Thursday, 24 November 2016

Economic Myths: Cost-plus

The point of the post Economic Myths: Business Rates hike may force UK's shops to raise prices is that prices are set by where marginal revenue and marginal costs per unit happen to cross on the supply-demand chart.

Fixed costs quite simply have nothing to do with it. In the very long run, most fixed costs are actually variable costs. It is a question of fact and degree. But clearly rent and rates are a fixed cost for these purposes (from the point of view of the tenant).

The chart showed the supply-demand curves for monopolistic competition, but the same principles apply wherever a business is on a sliding scale between perfect competition and absolute monopoly. Most businesses are somewhere in the middle.

(Land ownership is a not a business for these purposes, that is a pure monopoly. By putting up and maintaining buildings, land owners act like businesses of course, they have a dual role and it helps if you don't confuse the two distinct functions.)

From the comments:

Dinero: However I don't see the relevance of the chart from Economics help.

Me: A change in variable costs per unit = changes the optimum price/output level. A change in fixed costs = has no effect. Business Rates and rent = fixed cost = have no effect. That is why the linked chart and article ONLY mention variable unit costs (or marginal costs or whatever you want to call them).

Dinero: The chart is a diagram of profit maximizing price setting for a monopolistic supplier (1). Retail is competitive market (2), where prices are a competitive level of profit plus variable costs (3) plus fixed costs.(4)


Wrong on so many levels.

1. Even with perfect competition, the market clearing price is where revenue and marginal costs per unit happen to cross on the supply-demand chart. Same for monopolistic competition, cartels and a pure monopoly. Fixed costs have no impact on prices; they affect profits.

2. Yes, bricks and mortar retail is competitive, but not that competitive. Most shops have their own niche, customer base or brands etc. And by occupying space (and crowding out competitors), most shops have some degree of local monopoly. Even if it were competitive, see 1.

3. That misses the whole point of the article and pretty much everything else you need to know about economics. With most industries without absolute barriers to entry and even with cartels, abnormal or super profits are competed away, so that prices end up at a level of what looks like cost-plus. This is not because each individual business decides to aim for cost-plus, it is because of the competition.

4. For 'fixed costs' read 'rent'. Rent is not a 'cost' in economic terms, it is an appropriation of the earned profits of the business. Profits (or the profits of potential other tenants) are what dictates rents, not the other way round!

I've done this one dozens of times.

Imagine a partnership running a business, the two partners share profits 50/50. One partner might secretly consider himself the senior partner and consider the other partner's profit share to be a 'cost'. It might be a cost to him personally, but it is not a cost to the business. Perhaps they change the profit share ratio to 60/40. Does that change what customers are prepared to pay or the optimum level of output of that business?

Does it heck.

In the same way, maybe this year, the landlord is taking half the profits in rent and next year ups the rent to 60% of the profits, makes bugger all difference to prices and output. That's a dispute between the business owner and the land owner.

In the same way, the local council takes a slice of the rent from the landlord (Business Rates). The business tenant, as 'customer' of landlord (who provides the building) and the local council (which provides pretty much everything else) couldn't care less how they split up the rent between them. Each tenant has his own pain threshold, if landlord and local council demand more than he is prepared to pay, that's it, he vacates the premises, end of.
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UPDATE: Dinero: And so the opportunity to set a price using a profit maximizing policy , marginal revenue vs marginal costs, is more or less removed by competition, and so the suppliers to the market are left with selling at the minimum acceptable profit plus the costs.

To reiterate: in a reasonably competitive market with sufficient reasonably well-informed consumers the market clearing price is still set by the basic rule tends to settle at, price = marginal revenue = marginal cost + 'minimum acceptable profit'. This happens to be the point at which - given the competition - an individual business (or indeed the whole industry) maximises its gross profit. Prices are NOT dictated by fixed costs. Gross profits dictate 'fixed costs' i.e. rent.

17 comments:

Dinero said...

considering a competitive market, and as you say, Point 3

"With most industries without absolute barriers to entry and even with cartels, abnormal or super profits are competed away, so that prices end up at a level of what looks like cost-plus. This is not because each individual business decides to aim for cost-plus, it is because of the competition."


And so the opportunity to set a price using a profit maximizing policy , marginal revenue vs marginal costs, is more or less removed by competition, and so the suppliers to the market are left with selling at the minimum acceptable profit plus the costs.

Dinero said...

reply to your update

A competitive market drives down prices. How far does it drive them down? Ultimately it drives them down to the fixed costs plus the variable costs plus a minimum acceptable profit.

If the fixed costs for all the traders goes up the price goes up.

I get the point that in the case of rent , rent is calculated after the profitability of the site has been identified , however business rates are a government set tax and if a business rate rises for all traders in the absence of a productivity rise, and it is not absorbed by the Landlord ,the traders can and will put up the prices.

Mark Wadsworth said...

Din: " if a business rate rises for all traders in the absence of a productivity rise, and it is not absorbed by the Landlord.."

1. Forget productivity rise, when you are doing comparisons you can only change one variable.

2. ultimately the rate rise WILL be absorbed by the landlord. Even the "British Property Foundation" arch Homeys acknowledge this (although they see it as A Bad Thing).

"… the traders can and will put up the prices."

They can't. For the umpteenth time, prices for transportable goods are the same all over the UK, regardless of whether you buy them in a high rent area or a low rent area.

It is just that in some locations, retailers can shift a thousand units per day and in other they can only shift a hundred. Clearly, they will give up some of the extra profits from the extra nine hundred units in terms of higher rent/rates.

You keep working backwards from rent and saying that prices = rent + cost + profit margin.

Wrong wrong wrong. Prices are fixed by the market, volume is fixed by the location and rents are a balancing figure derived from the extra volume you can sell at the location.

And B Rates are a "tax" in the sense that the government gets it, but actually it is an appropriation of rent in the same way as rent is an appropriation of profits.

The UK govt has tried many a time with business rates exemptions and business rates free zones and all that happens is that the rents go up.

All this is easily observable and understandable, I don't know why so many people refuse to accept the real world as it is.


Bayard said...

"The UK govt has tried many a time with business rates exemptions and business rates free zones and all that happens is that the rents go up."

Isn't that the idea?

Dinero said...

Prices are fixed by the market and that market includes competitive pricing.

Any price asked above that minimum profit can be undercut, so ultimately it comes down to that minimum profit plus costs.

You say that costs are derived from profits, but that is not the case, some costs go up and down depending on the variable amount of time required to produce the product due to for example changes in the weather.

Mark Wadsworth said...

Din, do you want me to just throw in the towel or explain it again?

OK, one last go… any more stupid comments and I'm sending you to spam.

Costs = using up natural resources and labour (which is a kind of natural resource).

Finished products are the result of lots of different processes, all with their own costs. If the amount of natural resources or labour required to make the end product changes, then the price/output level of the finished unit will change (assuming constant demand for simplicity).

The difference between the value of the finished product and all the input costs = profit (or surplus or whatever you want to call it, a net gain to humanity).

That profit spills over into higher rents. Rents - the main fixed cost - is derived from profits.

I never said anything as fucking stupid as "costs are derived from profits". I have said eight thousand times over the past ten years "rents are derived from profits".

Can you really not tell the difference between

a) input costs (using up natural resources and labour) and

b) the overall profit or surplus and

c) that the overall surplus is split between business and landowner/protection racket?

Dinero said...



You acknowledge that if the amount of natural resources or labour required to make the goods goes up then the price of the goods will go up. So it follows that if the Business rates for every single shop in the country goes up and the Landlords do not absorb the increase then the price of the goods will go up.

Mark Wadsworth said...

Din, are you a closet Homey?

"if the Business rates for every single shop in the country goes up and the Landlords do not absorb the increase then the price of the goods will go up…"

Firstly, LLs will absorb the increase sooner or later. Fact. Secondly, if they dig their heels in, how does that increase the amount of natural resources or labour required to make the goods? It clearly doesn't. LLs control the same amount of land before and after. Their "supply" of land has not changed, neither has the amount of land "consumed" to exhibit and sell the goods.

Right, that's it, I am sending your future comments to spam. Sorry, those are the rules and don;t say you weren't warned.

Physiocrat said...

There is this question about the UBR. Although the UBR is not LVT, the UBR payment comes out of land value even though it is nominally assessed on land plus buildings and plant. There may be situations where the UBR charge is more than the land rental value. This could be the case - a steelworks in somewhere like South Wales, for instance, where the amount of the UBR payment is more than the site rental value.

If that were the case, then the site becomes sub-marginal and will go out of use.

Mark Wadsworth said...

Phys, correct.

But under the simplistic "cost plus" approach to economics, the landlord can charge whatever rent he likes, the government can charge whatever BR they like and the tenant happily pays it all and just increases his prices :-)

Physiocrat said...

Does this mean that a "rates holiday" in places like Sunderland, apart from the central business area, would bring land into use rather than just lead to a hike in rents? I am thinking here, obviously, of an outfit like Nissan, which are paying heavy business rates on a site worth next to nothing.

Mark Wadsworth said...

Phys, the ratio between land values on farms and heavy industrial estates is practically nil, the real value is difficult to ascertain and it is not worth taxing (not by LVT and certainly not by B Rates).

95% of the value is in urban areas (easy to assess), and a quarter is the tiny area is town and city centres (where you get most benefit from taxing). That's what's worth taxing. Farms and heavy industry in out of town locations, just ignore them.

Physiocrat said...

In Sunderland and places like it you could have a permanent UBR holiday for industrial premises and it would not lead to an increase in rents but to the development of sub-marginal land.

That is my hunch. A nice sweetener for the likes of Nissan, and it breaks no rules.

Mark Wadsworth said...

Phys, yes, agreed of course.

The same goes for power stations - the value is not in the location as such but being linked to the National Grid.

Sid (Plymouth) said...

You say:

The price is still set by the basic rule, price = marginal revenue = marginal cost + 'minimum acceptable profit'.

As you would also say: "Wrong, Wrong, Wrong".


Try this:

The price is decided when two sides of a deal are content to undertake the exchange because they both gain. Which they individually decide for themselves. The agreed "price" is just an indicator of the value of the exchange to them both.

or:

Price is an ordinal number NOT a cardinal number. (Discuss.)

Except as used in sentences expressing the sentiment of this one, anyone who links the word "price" with words such as "Set", "Control" or "Regulated" is, at best, committing "A fatal Conceit" (https://en.wikipedia.org/wiki/The_Fatal_Conceit) and is very likely to be (one, two or all) of the following sorts of person:
+ a socialist
+ a Keynesian
or,
+ an Intellectual. (*)

Furthermore such people are likely to think that being "Austrian" only means "Someone who was born in the country of Austria".

If you have read this far, you might find below this an interesting "lead" for further reading.


This is the final paragraph from an article at this link:

NB the use of the word "set" is shorthand for "declare"

https://fee.org/articles/who-sets-the-price/

In our competitive marketing system, anyone can set a price, but he cannot force the customer to buy, nor can he force others to set the same price. The customer is free to select what he, or she, considers the best buy from the many choices available. The exceptions to this principle are almost all due to governmental policies.

* Why "an Intellectual"? Try this:

https://mises.org/system/tdf/Intellectuals%20and%20Socialism_4.pdf?file=1&type=document

Merry Christmas!

Mark Wadsworth said...

Sid: "The price is decided when two sides of a deal are content to undertake the exchange because they both gain. Which they individually decide for themselves. The agreed "price" is just an indicator of the value of the exchange to them both."

When looking at one single, individual transaction, yes of course. Where have I ever said otherwise?

Like all smart arses, you are quoting me out of context. When I say "set" it must be clear to anybody but a nit picking arse hole that the "setting" is done by "the markets" and not by any individual business or customer.

Or do you Socialists. Keynesians and Intellectuals not believe in market signals any more?

Fuck off!

Mike W said...

Sid, a bit vicious,

When folks like Paul Johnson write stuff like, Intellectuals'(1988)and Hayek wrote the paper above, do you think they are driven to a somewhat paradoxical position; given that they are both clearly 'intellectuals' as well?