Cutting Corners and Nickel-and-Diming Customers

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In macroeconomics, the “circular flow of income” refers to the continuous flow of money between producers and consumers in the economy. Producers provide goods and services to consumers, who in turn pay for them. Producers then use this revenue to pay employees and suppliers, who become consumers themselves when they spend their incomes, and so on in a virtuous cycle.

Within this circular flow, some economists see savings as problematic, since saving effectively takes money out of the circular flow. However, saving is also important to provide funds for investment, which will spur future consumer spending at a later date. It is primarily hoarding of cash that is problematic and removes funds from the cycle.

But there is another kind of “leakage” from the circular flow system that often goes overlooked: this is the leakage of unpriced benefits that consumers receive from market transactions. While money spent to make a consumer experience more delightful will have a corresponding receipt as it forms income for another individual, it may also entail an efficiency loss in that aggregate income would have been higher had the spending gone toward some other purpose. 

Consider the example of an auto mechanic that spends money on free coffee for customers while they wait for their cars to be repaired. Although the activity does provide income for the coffee company, the payment also results in an efficiency loss in that resources devoted to coffee could have been invested in more productive business activities that reduce costs, generate revenue, or increase output for the firm.

This lost efficiency applies to unpriced consumer surplus more broadly. Consumer surplus refers to the difference between the price a consumer pays for something and the maximum they would have been willing to pay. For instance, if one spends $300 at an auto mechanic, but would have paid up to $400 due to the trustworthiness of the mechanic, that person has received $100 of consumer surplus. 

Read the full article on Econlib.