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Source link: http://archive.mises.org/14960/whats-cost-got-to-do-with-it/

What’s Cost Got to Do with It?

December 9, 2010 by

Past expenses incurred during the production of a good are completely irrelevant to the determination of the current price of a good. The market price of a good is determined solely by the relative valuations of goods and money by the buyers and sellers of the good. FULL ARTICLE by Joseph T. Salerno

{ 89 comments }

A Liberal in Lakeview December 9, 2010 at 10:26 am

Past expenses incurred during the production of a good are completely irrelevant to the determination of the current price of a good. The market price of a good is determined solely by the relative valuations of goods and money by the buyers and sellers of the good.

Written like someone who either never paid much attention to what he was doing while running, or helping to run a business, or never had access to confidential cost info while working for a business, or surfed in and out quickly as consultants do at $nnn per hour, or who simply never worked in business at all. The essay also reminds me of dozens and dozens of sales reps and marketing people (the promo and positioning hacks, but usu. not product and price guys) that I dealt with in telecoms.But the fact that there is a current good or service at all is sufficient reason to suspect that expenses, and knowledge of those expenses, is factored into the price of a good. Costs enter into price even before product or service is developed, just to see if the businessplan makes financial sense. If the numbers don’t work, if revenues can’t pay for expenses, then, usually, the venture is not begun. (I’ll return to this idea in just a moment.) The current prices are thus skewed such that the goods and services that meet the cost criteria are just about the only goods and services offered for sale. Ideas for stuff deemed too costly, and thus requiring too high a price to pay the bills, are bounced. Costs are not just a determinant of prices, they are a preoccupation. Businesspeople who ignore this simple rule eventually run into the hard wall of business reality where revenues must exceed expenses. Even if we had a free banking system and annual deflation of prices, as I expect there would be under such conditions, this rule would still hold, once you accounted for the price deflation.In the meantime we treat the issue based on the facts which obtain for a money and banking system rigged for inflation of money supply and of prices.Now, I tell you, based on personal experience, that prices, both offered and bid are frequently informed by knowledge of the costs, even for services the cap ex of which is already a liability of the business. Hardly a day can go by in business development or product management or finance without asking, “what the the gross margin of the deal?”, “what’s ebitda for this service?”, “how long will it take to recoup the expense of acquiring this or that expensive equipment needed to serve the customer?”, and “will this deal bring in enough revenue to pay for the expenses already accrued and which we will continue to accrue?”. If you can’t keep the doors open, because you can’t pay for operating costs, you won’t be able to stay open long enough to pay the debt that was accumulated when you set up your operation. And you won’t be able to provide investors with a return on their investment, which is probably tied up in plant and equipment which can be sold only at fraction of original cost. At a bankruptcy sale.It’s disappointing that Salerno lives in an academics’s fantasyland. Sure enough, he leads off his explication with a silly example that is unrepresentative most stuff offered by most businesses, when they sell material goods. But did Salerno consider the possibility that margins of ” ‘fancy intense pink’ diamond” were expected to be so outlandish that it was a no-brainer for Sotheby’s finance guys or owners to approve the deal to broker the exchange, or even to acquire it outright before the auction?The Walgreens example, too, is weak. Store managers probably have little or no idea what the COGS are for most of the goods in their store. The snowman deal can easily be explained by the fact that it doesn’t cost much to get snowman to the store relative to revenues and to qty of capital required to build the store in the first place. It’s a nit, but in return Walgreens buys the goodwill of someone who will gush with enthusiasm about how much The Big Chain is like a family store on Main Street of a Norman Rockwell painting. Of course, you should be able to tell that the snowman deal won’t scale very well. You can’t make up your losses on volume, and certainly you will not set up all of your snowmen as in-store displays. (Recall what I said about sales reps and marketing hacks.)Every person at LvMI who agrees with Salerno’s nonsense is likewise in a fantasyland, as in my experience are all people I’ve met who call themselves libertarians. In reality, all expenses must be past expenses to count as expenses, and they do enter into the determination of the current price of goods and services offered for sale. Recall that most business people won’t launch a venture unless they are confident that revenues will far exceed COGS. Well, maybe a few businesspeople here and there have a VC to provide them with money to get their operation up and running, then shined and polished for some foolish MBAs who work for a huge multinational.Maybe under some conditions we could say, tongue in cheek, that costs don’t enter into determination of price. Just about the only time I’ve even seen or heard of such behavior is when a business is liquidating inventory and abandoning a product line. Or going out of business.It so happens that the first week of December is about the time that a store manager has to think about liquidating his snowmen to make the space desired for the new spring clothing line, for the new barbecues, the lawn furniture and so. And manager has had winter stuff laying around since early October, or even since September, in the loading dock, so he’s sick of looking at it. Force of habit applied generally to snowmen and other products, to make space for the next seasons’ stuff, explains this particular case of the snowman, and we’ve already mentioned that manager of The Big Chain can be sensitive to the need to cultivate good will with shoppers. About all that’s needed is to show that the store manager is given a short leash on which he is permitted to make such deals. Nearly all the haggling, esp. about the length of the leash, used to close the snowman deal was done before Salerno and his wife showed up at the store, and that haggling was done internally, among employees of Walgreens.When you encounter an incoherency, both propostions, p and q, of which you are supposed to believe in, check your premises. At least one of them must be wrong.

bionic mosquito December 9, 2010 at 10:38 am

Your comment, written in one run-on paragraph, is almost impossible to read. But to the extent I was able to follow your thought, it demonstrates Salerno’s point. If price was determined by cost, you would not have to spend one minute on a business plan to identify the gross margin, or anything else.

If price was determined by cost, there would always be a positive gross margin.The fact that you do this analysis demonstrates that Salerno (and those whose work he builds on) is correct. In your business plan, you are struggling to find if the costs which you have planned can be covered by the prices you expect the market will allow.

To the extent I have misinterpreted your remarks, the fault lies entirely with you. Please learn to write in a manner that can be read.

Patrick Barron December 9, 2010 at 3:47 pm

Devastating and completely accurate!

J. Murray December 9, 2010 at 12:02 pm

Cost dictates your asking price. The selling price is a whole different animal and dictates if you actually plan on making another one or not.

Matthew Swaringen December 9, 2010 at 2:17 pm

I know you likely edited that, but I’d suggest repasting from notepad or something so that you have paragraphs, big walls of text like that are totally undesirable.

Smack MacDougal December 9, 2010 at 2:47 pm

HA HA HA. Your comment reads like it has been written by a mediocre businessman.The one, true, great, invariant law of economics, it’s undergirding principle is all you need to know: the Law of Prices.

The Law of Prices holds that the winning bids of demand in the face of supply set the price.

You have gone at length to share your false beliefs about all things economics, A Liberal in Lakeview. What you fail to get what spurs on an entrepreneur into a venture. If an entrepreneur believes that sum of expected sales shall exceed costs of production, such an entrepreneur might undertake the venture. We say that the entrepreneur has inducement to production.

Thus, if an entrepreneur can be among the winning bidders to gain capital goods, which he fabricates into final goods; and if the entrepreneur can buy cash with his final goods, i.e., sell those goods for a sum that exceeds his cost of production, then that entrepreneur can remain in business to sell another day. However, the entrepreneur lives and dies at the mercy of the winning bidders for his final goods.

Costs of production HAVE NOTHING TO DO with the price of goods which he sells.

The Kid Salami December 10, 2010 at 3:16 pm

“The one, true, great, invariant law of economics, it’s undergirding principle is all you need to know: the Law of Prices. The Law of Prices holds that the winning bids of demand in the face of supply set the price.”

Smack, old chum, what does “of demand in the face of supply ” mean precisely in this? If we removed that and it just said your one great law was “The Law of Prices holds that the winning bids set the price”, what would be the difference?

Beefcake the Mighty December 10, 2010 at 3:19 pm

Good question. Good luck getting the smack-meister to explain his grand theory, however.

Craig December 9, 2010 at 6:21 pm

“the fact that there is a current good or service at all is sufficient reason to suspect that expenses, and knowledge of those expenses, is factored into the price of a good”

Well, of course they’re factored into the original asking price, but an accomplished businessman such as yourself must surely know that customers may not be willing to pay that. That’s all he was saying — but, judging by your rant, it’s still a revolutionary concept.

Steve December 9, 2010 at 8:59 pm

I guess you’re partially correct so long as you own a business, with government connections, that has access to the pockets of tax payers. However, asking price and the price at which a consumer will buy (unless forced) can be two very different things.

bionic mosquito December 9, 2010 at 11:04 am

Now, to my far more important point: Salerno, Why on earth are you giving tickets to a 76ers game as a Christmas present? This isn’t Halloween, it isn’t “trick or treat.”

Spend a couple extra bucks. Go for the Lakers if you want the gift to mean something (positive)!

GreenLeaf December 9, 2010 at 11:04 am

@ A liberal in lakeview

Estimation of price by entrepreneur is factored in while incurring cost of production. But by the time product hits the shelf the conditions could be very different than what the entrepreneur had in mind. That’s the risk he takes. Once the product is on the shelf his only job is to sell it at a price which achieves 2 objectives. One is that he has to sell all the items on the shelf by the end of his targeted time. And the second objective is to see that there us no more demand left after he has sold it all. These 2 objectives can be achieved only at a certain price point. In other words, achievement of these objectives is what determines the price. Since supply is already fixed (that is… the cost has been incurred and the items are already on the shelves ), it is solely the demand that determines at what price the given supply will completely satisfy available demand. The cost of production has ABSOLUTELY NO BEARING on the final price. Suppose the cost was higher than the price and he incurs a loss then he’ll have to go back and reduce costs in the production chain or else close shop!

For your reputation sake, I hope your are not a professional economist, because you just got owned by a medical student!

Snorkel December 9, 2010 at 2:22 pm

I believe you mean “pwn’d”. This is the interwebz after all!

Tim Kern December 9, 2010 at 11:10 am

Salerno’s proposition (with deference to all Austrians) works better and better, to the extent that the good or service is differentiated. An attorney can charge $500 to write a will; the product is differentiated — c’mon — he’s not charging for the paper and ink! The Nets and 76ers hold a monopoly on “pro” basketball that night, in that venue. They can charge whatever they want — but they may maximize their profits by charging more and filling fewer seats, or by filling more cheap seats and selling more $12 hot dogs — it’s their call, and they’re constantly tweaking the algorithm.

I’m a writer — because no one else writes exactly as I do, I can charge “whatever I want,” but my price must be below the value perceived by the editor, of comparable work.

Prices can be anywhere for a unique item, and the closer the item is to unique, the more variability in pricing one can expect. For instance, I own the license plates to the 1948 Tucker automobile: Illinois Manufacturer 1, subhead 1, issued 1948 and never put on a car. How much can I sell them for? Who knows — there simply are no comparable items. As scrap steel (a commodity), they’re not worth much. To a Tucker owner…?

The seller of a commodity item, however, sells to the market price. The seller of a near-substitute product in a large market must take the going rate into consideration. The advantage to this producer, therefore, is achieved in his reduction in cost; price is relatively inflexible, during a given time, in a given geography.

The item’s placement on the continuum between pure commodity and unique good, tempered by laws and restrictions, taxes, transportation and storage, and further factored by the perishability of the good or service (as demonstrated in game-day prices) determines how far from “cost of production” the price may wander. That is what allows monopolies to charge “monopoly prices.” (My neighbor is just as pretty and talented as Angelina Jolie, but she can’t get $8 million per movie! She’s simply not Angelina Jolie — Angelina holds the monopoly, and commands the monopoly price.)

As for the Walgreen’s manager, consider how much time and trouble he’s going to save, not having to explain to other shoppers that the Santa is sold out! (It’s a cinch he did.)

Brandy December 9, 2010 at 11:29 am

Thank to you Salerno and Kern! Lakeview is out-to-lunch and should stay there, whatever happen to brevity. When displaying your ignorance Lakeview should dig a smaller hole to climb out of.

Tyrone Dell December 9, 2010 at 11:48 am

Unless Lakeview was being an obvious troll (which from what I could discern he wasn’t), its attitudes and comments like yours that hurt more than help. There’s no reason to get nasty.

Michael McLees December 9, 2010 at 4:15 pm

It could make Lakeview think twice before posting another wall of text, twice as long and fallacious, for us all to gawk at.

GreenLeaf December 9, 2010 at 11:31 am

@ Tim Kernel

you mistakenly assume that it is Angelina Jolie who determines her rate on her own without any other factor involved… if it were only up to her, what is stopping her from demanding $100 million? She certainly gets to determine her rates but only after raking into account the ability of the producer to pay her that much and the PRODUCER WILL DECIDE if she is worth that much. She can list $100 million and sit at home for her life or list $10000 and be underpaid and overworked. It is only at $8 million that she balances both. Again it is the market that forced her to list her price not she on her whim.

Tim Kern December 9, 2010 at 6:22 pm

There’s no “mistake.” AJ charges monopoly price. What the producer will pay determines whether the transaction takes place. She can demand anything she wants, but when the producer can get a close substitute for a lot less, the transaction with AJ won’t happen.

As you note, “if it were only up to her.” And of course it isn’t — a transaction requires at least two parties. You and I have no difference here.

Stephen Adkins December 10, 2010 at 10:52 am

Rothbard writes in Man, Economy, and State that in the absence of legal privilege the term “monopoly price” is purely arbitrary. If Jolie charges a monopoly price so too does every single other person in the market. Rothbard says something to the effect that the lawyer Joe Smith has a monopoly over the legal services of Joe Smith, and the doctor Bill Jones has a monopoly over Bill Jones’ medical services. This is because “close substitutes” is not an objective attribute, but a judgment made by market participants. There are some who would say that Jolie is in a class all her own and there are simply no substitutes for her, while others would say she’s a run-of-the-mill actress and practically any replacement would do; Jolie’s position as a “monopolist,” and her ability to charge a “monopoly price” entirely depend on the whims of others? It seems strange.

Rothbard says, rather, that the term monopoly is only helpful to us if we understand a monopoly as that arrangement by which a firm or group of firms has the legal privilege to be the sole seller of a good or service. In such a case we can then be free to analyze the price charged as a monopoly price, because there is a conceptual difference between the price charged and what would arise with the introduction of competition.

Thus, except to the extent that the SAG has a hold on the film industry, and unless there are legal arrangements I am not aware of, Angelina Jolie should not be considered a monopolist. She charges the market price.

lenita December 9, 2010 at 12:15 pm

what a fashionable perception of services and goods! How much are you willing to pay for something? Never internalized the aspect of perceiving, desiring and willing to pay a certain amount of money for a particular item or service. is there any thing called the cost of banality? Maybe not! Who knows…The only thing I can think is that I might be willing to pay for a pampering day than for a basketball game, a little bit more. In regard to Angelina Julie’s price tag for a movie, I do not particularly like her as an actress; therefore, will no pay to see “The Tourist”. However, she is a very, very likable woman among many other women and a desire subject- not to call her object- to many men. Will that be count in her price tag? Beside the technical aspect of being profitable in any business, to me, is quite interesting how perception and emotion can drive someone to pay as much as Mr. Graff paid for a diamond…ouch!

greg December 9, 2010 at 1:35 pm

Cost has more to do with the price a item is sold than your simplistic example. You were able to get $5 knocked off the price of the snowman because of the cost of maintaining that inventory and the amount of floor space that item was taking up in the store. Add to it the seasonal aspect of having something that will not sell after December 15, your wife could have bought the snowman for $10 less.

In any negotiation, if the seller takes your first offer, you paid too much.

Matthew Swaringen December 9, 2010 at 2:22 pm

Inventory and floor space applied to the packaged version of the item as well.

I also think “any” is way too strong of a term regarding negotiation.

greg December 9, 2010 at 2:50 pm

Yes, inventory has a cost, but to a retailer, floor or shelf space has a market to itself. For example in the grocery business, most stores work a a very slim margin and they make up the difference selling retail shelf space to the suppliers. Therefore, items stored in the retail space have a cost point higher than the inventory stored in the back room.

In a negotiation, if the seller accepts your first offer, you really have to ask yourself, “what if I would have offered him less”? You will never know.

Matthew Swaringen December 9, 2010 at 3:06 pm

I agree with your revised point on negotiation. I think you are being a bit nit-picky on this matter of stores pricing of different areas of space on the floor, however. I’m not denying there are different opportunity costs to different spaces. The writer of the article certainly wasn’t saying this either, and I don’t think your original point about cost was correct on the basis of these details. Your argument applies to that example of his, but it certainly doesn’t apply to every example of a good that is sold for a price different than the sum of the costs of production, storage, etc.

Charlie Virgo December 9, 2010 at 3:05 pm

You have a self-defeating argument. If cost were truly factored into the price, there’s no way Salerno’s wife would have received the snowman for $10 less instead of $5, because that would be even further from the cost. The point about the seasonal desire of the snowman is a good one, but it proves Salerno’s argument, not yours. If the season dictates the price, it is because consumers value it more, not because the cost is being taken into consideration.

Tim Kern December 9, 2010 at 6:27 pm

Quite aside, but here you make a good point against the initiation of a VAT, where taxes are added at various stages of a product’s genesis. When the product falls out of favor and the VAT has already been paid, it puts a real squeeze on the end-seller, who is left with a bag of accumulated tax receipts and a product that must be sold under his cost. The storekeeper thus subsidizes the ravenous government.

elgecko84 December 9, 2010 at 11:09 pm

Interesting, I hadn’t thought about that.

Alex December 9, 2010 at 2:55 pm

If someone values an item at $20 that can be produced for $10, we might have a transaction ensue, but if the item costs $25 to produce, we won’t. Also, if the item costs $10 to produce, the final transaction price may be $11, $12….or $19.95, but it won’t be $8, since the cost is $10. Of course production cost influences prices. Just because short run variable costs may be zero, while short run prices exceed zero, does not negate the fact that long run costs in combination with subjective value jointly determine long run prices.

Matthew Swaringen December 9, 2010 at 3:11 pm

“if the item costs $25 to produce, we won’t”
If you were correct no item would ever sell for less than it’s costs of production, and yet this does occur. The reason is costs of storage and recovery of loss. Even a less valuable product is worth greater than zero.

“Of course production cost influences prices.”
So when you go the store and find something higher than the price you are willing to pay you buy it regardless? No, you only pay what you are willing to pay. This is certain, by definition of “willing.”

Alex December 10, 2010 at 11:19 am

We should not confuse sunk costs of an item (costs that have already been incurred to produce an item that has been produced and stands ready to be sold) with the cost of producing future items for sale. If the sunk variable cost to produce an item that already has been produced is $10, profit maximizing behavior may lead to selling the item for various possible prices (dependent only on demand) from zero up. Let us suppose that the most the item can be sold for (dependent only upon subjective valuation by potential buyers) is $8. In this situation it is correct to say that the market price is determined not at all by the particular item in question’s cost but only by demand valuation.

However, the preceding case does very little to explain why 10 inch pizza’s sell for around $7 or why new cars sell for thousands of dollars. Part of the reason why new cars sell for more than 10 inch pizzas is that new cars cost more than 10 inch pizzas to produce. Of course new cars are actually sold at thousands of dollars partly because people value them at those prices. But if it cost only $7 to produce a new car, do you think they would sell for thousands of dollars?

J. Murray December 9, 2010 at 8:55 pm

You’re making the assumption you know what the product will sell for. That’s the risk component of running a business.

Greg December 10, 2010 at 1:07 pm

Precisely. The future is uncertain. Alex could modify his statement to say that if an item estimated to be valued at $20 when completed is estimated to cost $25 to produce, production will not commence. Once the item is actually produced, it is sold for whatever maximizes profit, even if the maximum is negative.

Those who can anticipate future needs are rewarded and are given the opportunity to make more predictions. Those who do a poor job at anticipating future needs are punished and are less likely to try and make predictions. This is the beauty of the free market. It’s almost like the liberal utopia where our smartest people go about the job of managing the world, except that this way actually works.

prettyskin December 9, 2010 at 3:01 pm

Market price is determined only by the buyer. The seller is at the mercy of the buyer. Unfortunately, the buyer tends to relinquish this natural authority by succumbing to the seller’s tactics. How much the market will bear? Is how much the buyer is willing to spend, regardless of needs and wants. If the buyer refuses to buy, eventually, the seller ups the antics and offer a lower price visible to the buyer but yet at the same original offer using hidden cost to the buyer. Taking all the misleading seller’s tactics away, the buyer names the price, naturally.

Smack MacDougal December 9, 2010 at 3:44 pm

Shame to Joseph T. Salerno to credit Carl Menger for what economists knew already in the 1850s.

This is typical of those connected with Mises.org. They go at length to proclaim the Austrian School (and rightly, it’s the Austrian School of Neo-classical Economics, replete with many fallacies of Ricardo and Mills, such as marginal utility) as the one true school. Yet, Menger, Mises, et. al, were mere copycats, lifting their purported original economic thought from guys who preceded them by decades.

Dennis December 9, 2010 at 8:30 pm

You are not correct on two points regarding the (British) Classical economists, e.g. Ricardo and Mills. First, they did not incorporate the concept of marginal utility into their analysis. That concept was developed, albeit somewhat differently, by Menger, Jevons, and Walras in the early 1870s. Also, according to the (British) Classical economists, prices are determined by the costs of production, which usually meant the labor costs of production, hence the labor theory of value.

Smack MacDougal December 10, 2010 at 2:24 pm

@Dennis Go hire someone to teach you reading comprehension skills.

No where in my writing on this blog post did I write that Ricardo and Mills incorporated marginal utility.

I wrote that it is right to say only the Austrian School of Neo-Classical Economics, because that is from where it comes and the basis of economic thought. Neo-classical economics subsumes classical economics — Smith, Ricardo — and thus incorporates all its fallacies.What has been added to neo-classical economics is a false psychology in the form of marginal utility, foolishly pushed by Jevons and allegedly by Menger at the same time.

What else would you like taught to you?

Beefcake the Mighty December 10, 2010 at 2:37 pm

Smack, you really are a foul shit-for-brains. You wrote

“They go at length to proclaim the Austrian School (and rightly, it’s the Austrian School of Neo-classical Economics, replete with many fallacies of Ricardo and Mills, such as marginal utility) as the one true school. ”

How is it unreasonable to attribute to you the claim the Ricardo and Mills employed the concept of marginal utility? Do you not read what you post?

Bala December 10, 2010 at 6:37 pm

” What has been added to neo-classical economics is a false psychology in the form of marginal utility ”

If “marginal utility” is false psychology, so must be “utility”. So what according to you explains why humans act?

Bala December 10, 2010 at 6:38 pm

“and thus incorporates all its fallacies.”

Please list them.

Matthew Swaringen December 10, 2010 at 7:39 am

Shame to Smack to cite no sources whatsoever from 1850 in his supposed shaming of Joseph T. Salerno.

Surprising? Not exactly.

Smack MacDougal December 10, 2010 at 1:56 pm

Boo hoo. Poor widdle Matthew. You suck and swallow whole and hard everything that gets spoon fed to you but are unwilling to do any heavy lifting yourself to discover a greater reality about economic thought.

Joe B December 10, 2010 at 8:37 am
Smack MacDougal December 10, 2010 at 2:02 pm

Good link Joe.

Murray Rothbard has a great way of telling history. Those at the Mises Institute would like to suggest that Rothbard resurrected Whately in the aforementioned work.

But we can go back to the 1860s to see Whately discussed at length and his attacks on the many fallacies of Ricardo.

Smith and Ricardo form the basis for Marxist economic thought.

Dennis December 10, 2010 at 4:01 pm

“Smith and Ricardo form the basis for Marxist economic thought.”

I think it would be more accurate to say that the labor theory of value that was championed by Smith and Ricardo forms the basis of Marx’s economic thought.

Beefcake the Mighty December 10, 2010 at 4:06 pm

Even here the smack-meister is not distinguishing between Smith’s LTV and Ricardo’s LTV; it was the latter of which Marx adopted, and which is usually what people mean when speaking of “the” LTV.

Jim December 9, 2010 at 3:50 pm

Could we perhaps say that, broadly, production costs put a floor on prices? Yes, items sell for less than their production costs all the time, because as previously pointed out, the seller would rather recoup something, in that any money received would be greater than $0.

However in reality, almost no one would bother to mass-produce things unless they thought they could recoup their costs eventually. Hence, the existence of cost determines the existence of a price.

If Ford puts $13,000 into making a Focus, the dealership buys it from them for $14,000, then lists it for sale at $15,000 (purely to use simple numbers), then yes if the vehicle doesn’t sell at $15,000 they will begin to trim price. If that particular vehicle never sells, they may eventually uload it at a “loss”. However, in the vast majority of cases, the salesman will hold firm at some price point to keep some profitability for the dealership. If one buyer walks, the odds are another will buy at that price. If that wasn’t the case at least a majority of the time, then no dealerships would ever be profitable. This would be an example of cost determining a minimum price at which the seller is willing to part with the item.

I think the issue is using terms like “never” and “always”. I don’t think it can be painted in such absolute terms. True, no one can ever sell anything for more than what someone else is willing to pay for it. But in reality, very little is produced without the expectation of being able to sell for more than what something cost.

I would also like to inquire about the working definition of the word “price” here. I think some confusion can be cleared up. The argument being made that costs have no impact seems to define the word price as the amount of money someone would be willing to exchange for a product. The counter-argument seems to view price as what the merchant is charging, seperate from what someone is willing to pay. For example, a business makes an expensive to produce product that turns out to be unpopular. They can’t lower their prices enough to keep the business profitable, so they go out of business. The price existed, and was at least in part determined by the cost. However, no-one was willing to pay that price, but the business was unable to lower it enough to entice transaction.

Patrick Barron December 9, 2010 at 3:50 pm

Thank you Dr. Salerno. I will use this, if you don’t mind, in my discussion of subjective value next term at the U. of IA.

stephen December 9, 2010 at 4:10 pm

“Hence, the existence of cost determines the existence of a price.” Actually, the existence of a price (i.e., the fact that people would be willing to purchase a given good or service) justifies the entrepreneur’s incurring the cost.

Successful entrepreneurs anticipate the market price, and, as much as is possible, create a spread between costs and prices. Of course it’s true that entrepreneurs can and do often base their _asking prices_ on costs of production, but if no one is willing to trade at that price it is a moot point and the entrepreneur will fail.

“They can’t lower their prices enough to keep the business profitable, so they go out of business. The price existed, and was at least in part determined by the cost. However, no-one was willing to pay that price, but the business was unable to lower it enough to entice transaction.”

I think in this case one would have to look at what happens to those goods after the business folds. Generally the goods are liquidated. This liquidation is as much a part of the market as is the business’s setting a price which no-one is willing to pay.

There is a difference between the price and the asking price. The asking price is determined by the seller, and the seller may well be guided by costs to arrive at this figure, but the final price at which the good or service is traded arises out of subjective valuations by the consumers.

stephen December 9, 2010 at 4:26 pm

Also, Jim, I think you might be referring to the fact that in the long run (ERE), prices and costs do equal each other. This may seem to indicate that prices are determined by costs, but that’s just not the case. It is simply that in the long run, all those entrepreneurs whose costs exceed prices will go out of business and exit the market, and because of competition, entrepreneurs making profits will see their prices driven down to the lower limit of costs.

Thus, again, there may very well be cases in which businessmen, who perhaps have no formal economics training, solely use costs to determine their prices; if such a businessman were to read this article, he might find it ridiculous and feel that his own experience invalidates it. However, the point is that if prices are too high for buyers, it makes no difference what the costs of production were.

Jim December 9, 2010 at 4:41 pm

Actually Stephen I think you hit the nail on the head by distinguishing between “asking price” (which is what I think average, non-economic theory minded people are envisioning when they hear the word “price”, esp. since we live in an almost entirely non-negotiating culture in the US v. say, Mexico) and “actual price”, including the cost of liquidation were a business to fail. That distinction certainly makes the article’s argument easier to understand.

Milton Recht December 9, 2010 at 5:21 pm

Two points.

1. Health care costs, direct and insurance, were and continue to be a big issue, but they follow the same pricing principles mentioned. All the economic articles and research I have seen on the topic discuss, analyze, and provide solutions on the cost side of medical services and health insurance especially that costs are higher in the US than other countries and the US spends more per capita for medical services. They ignore the value to the consumer.

Like all other products and services, the price paid is determined by the value to the consumer. The US has very high GDP per capita and very high productivity rates. These factors would make a worker’s opportunity costs, on average, high in comparison to other countries.

With a high opportunity cost, one would expect US medical prices would be higher than other countries as long as the higher price lowers the opportunity costs of medical services to the consumer. Delays caused by waiting for doctor appointments, specialist appointments, medical tests scheduling (such as MRIs, etc.), use of less efficient older technologies, use of older less efficient drugs that require re-treatment, lost productivity from the medical condition, etc. have a high opportunity costs for American workers (who often also have to take off work time to care for an ill child, parent, or spouse). Using new, efficient (in the sense of diagnosis time and treatment) technologies and decreasing the total time (and opportunity cost including lost productivity) to the consumer from the first phone call for an appointment to final result is expensive and will result in higher US medical costs. Most looks at other country medical services find the US had shorter wait times, newer technology to speed diagnosis and treatment, newer, more effective (and more expensive) drugs, and fewer doctor visits per year and per medical condition. This is not to say anything about end results, which are often used as a measure of comparative health care. It is about the speed of reaching that end result, the opportunity costs, beginning from a consumer’s awareness of the condition (not first doctor appointment, but the wait for the first appointment) to final recovery.

To me, medical costs in the US are high because these services have a high value and lower opportunity cost to Americans. All attempts to directly control medical costs will fail because the value of the service to the consumer will remain high. American consumers will find ways to spend more, under any medical cost regime, to reduce their opportunity costs while receiving medical services.

Medical costs in the US will rise until they are equal to the consumers’ opportunity costs and value.

If the value of the medical services were lower to US consumers, the medical establishment would find ways to reduce costs.

2. To all the comments that say costs are factored into price before production are ignoring that many businesses fail, despite adequate business plans, because consumers are not buying the goods in sufficient numbers for the business to remain viable. At a lower price, the business will sell more, but at a loss. Lack of demand kills many businesses.

Businesses I know consider demand as much as production costs and some will even regularly sell items at or below cost, such as loss leaders, in hopes of increasing overall demand and hopefully increase sales of their other goods. If costs were the main or only consideration, then profit margins would be much higher than they are at most businesses. Demand is determined by value and it sets an upper limit on price and profit.

Mushindo December 10, 2010 at 2:26 am

while I agree with the substance of the article, I will allow that cost of production CAN have an influence on its price. But only in so far as knowledge of the cost informs

a) the sellers willingness to accept an offer that is lower than what he expended on the item, and

b) the buyers willingness to pay the price asked by th eseller for an item he views as overpriced.

In other words, value of course remains subjective, but that subjectivity is at least partly informed by the participant’s knowledge of production cost – however imperfect that knowledge may be.

Greg December 10, 2010 at 1:29 pm

If someone receives an offer for $15 on an item they produced, the only thing that determines whether the seller thinks they can sell it for more to another person (or how much they themselves value it, i.e. selling to themself). Whether it cost them $10 or $1000 to produce is irrelevent.

matt470 December 10, 2010 at 6:20 am

I also agree with the substance of the article but this is how I kind of see it (and happy to be corrected)…

Prices of reproducible goods in an unhampered market system will TEND to approach the cost of production (minus originary interest) due to the forces of competition. This is not to say they will reach cost or how quickly this fall will occur or even that it will definitely occur at all (ie. in some cases demand patterns may shift significantly before this can occur). In this sense, cost of production may still have a significant influence in where pricing may reside for a significant amount of time.

If we have a certain good in a competitive market and one producer manages to significantly reduce their COGs then they will begin to “buy” market share from competitors which will force these competitors to reduce margins (or adopt similar lower COGs) and the price for that good will fall. In this sense I think it could be said that cost of production has had an effect on the price. I agree this doesn’t make cost the determinant factor of pricing though.

Obviously prices can fall below COGs and this will then remove producers from the market which will reduce supply, but assuming demand remains for the good then the price will head back up to the market clearing level.

I heard a good audio file from an LvMI course (can’t remember the speaker sorry) explaining price patterns after the ball point pen was first introduced to the market. In a nutshell, as costs dropped significantly so did the market price. Hard to accept that and then say as Smack MacDougal has above that “Costs of production HAVE NOTHING TO DO with the price of goods which he sells”.

Alex December 10, 2010 at 11:27 am

We should not confuse sunk costs of an item (costs that have already been incurred to produce an item that has been produced and stands ready to be sold) with the cost of producing future items for sale. If the sunk variable cost to produce an item that already has been produced is $10, profit maximizing behavior may lead to selling the item for various possible prices (dependent only on demand) from zero up. Let us suppose that the most the item can be sold for (dependent only upon subjective valuation by potential buyers) is $8. In this situation it is correct to say that the market price is determined not at all by the particular item in question’s cost but only by demand valuation.

However, the preceding case does very little to explain why 10 inch pizza’s sell for around $7 or why new cars sell for thousands of dollars. Part of the reason why new cars sell for more than 10 inch pizzas is that new cars cost more than 10 inch pizzas to produce. Of course new cars are actually sold at thousands of dollars partly because people value them at those prices. But if it cost only $7 to produce a new car, do you think they would sell for thousands of dollars?

Stephen Adkins December 10, 2010 at 12:16 pm

I don’t think a new car would sell for thousands if it cost $7 to produce, but I also don’t believe that shows a direct link between costs of production and selling price. I believe that, if a process were developed by which a car could be produced that cheaply, the effect would be a drastic increase in supply, which would drive the price down. This is of course the story of capitalism generally. Technological innovation and capital accumulation allow for greater efficiency in production, leading to prices being driven down (dramatically in many cases).

Of course no car company could afford to sell a car for 7 dollars today, and this is because costs are so high, but that doesn’t mean costs are determining the price. The price is thousands of dollars today because car companies can find people willing to spend thousands of dollars. They of course would love to charge millions of dollars, but they wouldn’t find anyone willing to pay that much. After advances in technology, companies would still prefer to receive the same prices they charged before, but competition inevitably drives prices downward.

Alex December 12, 2010 at 11:16 am

Sorry to respond so late, but I was on the road.

“I believe that, if a process were developed by which a car could be produced that cheaply, the effect would be a drastic increase in supply, which would drive the price down. This is of course the story of capitalism generally. Technological innovation and capital accumulation allow for greater efficiency in production, leading to prices being driven down (dramatically in many cases).”

Exactly! The improvement in technology leads to lower costs of production (an increase in supply at any given price) and lower market prices.

“Of course no car company could afford to sell a car for 7 dollars today, and this is because costs are so high, but that doesn’t mean costs are determining the price. The price is thousands of dollars today because car companies can find people willing to spend thousands of dollars.”

As you have agreed in your two quoted statements above, costs influence selling price. They determine prices not by themselves but are a joint determinant with demand (subjective value).

Stephen Adkins December 12, 2010 at 1:50 pm

As many, including myself, have already said, costs influence asking – not selling – price. Asking price is influenced by cost because businesses generally desire to make profits. Selling price is not determined by your joint determinants (blades of a pair scissors, perhaps?). It is entirely subjective value. In Salerno’s article, quoting from Menger (or was it Bohm-Bawerk?), the example of prices determining costs should be enlightening. The highly specific cigarette machine loses all of its market value when the demand for cigarettes goes to zero. How can this be explained by looking at joint determinants? Did the historical cost of producing that machine also change? Of course not. That is squarely in the past, and it still may influence what its owner would SET the price at, but that has nothing to do with what it would actually obtain in the market. When I go to the store I have no way of knowing, and don’t care enough to try to find out, how much each good I purchase cost to produce. The determinant in whether I purchase it or not is marginal utility, a subjective matter. Another example I’ve heard comes to mind. In looking at the differences between the prices of certain wines, it was remarked that a bottle of champagne was more expensive because the land in that part of france was more expensive. Actually, though, it is the other way around: because there is a higher demand for champagne than, say, merlot, the factors of production increase in demand as well. The land is more expensive because subjective demand is higher for the goods it produces.

Make no mistake: we do not agree.

Alex December 12, 2010 at 2:07 pm

Stephen, the fact that both costs and demand determine price is not at all inconsitent with your example where the subjective net value of smoking goes to zero, thus reducing the price of cigarettes to zero. Naturally, if demand falls to zero price falls to zero. At this point. let me reproduce a comment I made below in this blog.

A one person economy. Person X has had some coconut to eat today but would gain some enjoyment today from some more coconut. In order to get some more coconut for today’s consumption X must climb a palm tree to shake the coconut loose. However, he regards the effort (cost) of climbing the tree today as not worth the extra coconut consumption, so he doesn’t climb the tree to acquire his coconut for consumption.

The next day he wakes hungrier than he was the day before, so the value to him of climbing the tree and shaking loose another coconut has increased, and he climbs the tree for another coconut.

Now, consider the prior day again. If the individual had thought of using a big stick that was lying a few feet from him to poke at the coconut, he wouldn’t have had to climb the tree, and he may have been quite happy to acquire the additional coconut by poking. The use of the poking stick is essentially a techonological advancement (over treeclimbing) for acquiring coconuts that reduces the cost of coconut harvest. His subjective valuation of the extra coconut consumption didn’t change when he used the stick; it was the reduced cost of production (if you will) that increased his coconut supply.

Now if there was a second individual who fished, but who also was willing to trade fish for coconuts, the technological discovery of the pokirng stick that reduced the costs of coconut production and increased the supply of coconuts relative to fish would mean that the relative price of coconuts to fish would fall. Note that it is the reduced cost of coconut production that reduced the price of coconuts (absent any change in subjective valuation of coconuts or fish).

Wildberry December 10, 2010 at 2:16 pm

Sorry I’m late. There have been a number of good comments already, so I’ll attempt to summarize…

Isn’t the primary issue here monopoly, not production costs?

In all the instances mentioned by the author, there was only one source for the goods in question. By virtue of the private ownership of the means of production, the producer has a monopoly on the output of the good.

The question is whether these are monopoly prices. That depends on 1) if you have a choice, and 2) if the price asked passes your threshold of willingness to pay or not, i.e. what the market will bear. If you have no choice, there is no limit to what you’ll pay, if you have enough cash. The alternative is death. That is monopoly pricing.

If you have a choice, it can’t be monopoly pricing, because you can always choose to abstain. Therefore 2) is the primary pricing mechanism for the good. If you own the means of production, then you don’t give consumers a choice to get YOUR goods from someone else. If you don’t own it, you can’t sell it. That is the right of owning property.

Your choices for basketball tickets are 1) authorized outlet 2) scalpers, who are just agents for outlets, 3) counterfeit, or finally 4) watch it on TV or do something else (abstain).

Therefore, the price is set by what the market will bear. If the market cannot bear a price that returns (eventually) your capital and marginal costs, it’s not a profitable business. If the market will bear a price that completely swamps your production cost, well, that is the business we are all looking for.

Is it really any more complicated than that?

matt470 December 10, 2010 at 5:57 pm

@ Wildberry

Monopoly prices are not only applicable to things made by one producer that we must have in order to survive. The Australian Government’s Department of
Foreign Affairs & Trade (DFAT) has a monopoly on issuing passports and charges monopoly prices yet I can hardly claim that without access to a passport I’d die (I’d be mighty annoyed though!!).

Monopoly prices potentially exist whenever there is only one supplier/producer of a good because of their ability to limit supply to a lower level than would occur under free competition with an existing demand.

I think you’re still on the right track though about making distinctions between such goods as those Prof Salerno puts forward in his article and mass produced consumer items. The Santa he refers to might be a mass produced good but he’s looking at the pricing of the one left in the whole shop that is a “demo model” so it has become a bit unique again.

In order for specific goods to be continued to be produced then there must be strong enough demand (a willingness to pay a certain price) to allow the producer to make at least the interest proponent of profit (ie. doesn’t need to be any entrepreneurial profit left) otherwise the capital required for the good’s production will be steered into more profitable ventures.

Of course once a good has already been produced then the cost that went into it’s production is completely irrelevant. As much as I love Austrian Economics I cannot see that cost of production plays NO ROLE in explaining market prices.

Wildberry December 10, 2010 at 6:39 pm

Matt,

“Monopoly prices are not only applicable to things made by one producer that we must have in order to survive. ”

I think you are making my point. If the DFAT is the only source of a passport, they have a monopoly. But you can decide not to travel. You are taking my argument one step futher by making this a government entity. Government is not a free-market actor, and so the price mechanism is not functioning in the transaction. So you have to pick a market player to talk about pricing. Government (bureaucracies) usually operate on a cost+ basis, because that is all they can really measure. They are not intented to make a profit, (pre-Obama, that is).

“Of course once a good has already been produced then the cost that went into it’s production is completely irrelevant.”

It is irrelevant to the buyer, but not to the seller. For the seller to stay in business, he needs to turn a profit. Selling price-costs = profit. This is why costs are not irrelevant to the seller.

As a buyer, I don’t care if you go out of business. On the other hand, if costs are 1/10,0000,000 of the selling price, and you still want to buy it, you get your goods and I make a HUGE profit. Life in the free market is good.

matt470 December 10, 2010 at 11:14 pm

Wildberry,
Yes I accept that “Government is not a free-market actor, and so the price mechanism is not functioning in the transaction” so perhaps my example of is not a good one.

“I think you are making my point” I can’t see how even accepting my example wasn’t great.

“If you have no choice, there is no limit to what you’ll pay, if you have enough cash. The alternative is death. That is monopoly pricing.

If you have a choice, it can’t be monopoly pricing, because you can always choose to abstain”

Just because you may have a choice to abstain doesn not mean an item cannot be subject to monopoly pricing. If I go to a music festival and there is only one company selling the alcohol (usually all drinks with the exception of water) then they can charge monopoly prices for the duration of the event. Of course I could abstain but I’m more likely to begrudgingly pay the 100%+ premium price (monopoly price) and perhaps just have a couple less (that doesn’t sound like me though!). Here the price mechanism does function in rationing supply and demand within the bounds of the event, the seller may decide their turnover was too low and hence their profitability was down at the last event when they charged a 200% premium price or they may decide they were too cheap and also sacrificed some of what they could’ve made. Okay so yes people will next time factor-in the alcohol rip-off when considering whether they want tickets to that event or not but within the bounds of the event a monopoly on drink sales exists regardless of whether people can abstain or not. If they can’t abstain (death is the only alternative as in your comment) then the monopoly provider has the power to charge anything at all – eg. the sole water owner in an oasis type scenario. This is not a criterion in deciding whether a price is a monopoly price or not – the only requirement is that price is HIGHER than what it would be would be should other competition exist.

Monopoly prices are everywhere as a result of patents and copyrights because the IP holder has the ability to keep supply of their good lower than the market would otherwise have it and this in turn means they can demand a higher price. This is not the place to get into the can of worms about whether patents and copyrights provide an net benefit to society (although Kinsella’s work on whether IP is truly a form of property or not is very compelling in my opinion).

With your second point, yes it is not completely irrelevant whether I sell something below my cost after it has been produced (my managers certainly don’t like this) but if we’re forgetting about whether or not I product more then I can only charge what a buyer will pay for it and will do this everytime to clear the stock even if it is below my cost because otherwise it will clog-up my inventory and working capital and then cost us more.

Wildberry December 12, 2010 at 11:28 am

Matt,

I was talking about this elsewhere with Phinn. I referred to Mises’s discussion of this in HA, p.277.

Monopolies do not exist just in IP, they exist everywhere. Monopoly prices only occur when the monopoly holder can make more net returns by withholding supply. I think the diamond industry is a good example of this.

Most monopoly holders have no desire to withhold their goods form the market, and monopoly prices don’t arise, in IP or any other good. (But yes, many find Kinsella persuasive)

Your last paragraph is about business tactics; “loss-leaders”, “inventory reduction sales”, and most famously, “making it up in volume” are all part of the business environment. However, when the final balance sheet is summed, there is either something left over (profit) or not. Even then, companies may operate at a loss for quite a while as long as the credit holds out, before they actually go under.

So, we are discussing this in a simplified, generalized way. However, the exceptions listed above still have to fit the general theory, and they do.

Peter Surda December 12, 2010 at 3:44 am

Wildberry,

Government is not a free-market actor, and so the price mechanism is not functioning in the transaction.

This is a misleading description. I already complained about this to you in the past, I don’t remember however how you responded. Government’s agents might prefer to use force instead of voluntary trade, but that does not mean they are not subject to economic laws. Just like any other actor, they need to use scarce resources in order to achieve goals, and they need to select among the unlimited goals. To do this rationally, economic calculation is required.

usually operate on a cost+ basis

Cost+ is only possible within the context of the company, where the upper management determines goals for the section of the business. The business itself still needs to make profit and the market mechanism to guide its goals.

I’m going for a vacation today so my response speed is likely to decline for a while.

Wildberry December 12, 2010 at 11:13 am

Peter, Nice to hear from you. Vacation? good. That gives me more time to consider our other, challenging posts!

All I am really saying about governemt here is that the catallactics are different because there is not “profit’ to calculate, there is coercion built into the trade, they operate with a budget and allocate that budget over the costs as represented by willing sellers.

That is most often done on a cost+ basis because the governemt is a monopoly buyer. That is a different economic case than a for-profit business selling goods in a free market.

It is difficult to treat it as apples to apples when discusing costs, prices and profits.

That’s all (for a change).

Don’t recall you complaint, and can’t imagine what it was, but have a good time off.

Jonas December 11, 2010 at 5:55 am

The way I see it, it’s really quite simple: costs dictate the lower bound of the price range as far as long-term production is concerned (you’re not going to continue producing a good at a cost higher than the prevalent price.) The upper bound is set by the market, and has nothing to do with the cost (short of any perceived value due to the costs.) If the ‘upper’ bound is actually below the ‘lower’ bound, production will (hopefully) cease, price of a sell-off will be determined by the ‘upper’ bound and resources will be reallocated.

I don’t understand where the confusion is.

Beefcake the Mighty December 11, 2010 at 8:23 am

I would suggest the confusion is on your part: how is “long-term production” relevant in any way?

matt470 December 11, 2010 at 11:34 pm

Actually I thank Jonas for simplifying it a bit.

His phrase “Long-term production” I think is only being used to distinguish the difference between production of a good that is ongoing in a fairly standardised manner (eg. car manufacturing as it is performed today) versus production of a good that has already occurred (eg. ‘sunken costs’). One version of production costs are forward looking and another is backward looking. It seems logical that forward looking costs will have an impact on the ‘lower’ bound of pricing (because resources will be reallocated otherwise) whereas backward looking costs do not (the cost to produce it have already been incurred so even recouping some of those costs would be a bonus if demand drops significantly).

Richard M December 11, 2010 at 8:45 am

“The way I see it, it’s really quite simple: costs dictate the lower bound of the price range as far as long-term production is concerned ”

Okay, but what determines the costs of factors that dictate the lower bound? These costs are determined by prices – prices that people are willing to pay for goods that require the same factors to produce.

Wildberry December 11, 2010 at 12:06 pm

Cost of inputs.

matt470 December 11, 2010 at 11:41 pm

Your response is circular reasoning. Richard is talking about what sets the price for those inputs? The answer can’t be the cost of them….. the cost of them is the price, it’s the same thing!
I think Richard is right, the cost of the factors of production is set by the level of demand for the final good and at the same time alternative final goods that could also be produced with those factors of production.
After some serious thought over the last 24 hours (and the many contributors to this blog) I’m totally back on board with Salerno and Menger’s stance.

james b. longacre December 12, 2010 at 12:40 am

Your response is circular reasoning. Richard is talking about what sets the price for those inputs?

are you asking richard or telling others?

Richard is talking about what sets the price for those inputs? The answer can’t be the cost of them…..does the cost of other inputs ‘set’ the price??? o fjus tomeones say so that sets the price?? can prices be unaffordable for some?

matt470 December 12, 2010 at 2:41 am

“are you asking richard or telling others?”

Both I guess. It is presumptuous of me to speak for Richard but I also presuming Richard can set me straight if he thinks my interpretation is wrong. Ok and “set” was a bad choice of word but surely most people reading this would get the gist? I perhaps should have said what “predominantly influences” rather than sets. I’ll admit I sacrificed accuracy and clarity for brevity.

Let’s now talk about your post then james. You’re saying exactly what?

“does the cost of other inputs ‘set’ the price??? o fjus tomeones say so that sets the price??”

It hurts me to even repost such nonsense so before I attempt to decipher it do you want have another go at making a point?

“can prices be unaffordable for some?”

At what point is anyone here even talking about prices being “unaffordable for some”? Isn’t that a factor operating in every market for every good? It is part of the rationing function between supply and demand. Did you accidentally end up on this site? Oops I’ll unconditionally withdraw that remark Your Honor.

Wildberry December 12, 2010 at 9:22 pm

Matt,
Is this your most recent post? You are going backwards…

I guess we could quibble about how the asking price for production goods might be influenced by demand and selling price of the consumer good, depending on the distance to the final concsumption and universal understanding of what that consumper price was actually going to be.

However, in general, the further away in the manufacturing chain from final consumption, the less influence this would have. To use the cigarette example posted earlier, if the demand for cigs went to zero, the utility of a machine to make them would fall dramatically, but not to zero. At the least, it still has scrap value, and any components that can be repurposed would have some value, but not in any way related to cigs. As the machine was dismanteled and sold off, they would become inputs for some other production process.

Mises used a formula for equilibrium to demonstrate this effect. I don’t have the reference, but he was showing that a tendency towards euilibrium does not mean the market actually gets there, because the relationship between the cost of inputs adn the price of consumer goods is always changing, especially as new tecnologies, changes in demand, changes in preferences, etc, continue to fluctuate. This non-equilibrium is the arbitrage for profit.

Richard M December 12, 2010 at 10:22 am

What establishes the cost of the inputs? Is the ‘input’ cost established by the cost of its own ‘inputs’? Where do those cost come from – from their inputs?

The proposition that costs determine the price of a good only begs the question; where do costs of the inputs to the inputs come from?

Input costs are determined by the prices people are willing to pay for other goods that require those inputs. Costs are determined by prices.

Wildberry December 12, 2010 at 12:00 pm

Richard,
Is this a comment directed at me?

“Input costs are determined by the prices people are willing to pay for other goods that require those inputs. Costs are determined by prices.”

I think this is a misunderstanding. Input costs (seller) and prices (buyer) are determined by the trade between buyer and seller of the production good. Output = income.

If the buyer is a manufacturer of consumer goods, and he is buying goods as inputs, like in all economic trades the price is negotiated. If you have ever been in a manufacturing business, you know what I mean. The negotiation between seller and buyer rarely includes a discussion of what the buyer’s profit will eventually be; sometimes, but that is a special case.

Mises describes this as the entrepreneurial function. The entrepreneur formulates a plan that “inputs + manufacturing = cost”, and “price – cost = profit”, then he attempts to implement that plan. If everything was known for certain by everyone in the supply/consumption chain, then the future price of goods would be factored into all of the inputs and there would be no profit.

Of course this is not the case. Only the entrepreneur knows for sure what the plan is and how efficiently he performs against that plan, and if he is right, he makes a profit, and if he is not, he fails.

The price of inputs operates the same way on up the supply chain, all the way to say, the mining of the minerals. You might think of this as the highest order good, the transformation of a natural resource into a good. The price is based on demand. The demand is based on utility. If there is no demand, there is no price, and even a cost of zero would not turn a profit.

Imagine a natural resource, like iron, that can be eventually formed into infinite numbers of consumer goods. It is not reasonable to argue that the seller of iron is somehow basing his price on the selling price of all of these finished goods, right?

No, he looks at his universe of buyers, and his universe of costs, and attempts to offer a price. If there is strong demand, he may raise the price, if there is low demand, he may lower the price, each time affecting his profits. Or he may respond to low profit by modifying his costs with some capital investment, resulting in more profit with the same price.

His universe of buyers is not the consumers who will buy the finished goods. It is the operators of the next stage of manufacturing that require iron as an input. It is there that the price of the production good is determined.

matt470 December 12, 2010 at 8:27 pm

Very well written Wildberry.

Wildberry December 11, 2010 at 12:09 pm

Bravo! Simple…

RC December 11, 2010 at 6:40 pm

Example: ET for Atari.

james b. longacre December 12, 2010 at 12:41 am

Past expenses incurred during the production of a good are completely irrelevant to the determination of the current price of a good…..

i believe that to be false

matt470 December 12, 2010 at 2:52 am

Company A spends $x producing a widget. Company B spends more than $x to produce an identical widget. Do shoppers in the market for such a widget care that Company B spent more producing the good? Of course not. Economically speaking they will buy the widget for the lowest price (assuming it is identical to the higher price one).

Alex December 12, 2010 at 11:41 am

A one person economy. Person X has had some coconut to eat today but would gain some enjoyment today from some more coconut. In order to get some more coconut for today’s consumption X must climb a palm tree to shake the coconut loose. However, he regards the effort (cost) of climbing the tree today as not worth the extra coconut consumption, so he doesn’t climb the tree to acquire his coconut for consumption.

The next day he wakes hungrier than he was the day before, so the value to him of climbing the tree and shaking loose another coconut has increased, and he climbs the tree for another coconut.

Now, consider the prior day again. If the individual had thought of using a big stick that was lying a few feet from him to poke at the coconut, he wouldn’t have had to climb the tree, and he may have been quite happy to acquire the additional coconut by poking. The use of the poking stick is essentially a techonological advancement (over treeclimbing) for acquiring coconuts that reduces the cost of coconut harvest. His subjective valuation of the extra coconut consumption didn’t change when he used the stick; it was the reduced cost of production (if you will) that increased his coconut supply.

Now if there was a second individual who fished, but who also was willing to trade fish for coconuts, the technological discovery of the pokirng stick that reduced the costs of coconut production and increased the supply of coconuts relative to fish would mean that the relative price of coconuts to fish would fall. Note that it is the reduced cost of coconut production that reduced the price of coconuts (absent any change in subjective valuation of coconuts or fish).

matt470 December 12, 2010 at 10:33 pm

“Now if there was a second individual who fished, but who also was willing to trade fish for coconuts, the technological discovery of the pokirng stick that reduced the costs of coconut production and increased the supply of coconuts relative to fish would mean that the relative price of coconuts to fish would fall. Note that it is the reduced cost of coconut production that reduced the price of coconuts (absent any change in subjective valuation of coconuts or fish).”

I like the simple RC economy type approach but can see a couple of assumptions loaded into it.

Without other coconut suppliers competing for coconut demand why would the price necessarily fall relative to fish – unless the stick “technology” was passed on to the fisherman so he could now choose to more easily harvest his own coconuts rather than exclusively trade for them? Wouldn’t the coconut collector’s demand for fish have to be elastic – if it were inelastic and all he wanted was 1 fish a day to satisfy his needs for fish entirely then where would be his incentive to trade more coconuts for more fish?

Alex December 13, 2010 at 1:30 pm

You might also have said that if the coconut producer didn’t like fish at all, or if the fisherman didn’t like coconuts at all, then there would be no trading, and thus no relative price of coconuts for fish. All there would be then is a relative price of coconuts for the coconut harvester’s leisure and a relative price of fish for the fisherman’s leisure. In a real economy, however, demand for normal goods is elastic. That is to say, if their relative price falls people will purchase more. In my two person economy I am assuming trade and non-satiation, that is to say, both people will consume more of the other good if its price in terms of the first good is lowered. This is the case in general in the real world. Thus, as I have shown, in general, cost influences price.

matt470 December 13, 2010 at 10:31 pm

Yeah fair point – your two person economy assumptions are fine.

In the context of Mengers work (although admittedly I haven’t studied it directly and am reliant on other Austrian economists such as some of those at LvMI like Salerno), cost of production is really just broken down into asking the same questions about demand but this time for the factors of production (higher order goods) – it is competing demand for those goods that influence the price.

To go back to the RC type 2 person economy analogy, you are forgetting the unseen consequences that this new technological advancement has brought about. Now that person X has freed up more of his time by being able collect coconuts more easily he’ll be able to start collecting berries also. The fisherman will now have a choice to trade fish for coconuts or fish for berries which will help direct where the islands capital (human labour) will be more efficiently directed to serve his needs. In this way the cost of production of coconuts is actually being influenced by demand for the factors of production of coconuts versus demand for those same factors that could be used to make alternative goods (eg. berries).

A technological breakthrough actually increases the overall production of the economy in a one-off manner in essence making all goods cheaper.

I think we could get stuck going in circles here though because perhaps we’re defining things in different ways. Looking at a single product in isolation (eg. coconuts), you’re correct to say that should their cost of production go down then this will influence price down also. If I’m correct though, the Austrian economists are saying that ultimately the things driving the cost of production is demand for those higher order goods and not some intrinsic or tangible value that is transferred to a good dependent on what is spent producing it. Therefore the source of pricing is demand for the good and for the factors of production that are utilised in making it. Technological breakthroughs are one-off gains that shift the equilibrium point of the ERE (evenly rotating economy).

Alex December 14, 2010 at 10:33 am

“To go back to the RC type 2 person economy analogy, you are forgetting the unseen consequences that this new technological advancement has brought about. Now that person X has freed up more of his time by being able collect coconuts more easily he’ll be able to start collecting berries also. The fisherman will now have a choice to trade fish for coconuts or fish for berries which will help direct where the islands capital (human labour) will be more efficiently directed to serve his needs. …

“A technological breakthrough actually increases the overall production of the economy in a one-off manner in essence making all goods cheaper.”

Sure, there would be other consequences of the technological advancement that reduces the cost of coconut production and thus the relative price of coconuts to other products (fish, berries, etc.), but these feedbacks could not raise the relative price of coconuts to other products above what it was before the technological cost reduction of coconut production because all other feedbacks depend upon the reduction in the cost and relative price of coconuts.

MLJ April 11, 2011 at 2:34 pm

To the Liberal In Lakeview, I’ve attempted to sell a car and, in my younger day held a few garage sales. The cost of an item dictated the price I ASKED for it, but had nothing to do with the price I ACTUALLY GOT. The cost of producing the Beatles “butcher” album was no more than the cost of producing some old LP that can’t be sold for a frisbee. The price you GET for the album is higher!

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