Sunday, February 22, 2015

Subsidies of Scale: how the poor and middle class help pay for the lifestyles of the rich

Preface: I'm well aware that genuinely new ideas in virtually any subject are few and far between. I haven't seen the following concept discussed anywhere before here and now. That doesn't mean it hasn't been. But if I've come up with a new insight, well, good for me!

The idea in a nutshell: economies of scale achieved by mass-producing goods for the lower classes help to make high-end versions of these goods more affordable for the upper classes. Absent the demand generated by the lower classes, these economies of scale would not be attained, and luxury goods would cost far more. Thus, the lower and middle classes are in effect subsidizing the lifestyles of the rich and famous. 

Most of the parts in a Cadillac are identical to, or derived from, parts in a Chevrolet. Most limited-production high-end spirits are produced by distilleries that sell large volumes of more affordable brands. In fact, a large proportion of luxury goods depend on mass consumption of less-costly versions for their availability and affordability.

Let's stick with the Cadillac–Chevrolet model for now. Tooling up to build a car is enormously expensive. The only thing that makes today's cars affordable is the fact that they are cranked out by the millions, so the tooling costs can be spread out over all those millions of units. In fact, key components like engines are almost always shared between different models and brands of cars, to achieve greater economies of scale and hence lower costs (as an example, the engine in my very modest Saturn was a joint development effort of GM, its German subsidiary Opel, Saab, and Lotus, and was used in numerous GM cars, including some Cadillacs).

Imagine that wealth inequality in America continues to increase, to the point that only the rich can afford new cars. The market for Chevrolets dries up, while the demand for Cadillacs booms. Where are those Cadillacs going to come from? Without a large base of Chevrolet parts to choose from, Cadillac engineers will be forced to design and tool more of their own. But instead of spreading out these costs over millions of vehicles, they'll only be able to amortize them over a few thousand luxury cars. Bottom line: the per-unit cost goes up massively. A Cadillac you can buy today for $60,000 could easily cost twice that or more. At $120,000, even a few rich people might think twice. If sales decline, the unit cost goes up even more, leading to a classic downward spiral.

So the key point is this: middle-class purchases of mass-produced goods subsidize luxury versions of these goods. Every new Chevrolet that's sold to a factory worker helps the worker's boss afford a Cadillac.

By providing support at the bottom of the market, in the form of demand for clunkers on their last wheels, even the poor help to subsidize fancy cars for the rich. If poor people could no longer afford to buy these cars on the used market, their current owners would wind up hanging onto them longer, depressing the demand for new Chevrolets, and again making Cadillacs more expensive.

This effect is just one of the things I've been thinking about, under the general topic of Rising inequality: how does this end? Taken to its logical extreme, inequality has consequences that even the 1% might be wary of.

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