Supply Destruction

This is the other way to combat deflation I talked about in last blog. If there is an excess capacity in the economy for producing a certain good or services, it will drive down the price being charged for that good or services. Basic microeconomics of supply greater than demand leading to lower prices. and lower average prices of all goods and services in an economy is deflation. In a normal economy, as competitors get more efficient, prices go down, businesses in the lower quartile of operating costs in the industry will shut down when the prices go down below their operating costs. This is a normal economic fundamental and weeds out the inefficient businesses and allocates the resources to more efficient activity. This happens all the time in a competitive economy and is very good for economic growth. The demand for the products is there and the more cost efficient competitor is able to capture a bigger share of the demand by being able to drive down costs and in effect charge lower prices than other competitors.

If the demand for a certain product and services in the economy goes down, that is ok as the human and capital resources could be shifted to other products and services that are high on demand. But what if the demand for all products and services in the economy go down, that creates deflation. Suddenly there is excess capacity in the economy compared to the demand. Companies are cutting jobs just to survive but due to high fixed costs, are willing to cut prices to move products. There are only a few big survivors in any given segment of an industry and they are not willing to shut down to reduce capacity - the govt doesn't want to shut them down and are more prone to bailing them out. This creates deflationary conditions. One prime example is housing industry - there are more homes now than what people need right now. So the supply is greater than demand and the sellers are willing to cut prices just to make a sale. This price cut then affects the value of all the other neighbouring homes.

One way out of this to cause supply destruction. Instead of selling homes at a lower price, the govt or some other body could buy them off and destroy those homes. They may be spending money on buying those homes but they are also taking away future supply from the market, thereby reducing the price fall. akin to a stimulus spending. The problem with this approach is how to implement it. Any way of implementation will be highly unfair to a number of segment of people and that's where it will be conterversial. What price should the govt buy the house at, which houses should the govt buy - it won't be easy. Supply destruction other than thru market forces is very difficult to implement unless nature somehow works to create hurricanes, tornadoes etc nationwide to take supply out of the market but again nature may be taking the wrong supply out of the market, exacerbating the situation.