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Pricing and Large-Scale Production

(Part of a series of articles on pricing.)

Last time I discussed how different goods, and even methods of production, are always in competition with one another to be used in the satisfaction of human purposes.

Production on a large scale adds important elements to the topic of pricing.

The law of diminishing marginal utility implies that a factory owner who produces 5000 widgets will not place a high marginal utility on additional widgets, yet marginal utility is the fundamental determinant of prices — trade will only take place at a price between the marginal utility of the seller and the buyer.

With large-scale production, the seller's marginal utility is likely to be near zero or could actually be negative due to costs of inventory storage and transportation. What impact does this have on the price?

In order to answer that question, the issue of time also needs to be addressed. If the seller must liquidate his inventory quickly he would indeed be willing to virtually give it away. In contrast, if the seller is in no particular hurry, he will plan his sales in an effort to maximize his revenues.

The seller will prefer to sell his product gradually instead of all at once. because the buyers are also subject to the law of diminishing marginal utility. At any particular point in time, there are a finite number of buyers for his product, say 100, making an average of 50 widgets available for each person. Those people will attach very little marginal utility to their last widgets and would therefore be willing to pay very little for them.

Imagine that the users of widgets consume them over time at a rate of approximately one per week. The 5000 widgets thus represent approximately a year's supply of widgets for the 100 buyers. If the seller can make a transaction with each buyer once per week instead of once per year, he will benefit by bargaining against each buyer's full marginal utility (the difference between having one unit and having none at all) each week. This strengthens his bargaining position.

The foregoing may not be obvious because there is another principle implicitly at work in that example: Time preference. Due to uncertainty about the future (and other factors that would take us off-topic) people place a higher value on having their wants satisfied in the present than in the future. People prefer to have their diverse short-term needs met before obtaining a large supply of widgets not needed until the future. Several practical concerns factor into this: The possibility of buying other more urgent and perishable things (such as food) with the funds spent on the 49 "extra" widgets, the need to store all those widgets through the year, the attractiveness of the widget-pile to widget-thieves, and even concern that widgets may become obsolete during the year so that buying so many would be a waste of money.

A robot might value 50 widgets all at once equally with 50 widgets throughout the year, but a person would not. A person would only purchase all 50 at once if they could get them at a discount — that's the effect of time preference, that's why one unit per week has a higher marginal utility to the buyer and therefore a potentially higher revenue for the seller.

The issue of time has another impact as well. Over a long period of time, there is effectively a floor on the price of a widget: For the widget producer to remain in production, his revenue must be sufficient to cover the costs involved in producing the widgets he sells. The average revenue from a widget must equal or exceed the average cost of producing a widget. This is not a "hard" price limit because it is possible to run the factory at a loss for a short period of time, but it must be taken very seriously when considering what is possible and what is not possible in the long run.

UPDATE 2004-01-04 21:40:08 UTC: Removed the last paragraph because I decided to adjust the order of future installments.

Tiny Island