Jun

12

The economic analysis of "dead weight loss" puts in perspective the loss that occurs to the totality when an external body spends money on things that consumers would not buy voluntarily. Without intervention, consumers buy things where the price does not exceed the value they place on it. For all units purchased except the last, there is excess value or utility that consumers receive over and above the price they pay. With intervention, money is spent on goods that consumers were not willing to pay for before. The real cost might be assumed to be higher than the amount that is paid. There is a dead weight cost to extent that the price of the good is higher than what consumers would have voluntarily paid.

Let us consider all the earmarks in the bail out bill, and all the environmentally friendly improvements to government buildings, and all the construction projects that were earmarked to special groups or unions. How much of this is a dead weight cost? Perhaps 95% of the amount spent. The value of the total output of the economy is reduced by this amount. There is a smaller total to divide among consumers. This to me explains why the economy is having a much smaller recovery from a recession than in the past. See Consumer Surplus.

I have not fine tuned the analysis in the above, and would have to go take into account many other variables and factors, and would have to make my analysis much sharper for it to be dispositive, but I think it catches the essence.

Rocky Humbert writes: 

I agree that deadweight costs influence economic performance, but I believe the literature is inconsistent on the magnitude of the costs. A simple example puts this into context. Assume that there are 1,000 unemployed construction workers in Podunk, and lots of potholes in the streets of Podunk. The mayor of Podunk has no money to fill the potholes because his budget has been exhausted by pension contributions to the teachers union, combined with a decline in real estate tax collections (due to the housing price decline.) The mayor has fired a number of employees and cut back his maintenance cap. ex. budget. If the Federal government borrows money from China and uses that money to hire the unemployed Podunk construction workers, and pays them to fill potholes, there are obviously deadweight costs associated with these transfer payments — in particular, the salaries of the government tax collectors, bureaucrats managing the program, debt issuance costs, etc. (The effect of debt is beyond the scope of this example.) The Podunk workers fill the potholes, pay 30% of their wages back to the government (income taxes), get the psychic benefits of productive work, and the other residents of Podunk are able to drive faster, require less car maintenance, etc, and perhaps Federal Express even considers opening a new distribution center in Podunk because of the improved roads. In this example, there's no way the deadweight cost can be 95% — if only because more than 30% of the wages are making a round trip — and this doesn't consider the increased consumption by the hired workers — (which of course raises prices for some stuff they are buying–a "good" deadweight cost!?) — but the increased goods prices benefit the shopkeepers/(owners of private capital) in Podunk who are making more profits.

There are several other assumptions that I made in this example (including the level of wages paid to the Podunk workers, what China would have done with its dollars other than buy US Gov't debt, etc) but the gist is clear — it's unclear how the deadweight cost can be 95% of the money spent. I may be mistaken, but for the deadweight costs to be 95%, it would require a stimulus multiplier that is close to zero. Today's WSJ has two good articles that are on point. On the opinion page, the story "Obama's Real Spending Record" argues that growth is lower when government % of GDP is higher. While I am sympathetic to their view (for many reasons), the authors fall into the trap of using correlation<->causality. That is, ceteris paribus, if gdp is lower, than government spending and taxes as a % of GDP will be higher UNLESS the government engages in pro-cyclical behavior like the private sector does. The second article is "Median Family Net Worth Falls 40% From 2007 to 2010". (This is based on a Fed analysis, and is largely due to the housing price decline.)

Apart from incentive destruction, increased regulation, tax policy uncertainty, foreign labor competition, years of debt-financed consumption, etc. etc., I believe that an important cause of the slow economy is the Wealth Effect. The US economy is highly geared towards consumption — and families that see their largest asset value decline (and stay down) make lasting changes in spending/saving behavior. Apart from reducing worker mobility (due to underwater home prices), I believe that the pernicious reverse wealth effect can be blamed as easily as the deadweight loss effect.


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1 Comment so far

  1. Olivier on June 16, 2012 1:42 am

    The dead weight cost is infinite; simply, it hinders the astounding human evolution which would be under way without it.
    Perhaps the pot holes fillers would instead be permaculture farmers, sculptors and wooden boats builders!
    Thus, I consider the dead weight cost to be beyond the ability of quantitative analysis to approximate even remotely.

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