I wrote a post some time ago titled: 30 Basic Points on Economics.
Point #6 was:
“Cost has nothing to do with price, other than to say: If it costs more to make something than it can be sold for, it does not get made.”
This concept – that price has little to do with cost – is hard for many to get their head around.
A great example, of this, is a conversation I had when I worked at a summer camp years ago.
I occasionally helped out in the camp store, and one afternoon the store manager and I were busy putting price tags on t-shirts.
The manager casually said: “We paid $10 for each one of these shirts. Should we charge $15, or $20 for them?”
I replied: “Who cares what they cost. What do you think we can we sell them for?”
The manager replied:
“We are charging cost-plus. We sell these shirts for 20% over cost. And this stack here, we always charge 50% over cost.”
I took a few steps back and pointed to the bargain bin of dishevel discount shirts:
“How much over cost do we charge for these?” I asked.
“See? Price has nothing to do with cost. All that matters is what we can sell them for. These bargain shirts have been here for years. They are marked down to $5 each. And we can’t even sell them at that price! The same goes for this stack we just bought. If we sell out of them charging $40 each, wouldn’t we order more and start charging $50 each.”
What the store manager didn’t get is that the price paid, or charged is what someone is willing to pay for it.
What if you ran an oil company?
Maybe you have an LLC in your name and own 1 oil well.
The cost of getting the oil out of the ground and ready to be sold is $40 per barrel.
Guess what? You are going to sell that oil for the market price – your cost has nothing to do with it.
The second part of what I said originally was: “If it costs more to make something than it can be sold for, it does not get made.”
The example of your 1 oil well-owning company still applies.
If the price of oil is $30 per barrel for an extended period of time, guess what?
You are going to quit running your oil well. You turn it off!
Which is another way of saying the same thing:
“If, in the long-run, it costs more to produce oil than oil can be sold for, know oil reserves will not be harvested.”
And you know what?
The same is true for t-shirts:
If in the long-run, it costs more to buy camp t-shirts than camp t-shirts can be sold for, people will eventually stop ordering camp t-shirts.