Capitalism and resource allocation

Capitalism and resource allocation
Benkei
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Posted Nov 18, 2008 - 7:29 AM:
Subject: Capitalism and resource allocation
I was wondering how lowest cost don't necessarily produce the most efficient allocation of resources.

Let's say that we have two countries and that both economies are completely geared towards producing TVs. Both countries produce the same type of TV and therefore each TV uses the same amount of natural resources. However, in land A wages are much lower than in country B. As a consequence, it would be logical that A produces all the TVs for the demand that exists in both countries. From a resource allocation point of view this will not lead to an optimal allocation of resources as my example below should illustrate.

The TV in country A costs 10 EUR of natural resources whereas in country B it is 10 EUR for natural resources AND 10 EUR in wages to get those resources out of the ground. Assembling the TV in country A costs an additional 30 EUR in wages and energy and for country B it is 60 EUR.

The total costs for producing a TV are therefore as follows:

40 EUR per TV in country A
80 EUR per TV in country B

The TV's as stated before all use the same amount of natural resources. Let's say that each TV uses 100 units of natural resources and that each country has 1 million units of natural resources available. Each country can therefore produce 10,000 TVs if their full production capacity is geared towards this for an aggregate of 20,000 TVs.

Now that TVs are cheapest in country A all of the TVs are produced there and 50% of total production is exported to B to fulfil demand there. For simplicity's sake let's assume production in land A is exhausted before it is moved to country B and then exhausted there.

At all times a steady 50% is exported from one country to the other, depending on where the production is situated.

Over the total period there are therefore 10,000 TVs shipped. Now, let's assume that shipping costs 2 unit of natural resources per TV. The average cost of a TV is therefore 101 units of resources (102 for exported and 100 for domestic use), which means instead of 20,000 TVs only 19,802 TVs can be produced due to the allocation necessary for shipping. This means A and B together are 198 TVs poorer because market forces would lead to a preference for the cheap TVs first.

This problem is further excarbated due to the fact that country A has to build a factory twice as big to cater to total demand, which factory is only used for half of the total time and production is shifted to country B who again has to build a factory twice as big to meet total demand and this factory is only used half of the total time (total time assuming limited resources until these are exhausted). This is again an inefficient allocation of resources.

Now, I realise this is an oversimplification but the ramifications seem quite clear. Where in countries A and B 198 families could be made happy with their own TV set, this benefit is in effect lost through shipping resource costs and the societies taken together are poorer even though they spent less money on TVs than they otherwise would.

From this seems to follow that cost efficiency is not the same as resource allocation efficiency but also that the price mechanism does not lead to resource allocation efficiency as claimed by classical capitalism. The extreme conclusion of this would be that all goods ought to be produced locally to maximise resource use efficiency. This is clearly unworkable.

However, how can you stimulate people to take this into consideration? How do you calculate the optimum relationship between cost efficiency, specialisation of production, necessities for mass production and an adequate shipping range?
Fried Egg
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Posted Nov 18, 2008 - 8:23 AM:

Sorry but I don't understand why you beleive market forces wouldn't/don't take into account shipping costs? If the savings made by outsourcing production minus the shipping costs don't increase profits, it would not happen. Therefore minimising costs do lead to an efficient allocation of resources.

It is perhaps worth bearing in mind that using a common unit to measure costs is helpful otherwise no calculation can be made. Further, it is wrong to seperate out the cost of labour from the cost of other factors of production.

Note, in your above example, it does not just matter how many TV's are produced but at what cost.
Benkei
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Posted Nov 18, 2008 - 8:58 AM:

The example is a simplification. If you want me to change the example to also make the TVs slightly more expensive than they are now due to transportation costs (at leas the ones that would be exported ,e.g. 45 for country A and 87 for country B) it still won't change the principle that country A will produce much cheaper than country B, leading to specialisation and resource costs necessarily allocated to transportation. This ultimately leads to a lower number of TVs.

The separation between labour and other costs was made to give an idea where these differences often come from (e.g. why TVs are assembled in Asia and not in Europe) but again not meant as a realistic representation of reality.

It therefore does matter how many TVs are produced because 20,000 TVs instead of 19,802 TVs means the first represents more wealth for those societies than the latter. 198 TVs were lost due to the costs in resources for transportation despite the fact that this was the cheapest (in terms of money) solution. So in the long run cost effectiveness causes inefficient allocation of natural resources.
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Posted Nov 19, 2008 - 5:17 AM:

Benkei wrote:
The example is a simplification. If you want me to change the example to also make the TVs slightly more expensive than they are now due to transportation costs (at leas the ones that would be exported ,e.g. 45 for country A and 87 for country B) it still won't change the principle that country A will produce much cheaper than country B, leading to specialisation and resource costs necessarily allocated to transportation. This ultimately leads to a lower number of TVs.

The separation between labour and other costs was made to give an idea where these differences often come from (e.g. why TVs are assembled in Asia and not in Europe) but again not meant as a realistic representation of reality.

It therefore does matter how many TVs are produced because 20,000 TVs instead of 19,802 TVs means the first represents more wealth for those societies than the latter. 198 TVs were lost due to the costs in resources for transportation despite the fact that this was the cheapest (in terms of money) solution. So in the long run cost effectiveness causes inefficient allocation of natural resources.

I've already pointed out your mistake. You cannot focus only on the number of TV's, but must also take into account the cost for producing (and transporting) them. It does not matter that only 19,902 TV's were produced rather than 20,000 because what other things could they produce with the savings attained?
Benkei
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Posted Nov 19, 2008 - 5:44 AM:

Well, I don't think you have pointed out any mistake since you do not seem to understand what I am driving at.

I also consider I am taking the cost of transport and production into account in the sense of resource units (which include man-hours, energy, composite materials, the whole shebang... it's not necessary to specify exactly as long as it is clear transportation costs more resources) By focusing only on the number of TVs I try to clarify how the resource cost of transportation "destroy" real value because less durable goods can be created as a consequence. Instead of those TVs it could also have been refrigators or cars for all I care. That's not the point.

The point is that in our drive for cost efficiency and the possibilities of economies of scale that corporations can achieve a continuous waste of resources is created due to much higher use of resources for transportation that would otherwise exist. These "wasted" resources could be allocated for durable goods instead. This is not to say that transportation does not foresee in a valuable service but that there is an optimum balance between reaching resource efficiency, which is not obtained through purely pursuing cost efficiency.

Logistical networks are on average bigger and more complex than in a situation where products would be produced more locally (depending on the product market local can mean Europe or within a city or even global, there is no golden rule for this). The size and complexity mean an increase in resource cost, even if it is most likely more cost efficient.

There is in my mind a clear difference between the logistical optimum for resource allocation for the creation of goods and what is cost efficient in the market. The example was meant to illustrate that if both countries chose to produce TVs at the same time (ignoring the problem of price differences in such an event) this would lead to an optimum allocation of resources because we would end up with more TVs (or cars or refrigators or whatever could be produced with those resources that are no longer necessary for transportation).
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Posted Nov 19, 2008 - 6:03 AM:

Yes, you are right, I do not understand what you are driving at.

You are only taking into account that 198 less tv's are bring produced. What about all the additional production that can now take place of somethign else in country B? The total number of goods that can be created will have increased dramatically.
Benkei
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Posted Nov 19, 2008 - 6:28 AM:

I wasn't allowing for that possibility in my example because that is not the point. Of course it is clear that in a "real" situation B won't sit idly by and wait until it is its turn to produce TVs but this still does not solve the problem I raise. I can avoid the issue you raise by assuming that there is a particular resource that is ONLY usable for TVs and nothing else so that B has no application for that resource and they simply have to wait until A has exhausted its resources.

But even following your example, my problem continues to exist:

It will be certain Country B will be producing different goods than TVs in the meantime. Let's say VCRs and for simplicity let's make it as complex and resource costly as a TV and 50% of those VCRs are transported to country A. Then we end up with approximately 9901 VCRs and 9901 TVs instead of 10,000 TVs and 10,000 VCRs if no transportation would take place (or 20.000 TVs in the original example). Again we lose wealth due to transportation as not as many goods could be produced as would be possible with only local transportation.

Now, the assumption is that the economies of scale free up other resources to such an extent that going for cost efficiency leads to an optimum allocation of resources; I'm challenging that assumption because in the original simple example it seems to fail because of the following:

- higher resource costs for transportation because 50% of the goods need to travel longer distances
- two BIG factories need to be build that are used only half of the time (first to exhaust resources in country A then in country B) to cater to the demand instead of two smaller factories that produce the entire time (in the adjusted "VCR" example two BIG factories exhaust the resources in half of the time as in my original example).

I do not see how these effects are translated in the price-mechanism as in effect the price mechanism seems to be in favour of such a "wasteful" allocation as long as prices are low enough.
keda
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Posted Nov 19, 2008 - 6:41 AM:

There seems to be the assumption that the more TVs per resources the better. However if it would cost you 1000 EUR to produce a TV for 50 units of resources, would you bother making them? You'd get twice more TVs but it would cost you 25 times more.
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Posted Nov 20, 2008 - 2:30 PM:

I think you're right in saying that waste is inevitable in capitalism, but there is more to the distribution of resources than efficiency. How quickly those resources can be distributed is also important. If the TVs are more expensive to produce, fewer people will be able to afford them (at least initially), and so it will take more time to convert natural resources into tangible wealth. This is analogous to driving a car: accelerating quickly can be nice, and is necessary in some situations, but it consumes more gas. It costs something to increase production speed.
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Posted Nov 20, 2008 - 2:47 PM:

The economic model is fatally flawed by its total dependence on the cost/price mechanism which ignores the true cost by excluding externalities like social and enviromental costs.
Country A can have a temporary advantage of reduced labor costs and generate a temporary higher return on capital investment by foregoing pollution controls and ignoring social costs but this temporary advantage will dissapear as at some point country A must clean up its environment and confront the social costs.

Meanwhile, Country B, having already dealt with these issues, will make a big comeback in competitiveness. So, as country A diverts capital to paying pension and health care costs, cleaning up its act and incorporating all this into its cost structure, Country B will be making and selling its biodegradable, non-toxic ultra quantum 3D TVs all over the world at a price that cannot be beaten.

The race to the bottom of the cost structure has a floor and that floor is always rising. Manufacturers who obsess on lowering costs without regard to increasing the efficiency of production will always lose out eventually.
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