Deadweight loss reduction through the sharing economy

¶ … Sharing Economy

Deadweight Loss

When it comes to the environment impact of humans on the planet, overconsumption is not necessarily the issue; it is overproduction. Overproduction creates a situation where there is more supply than there is demand. Thus, some supply in the marketplace goes unused. This is an inefficient use of resources, or a deadweight loss to society (Investopedia, 2015). There are a number of different reasons why deadweight loss arises. The sharing economy has emerged as a response to deadweight loss that derives from overproduction.

Overproduction occurs in many industries, largely because companies are competing for customers. Demand fluctuates, and companies will typically have more production capacity than they need, in order to be able to meet the peaks in demand and therefore not lose business. Overproduction is therefore inherent in any market economy. But overproduction creates deadweight loss. A market that has a high degree of flexibility will be able to manage overproduction to some extent. The market for clothing in the United States provides an example of how this works. Clothing is initially sold at big department stores or own brand stores at full price. Clothing that is unsold (excess production) is then sold off to discounts and off-price stores (i.e. Marshalls, TJ Maxx) where many of these clothes can find a market among people who are willing to sacrifice selection and newness for a lower price. Clothes that still remain unsold can find their way through other channels, sold at a price just below disposal cost, to vendors who may then sell these clothes in other countries. The system has evolved in a manner to manage overproduction, while extracting maximum profit. If it was possible to perfectly align production with demand, off-price retailers would not have inventory, but a certain amount of overproduction is built into the system (Chernikoff, 2010).

When the system adapts to manage overproduction, it is more economically efficient. There is less deadweight loss because a higher percentage of production is sold, even if for a lower amount of money, and it is still being sold at a profit. In other industries where the sharing economy has emerged, that emergence reflects an environment of overproduction, and a need/desire to utilize existing capacity more efficiently. Two such cases will be examined -- cars and homes.

AirBnB

AirBnB is a website where people can rent out real estate on a short-term basis. The vendors will often not be professional, registered vendors of such space, but rather people with spare apartments, unused houses, or spare bedrooms. AirBnB is a way for people to make money without the investment that goes into running an official guesthouse. This sharing economy arises for two reasons. One is that governments typically exert tight control over the market for accommodations, in particular through licensing. The supply of accommodations being managed gives way to an increased bargaining power for suppliers. There are only a few different accommodation types, they are often clustered in specific areas, and as such there is insufficient competition. This creates latent demand in the marketplace, for greater variety of accommodation options and for more competitive pricing. There are many people who have extra supply -- spare properties or rooms that are presently unused.

Thus, there is unused capacity in one area of real estate, and a shortage of capacity in other area. Naturally, the latter results in buyers being price takers, and at the same time there is unused capacity elsewhere this represents significant deadweight loss. Moreover, this economic inefficiency spurs wasteful production -- building new hotels when none should be needed. The sharing economy delivers greater economic efficiency by using existing surplus real estate to absorb the excess demand, and the provision of more flexible options only improves the economic efficiency of the accommodation market. Of course, greater economic efficiency reduces profit-taking opportunity for existing players, so they have a tendency to seek greater protections for their profit streams (Surowiecki, 2013).

Profits

Profits are a form of economic inefficiency. In a state of perfect competition, there are no profits. Perfect competition arises where there is an undifferentiated product, both buyer and seller have perfect knowledge, and sellers are price takers. The taxi industry has moved to standardize its product -- hotels are largely standardized these days as well -- but they are price setters because of regulatory limits on competition. What the sharing economy does is opens up those markets so that they can become more competitive. In doing so, they move these markets to be more competitive. Consumers have more information, and more bargaining power because of competition. Remember that both cars and accommodations are perishable goods, which encourages competition so that suppliers can cover their fixed costs. But the higher the level of competition, the less opportunity for profit. Economically, this is good. Consumers benefit, and profit is nothing but deadweight loss because in order for profit to exist, there must be some sort of inefficiency in the market. In the case of cars and accommodations, that inefficiency derives from government regulations that limit competition. By going around those restrictions, companies like AirBnB and Uber have been able to create greater economic efficiency.

This is ultimately less wasteful for society. In a world characterized by rising populations and resource strain, greater economic efficiency should be desirable. The current system has the protected industries profiting at the expense of consumers. The sharing economy shifts some of that profit to consumers, creating more equitable distribution of capital via a freer market. This delivers less waste, as it uses existing capacity to soak up excess demand, reducing the need to produce new capacity. This is better for the environment, and better for people, to use the power of the market to pull profit back from companies that have lobbied their way into profit-protected industries. The sharing economy is a much purer form of capitalism, and as such it delivers a much greater degree of benefit by eliminating some of the major sources of deadweight loss in our economy.