Maximizing social welfare: price versus use

In the field of regulation and competition, the ultimate political objective should be to maximize social welfare. Despite the abundant literature on the subject, misconceptions about the nature of well-being persist. The objective of this post is to recall the basic economic logic that underlies such a concept and to reflect on whether the traditional focus on prices as a political objective is well oriented.

Usage Drives Value

The basis for calculating welfare is the demand curve. Assuming that we can approximate the value from the willingness to pay, the demand curve represents the value that consumers attribute to each unit of product or service consumed. This curve is usually represented with a downward slope, to show that, as the quantities consumed increase, a smaller value is assigned to each additional unit consumed. [1].

Representation of a typical demand curve with the value generated for a consumption Q

The total value created by the consumption of a certain quantity of a good or service is the sum of all the values ​​attributed to each of the individual units. It can be represented graphically as the area under the demand curve, as shown in figure 1. It is clear that the value accumulated by consumers depends on the use: the greater the use, the greater the value generated.

Production costs determine the net value to society and social welfare

Before being consumed, goods and services need to be produced. Production requires resources that, if they are dedicated to a specific good or service, cannot be used in another activity. Even the most basic activity, like picking berries from a tree, will require time that could be spent elsewhere. Therefore, to determine the social welfare created by the activity, we must subtract the cost of production from the value acquired by use.

Graph 2: Representation of the net value generated for a given demand curve and a given cost curve


In this graph, the curve shows the average cost of production for each total quantity produced, that is, the total costs divided by the number of units produced). In turn, it decreases as the number of units produced increases, which always happens if there are relevant indivisible costs, such as a production machine or a mobile network antenna. For simplicity, we will assume that there is only one producer.

Prices determine how value is shared between consumers and producers

Even from the earliest stages of an economy’s development, most of the goods consumed by one individual are produced by another individual and obtained through trade.

An exchange price then appears that, in some way, distributes the welfare created between the two parties involved, that is, the end user or buyer, and the producer or seller. Of course, both the consumer and the producer will try to keep as much value for themselves as possible, but it is important to note that the actual distribution does not have a direct impact on total welfare, at least not in a static context.

Representation of welfare distributed between consumers and producers as a consequence of the exchange price


Figure 3 illustrates how prices determine the distribution of welfare, assuming that the price is the same for all units and is set at a level equal to the willingness to pay for the least valuable unit consumed. The corresponding consumer surplus and producer profits are deduced graphically.

It can easily be seen that although the welfare created for consumers by this particular activity always increases with use, for that result to be sustainable the producers have to at least cover their cost of production. Investments can be taken for granted in the short term, so consumers’ welfare can be increased with little effort by simply squeezing an existing production machine or telecommunications network to its maximum capacity, and allowing consumers to enjoy the consumption of all production. However, this situation is not sustainable unless producers cover their production costs and are therefore incentivized to invest and renew assets as they deteriorate and become obsolete.

So how can social welfare be increased?

In the very short run, when both the value to consumers and the means of production are given, the most immediate way to increase total welfare is to induce increased use by lowering prices. A benevolent regulator might try to estimate the cost of producing one additional unit (the “marginal cost”) and cap prices at that level (see Figure 4).

However, this raises two problems. The first is the fact that, while consumers always gain from lower prices, producers obviously do not. In general, it is argued that as long as the increase in consumers’ surplus is greater than the decrease in producers’ profits, society as a whole will be better off, at least in the short run, but it remains true that the result will be obtained at cost of one of the parties.

The second is the risk of setting a price that does not allow the producer to recover fixed costs (see the red zone in Figure 4). The information on cost structures and the shape of the demand curve available to the regulator is never complete or totally accurate, and the pressure to induce price reductions is high. It is easy to see that there is a risk of underestimating the costs that the producer must be allowed to recover, or of overestimating the consumption levels for a given price. If that happens, the payments of the consumers will not allow to recover the fixed costs and the future investments of the producers will be in danger. [2].

Representation of a situation in which social welfare is increased by forcing a reduction in prices

A second way to increase welfare is to take advantage of economies of scale. In industries with high fixed costs, the average cost per unit decreases as more units are produced.

When this occurs, having multiple producers is not cost efficient. This is illustrated in the graph below, where merger synergies are created without impacting consumer surplus, freeing up resources that can be used elsewhere.

Illustration of the increase in social welfare that can be achieved by increasing the scale

Even more interesting is the fact that much larger increases in the welfare created by an activity can be achieved by shifting the demand curve to the right, which means increasing the value that consumers extract from consumption. This idea is shown in Figure 6.

Producers have every incentive to trigger and promote this process, which is why companies dedicate a great deal of resources to innovate and facilitate user adoption.

Facebook/Meta, for example, is spending billions on R&D for Virtual Reality (VR) headsets because it believes the value of social media to end users will be much greater in a VR context. In terms of our simplified economic model, what they are trying to do is precisely shift the demand curve for social networks to the right.

Graph 6: Increase in social welfare as a result of the shift in the demand curve to the right


A relevant question for policy makers and regulators is whether the current profit level can influence the probability of future shifts in demand such as the one depicted in Figure 6.

Both regulators and competition authorities tend to consider that consumer preferences are an independent variable, unaffected by producer profits, but this assumption is not fulfilled when other dynamic considerations enter the analysis.

It is more realistic to assume that the level of profits, both current and expected, largely shapes the incentives and possibilities for producers to invest in improving the value of their products, as described above.

If this is the case, policy makers should not assume that promoting lower prices to induce higher use through a movement along a given demand curve is always positive for social welfare. They should also assess whether their actions hinder future shifts in those demand curves that would reflect an increase in the value of products and services to consumers.

conclusion

1. Social welfare is a measure of how a productive activity improves the lives of individuals. It is governed by the use made by consumers and the utility they extract from the activity.

2. Prices do not have a direct impact on social welfare, but determine how the value created is shared between consumers and producers.

3. In the short run, lower prices can increase social welfare by shifting the equilibrium point to the right on the demand curve. However, this risks hampering future investment if producers are limited in recovering their fixed costs.

4. The best way to increase social welfare is to shift the entire demand curve to the right. It is a process usually driven by the producers, through a discovery process fueled by the resources available to them and the expectation of future benefits.

References:

[1] See Varian, HR (2019): Intermediate Microeconomics: a modern approach, 9th edition. Norton, New York.

[2] See Hausman, JA (2000) “Regulated costs and prices in telecommunications”, Massachusetts Institute of Technology, Cambridge, USA. Available in Doc 7 . tif (mit.edu).

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