Often used interchangeably, the three concepts — cost, price, and value — are related but distinct. They are elementary and understanding them precisely is essential for reasoning about our world of production, exchange and consumption. People, including yours truly before learning economics, don’t even realize that they are confused about those simple concepts.
Let’s begin with value since it’s personal and therefore most intuitive. I want what I value, and vice versa. In nearly all cases, I have to give up something (S) in exchange for what I want (W). Logically, I must value S less than I value W if I do the exchange voluntarily. It would be irrational for me to give up something of greater value in exchange for something of lesser value to me.
Also note that because I am doing the valuation, the values I assign to S and W are subjective. Our subjective valuations of things must differ if we enter into any voluntary exchange. If I value a cup of coffee more than I value the $3 (the price) I give up to buy coffee from you, you must necessarily value $3 more than you value the coffee you sell to me. Same object, same amount of money but different valuations. The price does not equate to value.
Easy enough for us to realize that value is subjective once it is explained to us but that realization is surprisingly recent, only about 150 years old. Three people independently came to the “subjective theory of value”, namely Menger, Walras and Jevons. Classical economists like Smith, Ricardo and Marx had not figured that out; their theory was the “labor theory of value.”
The labor theory of value says that the value of a thing is a reflection of the amount of labor involved in its production. Seems like common sense. It takes a lot more labor (and materials) to produce a car than a bicycle. Therefore cars have a higher value than bicycles.
But the labor theory of value is actually not true. The amount of labor is immaterial and irrelevant in determining the value of stuff (the technical term I use for “goods and services”). What is material and relevant is the subjective valuation of stuff by people.
Simple example. An unskilled cook may have labored for 8 hours to produce a dish that is inferior to the dish made by a skilled chef in 2 hours using the same ingredients. People may value the latter dish (and therefore be willing to pay more for it) more than the former.
No one is willing to pay me even though I labor for hours on end writing this stuff. Their valuation of zero has nothing to do with the labor involved in the production. The labor theory of value — unfortunately for me — does not hold water.
The subjective theory of value explains a lot about the world. If a lot of people value something, it gets produced; otherwise not. You would not have much success in selling tandoori chicken in a community of vegetarians.
Moving on. What is price? It’s whatever a buyer and seller agree upon to do the exchange. Suppose I value a cup of coffee, at say, $5, and the seller of a cup values it at $2. So I’ll be willing to pay up to $4.99 and the seller will be willing to accept $2.01 and above. The price we eventually agree upon will be something in between, say $3. That’s the price.
We of course don’t go to a coffee shop and negotiate the price of a cup. We simply pay the posted price and get on with our lives. How does the coffee shop arrive at the $3 price? At the lower end, the shop has to post a price that at the very least covers its costs — the cost of the materials, the workers’ wages, the rent for the shop, etc. If at the posted price, lots of people buy coffee, they’re in business; otherwise they shut shop and go do something else.
The higher the price the shop charges, the higher the profits. But fewer people would buy higher priced cups of coffee, and therefore the shop has to moderate its price to levels that are consistent with other coffee shops in the neighborhood. More competitors, lower prices and therefore lower profits.
That is, the market disciplines participants in a free market. Prices emerge out of the interactions between suppliers and demanders. That’s generally represented in the classic demand-supply diagrams in econ textbooks.
In other words, prices in free markets emerge through a process that no one is in control of — not some arbitrary authority like the owners of firms, or the customers, or bureaucrats and politicians. The market process discovers the price.
Emergence is an interesting phenomenon. Who decides how many goals will be scored in a football match? No one. Each team attempts to maximize its goals, and the outcome of the game emerges without any player or team determining the final score. The game is a process that discovers the score.
Let’s note that markets are where exchanges (or trades) take place. Free markets are markets which do not have barriers to entry or exit. If anyone can sell coffee, then there are no artificial barriers to entry. If you need to have a license to sell coffee, it’s not a free market. If anyone can buy coffee without a permit or license, it’s a free market. If you can refuse to sell coffee or refuse to buy coffee, it’s a free market because there are no barriers to exit.
Free markets generally tend toward socially optimal allocation of resources. They are economically efficient. Efficient means that waste is minimized in the production, exchange and consumption of goods and services. Entry and exit barriers distort markets and that leads to avoidable waste. In the extreme, the distortions can be so severe as to impoverish the people — as is the case in India and other socialist countries.
OK but what’s the relationship between cost and price? The cost imposes a lower bound on the price. If it costs $10k to produce a car, then the price has to be at least $10k. But if the people are not willing to pay $10k, the car would not be produced. Of course, a car that costs $10k to produce may sell for whatever price above $10k people are willing to pay for it.
Luxury goods sell for way more than the cost of production because wealthy people value them highly and therefore are willing to pay high prices. Branded goods like Louis Vuitton handbags sell for thousands while the production costs are a fraction of that.
The prices of commodities (steel, wheat, memory chips, TVs, etc.), which are normal goods, generally track the cost of production. If the costs go up, the prices go up, and if costs fall, the prices fall. The higher the degree of competition in a market, the tighter the link between costs and prices.
But wait, there’s more. We know that value is subjective. The higher people value something, the higher the price they are willing to pay. How much they are willing to pay depends on their budget constraint. I value first-class travel but my willingness to pay is constrained by my travel budget. Wealthy people value comfort and they are able, and willing, to pay more for first-class travel than I.
The demand schedule (simply known as demand) is the relationship between the price and the quantity demanded. But the quantity demanded depends on the subjective valuation of a good. Therefore demand is subjective.
The supply schedule (simply known as supply) is a relationship between the quantity supplied and the price. Question: Is supply, like demand, also subjective? The answer is yes. This surprising result comes from the fact that costs are not objective; they are subjective.
How so? That explanation is for paying customers only. Meaning, people have to value it and then I will incur the cost of producing it. 😊
Here endth the lesson. Peace.