Thursday, 27 July 2017

Infrastructure costs are going to rise

We've been covering the interactions between markets in ECON100 and ECON110 over the last couple of weeks, so I thought an example might be useful. Brian Roche (chair of the Aggregate and Quarry Association) wrote in the New Zealand Herald on Tuesday:
Aggregate makes up 75 to 90 per cent of all the concrete used in buildings, roads and other infrastructure like airport runways or bridges...
Current total annual demand in Auckland is 13 million tonnes. This will rise to 16.5 million tonnes by 2031, assuming medium growth, or as much as 20 million tonnes, assuming high growth. The latter is likely given the Auckland Unitary Plan allows for more than 100,000 new houses to be built, mainly in newly developed areas.
Demand is good but only if it's matching supply. Get that out of whack and the greywacke that's widely quarried and used in aggregates will rise in price, adding more costs to our already high cost of building.
If more infrastructure is to be built, that will increase the demand for aggregate. The effect is pretty straightforward, as shown in the diagram below - demand for aggregate has increased from DB to DA, and price increases from PB to PA.

How does that affect the 'market' for infrastructure though? The demand for infrastructure (to be built in any given period of time) is downward sloping - if costs rise, we'll built less infrastructure (perhaps deferring some of the least essential projects to sometime in the future). The increase in the price of aggregate causes an increase in the cost of production for infrastructure, which is essentially the same as a decrease in supply. As shown in the diagram below, supply shifts up and to the left, from S0 to S1. This increases the price of infrastructure from P0 to P1, and because infrastructure is now more expensive, we invest in less of it now (deferring some needed infrastructure to the future).

What about if we don't defer investment in infrastructure in response to the increase in the price of aggregate? In that case, the demand curve is vertical (perfectly inelastic) - the quantity demanded doesn't adjust in response to a change in price (that is, the quantity of infrastructure is fixed at Q0). As shown in the diagram below, the decrease in supply from S0 to S1 now leads to a much higher cost of infrastructure (P2), compared with the price if demand was downward sloping (P1).

Overall, regardless of whether we defer infrastructure spending or not, the increased price of aggregate is going to lead to higher costs of building infrastructure.

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