The Flaw of Marginal Cost

droughtIt’s been awhile since I’ve written for my blog but this is a topic I’ve been meaning to address. I think there are many distortions in the Capitalist system but I think one of the most serious is the concept of marginal cost.

Rather than provide a long-winded critique, I’ll simply point out the California drought as a prime example of marginal cost gone wrong. Adam Smith once compared the prices of water and diamonds and made the observation that, because diamonds are much harder to extract, it made sense that they were more expensive than water. In other words, the amount of resources it takes to bring each subsequent diamond to the market is significantly greater than the amount of resources it takes to bring the next gallon of water to the market. This is a simplification because I’d guess that infrastructure costs for providing water are far greater than those needed for diamond mining. But, once that infrastructure is in place, it costs very little to provide each subsequent gallon of water while it still takes a great deal of effort to produce the next diamond for sale.

The first thing I’ll point out is that I don’t think the market cares what it costs to produce a thing so pricing is never truly a factor of marginal costs. Case in point: Apple products. Apple sells products for significantly more than they cost to build and distribute. In fact, it is so good at it that it has roughly two hundred billion dollars in profits sitting in banks all over the world. Few people care how much it costs to produce an Apple product, the only thing that matters to them is if they can afford it. Because of its ability to produce high quality products in massive scale, Apple is able to set a relatively low initial price point. But, make no mistake, it is Apple that sets the price point, not the market.

In the case of Adam Smith’s famous example, I don’t think the price of diamonds is a factor of marginal costs. Indeed, diamond prices are set almost exclusively based on what people are willing to pay for them. Diamonds are priced far more for their perceived value and durability rather than their marginal costs. It makes more sense to me that the need to almost never replace a diamond due to natural wear is why they are actually so much more expensive than water. The same pricing strategy applies to many items that have long replacement cycles, such as Dyson vacuum cleaners and bed mattresses. In the end, perceived value and durability seem to play a greater role in pricing versus marginal costs. Indeed, I’ve long championed the notion that even affordability is an externality rather than an inherent factor in pricing.

The next thing I’d like to point out is that intrinsic value is not factored into marginal costs. Beyond a shadow of a doubt, water is far more important than many things that are far more expensive. Particularly in the case of water, its intrinsic value and low marginal costs are in diametric opposition. Low marginal costs encourage greater consumption; the notion is that total exhaustion of a resource is unlikely because, as it becomes more scarce, its price rises to the point that it becomes so expensive that its consumption will eventually drop. The flaw in this thinking is that a resource is highly unlikely to become so expensive that no one can afford it. In the case of California, water consumption has actually increased among the wealthy. The likelihood that water can be priced to prevent high consumption by those who can afford it is almost nil.

The California water drought clearly shows the flaws of marginal cost pricing. Pricing a thing based on the cost of producing each subsequent unit is not always sensical. In a system designed almost entirely for consumption, what are the incentives for conservation?

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3 thoughts on “The Flaw of Marginal Cost

  1. Pingback: The Concept of Marginal Utility is Overrated | The Currency Paradox

  2. Pingback: A Marginal Cost Redux | The Currency Paradox

  3. Pingback: The Fed and Neo-Fisherism | The Currency Paradox

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