Wednesday, April 02, 2008

Economics: value and cost

See my proviso on economic discussions.

Let's say that 10 people can make 1,000 widgets. At this volume, the "inherent value" of each widget is $2.00, and each widget "costs" $1.00. Therefore, every time we make a widget, we're creating $1.00 of excess value.

The excess value of something is the difference between its "inherent value" and its "cost".

When I talk about the "cost" of a widget, I mean the true cost: The bare minimum it would cost to make. This assumes that everyone making the widget — everyone, including the CEO and the janitor, the guy who digs up the iron, the person who makes the widget-making machine and the other person who trains others to work the machine, and everyone feeding the people making the widget, etc. is being "paid" the bare minimum to survive (and reproduce).

The true cost of something is the absolute minimum required to make that thing.

Who gets the excess value? That's the $64,000 question.

Some of the excess value will go to resolving bottlenecks. Some, but not all; indeed not very much at all.

A bottleneck is just something where the demand for that thing is greater than the maximum practical supply. If the bottleneck is something other than people's time, let's say it's iron, then the excess value of the widget gets moved to the excess value of iron. We've moved the excess value around, but nobody has actually received it. So we'll concentrate on the idea that the bottleneck is people's time, because people can actually receive and use excess value.

There's also the opportunity cost. If there are only 10 people, and if those 10 people are making widgets, they're not making gizmos. A gizmo, like a widget, "costs" $1.00 to make, but when we make 1,000 of them, they're "worth" $1.60 each (for an excess value of $0.60). Thus we add a $0.60 "opportunity" cost to the making of each widget, making the opportunity-adjusted cost $1.60 per widget.

The opportunity cost is the the excess value of the most valuable thing which is not made as a result of making something.

The opportunity-adjusted cost is the true cost plus the opportunity cost.

Another way of looking at opportunity costs is: if I personally wanted to hire the 10 people to make widgets, I would have to persuade them to not make gizmos. Therefore, I would have to pay them enough to work for me instead of the gizmo factory. Since the gizmo factory could give them at most 100% of the excess value of a gizmo ($0.60), I have to pay widget workers an extra $0.60 per widget, i.e. the opportunity cost.

However, suppose there are 20 people available. We can make both widgets and gizmos, but we can't make doodads (which "cost" $1.00 but are worth $1.50), So the gizmo makers have an opportunity cost of $0.50 vs. doodads. However, since there are 20 people, and only 10 make gizmos, there's no additional opportunity cost associated with making the more valuable widgets; the opportunity cost of making widgets is now $0.50, down from $0.60. If we have 30 people, we can make widgets, gizmos and doodads, but we can't make gegaws (excess value of $0.40); and the opportunity cost of widgets, gizmos and doodads falls to $0.40.

All opportunity costs of production that share the same bottleneck are equal.

As the economy gets larger* the opportunity costs tend towards zero, and therefore the opportunity-adjusted cost tends toward the true cost.

The excess value that goes to resolve bottlenecks tends to be minuscule. So where does the excess value go? It's not a simple question.

*All else being equal, which is not the case, as I'll discuss in later posts.


  1. Larry,

    I'm confused.

    If we have 30 people, we can make widgets, gizmos and doodads, but we can't make gegaws (excess value of $0.40); and the opportunity cost of widgets, gizmos and doodads falls to $0.40.

    suppose some of the workers not making widgets are capable of making them, wouldn't the opertunity cost of units of widgets they make, be grater than the O.C. for widgets made by workers only capable of making gegaws?

  2. We're still assuming that each person is inherently capable of making anything. The only constraint is on how many of each item are wanted: we can make only 1,000 widgets; the 1,001st would simply be wasted.

    This is, of course, a simplifying assumption and will need to be reexamined later.

  3. I still remember the first economics lesson my dad ever gave me as a child - it took me sometime to figure it out.

    He gave me an orange (or something) and said, essentially, "this is the only thing for sale in the entire world - nothing else exists". Then he said that the total sum of money that existed in the world was something like a million dollars. Then he said, "and given that, the orange will sell for one million dollars"

  4. How are you defining “inherent value”?

  5. How are you defining “inherent value”?

    It's the price at which the consumer would feel that she had made an irrelevant exchange. It would be a rip-off at a higher price, and desirable at a lower price. Statistical interpretations apply when dealing with multiple consumers.


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