The Cigarette Lighter Problem

I have mainly been talking about the UK economy, but for a moment I would like to talk about the 'cigarette lighter problem'. It is a rather unusual way of looking at the underlying functioning of economies that I came up with when discussing economics with some friends.

The starting point is my purchase of a disposable lighter in China for approximately $NZ 0.19. I purchased an equivalent lighter in New Zealand for $NZ 1.80. In both cases I purchased the lighter in small shops. In both cases the lighters were equivalent products, and the convenience of the shops were identical, and the service provided identical. In both cases the lighters were manufactured in China.

The problem arises as to why the prices were so different.

At this point it is very tempting to get into discussions about purchasing power parity, but I am going to put that to one side and consider the real implications. The problem here is that, for some reason, the lighter in New Zealand is about 9 times more expensive.

Before continuing it is necessary to remove one factor in the consideration of the price; the cost of transport of the lighter from China to New Zealand. When we think of the size of lighter, and the cost of shipping, it will be apparent that the cost of shipping is going to add virtually nothing to the cost of the lighter.

So where does this additional cost come from? It is first necessary to track the journey of a lighter through the distribution systems until it reaches my hand.

In both cases, once the lighter has been manufactured, the journey of the lighter to a corner shop will start in a warehouse. Someone will be selling the lighter to wholesale. When the wholesaler purchases the lighter it will be transported from this warehouse to the wholesalers warehouse. The wholesaler will be providing an aggregation service to small shops, providing a range of products to service the small shop sector. The small shop will then purchase the lighter, along with other lighters and other products stocked by the wholesaler. There are then 2 options here. One is that the wholesaler will deliver, or the other is that the purchaser will be purchasing from a 'Cash and Carry' type wholesaler, such that the owners transport the lighter to the shop themselves. Using either method, there should be no significant cost differential. In both cases the shop owner took the lighter out of the packaging and onto a shelf. In both cases the shop owner took the lighter off the shelf and placed it in my hand, before accepting my payment.

When we look at this process, we have to ask ourselves where exactly is NZ 1.60 (approx.) of added value coming from? When we view this process this way, we see that near identical systems of distribution of exactly the same product and service, result in a massive price differential. Is there any added value in the process whatsoever?

The answer, of course, is 'no'.

So why does this matter? If we then think of any economic activity whatsoever in New Zealand (or any other OECD economy), we have to factor in the fact that, whatever activity occurs, this kind of cost escalation is going to be built into the activity. The result of this is that the overall economic activity of the economy overall must generate massive added value to support such cost escalations. For example, manufacturing of products, and the provision of services must be creating huge amounts of value in order for a system of such cost escalation to be supported.

So why does the lighter cost more in New Zealand? The key difference in the process of distribution of the lighter is not in any added value, but in the cost of wages, and the cost of government through taxes and regulation, the cost of warehousing through higher land costs.

In order to support such additional costs, the economy must have elements that are creating wealth for redistribution on a massive scale.

The question to then ask is; where is such wealth generating capacity in the New Zealand economy. The same question can be asked of the U.S. or the U.K. and so on.... Having asked this question, the size of the problem becomes apparent. In the case of the lighter, the cost of the lighter is nine times the cost in China. How can an economy be generating enough added value to sustain these kind of differentials?

I am aware that a lighter is just one example, and not all products have the same differential. However, the point remains. How can the OECD economies justify, and continue to justify, such massive differentials of cost without creating massive added value in other areas of the economy. When we think of the real economy, and compare this with China, where is such massive added value taking place? China increasingly has similar manufacturing industries, service industries, distribution and so on. Despite this, they are able to sell a lighter nine times cheaper than in New Zealand.

It raises the possibility that something is very wrong and unbalanced in the world economy. The question this raises is how big is the imbalance, and how will it be corrected? My own view is that we are just now starting to see the correction, and are just now starting to see the pain of the correction.

Note added 30 Jan 2009:

I have had a very good comment on this post, which was added to another post. As such, I thought I would add the comment here, along with my response.

This is the comment from Aantonikl:

I'm not convinced that we are "much poorer than we think". Your cigarette lighter argument shows that exchanges rates are out of line with purchasing power parity, but that is unrelated to how poor we are. In china, the minimum monthly wage is in urban areas somewhere about 800 RMB a month http://www.marketwatch.com/news/story/china-raises-minimum-wages-calm/story.aspx?guid={B120D814-3C01-468A-9C11-B7596BCE1A35}
This ignores the rural population. But the rural population do not count towards the increase in global labour. Thus in china, on the minimum wage I can buy (according to your figures) 1150 lighters.

In the uk the monthly median wage is about 2075 pounds (http://www.statistics.gov.uk/cci/nugget.asp?id=285), and the relation between the minimum and median wage is about .45 in the uk (http://stats.oecd.org/wbos/Index.aspx?DataSetCode=MIN2MED)
Thus in the UK, someone on the minimum wage will earn about 900 pounds a month. Lighters are .59 pounds (http://www.sainsburys.com/groceries/index.jsp?bmUID=1233139730826)
So I could buy 1500 lighters.

So, the difference in what labour buys between the UK and China is not so great, especially since I suspect they work longer per month in China than the UK. Our cheap labour is worth about the same. For more expensive labour, the UK can pay more as it is more efficient, re infrastructure, rule of law, etc.

So whilst the world economy is in big trouble, and things are going to change, I'm not convinced the man is the western street is suddenly going to be poorer. He may have to change job, and move to an industry that produces more value, but what his labour will buy him should stay the same.

My response was as follows:

Aantonikl:

Thank you for an excellent and very well thought out response to the 'Cigarette Lighter Problem.'

For other readers, the original post can be found here:

http://cynicuseconomicus.blogspot.com/2008/06/cigarette-lighter-problem.html


Your point about the rural population in China is interesting, but we have an equivalent in the long term unemployed. The difference perhaps is that one group is self-sufficient, the other is not. In fact the latter group in the UK could be described as the minimimum wage?

Your analysis reminds me of something I read recently on measuring salary in terms of Mars bars purchasing power - which showed that there was very little real change in the salary of new graduate starting salary at ICI from (I think) 1950 and now.i.e. you can buy roughly the same number of Mars bars now as then with the salary.

Essentially the Mars bar comparison highlights that the measure of inflation is very dubious.

However, returning to your excellent analysis. I am not sure that you have followed it through to the logical conclusion.

You correctly identify that exchange rates are out of line with PPP. In this case I could change £1 and buy several lighters if I took that money into a Chinese shop.

This has been one of the consistent arguments of this blog. Exchange rates are going to have to shift.

You suggest that is that there is not much difference in the value created by our cheap labour and that of China, so we will not be poorer in the future. However, it is evident from your own argument that our purchasing power is being significantly subsidised by China (and I would add - many others).

The imbalance in the exchange rates means that we have not been paying the full value for the goods that we purchase. We have had our purchasing subsidised by China.

If we take away that subsidy (exchange rate corrects), then our purchasing power will diminish significantly. This, by any reasonable definition, means that we will be poorer. At its most simple, the lighter we bought for 59p will go up in price.

One point of contention. You use the price from a major UK supermarket for a comparison. However, in my comparison I used a New Zealand dairy (corner shop/convenience store) and an equivalent sized shop in China.

I do not remember/know what a lighter would cost in a supermarket in China (e.g. there was a Walmart near where I lived in China), but would guess that the price would be considerably lower than that which you used.

Another point of contention is your assertion that:

'For more expensive labour, the UK can pay more as it is more efficient, re infrastructure, rule of law, etc.'

I think that you are making some very bold assertions here. For example, infrastructure in China (in the cities, but also increasingly so in the countryside) is surprisingly good, whether transport, power, or telecoms. Clean water still leaves a lot to be desired, but that is about it.

Your other example is lack of rule of law, which is true, but the lack of rule of law in China has advantages. For example, they can use our intellectual property without paying for it. The absence of law is also a positive in that regulation is less, and often can be ignored, such that costs of regulatory compliance are lower, and so forth.

The cost of this lack of law is uncertainty and corruption, and lack of incentive to develop intellectual property (IP). However, as soon as the balance is to the advantage to China to enforce IP rights, you can be sure that the rule of law will (as if by magic) be enforced.

I think overall you are making some assumptions in your proposed advantages, at least in the examples you cite. If you were to visit a Chinese city/live in China, you may be very surprised, and the same might be said of many of the towns, in particular in the most developed provinces (e.g. Guangdong).

Finally, there is the most fundamental problem. If we accept that our economy has been supported by borrowing, one of the central themes of this blog, then the problem becomes worrying.

In particular, borrowed money circulates through the economy, pushing up activity, pushing up employment, and so forth. All of this offers a higher standard of living for everyone (in the short term)and this reflects in the cost of everything.

As such, every part of the economy appears to have greater wealth than really is the case. For example, the borrowed money is supporting higher wages through higher employment levels.

As such, if you think about it, just taking the case of wages as an example of a factor, those higher wages impact upon the selling price of that lighter. Many people are involved in finally putting that lighter on the shelf, though their overall % contribution to the price will not be that large.

However, this is just one factor, but another might be the cost of real estate, and so forth...the cumulative impact of the higher costs finally ends up in the lighter.

Returning to wages, the cost of the lighter is higher to support the higher wages, and the higher wages are partly resultant from the artificial boom in the economy. The artificial boom is the result of borrowing.

What we have, therefore, is a situation where a part of the price of the lighter originates in borrowed money. As a purchaser, I am also in part spending borrowed money, even if I am buying it from my wages, for the same reason as I have just explained for the cost of the lighter. In other words, part of the transaction is financed by economy wide borrowing.

This is difficult to grasp, I know, but when I buy a lighter with cash (not borrowing), I am in reality using partly borrowed money to purchase the lighter, and the price of the lighter is higher than it should be because of borrowed money.

However, thank you for an excellent and well thought out comment. At some point I may copy your comment and this reply to the original post.

I will welcome a response to my reply. In particular if you feel that you still disagree with my assertion that we are poorer than we think.

More comments are welcomed.