I want to proclaim The Overhead Revolution.
About 150 years ago, economics had the marginal revolution. The idea was to solve the diamond/water paradox. How could a diamond, which is a nice-to-have, fetch a high price, while water, which is essential for life, has a low price?
The marginalists said that price is determined by the marginal benefit and marginal cost of the next unit. If you have sufficient water, the marginal benefit of the next ounce of water is low. Also, the marginal cost of providing you with the next ounce of water is probably low. But the marginal cost of providing you with the next diamond is high. And for someone shopping for a wedding ring, the marginal benefit of the next diamond is high.
Fair enough. Point taken. And when goods were tangible, like diamonds and water, and value came primarily from atoms rather than from bits, the law of diminishing returns generally held and marginalist reasoning worked.
But marginalism went too far. Economists said that profit-maximizing firms will equate marginal revenue with marginal cost. In a perfectly competitive market, or so they said, price will equal marginal cost. (In a less than perfectly competitive market, as the firm expands output, it has to lower its price. Taking its demand curve into account, the firm sets marginal revenue—a number that is less than the price that it charges—equal to marginal cost.)
Neoclassical economists said that your wage as a worker will be set equal to the marginal revenue of what you produce. If an additional hour of your work enables the firm to produce 10 more widgets, and widgets sell for $2 each, then your wage will come to $20 an hour.
In the twenty-first century, marginalism does not apply to pricing or to wage-setting. To understand the contemporary economy, we have to think in terms of overhead. Real-world business is often dominated by overhead.
Overhead, or fixed cost, is all of the cost that a firm incurs even if it sells no output. You need to pay for tax compliance. You need a business license. You have advertising and marketing expenses. You need to develop and refine your product. You need IT infrastructure. As you get bigger, you need middle managers, a human resource department, finance and accounting, a legal department, janitorial staff, security guards, and on and on.
Next time you are hospitalized yourself or visiting someone else, look around you and note all of the overhead. Compare it to the marginal bag of IV fluids or the marginal time spent being worked on by a doctor or surgeon.
For many businesses, the marginalist approach would suggest a price that is too low to cover overhead. In fact, the marginal cost is often zero. The marginal cost is close to nothing for:
—an airline with empty seats to carry another passenger
—a telecom firm to provide the bandwidth you need for a phone call or to view this web page
—an app to serve an additional user
—a college to allow an additional student to take classes
In all such cases, if the seller were to follow the marginalist principle, its price would not be high enough to cover overhead. It would lose money and go out of business.
A better pricing rule would be to set price equal to or higher than expected average cost, which is based on a projection of the number of users.
One of the first examples of this that caught the attention of economists was amusement parks. Their costs are almost all overhead. Walter Oi wrote a paper about it, with the delightful title: A Disneyland Dilemma: Two-part Tariffs for a Mickey Mouse Monopoly.
Price Discrimination Explains Everything
An even better pricing strategy is to come up with a way to charge more to customers who are willing to pay more (inelastic demand), and to allow other customers (elastic demand) to pay less. That way, both types of customers contribute to covering your overhead, with the inelastic customers paying more.
There are many examples of price discrimination in practice. If Disneyland charges an entrance fee plus a per-ride ticket fee, it gets the most out of both types of customers.
Why do stores issue discount coupons? Because coupon-users are sensitive to price, but people like me are not so sensitive. So you charge more to people like me. Special sales also serve to attract price-sensitive users, while less price-sensitive users ignore the sales and pay more when they buy.
Why do airlines charge less to people who book weeks in advance or who fly standby? Because other who make reservations a few days in advance are likely to be business travelers, who are less flexible in their travel plans and are willing to pay more to get on a specific flight.
Why does a quart of milk cost more per ounce than a gallon of milk? Because the person buying the quart isn’t going to run to another store to get a lower price per ounce, but the person buying the gallon might do so.
One of my catch-phrases is price discrimination explains everything. By that I mean that most of the strategic decisions that firms make in marketing their products are attempts to implement price discrimination. This in turn helps them to cover overhead.
Business strategy ignores the marginalist rules. Managers put a lot of effort into coming up with ways to implement price discrimination. They don’t put effort into making marginalist calculations.
Conversely, economics textbooks ignore business strategy. They devote little attention to price discrimination. We need The Overhead Revolution.
Most Labor is Overhead Labor
Garett Jones once observed in a tweet that most people don’t produce widgets. Instead, they work on producing organizational capital.
Organizational capital includes new products as well as projects to improve the efficiency of production and distribution. It includes all of the business functions that we earlier said go into overhead—tax compliance, human resources, etc.
Organization capital is produced in “lumps,” not in discrete measurable units suited to marginalist calculations. Moreover, it is produced by teams, not by individuals. There is no sense in which a firm can measure the marginal product of a tax accountant or the marginal contribution to a product enhancement of a member of the team working on the project.
So how does the firm decide how much to pay you? It tries to pay you just enough to keep you from quitting (or from “quiet quitting”), but not much more than that. And if it decides that your team is not producing organizational capital that is valuable enough to justify the expense, it probably will decide to lay off the whole lot of you rather than reduce everyone’s salary and wait to see who quits and who stays.
Marginalism is an interesting theoretical construct, worth learning. And there may be some situations in which it provides a decent approximation for research purposes.
But the real world of business is increasingly dominated by overhead. Economists should more fully embrace The Overhead Revolution.
This essay is part of a series on human interdependence.
Arnold
I’m a small business owner. Four employees. Service not manufacturing.
And your right, my cost of next customer is minimal. Cost of first customer is huge.
After forty years, I’ve noticed that most cost is now paying for - to ideas .
Like, insurance, car, liability, employee, social security.
Accounting. Advertising.
And taxes.
Minimal costs for supplies, truck, tools.
Interesting
Thanks
Clay
Milton Friedman would agree with your comments, but with an important caveat. Businesses and consumers don't literally make decisions at the margin. But participants in competitive market situations behave *as if* they make decisions at the margin. The tools of marginal analysis help to explain how markets arrive at equilibria nonetheless. The HR director at a large corporation doesn't need to make decisions at the margin. Accountants command a certain level of compensation because of all the millions of decisions that accountants and their employees make over time and employers are willing to pay that level of salary after they figure out the work that the last accountant hired does is necessary to the company's success. At the margin, the (public) company that hires too many accountants will be less profitable, and investors (at the margin!) will be less willing to invest additional capital in such companies, etc., etc. It's as von Hayek suggested, the state of the economy is the result of millions of decisions made by millions of people (even if decisions are made by simple rules). One can still describe the state of the economy using marginal analysis if no one agent uses marginal rules for decision-making.