Friday, May 5, 2017

Bryan Caplan on Pricing and Market Power

by Levi Russell

Previously on the blog, I've shared Bryan Caplan's interesting perspective on monopoly and market power. He recently wrote another post that is at least as interesting as the first one I discussed. Below I reproduce the first half of his post.
In the real world, prices often seem far above marginal cost.  Yesterday, for example, I bought a pair of tweezers for $14.99.  But it's hard to see how the marginal cost - metal, electricity, transportation, miscellaneous - could even reach $1.00.  That's a markup well in excess of 1000%.  If you're steeped in the perfectly competitive model, where price always equals marginal cost, it's easy to feel "ripped off" whenever you make a purchase.

The obvious rebuttal is to point to all the fixed costs of production.  While the marginal pair of tweezers costs pennies to produce, the first pair plausibly costs millions.  Factoring in fixed costs, tweezer producers are probably roughly breaking even.  So how is that a "rip-off"?

But on reflection, this greatly understates what a fantastic deal we consumers get.  To see why, I often invoke my Consumer Gratitude Heuristic.  Here's how it works.  When I bought my tweezers, I asked myself, "How much would it have cost me to make these tweezers all by myself?"  On reflection, the answer is... more than my lifetime wealth!  I'd have to spend years learning the basics of mining and metallurgy to acquire minimal competence.  And after a lifetime of training, I still probably wouldn't have the skill to make a single tweezer as good as the one I bought at Wegmans.  $14.99 versus more time than I have on Earth: that's what I call a bargain.
Caplan goes on to note that this is not an exceptional case. Indeed it isn't; Leonard Reed's famous "I, Pencil" is really a great example of what Caplan is getting at as well. If you're interested in more technical economics on this, I suggest a (tragically forgotten) paper by Armen Alchian (short summary at the end of this FH post) on fixed cost and marginal cost.

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