Wednesday, March 23, 2016

Econ 101: Cost, price, and value

We often use the terms cost, price, and value interchangeably. Economists try to differentiate them. The comments below follow are a distillation and summary of other people’s ideas as I have come to understand them. I want to give them a precise content. I believe that most of us have a very poor notions of these concepts, and these poor notions are a major factor in creating the economic messes that we suffer from. We base our choices on our ideas. Ideas have consequences.

Framework: “The economy” consists of the systems we use to provide ourselves with the goods and services we need and desire. One can define the concept so that it applies to all animals, in the sense that the effort expended by the individual or the group or the hive must yield sufficient food to enable successful reproduction.

Observation: All human economies are trading systems. Regardless of how they are organised in detail, they all feature rules for exchanging goods and labour. All cultures strive for fair distribution of what we need and want. “Fair” varies somewhat between cultures, but all on the one hand promote fair exchange, and on the other hand punish cheating. All strive for equitable distribution of goods, and what inequality exists is justified by appeals to ideas about worth and social roles. Too much inequality creates social stresses that sooner or later cause political strife. In all cultures, economic and political power are intertwined.

Cost: The quantity of resources needed to make something or to provide some service. At the level of the economy, that is of trade, “cost” is some combination of energy (including human labour) and materials. Cost includes waste disposal, which ranges from waste as new resource (eg, gardening), to a variable fraction of the input cost, to waste as the largest component of cost (eg, nuclear power plants). Technology affects cost, because technological improvement is driven by a desire to reduce costs.

Price: The measure of cost. In a monetised economy it is stated in a currency, such as dollars. Through most of human history, economies were not monetised, trading was done without the convenience of pricing goods and services. Non-monetised pricing survived for a long time. When I was a boy, the cost of travel was measured in time, even when it was paid-for transport.

Archaeological evidence suggests that currency began as a system of IOUs sometime around 4,000 BCE. Clay seals were used to identify goods owed in an incomplete transaction, and clay tags were used to record taxes owing. It’s easy to speculate that the next step was for such seals to become objects of trade themselves. The final step would be inventing some abstract measure of price, such a gold. But the early history of money is not well understood.

Value: The measure of the buyer’s need or desire. In a monetised economy, value, like price, is stated in a currency. If a buyer assesses a price as equal to or less than the value, there will be an incentive to buy. The “law of supply and demand” is about value, not cost.

Trade is asymmetrical. For the seller the goods have a lower value than for the buyer. Needs and desires are mediated and modified by cultural variables such as obligations and status. Cost is also a factor; the desire to reduce the work of making something for oneself will raise the value of ready-made goods.

Implications

Measurement of Costs: Ultimately, since the production of raw materials requires energy, all cost reduces to energy. This observation implies that cost reduces to physics. In principle, it would be possible to state the cost entirely in terms of energy. “Carbon footprint”, usually stated as tonnes of CO2, is an attempt to state cost in fundamental terms. Since some quantity of CO2 represents a fixed quantity of energy, it’s a proxy for energy. It’s a complicated calculation, and inevitably incomplete and more or less uncertain. But it has the virtue of getting us thinking about cost in material terms.

The Role of Government, among many others, is to price externalities. There are three methods of doing this: regulate the storage and disposal of waste; collect fees for raw materials; and vary taxes on goods. Both producers and consumers resist these methods, but without them goods will be underpriced, which will distort the market.

Prices, Markets, Profits, and Sustainability: In an ideal market, price would be an accurate representation of cost. In practice, that doesn’t happen. The main reason is the cost of externalities, which are defined as unpriced costs. Hence the producer does not pay them, and they are not included in the price of the product. Another reason is the misconception about the role of profit. When inputs are priced, the seller must sell at a higher price than he paid. The difference, raw profit, pays for his input, often termed “added value”. Profit pays for the continued operation of the business, that is, his and his employees’ livelihoods, operation and maintenance of the plant, research and development, and future capital costs. In a share-holder owned company, profit also pays the shareholders a return on their investment.

The Temptation is to demand a greater profit than is needed to pay for continued operation of the business or a reasonable interest to the share holders. So on the one hand, omitting the cost of externalities underprices some goods, which leads to choices that distort the consumer market. On the other hand, excess profit overprices some goods and so sequesters capital, which distorts the capital market. Either way, the economy as a whole fails to operate correctly, and in the long run it will fail to provide a sustainable basis for human life.

2016-03-12

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