Wednesday, February 3, 2010

Econ 101: Cost, Price, Value

Hoisted from the comments on my most recent Economics 101:

Why should Anyone (me) pay virtually the same price for an e-book as for a paperback? I get less in terms of ownership rights, ie resale, or lending to friends and family, and apparently Amazon can take the damn thing back at any time without permission. I do have an e-reader , not a Kindle and I love it, I don't love the way publishers have diminished my rights of ownership.
I believe that this comment demonstrates a common conflation: value, price, and (covertly) cost. Let's unpack it and see.

Value is an intangible, subjective thing. It is the judgement, by an individual, of what something (an iPad, say) is worth to them. Market value is an accumulation of individual judgements of value.

Price is a tangible, objective thing. It is the statement, by the owner of a thing, of how much it would cost to purchase that thing (from them).

Cost is a tangible, objective (but different to calculate) thing. It is the accumulation of what had to be spent to create or acquire a thing. In a value chain, the cost of an item will vary as it passes through the chain. If we imagine a physical book, for example:
  • The cost of the book to the publisher includes: cost to acquire the book rights; cost to have each copy of the book printed; cost to store and ship those books; pro-rata overhead costs attributed to the book; etc...
  • The cost of the book to a wholesaler who purchases the book directly from the publisher is whatever the publisher charges them per book plus: accumulated costs to store and ship the books; cost to advertise the book in trade publications and sales/marketing materials; pro-rata overhead costs attributed to the book; and so on...
  • The cost of the book to a medium-sized chain bookstore that purchases directly from the wholesaler above is whatever the wholesaler charges them per book plus: costs to store and ship the books; cost to advertise the book in local publications; print and place signage in and around their stores; pro-rata overhead costs attributed to the book; etc...
  • The cost of the book to an end-user who buys it from the medium-sized chain is whatever the chain charged them plus: cost to drive to the chain store and park; cost of the coffee and cookie they bought because they were in the bookstore; etc...
As demonstrated above, there are many possible definitions for cost. Whenever you use the term cost you have to be careful to make sure to specify what cost you're dealing with.

In order to make a profit and stay in business over the long term, price has to be higher then cost. At each step of the value chain, the buyer is going to spend more for the item than the seller paid for it. Ultimately, each buyer must decide that the value of the item is higher than its cost. For anyone who is planning to re-sell an item, the value is easily set as the price for which it will be sold (with some allowance for shrinkage and the reality that not all of something will sell).

Economists assume that users make internally consistent and rational choices about the value of items. They don't, but economists like to assume that. So in any transaction, the buyer has decided that the value of the item is more than its cost (which is the price plus attendant costs to acquire), while the seller has decided that the value of the item is less than its price. Mathematically:

Which clearly shows that there must be a difference between Vb (value to the buyer) and Vs (value to the seller).

This is the essence of a market transaction.

With respect to physical books and eBooks, the question arises: is the price set according to the cost or the value? From a publishing/warehousing/distribution/retail perspective, costs set a floor on price. From a consumer's perspective, value sets a ceiling on price. If a book producer cannot create a book which has sufficient (average) value which is higher than the cost to produce, they can't stay in business.

The question a consumer asks themselves isn't "do you feel lucky?", it's what is the relative value to me of an eBook and a physical book? Some people say an eBook has lower value because of DRM (if we're talking about a Kindle book), limited capability to lend the book, requirement for batteries to read, or inability to recoup residual value (i.e. re-sell the book). Some people say an eBook has higher value because it occupies less volume, has less mass, or can be read in the dark. The point is that eBook value is idiosyncratic. Just like value is for everything.

Personally, I value the virtual volume and mass of eBooks. I have 100 banker's boxes of books in the garage. I buy eBooks and keep them on hard drives -- even Kindle books, which can be downloaded onto the computer and transferred to the Kindle via USB. I have several thousand eBooks (in various formats). I love the fact that they fit onto a hard drive instead of requiring more boxes in the garage (where they are inaccessible), more bookshelves, more house to hold those bookshelves and boxes (perhaps 20% of my house is dedicated to books and other media which could be reduced to bits upon hard drives).

That's a conscious decision on my part, that virtual mass and volume has value. I recognize the potential for losing a subset of my eBooks to: DRM; format changes; hard drive failure; or unforeseen issues. Just as I recognize the potential for losing a subset of my physical books to: theft; flood; vermin; physical loss; shrinkage; or unforeseen issues.