Cost plays an important role in consumption. When our cost rises we tend to buy less. When it falls we tend to buy more. Economists label this phenomenon as the demand curve. It graphically reflects increased consumption as cost falls. This is usually shown as a downward sloping curve with cost on the X axis and quantity demanded on the Y.
The logical extension of the demand curve as cost falls to zero is that demand becomes infinite! Now, nothing is really free: everything has a cost. But the important point is that goods that appear to be free have huge demand.
Decision Making in the Absence of Cost Information
However, we often see decisions made without knowing the cost.
Consider the hypothetical decision faced by an engineer who must specify the metal used in wire to transmit electricity between from a power plan through transmission towers to a factory. He has three materials to choose from: A, B, and C.
The engineer is under great pressure to quickly finalize the design and cost information is unavailable. However, he does know the conductivity of the alternative metals. C is a best conductor, while A is the poorest conductor. What material do you think he is likely to choose?
C is apparently the logical choice because it is the best conductor. Now it turns out that metal C is gold and it is a fact that gold is a terrific electrical conductor. But, as I write this gold costs $1822 per ounce!
Gold transmission lines could certainly be built and installed. However, the decision would be extremely expensive: certainly not cost effective. Moreover, there would probably be a lot of thieves risking life and limb to take down those lines! Since many decisions are made in the absence of cost information it makes one wonder how many metaphorical gold wires are out there.
Today’s market price for metal A is in the range of only $.08 to $.16 per pound. This is less than a thousandth of gold’s cost. Should the engineer choose metal A because it is the lowest cost material? Well, it turns out that metal A is cast iron and it is such a poor conductor that it glows red hot went transmitting electricity. That’s why it is used in heating elements for hair dryers and toasters!
Cast iron transmission line could certainly be built and installed. They would be inexpensive and the glowing wires would also provide some light on dark nights! However, they would probably start fires, break easily, and require enormous amperage.
So it develops that cost is not the only criterion for decision making. Conductivity is also important. Metal B, copper, has very good conductivity and is the best choice even though it costs over ten times the cost of cast iron. This is a cost informed, not a cost dominated, decision.
Other Possible Economic Issues in the Demand Curve
The economic theory of the demand curve is very straight forward and logical. Economists, however, assume that cost is known and that cost is accurate. As shown above it can be unknown. It can also be the case that it is inaccurate
For example, I once saw a case where a very sophisticated aerospace company’s cost accounting system grossly understated the cost of electron beam welding. They thought they were the world’s best at electron beam welding because companies from all over the world were flying in parts for them to weld!
The reality is that they were losing money on every part. (See forthcoming blogs on allocation pitfalls.)
The opposite can occur to the company that grossly overstates cost. Demand for the apparently high cost goods will diminish and that company will be missing business where they should have been competitive.
There is great value in having accurate cost information when setting prices.
The Point
Cost is an important input to decision making that impacts choice and consumption. While it is not the only important factor for decision makers, it must be included in the decision making process. In the absence of cost information some other factor (like conductivity) is overvalued. Or worse: rules or laws might be imposed to artificially effect behavior.
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