Tuesday, June 24, 2008

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:


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:


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.


  1. Where does that added value go?

    Some of that value is expressed in the maintainence of an amenable Euro society in NZ.

    Well, do you want to live in NZ or China?

  2. Just a quick reply to anonymous. It is not where the added value goes, it is a question of where it is created.

    In other words, is the cost of the lighter supported by other parts of the economy creating enough added value to justify the price? Is there enough wealth overall in the economy to support this price on an ongoing basis?

    I think that you will find that the current financial crisis, the bursting of the debt bubble, suggests otherwise. There is not really enough added value being generated in the economies of the West to continue to support the prices.

    Take out the money that is created with debt growth, and there will not be enough money in the economy to support these prices. This is all about ideas such as the multiplier effect, that the debt gives an illusion of wealth, but is not real wealth.

  3. Having immigrated from an "emerging economy" to a "rich country" I experienced this phenomenon first-hand, but the explanation always seemed obvious to me: rich countries are rich because of currency imbalances. Much of the wealth of rich countries is founded upon (and funded by) artificial exchange rates. The answer to the "cigarette lighter problem" is that the New Zealand dollar is overvalued against the Chinese yuan by a factor close to the ratio between the prices of the lighter in both countries.

    The fundamental question is not "why the lighter costs more in New Zealand", but rather "why the income of workers in different countries is not commensurate with their productivity". I don't know the exact figures, but I'm quite sure that a convenience store clerk in New Zealand earns at least 10 times more than one in China, despite the fact that the productivity of both workers is roughly the same. As I said, I experienced this first-hand when I moved from one country to another and saw my salary instantly multiplied by 4, despite the fact that I have not become any more productive.

    So when you say that "something is very wrong and unbalanced in the world economy", I say "it's the exchange rate, stupid!". (I hope you recognize the "stupid" as an allusion to a commonly used phrase, not an insult). And even though I'm sure there is a lack of balance, I'm not sure it's necessarily wrong, for the simple reason I don't fully understand where it comes from.

    The one thing I can be quite sure of is that exchange rates are a matter of supply and demand, so the currencies of rich countries can only become overvalued by creating artificial demand for them. And the most obvious way in which I see this happening is through cultural influence. To take but one example, the fact that Coke is so popular in almost every nation on the planet is highly beneficial to the American economy, but such a high demand for a product with little intrinsic value can only be created by cultural influence. Surely if exposed to it without the accompanying marketing machine, most people would find the taste of Coke between trivial and repugnant (it is, after all, nothing more than water, sugar, and CO2)

    This is a complex topic and I have no room to expand on it, so I'll finish with my opinion on the future of the wealth of wealthy countries: there is not much to worry about, things won't change much. The current state of the world's economy is a product of politics and culture, not of worker productivity. A "service economy" is perfectly sustainable for as long as there are far more poor countries in the world than rich ones - a situation not likely to change in any foreseeable future. The most visible result of the "service economy" is that it creates a world market for things people in rich countries are no longer willing to manufacture; things such as cigarette lighters.

  4. This is a very interesting question. I have no pretence of being an economist, but I did notice that prices in China are enormously lower than in the UK and Europe generally.

    It certainly seems to me that there is a huge disequilibrium. But as another commentator has observed, part of this is the huge disparity of wages between NZ/UK/US and China. There is certainly no free movement of labour between China and these countries, so this disequilibrium seems set to continue.

    Another issue is the effective monopoly status that existing distribution channels have built up. I have spoken to many developers in the UK hoping to persuade them to import direct from China factories. This is relatively straightforward if you have the services of an export agent with the relevant licenses to help you (which we have!). Unfortunately there are uncountable reasons why, in practice, UK developers are extremely reluctant to do this. There are very many small ways in which the playing field is not exactly level, but one typical one is that the structure of the industry means that installation is nearly always done by lightly-capitalised subcontractors who cannot get the finance needed to import, but can fairly easily get trade finance from local distributors.

    Another issue is that there is a lot of hidden pressure on China to ensure that its products are not sold too cheaply into Western markets. There are many anti-dumping reports being written at any one time, and these terrify the Chinese as the imposition of anti-dumping tariffs can be hugely disruptive for exporters.

    A fourth issue is that distributors will punish developers/contractors who import direct. This means that a housebuilder has to adopt an 'all or nothing' strategy, and go to importing 100% of his supplies to make real savings. By adopting a marginal or incremental strategy he is likely to lose money by his existing supplier cutting discounts or even refusing to supply lines.

    When I first decided to open up my direct-import agency I imagined that competing with the distributors with their huge gross margins would be like shooting fish in a barrel. The reality has turned out to be very different.

  5. finially....
    i've done quite a bit of research since september and have come to the same conclusion you have. but, what is really eating at me is why no 'credible' source (msm, economists, etc) is willing to address this fundamental flaw in the economy. the only hope of truly fixing the problem is admitting we have one in the first place. if you know of anyone else who has spoken to this, please post a link. thanks.

  6. This is a really very interesting thread. I am still puzzled by this problem, but to me the key lies in the distribution systems in the various economies. There are many steps in the value chain between the Chinese factory in the consumer, and it is in the interest of virtually none of them to disrupt the existing supply chain. It certainly doesn't benefit wholesalers and retailers to have a collapse in the retail price of cigarette lighters.

    Another, I think related, phenomenon is the pricing of estate agency services. I have been an estate agent (admittedly only for letting properties, not selling them) and I can tell you that there is absolutely no significant extra cost in letting/selling a large property than in doing the same thing with a small cheap property. However, fees are invariably a (relatively fixed) percentage of the value of the transaction - rent or sale price.

    I have heard estate agents crying to me that although they sell large numbers of small properties that they cannot cover their costs and if only they could get some instructions to sell large properties they would be vastly better off. Yet this 'mispricing' continues indefinitely, certainly over the last fifty years. Occasionally a new entrant will try to offer a fixed-price selling service (I think one was charging £999, which represents the average commission on practically the smallest house that can be bought around here), but they seem to quickly exit the market.

    My own view is that the more rational pricing of estate agency services is an equilibrium state that cannot be achieved because of a huge 'activation energy' barrier. In chemical kinetics this kind of thing is very common - all organic materials are thermodynamically unstable in an oxygen atmosphere (i.e. the free energy of the system would decrease if all the carbon and hydrogen in our bodies were suddenly oxidized to C02 and water) but we continue to live perfectly happy for many decades, and wood, similarly, can persist in a thermodynamically unstable state for millenia without a sufficient rise in temperature.

    The effect of temperature is to give a proportion of the molecules in the system enough energy to surmount the energy barrier and find the lower energy configuration on the other side. Disruptive processes like global recessions may just be enough to cause sufficient movement and to lower some barriers sufficiently to create the conditions to move to move to the next equilibrium.

    I feel that I am starting to sound like a Hayek disciple here, so I'd better stop, because I am really not that sold his ideas.

  7. I can only assume that whatever extra value is not accounted for by NZs exports of agricultural produce, is represented by NZs National Debt of approximately $43bn (2005 figures).

    Hence all Western economies consume more than they produce, spending the extra on creating 'nicer' societies with welfare benefits, environmental protection and workers rights. None of which exist greatly in China.

    Eventually such munificence will no longer be affordable in the West. Whether the current crisis is the turning point or whether the day of reckoning will be postponed a while longer remains to be seen.

  8. Hence all Western economies consume more than they produce, spending the extra on creating 'nicer' societies with welfare benefits, environmental protection and workers rights. None of which exist greatly in China.

  9. Your theme that the OECD economies are living on "borrowed money" is intriguing, which follows naturally from the question that if we are not creating enough value to support the high price levels, then it can only be "borrowed".

    I am a Hong Kong resident and at the southmost tip of Guangdong, China, I can assure you that your comment on high performing efficiency and infrastructure of China is accurate.

    They are moving even faster than the traditional "four small dragons" - Hong Kong, Japan, Korea, Taiwan.

    Yet I cannot but help wondering: is it really possible for China to stop from lending.

    Sadly to say I think that if China is to keep the engine running, the continued "borrowing" is a price to pay.

    No one can conceive of a world order where the debt-ridden countries change drastically, be it politically or economically.

    No one ever wants the end of the world. That's kept us living throught the cold war era, when either US or USSR had more than enough to destroy every mortal on earth.

    Similarly, the borrowed money flowing keeps everybody happy today, and tomorrow's problem is "buried temporarily" down the rubbish bin, forever.

  10. I think people should stop smoking! Why are you doing it?

  11. excellent one problem though... you start with the lighter, so where do the raw materials come from? and the equipment and the companies to mine/drill for the raw materials?
    sorry but you cant just start with a manufactured item and just ignore the materials

  12. oops posted before i finished

    so what are the costs of shipping? do you know?
    i do, work in the business and if you want a quote let me know its probably going to shock you


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