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Cost, Price, and Value

Created by dave. Last edited by dave, 11 years and 353 days ago. Viewed 4,089 times. #2
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Cost, Price, and Value are three different things

When looking at things, it is important to recognize that cost, price, and value are three separate concepts.

  • Cost can be considered the cost of goods, effort, whatever, to make something.
  • Price is the numeric value of the money you sell the something for.
  • Value is a monetary amount equivalent to what the something is worth to the buyer.
For example, consider a candy bar:
  • the Cost is what the store pays to obtain the chocolate bar and place it on their shelves; let's say $0.75
  • the Price is what they sell it for; let's say $1.00
  • the Value is the maximum price the customer is willing to pay; let's say $1.25
You can compare these quantities; as long as the Price is greater than the Cost, the seller can continue to offer the transaction to the customer; as long as the Value is greater than the Price, the customer will continue to complete the transaction.

In other words, stores are unlikely to sell items at a loss; and if a customer wants his $1.00 more than the candy bar, he isn't going to buy it.

You can even back our example up a level and view the store as the customer:

  • the manufacturer's Cost is, let's say $0.65;
  • the manufacturer's Price to the store is $0.75;
  • and the store's Value is $1.00, the price it sells the candy to the end customer at.
(You could argue that the Value to the store is $0.25, the profit realized on the transaction; probably you'd want to call that something else, like maybe Realized Value. I prefer to see Value as being what the item represents; to the store, it represents the $1.00 the store will receive when the item sells.)

What has this got to do with anything?

Well, look at things which are (or "should be") "free", like music. Many on the internet argue that since the marginal cost of producing a copy of a piece of music is (practically) zero, the price for that copy should also be zero. This argument totally ignores the value of the copy.

To wit: if you want it, it has value to you. What the price is doing is monetizing a portion of the value the copy has to you.

If the price of that copy exceeds its value to you (and/or your ability to pay the price), you'll do without it. For example, I want a new computer; it has value to me. However, right now I'd rather hold on to the $1500 (or the lack of an additional $1500 in debt) this new computer would cost me.

As an extremely contrived example, let's pretend for a minute here that BMW invents a machine that lets them build 325i sedans and sell them in dealerships for $1. What should the price of that 325i sedan be? Well, the current price of a 325i sedan is $35,000. This implies that the current buyers of 325i sedans get at least $35,000 of value out of them.

Now as you lower the price of this car, you make the car sellable to those who would put a lover value on the car. This causes an increase in the quantity demanded (this is basic supply and demand theory). Just for illustration, say that if you lower the price to $25,000, you could double the number of cars sold.

BMW is in the business of making money, not building cars. BMW would probably do a lot of studies to figure out at what point on the demand curve maximizes their profit (the gap between Cost and Price), and set the Price to that amount.

Similarly, this is what the music vendors are trying to do: they are trying to find a point on the demand curve which maximizes their profits. Music vendors really don't care about the cost of distributing the music, as long as it is less than the price that it sells for. Music vendors also don't really care about the size of the gap between cost and price as long as it is there: it is the sum of the gaps across all sales which count.

Pretend it costs you $0.01 to make a copy of something. Which would you rather: sell one copy for $500, or ten thousand copies for $1? Or seven thousand for $1.25?

If the cost of manufacturing something sinks so far below the set price, competitors will enter the market and sell for a lower price. In the case of our fictional BMW machine, eventually GM will invent a similar machine that will let them put Malibu sedans in the dealerships at a cost to them of $3.50, and that will let them reduce the price to the consumer accordingly to reflect the increased competition that BMW's lowered price on the 325i provides.

This is where the music business gets tricky: you could argue that the cost of producing a competing hit by Madonna is prohibitively high, since one of the existing labels has an exclusive contract on her. This is called a barrier to entry. This is why there is no real competition in the music business.

You as a consumer should not have any concern over the cost of something. All you should be doing is comparing the price of the item to its value for you.

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