Sun, 15 Aug 2004

Price, Cost, and Marginal Value

Steve den Beste talks about economics. He does a pretty good job, but falls down on the parts he's not really talking about.

In a free market, over the long run, price == cost == marginal value. Everything that den Beste says about prices is true only in the short term. In the short term, the price is going to be higher than the cost in order to pay the entrepreneur who set up the business. However, that profit gets competed out, so that in time, the price of something equals the sum of the costs of it. Gotta remember that the cost must include everything: cost of goods sold, rent, power, light, salaries, interest and dividends. Interest is rent on money lent, and dividends are rent on capital ownership. Neither are profits to a business; the business pays them out.

The marginal value of something equals the price of it. If you valued the next one of something more than the price, you'd buy another one. There are obviously quantizing problems here (for most people, the first car is the only one whose marginal value exceeds its price), but if you average out the purchasing decision, it will close in on the price. For bulk-purchased commodities like loose candy, the value (to you!) of the last candy you slipped into the jar is equal to the price of it.

den Beste said that people have to value something more than its price or they won't buy. That's just a specific case of the marginal value being the value of the very first one.

So, all that said, is den Beste wrong about the inverse network value? Not at all. He is specifically not talking about a completely free market. He's talking about a market where the Rolls-Royce company has a monopoly on producing Rolls-Royce cars. The whole point behind trademark law is to allow producers to charge monopoly prices. In a completely free market, when Rolls-Royce tried to restrict production to keep prices up, other people would step in and create more Rolls-Royces. Not clear that anybody wants markets to be that free.

Update: Ron writes in with some confusion over marginal value: "The marginal value equalling the price depends on den Beste being right. It's the last customer that has value equalling price. If the price rises, he drops off and there's a new last customer at the higher price. If the price falls, another customer comes on and the former last customer makes a profit. All the customers but the last make a profit."

Ron, marginal value refers to the value to *you* of buying yet another one of the things. In the case that Steve is talking about (cars), very very few people buy more than one at a time. Therefore the marginal value in this case is going to be the same as the value. Quite clearly the value must be equal to or exceed the price for someone to purchase something. My point being that the marginal value might only equal the price. In the long term, in a free market, with something that doesn't suffer too badly from quantizing effects, it makes sense for somebody to keep adding items to their cart until the marginal value *equals* the price. This is true even if the first one purchased is the last one purchased.

Since I'm on the topic, what happens if the seller is deliberately quanitizing the price so as to "steal" profit from the consumer by arranging things so that the last one purchased always ends up with marginal value equal to the price? This is where the beauty of competition shines. Another less greedy seller could rearrange his sales so that he takes only half of the profit from that sale, and shares the other half of the profit with the customer (e.g. by offering a discounted price for buying that larger quantity).

I should note that transaction costs interfere with causing the price to exactly equal the cost, and the marginal value to exactly equal the price. Transaction costs suck, but then so does friction.

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