject to that pesky budget constraint...but, hey, nothing's perfect).

More for less and you decide what you want more of. Not a bad system when it works (and it often does).

Sometimes Things Don't Work Out

More recently, it appears that consumer surplus has been eroded. In financing of mortgages and consumer credit, obviously. Maybe in computer operating systems, like Microsoft Windows. It happens when private incentives don't align social objectives (i.e., investment banker's private incentives to get rich are at odds with social objectives to allocate capital efficiently and effectively to promote innovation, production, and anything else that enhances societal well-being). It happens when there are information asymmetries, that is, when buyers don't know exactly what it is they are paying for (think, for example, health care and insurance, sub-prime mortgages, and used cars). And it happens when a company is large with a dominant market share.

The last is called monopoly. It allows the firm to chose the level of output it will produce rather than supplying all that it could at a prevailing (competitive) market price. The firm will choose the level of output at which profits are maximized. This has two negative effects on consumers: it reduces total output available for consumption and it raises the price they must pay for units that in a competitive market they would get for less. It has a very positive effect for the firm: it makes profits higher than they would be in a competitive market and at higher cost to consumers. The excess of profits over what they would be in a competitive market is called economic rents.

Erosion of consumer surplus is also why taxes are Bad Things. They raise price, thereby reducing consumer surplus (and producer surplus, depending on the relative price elasticities of demand and supply). But they are viewed by most economists as worse than the kinds of erosion of consumer surplus above, because they result in something called "dead weight loss." In the scenarios above, when consumer surplus is eroded, the part that consumers lose is transferred to producers, so there's no real loss in the total scheme of things. Just a transfer from consumers to producers or sellers. With taxes, there is a reduction in demand (due to the higher price) and in supply (due to the absence of demand), the dead weight loss.

Of course, the tax situation is portrayed in a two-dimensional world in which only a single good is demanded and supplied. If the revenues raised by the tax produce some public good, say cleaner air, purer food, better child health and nutrition, perhaps even a redistribution of income that results in higher levels of societal trust and lower crime rates (imagine things you might value over and above the monetary price (the tax revenues) of producing them) or if there is some externality of production, then some of that dead weight loss might just be offset. But that would require us to imagine that there are other components to well-being besides output and individual income.

Where We Seem to Be Heading

It appears that over the last 30 years wealth and political power have become more concentrated as has market power and its natural bedfellow, political power. Incomes have become more unequal with the spoils of market and political power going disproportionately to captains of finance and industry. If not corrected, some among us may begin to question the value of an economic system that has ceased to deliver universal opulence to worker, rentier and investor alike.

The answer to this from those who still value a capitalist system appears to be creation of a new class of philanthrocapitalists who, like Andrew Carnegie, after eroding consumer surplus and perhaps a soupçon of individual liberty (along with workers' wages (I didn't talk about this)) to gain higher profits, will turn around and redistribute that wealth in some way of their own choosing. That redistribution will presumably benefit us all, though we may have little say in it.

And I, a big fan of Carnegie-financed libraries and universities and foundations, am left to ask the question I have always asked even of those same libraries, universities and foundations. Would we all have been better off if Carnegie had simply paid his workers higher wages? Would we all have been better off if Carnegie had simply charged lower prices? These were the opportunity costs of those libraries, universities and foundations. Wouldn't it have been better to increase consumer surplus and consumer sovereignty (and consumer wages)? I mean, my tastes and preferences happen to coincide with Carnegie's, at least as far as libraries, hospitals, universities, and foundations go. But what if the people working for him would have preferred to buy their own books or educate their children their own way? Or even party hard and long? Why do a wealthy philanthropist's tastes and preferences trump those of the people they employ? Make no mistake here. We're talking paternalism by a group of elites, just as surely as when the guvmint does it.

But let's bring this into the present. Why have I had to endure a klugey operating system with lousy file and memory management for nigh onto thirty years? Why have I had to pay outrageous amounts for every version of said operating system and put up with trojans and viruses and worms that are only possible because one operating system has captured 75% of the market? The homogeneity of our computing infrastructure is probably the single greatest threat to national security. And for it, we all paid monopoly prices, the proceeds of which are now being spent at the discretion of Gates and his foundation. Am I better off because of his philanthropy than I would have been paying lower prices, retaining some consumer surplus, having more market choices? If some rich philanthropist, either alone or in concert with a non-profit or a government agency, is making decisions about how to spend the "extra" money he gained from me, how is that different from the government making decisions about how to spend the tax revenues it gains from me? Do not both usurp my economic power and autonomy?

One answer to the last question (I had the audacity to hope) is that the government is constituted to be of, by and for the people. The people. All the people. So there is some hope that tax revenues might be spent in ways that benefit us all.

But maybe there is no difference between how a democratically elected government will spend my taxes and how a philanthrocapitalist will spend the economic rents he extracts from me. In that case, higher wages, lower prices, and a less unequal income distribution (that is to say, lower profits) would better enhance the two key elements of consumer economic welfare: consumer surplus and consumer sovereignty. I wonder what wealthy philanthrocapitalist or public-private partnership will deliver these to us?

Comments

[The Barefoot Bum]

I wonder what wealthy philanthrocapitalist or public-private partnership will deliver these to us?

I assume you're speaking rhetorically, but even so, why wonder? Why be passive? Passivity is the flip side to paternalism: If you're waiting around for someone to tell you what to do, sooner or later someone's going to step up and tell you to do something. You have a PhD in economics, and you have apparently studied no small amount of political science and philosophy. Who better than you is situated to do more than wonder, to actually positively work towards a better world?

I learned in 2007 that our "democratically elected" government isn't. It's not "democratic" in any sense of the word: It does not directly fulfill the will of the people, nor does it act as any kind of "expert" in making us happier despite our errors and misunderstandings. Instead, it has pretty obviously become an institution devoted to the interests of big capital, especially big financial capital, and its main interaction with the people is to lie, (if you'll pardon the profanity) bullshit, and directly manipulate elections where necessary.

Why should we leave the structure of society to those who lack the capacity for wonder, to those who have only the burning desire for power and control? Because if people like you sit back and wonder, those are exactly the people who will deliver what you're wondering about.

[DBonar]

I wonder about your separation of consumer surplus from producer surplus.

It seems to me that producer surplus is what goes to paying the wages that are the income/budget spent to generate consumer surplus (in the next period). Focusing just on consumer surplus makes the analysis more populist sounding, but I think it makes it weaker.

[Mel]

"separation of consumer surplus from producer surplus"

This is the boundary between macro- and micro-econonmics, is it not? By what I gleaned from somewhere in Krugman's blog, macro-economics views things at large, where every expenditure is also somebody's income, and everything (e.g. trade-balances vs current-accounts) nets to 0.

Micro-economics would take more limited views, such as a single class of transaction, buyers and sellers of apple pie, for example. It can help out a few decisions, like "should I get into the apple pie business?", "What might my life be like if I did?, etc.

I don't see this as polemics, where strong/weak plays a part. This is defining terms and creating intellectual tools. Nice blog article, by the way. DeLong blogged something like it, which I thought I might have understood. I'm pretty sure I understand this one.

[Kaleberg]

This is awfully simplistic. The problem of resource allocation is anthropological and sociological, and economics as you describe it is merely a poorly grafted side theory with little or no predictive value. Micro-economics has to make a huge number of assumptions in order to work, and every real transaction that any human has ever encountered or is likely to encounter violates so many of those assumptions that micro-economics shines little light on the real world.

[Bruce Wilder]

I'm with you on the politics. Power to the people! Go, team!

But, I am really disappointed in your treatment of the economics. Does no one know how to do this?

The model of so-called "perfect competition" is a model in which no one acts strategically. That's not possible, and making an impossible ideal into a standard to measure the performance of actual economic arrangements is really not very helpful.

You might want to follow your own link to Wikipedia on "economic rent". Economic rents can exist, even in perfect competition, if producer surplus exists: it's the same inframarginal excess of income over cost, just expressed in terms of factor (input) incomes. (The doctrine that rents can be competed away is just wrong; while the related "rent-seeking" parable of government as the source of all evil is just right-wing claptrap.)

Increasing returns to scale are not uncommon, and marginal cost can be falling in the range of market price/output. An actual "monopolist" of a durable good using a production process exhibiting increasing returns to scale or networks or whatever, like Microsoft, will not restrict unit output, at all, relying on price discrimination to profit. The monopolist may, in fact, flood the marketplace with its product.

There are real problems with winner-take-all contestable markets competition in the information age. But, the ideal of perfect competition is more misleading than enlightening, and the stylized "monopoly" of limited strategic awareness is just silly.

Here's a link to something I ran across today, that seems relevant:
http://jdeanicite.typepad.com/i_cite/2010/12/finding-the-one.html
(And, I think it is a girl economist, too!)

[Maxine Udall (girl economist)]

DBonar, PS is (in theory) the return to capital (aka profit). It is what is left over after the wage bill has been paid. If it has been artificially enlarged by monopoly or some other market failure that allows price to be set higher than marginal cost or wage rates to be set lower than labor's marginal revenue product, that "enlargement" comes from CS or from workers (I didn't talk about the latter). That (along with wanting to reduce word count) is why restricting the essay to CS is adequate for this brief overview. It can actually get quite complicated because general equilibrium results tend to ripple out through goods and labor markets and affect (usually consumers/workers) in other negative ways.

Bruce, some profit is good for a variety of reasons. If you can figure out how to sell the inframarginal units at a price that reflects each unit's (lower) marginal cost, you go. But then why would it not be wrong to price discriminate on the consumer side and extract all consumer surplus? Both sides need to "win" a little. I disagree with you about the perfect competition model. It's useful for establishing a standard or ideal, for understanding how deviations from it are likely to affect CS and PS, and for understanding the (unrealistic) conditions that would have to hold to obtain an ideal result. Far better to understand these things than to simply crash ahead tinkering in ways that may ultimately harm millions. (This is not to deny the harm done to millions by blind faith in an ideal that is seldom realized, but that would be another essay.)

BB, my job is to make people think and to provide an alternative moral narrative that supports sound micro and macro policy in an economy I would like to see remain based on commercial exchange and the productive allocation of capital. If I provide the answers, then people aren't thinking. (And, sometimes, I don't know the right answer, I only know the right question.) :-)

Good sources on this topic are Joe Stiglitz's textbook "Economics of the Public Sector" Parts 5 and 6 (Norton); and Atkinson/Stiglitz, Lectures on Public Economics (McGraw-Hill), which I think is out of print, but available in most university libraries.

Thank you all (including Kaleberg and Mel) for your thoughtful comments.

[Larry, The Barefoot Bum]

"BB, my job is to make people think and to provide an alternative moral narrative that supports sound micro and macro policy in an economy I would like to see remain based on commercial exchange and the productive allocation of capital. If I provide the answers, then people aren't thinking. (And, sometimes, I don't know the right answer, I only know the right question.) :-)"

I think you're defining your job too narrowly. I don't think it's just a matter of spoon-feeding answers to people, it's a matter of exercising moral and political leadership. I'd really like to see a person with your abilities, character and moral sense taking a more active leadership role.

-- Larry

[reason]

Maxine,
like Bruce, I'm not sure it is necessary to go into consumer and producer surplus to make the point about the paternalistic nature of philanthropie. I'm sure I recently (somewhere) made the point that governments should have a voluntary welfare tax account, that people can donate to if they want. If they don't choose that path, doesn't it suggest is all about power?

[reason]

You could also have an account for medical research etc.

[DBonar]

Maxine.

Thanks for the reply.

If we simplify so that the "producer" is just a craftsman or a small shopkeeper, it seems like producer surplus is part of his income. I agree that you can think of his income as just the income from alternative employment and any excess above that as rent on capital (in the form of tools, stock, materials, past training, talent, time, etc.)

At that point though, it seems pretty symmetric. The trade happens because both sides benefit. And both sides make the world better. Erosion of consumer surplus in one period just seems to be providing higher producer surplus in that period and thus more income for consumption in the next period.

The point I was trying to get at (very obliquely) is that the issues seem to come up when one person gets either an exceptionally large consumer or producer surplus.

In any case, I'm not pretending to understand the issue.