Economics lesson part 4

Product creation and pricing this time.

X coconuts per year sales - Y cost of raw materials - Z cost of labor - Q other costs = profit.

Let's reset with Herbert, Suzy and Tom.

Each has two coconuts.

We'll stick with Tom this time.

Tom knits hats. The raw material (yarn) costs one coconut for enough to make five hats.

Each hat takes one week to make, and he can sell a hat for one coconut, continuing to mean that his labor is worth one coconut/week.

At the end of five weeks Tom has made and sold five hats, and his materials cost one coconut, for a profit of four coconuts. That's X - Y = profit.

But what of his food needs? If that is one coconut per week, he's losing ground, because his expenses over five weeks were actually six coconuts (one yarn and five foods), and his income was five, meaning he's losing money.

Tom needs to work faster and make six hats, and hope that there's a sixth buyer.

OK, let's say there are LOTS of buyers. Tom can actually sell as many hats as he can make.

So can Tom make six hats in five weeks? Yes, but not because he becomes more efficient, he decides he has to work longer hours, about two more hours, but this gets it done, and now his income equals his needs.

This can continue indefinitely, as long as the cost of raw materials does not go up, and his customer demand does not go down.

In fact, if those two conditions are true, Tom can hire Suzy to make hats too,  but that is only going to work out if she makes hats at the same rate he does, otherwise HER hats aren't worth as much, and then his aren't either.

Wait, how is that true?

Tom makes six hats in five weeks, worth one coconut each.

Suzy makes FOUR hats in five weeks, but they are priced the same. So now two people are making ten hats in five weeks, and selling them to the tune of two coconuts per week. But Tom's previous sales rate was actually 20% higher. The hats are now worth less, because total production rate is down (where production rate is actually quantity divided by workers).

Suzy needs to improve or Tom has to fire her. Or achieve some other kind of efficiency or economy of scale. If he raises his sales price, that will reduce sales volume just slightly, but really not much changes.

Tom needs a knitting machine, but he lacks coconuts to buy one with. OK, let's skip that aspect, too complex. Tom's mother gives him fifty coconuts and he buys the machine. The machine can make one hat per day. Production volume is huge. Tom lets Suzy run the machine, he doesn't even MAKE hats any more. He handles the increased sales by himself. Instead of making 60 hats by himself per year, or 100 with Suzy, they now make 365 hats, and sell for 365 coconuts. This is WAY better.

The material cost of the hat hasn't changed, it's still 1/5 a unit of yarn = one hat, which means 73 coconuts per year material cost. (Actually that probably wouldn't be true, the machine probably wants a slightly different yarn, etc, but we'll skip that.) Suzy's labor cost is still one coconut per week, for a total of 125 coconuts per year operating cost (52+73), leaving 240 coconuts for Tom.  And Tom repays his mother after six months, for a net profit for the year of 190. Next year Suzy gets a raise of one coconut per month, aka 64/year. Sales are again 365, operating cost is 137, for a profit of 228. Tom is happy with this, because his final profit for the year is 176 after his own personal expenses. He was barely getting by before, but the machine ("automation") has made him rich, almost overnight.

After a couple of years the local market starts to saturate, and sales volume goes down. He has to expand his market. This will actually cost money, but it is a good investment to do so, and again his market rises to meet his manufacturing capability.

Then he discovers that he is receiving orders faster than he can fill them. What to do?

Two possibilities: (1) buy another machine. That doubles his production capacity, but could lead to market saturation sooner, again reducing sales. Or, (2), he could raise prices so that the demand drops off enough that sales orders = production capacity.

As always, the situation is more complex, because what happens when Suzy wants to get paid more? After a couple of years, Suzy decides she can buy the same machine and go into business for herself as a competitor.

At this point Suzy has to decide where to locate, else there is a local race-to-the-bottom on pricing, and Suzy is going to lose because Tom has enough coconuts reserve to ride out the price war, and she actually has debt from having to borrow to buy the machine.

So Suzy goes into business far far away, and all is good. Or she doesn't go far away, and figures out how to make a different kind of hat. That changes the competition.

But the pricing strategy is still pretty basic:

X coconuts per year sales - Y cost of raw materials - Z cost of labor - Q other costs = profit.

Pricing on a lot of things you buy is arbitrary--lots of businesses don't have too careful a price-determining method. "Charge what the market will bear" is the phrase. If there are enough customers at 100 coconuts per sales unit and you make an interesting profit, then 100 coconuts doesn't really have to reflect an actual cost.