Something you don't directly mention, but imply is training/documentation costs. People don't live forever, stay in the same job forever, and even if they do they forget things. So we often must make documents/procedures/aids for our future selves, new staff, reactivated staff, and of course our children.
In a very real sense this documentation/systemization is "capital" (personal, org, etc.) but unlike some physical capital, it requires a lot of attention to remain viable.
We see this in the costs of using automated devices like plastic injection molds or cnc milling machines - where it's quite common for setup costs to dominate until quite a large number of parts have been made. These setup costs are part specific - they aren't really "capital" - they're fixed startup overhead.
There's a long history in railroad economics with lengthy literature concerning price discrimination to deal with the problem of overhead. In the 19th century it was often called "value of service pricing." Moreover, there's also a classic article about this problem by one of Keynes's first students, Frank Ramsey: "A Contribution to the Theory of Taxation," Economic Journal (1927) 37, pp. 47-61.
Thank you for this lucid piece. Something to add - it seems to me anyway - is the Bureaucracy Factor. All large businesses become bureaucracies and those bureaucracies develop a life of their own and one that does not necessarily align with the best commercial interests of the business. An example is the commissioning of advertising. My father, who worked in advertising all his life, used to tell me that advertising often didn't have any commercial benefit; it worked to satisfy the advertising department - to make them feel useful, sophisticated, trendy , to provide contract handouts to their mates (in their social circle) etc etc. I think this principle (if widened out from my specific example) goes a long way to explaining the apparent paradox of huge corporations embracing 'Woke' - often with very negative consequences for their bottom line.
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.
The quart of milk may cost more per ounce because much of the cost is in the packaging and transport rather than the quantity of the product. So getting a quart of milk to the store shelf may cost nearly as much as the half gallon or full gallon, allowing the seller to make an acceptable profit while selling the milk in the larger package at a lower price per ounce.
Coincidentally, I stopped reading the blog entitled "Marginal Revolution", with links that are curated by Tyler Cohen and Alex Tabarrok, in favor of this substack. This entire post has a double-meaning
1 using very round numbers, I think Apple decided long ago that in order to double their market share, they'd have to cut their unit profit more than in half. I'm not sure where that is captured in what you say.
2 I think you are mostly right about the marginal unit cost being near zero in many cases (including railroads of over 150 years ago) but I'd say your examples leave a lot to be desired.
- milk: What you say makes zero sense. The store with the very lowest prices still charges way more per ounce for a quart than gallon. It has nothing to do with shoppers for the gallon being more price discriminate.
- airplane seat (and student). While airlines charge differing amounts to various passengers, the cost isn't per seat. It is per plane. And even on that plane there is a cost of adding a passenger if the plane is full enough that it could become oversold. And lately that has been a real risk as most flights are very full, even if in recent years airlines have gotten better at avoiding oversold situations.
To say this all differently, if a seller produces thousands or millions of units and they might add a handful of units here or there at virtually no cost, that really doesn't tell us their marginal cost is near zero in what is a meaningful way.
Telecommunications regulators in Canada have been practicing Ramsey pricing (incremental cost plus a markup to cover fixed costs that reflects inverse price elasticities) for some thirty-five years now. Granted, they seldom have precise price elasticities, but the principle is there, e.g. higher markups to business customers than to residential customers). I note in passing that, for traffic-based services, the marginal cost is zero: you can always carry an extra gigabit of traffic without any capital outlay or operating expense. The proper measure is incremental cost, i.e. the extra cost of the volume of traffic that you are considering in your decision. The cost will vary according to the decision you are contemplating. (This originates in James Buchanan's Costs and Choice, an often overlooked work.)
Exactly. This is the mistake know-nothings make about solar. They look at the kwh price for solar panels and think that means we should convert 100% to solar. But generation is less than 10% of the cost of electricity: most of the cost is overhead (operation and maintenance of transmission and distribution, billing, safety).
If you tried to imagine an optimal economy, it would be mainly overhead. I'm thinking of the machine - SPOILER WARNING - in Forbidden Planet, an old science fiction movie based on The Tempest. It was an immense machine, self maintaining, self improving, that could provide anything anyone wanted by merely thinking about it. That expensive machine meant zero marginal cost. - MORE SPOILER - How expensive was it? It's makers the Krell were gone. A spaceship was reported lost there. As the movie begins, a rescue patrol ship has arrived to investigate.
It's a surprisingly good movie for its era, both good science fiction and a fun take on Shakespeare. It also has an economics lesson for which I'll thank this blog.
> 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.
That also happens a lot. Hence why so many of these industries are either monopolies or near monopolies.
"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."
Economic theory suggests that a firm would never choose to set price equal to marginal cost. Either they have no choice over the price (price takers), or they choose to set price above marginal cost--above the point where MR=MC.
Economic models already fully account for "overhead", not sure what's wrong with these models.
As for milk, it's less than 4 times as expensive to retail a gallon of milk as a quart of milk, so the per ounce price would be lower even without price discrimination.
Great insight on economics, marginal analysis, and overhead.
A huge amount of overhead is to help with management decision making. What is the real status, how does it compare to our expectations, what can we do to improve our (team’s) numbers? Improvement involves lots of uncertainty about alternative decisions, with unknown trade offs between costs & benefits. I hope AI helps top management make better decisions, and think lots of overhead labor is at risk of becoming redundant, much lower value.
Lousy example of milk, tho, because efficiency of scale explains it better; Walmart lower prices are based on this. Why does 7/11 milk cost more than Walmart? Because of convenience, the total price of everything bought includes time, locations to travel, and storage costs at home.
Price discrimination does explain real business decisions better than marginal prices, but comparison to competitors is also important. For small companies, most important. Thus very few 7/11s open up next to Walmart, tho Walmart might open up near an older 7/11.
Alternatives, opportunity costs, dominate most decisions.
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
Great post. I was up at 4 am this morning, so got carried away with my response, looking at this idea in the context of the semiconductor industry, in case anyone’s interested in such things: https://nothingbadsofar.substack.com/p/overhead-revolution-semiconductor?sd=pf
Something you don't directly mention, but imply is training/documentation costs. People don't live forever, stay in the same job forever, and even if they do they forget things. So we often must make documents/procedures/aids for our future selves, new staff, reactivated staff, and of course our children.
In a very real sense this documentation/systemization is "capital" (personal, org, etc.) but unlike some physical capital, it requires a lot of attention to remain viable.
We see this in the costs of using automated devices like plastic injection molds or cnc milling machines - where it's quite common for setup costs to dominate until quite a large number of parts have been made. These setup costs are part specific - they aren't really "capital" - they're fixed startup overhead.
There's a long history in railroad economics with lengthy literature concerning price discrimination to deal with the problem of overhead. In the 19th century it was often called "value of service pricing." Moreover, there's also a classic article about this problem by one of Keynes's first students, Frank Ramsey: "A Contribution to the Theory of Taxation," Economic Journal (1927) 37, pp. 47-61.
Thank you for this lucid piece. Something to add - it seems to me anyway - is the Bureaucracy Factor. All large businesses become bureaucracies and those bureaucracies develop a life of their own and one that does not necessarily align with the best commercial interests of the business. An example is the commissioning of advertising. My father, who worked in advertising all his life, used to tell me that advertising often didn't have any commercial benefit; it worked to satisfy the advertising department - to make them feel useful, sophisticated, trendy , to provide contract handouts to their mates (in their social circle) etc etc. I think this principle (if widened out from my specific example) goes a long way to explaining the apparent paradox of huge corporations embracing 'Woke' - often with very negative consequences for their bottom line.
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.
The quart of milk may cost more per ounce because much of the cost is in the packaging and transport rather than the quantity of the product. So getting a quart of milk to the store shelf may cost nearly as much as the half gallon or full gallon, allowing the seller to make an acceptable profit while selling the milk in the larger package at a lower price per ounce.
Coincidentally, I stopped reading the blog entitled "Marginal Revolution", with links that are curated by Tyler Cohen and Alex Tabarrok, in favor of this substack. This entire post has a double-meaning
1 using very round numbers, I think Apple decided long ago that in order to double their market share, they'd have to cut their unit profit more than in half. I'm not sure where that is captured in what you say.
2 I think you are mostly right about the marginal unit cost being near zero in many cases (including railroads of over 150 years ago) but I'd say your examples leave a lot to be desired.
- milk: What you say makes zero sense. The store with the very lowest prices still charges way more per ounce for a quart than gallon. It has nothing to do with shoppers for the gallon being more price discriminate.
- airplane seat (and student). While airlines charge differing amounts to various passengers, the cost isn't per seat. It is per plane. And even on that plane there is a cost of adding a passenger if the plane is full enough that it could become oversold. And lately that has been a real risk as most flights are very full, even if in recent years airlines have gotten better at avoiding oversold situations.
To say this all differently, if a seller produces thousands or millions of units and they might add a handful of units here or there at virtually no cost, that really doesn't tell us their marginal cost is near zero in what is a meaningful way.
Telecommunications regulators in Canada have been practicing Ramsey pricing (incremental cost plus a markup to cover fixed costs that reflects inverse price elasticities) for some thirty-five years now. Granted, they seldom have precise price elasticities, but the principle is there, e.g. higher markups to business customers than to residential customers). I note in passing that, for traffic-based services, the marginal cost is zero: you can always carry an extra gigabit of traffic without any capital outlay or operating expense. The proper measure is incremental cost, i.e. the extra cost of the volume of traffic that you are considering in your decision. The cost will vary according to the decision you are contemplating. (This originates in James Buchanan's Costs and Choice, an often overlooked work.)
It would be interesting to see your list of revisionist economic ideas.
Exactly. This is the mistake know-nothings make about solar. They look at the kwh price for solar panels and think that means we should convert 100% to solar. But generation is less than 10% of the cost of electricity: most of the cost is overhead (operation and maintenance of transmission and distribution, billing, safety).
If you tried to imagine an optimal economy, it would be mainly overhead. I'm thinking of the machine - SPOILER WARNING - in Forbidden Planet, an old science fiction movie based on The Tempest. It was an immense machine, self maintaining, self improving, that could provide anything anyone wanted by merely thinking about it. That expensive machine meant zero marginal cost. - MORE SPOILER - How expensive was it? It's makers the Krell were gone. A spaceship was reported lost there. As the movie begins, a rescue patrol ship has arrived to investigate.
It's a surprisingly good movie for its era, both good science fiction and a fun take on Shakespeare. It also has an economics lesson for which I'll thank this blog.
> 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.
That also happens a lot. Hence why so many of these industries are either monopolies or near monopolies.
I'm not sure I know what this means:
"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."
Economic theory suggests that a firm would never choose to set price equal to marginal cost. Either they have no choice over the price (price takers), or they choose to set price above marginal cost--above the point where MR=MC.
Economic models already fully account for "overhead", not sure what's wrong with these models.
As for milk, it's less than 4 times as expensive to retail a gallon of milk as a quart of milk, so the per ounce price would be lower even without price discrimination.
Great insight on economics, marginal analysis, and overhead.
A huge amount of overhead is to help with management decision making. What is the real status, how does it compare to our expectations, what can we do to improve our (team’s) numbers? Improvement involves lots of uncertainty about alternative decisions, with unknown trade offs between costs & benefits. I hope AI helps top management make better decisions, and think lots of overhead labor is at risk of becoming redundant, much lower value.
Lousy example of milk, tho, because efficiency of scale explains it better; Walmart lower prices are based on this. Why does 7/11 milk cost more than Walmart? Because of convenience, the total price of everything bought includes time, locations to travel, and storage costs at home.
Price discrimination does explain real business decisions better than marginal prices, but comparison to competitors is also important. For small companies, most important. Thus very few 7/11s open up next to Walmart, tho Walmart might open up near an older 7/11.
Alternatives, opportunity costs, dominate most decisions.