Someone once said that economics is about price formation. The price of a reproducible good is set between two boundaries. The upper limit is governed by subjective marginal utility. I don't want to pay more for a product than it's worth to me, meaning: I will not forgo something of I value more in order to obtain something I value less. Neither will anyone else. Luckily the price is not set (in the long run) by utility. Why is this a good thing? Because I and everyone else I know love consumer surplus. We want maximum value at minimum sacrifice.
Under freedom of entry and open competition -- without government privilege or monopoly -- the price can be expected to be driven down from the upper boundary toward the lower boundary.
But what governs the lower boundary? The floor can't be zero because by and large people don't produce goods in order to give them away. They intend to sell them. So the lower boundary must be greater than zero. What determines that amount?
Talk amongst yourselves.
Thursday, January 06, 2011
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I would be curious to know what you think of Steve Keen's discussions of this from the empirical side, particularly lectures 2 and 3 on Managerial Economics here.
"I have no idea why an economist would want to know the exact cost of a product."
An economist wants to know the principles involved in price formation, not the exact cost.
Much of what ToryII says is true. But it is also true that under free competition and in the long run, economic "forces" are at work.
cost of production plus a small premium for profit.
But what exactly does "cost of production" mean?
Roderick Long has something interesting here. Scroll down to "Suppose (scenario A)..." But read the whole thing.
As it appears to me, cost of production is equal to:
(A) The total amount spent on each factor of production
+
(B) The marginal profit (i.e. ToryII's markup)
Now maybe I am uninformed, but I don't see the "cost of production" being dependent upon more than these two factors. Even better, from here we can see that each of these factors would have a bottom limit determined by secondary factors.
(A) Total input cost can be reduced through, among other things, research, development and/or investment in new technology.
This money spent would come from capital (total profit, saved or not), and so doesn't necessarily need to derive from a particular product's marginal profit.
(B) Marginal profit / markup could be affected by, among other things, Long's opportunity cost of not matching a competitor's price, as this value is subjectively determined by one of the individuals in the business.
Well, sort of, but also consider that most "costs" are themselves prices, markets are dynamic, not static.
So those costs also have an upper and lower bound determined by the factors of marginal demand and their input costs (which themselves are determined by those factors, etc).
However, there are costs in this chain which are not prices.
The exception I can think of is the disutility of labor, or leisure forgone.
The answer I'm most fond of is:
The bid price b of the consumer good x marks the point where the opportunity cost of selling an additional unit of x becomes critical to the marginal producer. He is the first producer to refuse to sell the downtick in the price of x — in view of his opportunity to refuse to buy the producer good y, his input in the production of x.
All producers of x are doing vertical arbitrage between consumer and producer goods all the time: they constantly shift their production lines from one vertical straddle to another. Their guiding star is the constellation of vertical spreads. As a result of the competition of producers the vertical spreads will shrink. But the spreads which belong to the two-legged vertical straddles with the same short leg x will not keep shrinking indefinitely. Their shrinking is checked by the marginal producer of x. His refusal to sell x and his refusal to buy y constitutes an opposite vertical straddle, and entering it will stabilize the spread.
Of course, the person of the marginal producer of x, and his input y, are subject to change. When another producer takes over that role from the first, the item y' he uses as his input for the production of x may not be the same as y. Indeed, over a period of time when the price of x undergoes a change, hundreds of different people may, one after another, play the role of the marginal producer of x, while y' sweeps through the spectrum of alternative inputs suitable for the production of x. This picture can be simplified if we personify the marginal producer of x and imagine that his short leg is anchored to x on the bottom rung of a ladder, while his long leg is trying to get a firm foothold on the next rung, touching the alternative inputs suitable for the production of x. This, then, is the mechanism whereby the market integrates the scattered knowledge of and power over the appropriate level of the price of x that resides in the individual producers, crystallizing it in the form of a single indicator: the bid price of x.
Our results can be summarized as follows. The asked price is determined by marginal utility. It can be characterized as the lowest price at which consumers can buy as much as they want without haggling — explaining how the asked price earns its name. The bid price is determined by the marginal profitability of production. It can be characterized as the highest price at which producers can sell all they have without haggling — explaining how the bid price earns its name. It follows that marginal utility must be higher than marginal profitability (otherwise no production will take place).
Antal Fekete
They write books on Costing.
The floor is not a constant. Most businesses expect to opearate at a loss for some period of time. In fact, consider Facebook, it started out without any ads and was all expense, i.e. a price of zero. Of course, there was an expectation that ads (and other revenue sources) would be introduced over time. Perhaps they had some type of model which determined the way to optimize profits over time based on acquiring users and so forth. I suspect that at least some of these decisions were made on a gut-feel basis, rather than being based on rigorous financial modelling. But this notion would point to the right answer, I believe.
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