What's Cost Got to Do With It?

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Three weeks ago I read the news that a 24.78-carat "fancy
intense pink" diamond sold for $46,158,674 at an auction held
by Sotheby’s in Geneva, Switzerland. The winning bid for "The
Graff Pink," as it was named immediately after its purchase by
London jeweler Laurence Graff, was the highest price ever recorded
for a jewel at auction and more than double the $24.3 price paid for
the 35.56-carat Wittelsbach blue diamond purchased by Graff in 2008.
Nowhere in the article was there any mention of the monetary costs
of producing either gem, although I presume that in each case they
were a negligible fraction of the diamond’s price – if anyone
alive today even knows those costs

Last week I
accompanied my wife to Walgreen’s to buy lighted outdoor Christmas
figures for display in my front yard. A snowman on display in the
store caught our eye and we decided to purchase it only to be told
by the manager that it was already out of stock. My wife, ever the
negotiator, proposed that the manager sell us the figure at a $5
discount from the advertised price of the snowman. He agreed, even
though the snowman on display probably cost the store $5 or $10
more to produce than the unavailable packaged item because it involved
an additional hour of a stock clerk’s labor to remove it from the
packaging and assemble it.

Last night
I was shopping online for tickets to a New Jersey Nets basketball
game as a Christmas gift. The Nets are an NBA franchise in transit
from New Jersey to Brooklyn, New York, and their temporary home
for the next two years is the Prudential Center in Newark, New Jersey.
On December 12, the Nets play the Los Angeles Lakers. Prices for
individual tickets in the upper corner sections (the "nosebleed"
seats) start at $24, in the lower center at $160, and in the courtside
section frequented by celebrities at $400. Two days later, the Nets
take on the Philadelphia 76ers: starting prices for tickets in exactly
the same sections are $1.00, $29, and $150, respectively. So the
price differential between the same seats at the Lakers’ and 76ers’
games ranges from two-and-a-half times higher for the priciest seats
to 24 times higher for the cheapest seats. Presumably the average
money cost of producing a basketball game for an individual occupying
the same seat is identical for both games and does not differ much
for individuals occupying different seats at the same game.

Now despite
countless instances like these that we all regularly encounter in
our market activities, most people still take for granted the view
that costs of production basically determine prices. Furthermore,
they believe that if prices greatly exceed costs, it is the result
of price gouging, monopoly, or some other nefarious scheme on the
part of producers. But as Carl Menger, the founder of the Austrian
School of economics, brilliantly explained nearly 140 years ago,
past expenses incurred during the production of a good are completely
irrelevant to the determination of the current price of a good.
For Menger, the market price of a good is determined solely by the
relative valuations of goods and money by the buyers and sellers
of the good, in conjunction with the number of units of the good
currently in existence. The records and memories of how much money
was spent to enlist the labor and other resources needed to produce
the good have absolutely no effect on how much money people are
currently willing to exchange for a unit of the good.

But Menger
went even further and demonstrated that the (anticipated) selling
prices of goods actually determine the costs of production for a
good. Using the example of tobacco, Menger argued that if people
completely lost their desire for consuming tobacco, not only would
the prices of cigarettes, cigars, and pipes fall to zero, but raw
tobacco and the machines specifically designed to produce these
items would cease to command a price greater than zero, no matter
how much it cost to produce them.

For Menger
and modern Austrians, then, the ultimate source of value is the
ceaseless efforts of individual human beings to use their scarce
resources and money to improve their well-being by interacting with
one another on the market to achieve their most cherished goals
and desires while renouncing less-important desires and satisfactions.
The actual market prices and costs of production we observe are
simply the objective manifestation of this war of scarcity in the
human soul. It is the current or future goods we have to sacrifice
and the opportunities for satisfaction that we have to renounce
that are the only relevant "opportunity costs" of the
things that we purchase. These subjective and immediate experiences
of renunciation and sacrifice – and not some recorded sum of
money that one guy paid another guy to perform a production task
last month or last year – these are the costs that will influence
our decisions about what to buy and what not to buy and, thereby,
determine the prices we pay during this Christmas shopping season.

Modern mainstream
economists portray the Mengerian-Austrian theory of price as "extreme"
and "one-sided," supposedly over-emphasizing subjective
value while ignoring money costs of production. But it is precisely
the one-sidedness of Austrian theory that makes sense of our market
experiences. The higher cost "display" snowman sells for
a lower price than the packaged snowman because most consumers view
the former as a less-valuable "used" item. They do not
care about the stock clerk’s past exertions or wages. The Graff
Pink commanded such a high price at auction because it is so scarce
in relation to the number of people who want to possess it and the
intensity of their desires for it relative to money and other things.
Even if the production costs of the diamond were the same, the sudden
discovery of 10,000 diamonds identical to the Graff Pink would drive
its price down far below the recorded auction price. And I need
not belabor the point that the price differential of up to 2,300
percent for the same seat in the same arena two days apart exists
because, for most basketball fans, the experience of watching the
talent-laden Lakers with their coaching icon and glorious tradition
shred the dreadful and itinerant Nets is vastly preferable to witnessing
a dreary contest between the Nets and the equally woeful 76ers.

The laws of
value and price discovered by Carl Menger are universal and immutable.
They are true and apply everywhere and at all times, so long as
human beings consciously seek to improve their well-being by using
their scarce time, energy, money, and material resources to attain
their most important goals.

Now, let me
go back online and check if the price of those unsold Nets-76ers
tickets has plunged below a dollar yet.

This is
reprinted from Mises.org.

10, 2010

Salerno [send him mail]
is academic vice president of the Mises
, professor of economics at Pace University, and editor
of the Quarterly
Journal of Austrian Economics

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