Why is the US so Cheap?

A Simple Question

A friend of mine in California asked me one of those questions which seem simple on the surface yet is anything but. One of the “top women in storage” as a leading business publication had rated her, she had gone home to Ireland for the Christmas holidays. In an email detailing how everyone was and what happened in Ireland, she concluded by asking, “So, Mr Economist, tell me why is the US so cheap?” The context of her question included the price-levels of various places she is familiar with such as the US, Western European countries, NZ, and Australia. My own comparison of Indian and US prices adds further validity to that question since I find that the US is cheap relative to India. Why is it so?

It is one of those questions that if investigated sufficiently in detail, it would involve the entire discipline of economics. You could start off with a study of Adam Smith’s “An Inquiry into the Nature and Causes of the Wealth of Nations” (aka “The Wealth of Nations”), published in 1776, the same year as the American Declaration of Independence; and end with reading the papers of such people as Stiglitz, Krugman, and Romer. Or you could just take the quick and dirty route of figuring that it all comes down to how efficiently the US produces and distributes stuff.

A Simple Widget Economy

If you don’t like arithmetic, skip this section.

Let’s do some arithmetic. Suppose 100 people with their bare hands over one year produce and distribute among themselves 100 widgets. “Widgets” is economist-speak, a catchall for the generic good. Economists are always talking about producing widgets without really going into the details of what they are good for and how they are actually produced. Strange but that’s how it is. Anyway, the GDP of this 100-person economy is 100 widgets. The annual per capita income is therefore one widget, the same as the annual per capita production. Let’s underline that point: production and income are different ways of looking at the same thing.

Now imagine they suddenly (magically) come in possession of fancy machines that allow the same 100 people to produce 1,000 widgets in a year. The income per capita goes up to 10 widgets per year. Two important things have happened for that increase in productivity. First, the machines represent a technological change. The same amount of human effort is expended but given the machines, the output has increased 10-fold. Second, the machines use energy. So the production process now involves the use of non-muscle power and machines.

But machines don’t fall out of the sky like gentle rain upon the ground beneath. Someone has to make them. Say at some time, only 50 people are making widgets using machines (total production 500 widgets) and the other 50 are busy building the next generation of machines. The new machines increase productivity by a factor of 20. So now if you want to maintain the overall production of widgets to 500 per year, you need only 25 people to produce widgets and it releases 75 people to continue to build even more sophisticated machines.

The story is simple. The more efficient they become in producing widgets, the more people are free to innovate upon the machines. And as the machines improve, it allows further reduction in the number of people engaged in direct production of widgets. Note also that all this increase in production requires the use of machines which require external sources of energy. Figuring out new energy sources and developing the technology to use them also involves people. And people have to be trained for doing the job of inventing new machines, and the technologies for discovering and using energy. Let’s call that activity of training people “education.” At some point we can imagine this to be the structure of the economy:

100 people economy
10 people producing widgets 10,000 widgets a year using machines
Per capita annual income: 100 widgets
20 people involved in the manufacturing of machines
30 people involved in the research and development of machine technology
40 people involved in the education of the entire population so that some can do technology R&D, some work in factories making widget-making machines, and some who make widgets on the machines

The Big Picture

If you have skipped over the previous section, here’s what the main point is. Economies produce stuff. The more stuff they produce relative to the effort expended, the richer they are. The US is more productive than other economies because they use lots of machines, lots of energy, and produce a great deal of R&D. History and geography have been kind to the US, besides. Somehow they got lucky and had a bunch of smart people who figured out that both economic freedoms and political freedoms are important. Entrepreneurship flourished. Geographically, the US is huge with lots of natural resources. It was not always as rich as it is today. At one point it was on average as poor as say the people of Bihar today and had as little technology available to it. But the US developed quite well. Cars, laptops, the world wide web, and Google came much later. What the people of Bihar (and India in general) don’t have today and which the people of the US had from the birth of that nation was the smarts to figure out a set of rules and institutions that made the people more productive, not just the land and natural resources.

The US is cheap relative to India because it takes a lot less effort to get something done in the US than in India.

The Cost of Gas

Yesterday, I ventured out to get a cylinder of cooking gas. I had run out a couple of days ago, and after much inquiry I heard of a store that was willing to sell me a cylinder of LPG (liquefied petroleum gas). The store was about 2 kilometers away. I could have leisurely walked that distance in 20 minutes. But I had to drive as I had an empty gas cylinder weighing 16 kilos. It took about an hour to drive the 2 kilometers. Total time expended in acquiring a cylinder of gas this time: 3 hours. Cost of the gas: Rs 550 (or around US$15.) Over the last couple of years that I have been in Pune, I estimate that the effort in acquiring cooking gas was about Rs 1,500 and three full days of running around.

Anyone running a middle-class household in India knows that there is a shortage of cooking gas. Demand for it at the government mandated price far exceeds the supply. The price is around Rs 300 per cylinder but the cost to the manufacturer is around Rs 500. The government subsidizes the consumption of cooking gas. Mukesh Ambani’s household gets that subsidy, and so does any household which is not so poor as to not be able to afford the gas stove. That subsidy is not available to the really poor as they do not have the money to pay for the capital expenditure involved in using the gas. And besides, if you are not already a consumer listed with some gas supplier, you cannot get one as the supply is severely limited and it is not easy to become a new subscriber. I tried but I was told that the bribe is around Rs 6,000.

The perverse effects of controlling prices should be evident to the meanest intelligence. Which makes one wonder whether those who make these policies don’t even possess the meanest intelligence. Their claim is that subsidizing cooking gas is good for the poor. But it isn’t. Only the comfortably middle-class and higher actually get the subsidy. That subsidy costs the public treasury billions of dollars. Removing those subsidies will free up funds for things that would actually help the really needy – such as say education or health care.

In the end, markets figure out the solution. The distributors of gas cylinders price the gas cylinder to those who desperately need it and who can afford to pay for it at the market-clearing price. I paid Rs 550 for the cylinder which the distributor is supposed to sell at Rs 300. In effect, he pocketed the major part of the subsidy that the government gives to the consumers of gas.

Socialism suffers from the persist illusion that by lowering the price of something below the actual cost it somehow benefits the poor. That is arrant nonsense because a price ceiling pegged below cost of production is the best way to ensure a shortage of supply, and the limited supply can only satisfy the demand of those who have the deeper pockets, thus rationing the poor out. Socialism hurts the poor. Indeed, socialism creates poverty by ensuring that production suffers and thus incomes are low.

The US and the former USSR were similar in many respects such as the quality of the people (talented, educated) and the stock of natural resources. The major distinction was that the US was a free-market economy while the USSR was a socialist workers’ paradise. The average consumer in the US faced market price, and found shelves overburdened with goodies in their supermarkets. The average consumer in the USSR faced bare shelves of phantom goods—goods if they had been there would have been sold at affordable socialist prices.

The Road to Poverty

While sitting in creeping bumper-to-bumper traffic yesterday on my way to somehow get a cylinder of cooking gas, breathing the exhaust of diesel trucks, assaulted by incessant honking of cars, three-wheelers, and motorcycles, I wondered where it was all going.

Economics is called the dismal science. It does not get any more dismal than when you are forced to confront the absolute stupidity that leads to waste of human potential of such gigantic proportions that the Indian economy barely produces enough to keep its body and soul together. India is unable to feed all its children—about 50 percent of children below 5 years of age are malnourished. India does not produce enough to be able to provide a vast segment of its people decent housing, education, sanitation, health-care, and even a clean glass of drinking water.

I don’t wish to dwell on the obvious shortcomings of the Indian economy gratuitously. The intent is to force attention to the basic problem, which is that we have through our own stupidity not paid attention to what it is that makes people productive. Here’s one line of thinking. If people are forced to spend hours on end getting from one place to another, it leaves a lot less time to do productive work. The roads everywhere are congested because they are too narrow. There is a one-time cost to building wide roads or even for leaving sufficient space for building wider roads in the future. But the saving in building narrow roads is dwarfed by the cost incurred year after year of wasting time and fuel crawling along congested roads. It requires only a bit of foresight, only a bit of reflection to realize that so many people would need to move from this place to that and so the transportation system has to be designed such.

That brings us to an important point. People need transportation, not cars. Cars are a means of transporting oneself from point A to point B. Cars are not the end but only one of the many means of getting around. Roads are one obvious solution to urban transportation needs but not the only one. You could have light rail, for instance. And even if you do go in for roads, you could plan for a healthy mix of private cars, taxis, public buses, bicycles, and footpaths. The important point is that it involves planning, not just a random sequence of interventions made by ignorant policymakers.

Private firms are good at meeting the demand for private goods. That is what the market does so effectively: provide private goods. A car is a private good but it depends rather heavily on the availability of a complementary good: roads. Roads are not generally a private good. In the development where I live, Magarpatta City, they have internal roads which are wide and well maintained. The developer of the township owns the roads and has planned them to reflect the capacity of the township. There are no traffic jams within Magarpatta City. But step outside the gates, and you are forced to crawl along the roads of Pune.

Unlike private goods like cars, roads are “collective goods” and have public goods characteristics. The market does not provide public goods automatically in what is called “socially optimal amounts.” In the case of some public goods (such as pollution, a public “bad”), the market over supplies, and in others such as roads, it under supplies. Correcting for such market failures is the job of what is called the government. This does not mean that the government has to get into the business of supplying the public goods. It only means that the government has to make such rules that will correct for the market failures and thus nudge the market to produce the socially optimal amount of the public good in question.

Tata Motors about to market an “affordable car” – the cheapest car in the world, we hear. I suppose if one is only interested in owing a car and not really much bothered with the matter of whether it will take you anywhere, then it is a grand thing to have. Because irrespective of whether you have a BMW 740i or the Tata car, sitting in traffic does not get you very far. The existing roads of Pune will not magically expand to accommodate the additional affordable cars. The average speed will drop further and the total cost of transportation will go up appropriately. The total cost of transportation includes the cost of the car, the cost of the fuel, and the cost of moving along at 2 km an hour. I don’t think that the Tata car will be all that affordable.

Indian Cities are Expensive

The US is cheap because it is cheap to produce stuff in the US. Try doing a business in India. It will take months of hard work to figure out a route through the bureaucratic jungle to get the various permissions and permits required to get the business started. Running the business will require constant approval from a large number of interested parties. Much of this approval depends on how much you are able and willing to pay as bribes. A lot of effort in the economy overall is expended in either extracting rents from those who produce stuff or in minimizing the amount of rents a producer has to pay. The end result is that most of India is in what is termed the unorganized sector – a sector that suffers from low productivity because it cannot gain from the economies of scale and specialization. The organized sector accounts for about 7 percent of India’s labor force.

Even in the organized sector, the costs are high. The organized sector is necessarily urban based. The stock of urban locations is low and therefore the rents (here we are talking of rents as what you play for a place to live and work in, and not the rents that are bribes to those who control the economic activity) are high. A decent apartment in a good location in Mumbai or Bangalore can be upwards of Rs 100,000 a month. On top of that, you have to make your own arrangements for a basic utility such as electricity.

The Solution

If not the solution, at least the outlines of what should be a matter of public debate in India. I am not minimizing the progress that India has made in the last couple of decades. It is a matter of great personal satisfaction to me that India has moved out of its 3 percent a year “Nehru rate of growth” achieved by his wonderfully brilliant socialistic license-permit-control-quota raj. But I am concerned that for India to grow at a sustained double-digit, some fundamental changes have to occur.

The first is continued liberalization of the economy. Economic liberalization would allow the entrepreneurs of India to produce stuff. Not just stuff, it will produce the most important ingredient of all: education.

Second, India has to plan new cities. New cities will be cheaper to live and work in compared to stuffing even more millions in the existing cities. The existing cities were built for a time when the population of India was a tenth of what it is today. Furthermore, they were built for a time when practically nobody owned cars.

Third, India has to invest heavily into figuring out a way of having cheap energy. The US and other currently developed economies had the luxury of cheap fossil fuels. India does not have that. Joining the struggle to get a larger share of diminishing stocks of fuel worldwide is a loser’s game. Investing in research and development for alternate energy sources is something that the private sector cannot fund. It requires public policy and public funding.

The problem fundamentally boils down to why we cannot have a rational growth plan and enlightened public policy. My conjecture is that it is due to our political setup. I will go into that matter in the next bit.

[See the followup post — The AN-WWTSD-MFGTT — for responses to some of the comments below.]