In every trade, both sides gain value. That’s why they choose to do it. In the modern world, one side gets money and the other some sort of asset or service that they would prefer to have over the money. But by how much would they prefer to have it?
Someone starving would be desperate for food but will pay the same low price for some basic food that the rest of us pay at the supermarket, including those of us who are well-fed and well-stocked but just fancy some little extras.
Similarly, I might place extreme value on an obscure and not very good board game that I played a lot in my childhood, while others do not care for it at all. A re-publication of the game will create great value for me but very little for a board game collector who likes to have new games but already has better.
‘Consumer surplus’ is the term for the value that a purchaser receives above the purchase price. It’s not just the price someone would be willing to pay if they had to bid for an item. Poor people get value from food, or travelling to see family and friends even though they cannot bid as much as a rich person who already travels first class. But the price someone would be willing to pay is a decent way to estimate the consumer surplus of small, individual purchases.
For example, I enjoy a certain brand of fruit pie. I was happy to pay £1.50 for a box of six, and stretched to £2 when the price went up, but I have better options now that it is £3. Back when it was £1.50, the consumer surplus was perhaps £1 of value.
We can immediately tell that profits and consumer surplus combine to make the difference between the cost of a product and its value. A higher price gives more profit and less ‘consumer surplus’. These two concepts must therefore be negatively correlated. As one goes up the other goes down, all other things being equal.
Basic economic theory teaches us that companies will sell at the marginal cost to produce a product: that competition in a perfect market will ensure that no company can charge more than the cost to make one more item, or else a competing product will undercut it.
One could regard this as a starting point: an economic model simplified enough to allow students to understand some basic concepts. This is the argument economists make, as no-one believes that companies can’t even recoup capital investment. The question is whether it’s a reasonable starting point.
Sadly, it’s so wildly unrealistic it’s like teaching biology by assuming that animals get their energy from the sun via photosynthesis, as (most) plants do. All of behaviour and biochemistry, and everything in between, contradicts this ‘simplification’. There is no perfect market, nor can we ever reach an approximation of one (in the whole economy: I am sure that some enterprising economist has found something at a moment in time that matches these fantastic ideas).
Some points about selling at marginal cost:
1. The economy is in constant flux, despite political incentives to zombify it to avoid people losing ‘their’ livelihoods, no matter how inefficient or uncompetitive they are. One of the principles of the perfect market is that it is in the equilibrium state. There can be no equilibrium; we are far from it. I entirely arbitrarily estimate that it would take the economy a decade to reach equilibrium, in which time no world events, no climate events, no political policies, no birth, death, education, ageing or change in tastes must occur. The economy is a melting pot; a bubbling mess of new ingredients, servings being extracted and mess scraped off the bottom.
2. There are many small markets for whom reaching customers is the bigger barrier than price. There is no infinite demand and infinite competition, nor equilibrium before which investment has been paid off, and so the marginal cost to produce cannot cover the overheads (fixed costs no matter how much one produces, such as the factory equipment and CEO salary). One could include a share of overheads in the marginal cost to produce, but that rather ruins the definition.
3. Investors demand a return. One could include investor service in the marginal cost to produce, but this makes a mockery of the idea of investing for profit, since costs are supposed to be obligate costs. Investor return requirements mean that the marginal extra production dilutes profitability. Greater absolute amount of profit is earned, but the costs need up-front cash even if there is no further capital or overhead requirement. Working capital (money needed to run the business day-to-day, such as buying materials before sales proceeds are received) is still capital, and investors might prefer it to be elsewhere even though this leaves demand unsatisfied. Higher investor returns across an economy or a sector mean less demand satisfied, as production will be skewed further away from marginal production (assuming that cost of production always tends lower to a minimum), and therefore less total consumer surplus.
On a side note, matching desires to products has a cost: typically one the customer bears in the form of time invested in reviewing options. Larger markets, with more options, increase that cost, such that there can be no perfect market with all options available, as consumers would take infinite time to review infinite options. Apparently there are studies showing that people tend, on average, to look at only seven options before making a decision. I do not know what products this was tested on. Hammers would be a very different market from cars, for example. Since reaching infinite consumers is impossible, price yet again cannot tend to marginal cost to produce.
Modern algorithms claim to help with this problem, but in my experience really do not; they are an advertising tool to create desires, prey on weaknesses and satisfice rather than maximise consumer surplus. A fuller criticism of advertising is a subject for a whole essay.
Let’s imagine that our entire economy is person A making a product and selling it to a customer, C.
But person B comes along with some innovation. Either the product creates more value for C, or B has lowered the cost to produce. The gap between the cost and the value, the potential consumer surplus, is larger. The increase will be shared between B and C depending on relative power; in the modern world, politicians have given up on representing the people and prefer to represent the wealthy owners of enterprises who are more likely to donate campaign funding – funding is far more powerful than the off-chance that uninterested voters will notice good things done in their name. Companies also sell to many customers, so customers have far less power.
Ideally B would produce at marginal cost due to all the ‘perfect’ conditions that comprehensively never apply to the real world, and the innovation would all (negligibly different from all) be consumer surplus: value to the consumer. Instead, B will recognise greater profits. There is a direct conflict between profits and societal good.
On which note, yes, some additional profit is required to incentivise innovation, assuming that innovators are motivated solely by greed and could find a good place in the undisrupted economy equal to the profitability of A’s original business. If more, why innovate just to reach a level of income that was already available? Innovation is risky: there must be some uncertainty associated with pushing the boundaries of possibility, or else the innovation has already been made. This is the argument in favour of risk that is trotted out whenever anyone wants to reward risk-takers. Sadly only a small fraction of risk is risk in innovation. Most is simply gambling.
For example, what innovations might cause someone to switch products? It could be advertising creating a (greater) desire for the new product; breach of regulation allowing cheaper production with some risk, a new market due to new discoveries made by others (new lands, new technologies…), social change, fraud or actual personal invention.
Let’s ignore all this and assume that B genuinely creates value and allows most of it to be consumer surplus.
Our little economy is ready to expand. Let’s imagine more people in it: B sells the new, better product to more people. Customers D, E, F, G …. D15 all buy the new product and B makes 365 times as much profit. Let’s assume that this is enough to cover the cost of the original innovation and provide B’s annual income; it is a functioning, solvent business.
B now has hundreds of data points about customer behaviour, an established business and a reputation with customers, suppliers and investors. He now has experience of running business in this sector. He can grow, expanding into new markets, perhaps recreating precisely what α used to sell to β, but β is now familiar with B and buys from him instead. α goes out of business and B is the only supplier. This is just one example; a business might grow as shown in the chart below.
As B’s business grows economies of scale kick in. He can get more from manufacturing machines because he can run them at full capacity and have a market for the goods. People naturally follow other people, including for reasons such as discussed above, that sifting through options is actual work, and trusting someone else’s choice is easier; and that people assume that familiarity and size correlate with trustworthiness (when often it is the opposite). People believe that popularity implies value, and if you can reach a threshold of popularity growth will become easy.
I shall call all of this ‘organisational thixotropy’. It is easier to do more of something when you have already done it, for a multitude of reasons. The systems, processes, customers, skills, supply chains, contacts and reputation are already in place.
The same size overhead in a bigger business is a smaller fraction of revenue, so B can keep prices low while still expanding into new markets or advertising for a bigger fraction of existing markets. Advertising and innovation have the same effect as each other; consumers perceive greater value in the product. The large company can afford to fund both and its size makes both easy.
Customer data allows for further insights. Business can be tailored to what customers do, both to extract money from them through methods such as reaching out to them when they are weakest, and by improving product offerings. Let’s still call this innovation, even though some creates value and some can be said to destroy value. The causes of B’s company’s growth in this little story are shown in the second chart, below.
B becomes a multi-billionaire. Let’s call him Jeff. A personal myth grows around him, and like most billionaires he believes it, that he is a hard-working genius who pulled himself up by his bootstraps. A phrase created, I believe, to describe the impossibility of such an action. Fawning writers (simps, to the younger generation) discuss his life story and hold him up as a role model; millions around the world either feel unworthy because they have not achieved so much or feel motivated to work very hard to get ahead in the system that allows such success.
All are deceived. How much value did Jeff actually create?
He created the small innovation that took 365 sales off B. In this story, that’s about £50k of value. At that point in our story organisational thixotropy took over. The rest of the profit obtained (one might traditionally say ‘value created’, but profit directly reduces value to the world) comes from riding a bubble of growth. Yes, there needs to have been some successful management along the way, but B will have had investors, advisors and employees contributing to decision-making and success; and powerful bubbles can override many bad decisions (c.f. early-years Facebook, when Zuckerberg was a hindrance that investors publicly complained about).
Jeff does not deserve billions from creating a monolith. The natural forces of the economic system we allow to exist created the monolith. Jeff created a seed; one of many, and his happened to be the one that rolled sixes in its early stages. Jeff created one marginal improvement and the advanced products now available are a result of societal/economic processes that cannot be ascribed to him. Even his one improvement, in a world of perfect competition and innovation, would have become rapidly outdated, so we cannot even say with certainty that the £50k he earned from innovation should be a regular income; it should dwindle as the product it created becomes out-competed by even newer ones.
So far this has been just a story. I believe it to be an accurate one, but even if it seems far-fetched to you, the question to answer now is: what part of the story makes it fiction, not an accurate description of the modern world? What fact or flaw in reasoning makes the whole thing fall apart? If there is any plausibility to it; any doubt at all about the merits of our billionaires; then we should be outraged that they are permitted still to be so wealthy.
On which note, ‘billion’ is just a word. It’s easy to lose track of how much money that is. Various people have calculated that Elon Musk is richer than Smaug, the fictional incarnation of evil and destruction that owned a mountain full of gold – more gold than exists on earth – and whose greed and lust for wealth whilst doing nothing of value is a direct metaphor for evil, and whose baleful presence kept all humans around him poor, even while it was their trade that had generated much of the wealth he hoarded.
The richest family in the UK was estimated a year or so ago to have wealth of £28,000,000,000. The median salary in the UK remains under £30,000 p.a. Let’s call it £28k/year. A skilled worker, with a valuable qualification and some intelligence, can earn double that. That means that three brothers (now two) had more wealth than it would take a skilled worker (not a lazy layabout!) 500,000 years to earn, even if he spent none of it. In reality, people probably accumulate a small fraction of their income as wealth. If we say 10%, a skilled worker would need 5 million years to save as much wealth as these men already owned.
Is it justifiable that an above-average earner would need the entire existence of humanity (300,000-800,000 years for homo sapiens; a few million years for homo habilis) to earn as much wealth?
Or, to put it another way, the current base rate of interest is 4.75%. The richest family in the country would earn £1,330,000,000 a year if they bought government bonds, equivalent to the earnings of 23,750 skilled workers. Let’s assume that each of the three brothers contributes fully, such that each is the equivalent of 8,000 skilled workers. Does anyone truly believe that one of these men gets more done in one hour than 8,000 skilled people? If we get one of them in a room for an hour, will we be doused with more insight than we could get from our choice of 8,000 people? I have met them, and the answer is no.
The question is not significantly changed if we allow it to be a family enterprise and assume that 8 relatives all contribute to each brother’s share: 1,000 skilled people are still far superior in every way to one person. For example, I used to work at the organisation that audits the whole of government, checking the financial figures of 40% of the economy. The National Audit Office is roughly 1,000 people. I challenge any reader to find me one human who, with any equipment currently available, can audit all of government.
If consumer surplus was small, then the incentive to switch to a new product is greater, even if the increase is small in absolute terms, because the multiple is greater: you might be getting many times as much value from the transaction as previously. This means that badly-run economies which are not maximising welfare are more susceptible to snowball effects.
This is why the unicorns and start-ups of today get investment and burn through it. Everyone knows, perhaps only subconsciously, that genuine innovation only gives small rewards. The goal is to use the potential consumer surplus of innovation or advertising (or the other sources mentioned above: fraud, breach of regulation etc.) to grab market share and create the snowball effect of organisational thixotropy. The whole technology sector, including the established entities and their oligarch investors and owners, is a lottery of winners and players hoping to win (again). No matter how hard you play at gambling your winnings are not earned. They are a quirk of chance.
Many of these tech oligarchs recognise this consciously. They talk about generating value but know that their wealth comes from luck, often bought with cheating such as breaking regulations. But even those that created some value, somewhere, are not responsible for billions in profits… they are merely responsible for choosing to make those billions profits rather than value for society.
If I had the chance to be a billionaire, would I turn it down? I only have the one life, and my welfare matters to me. Faust sold his soul for less – a cautionary tale that moral virtue does not lead to wealth, nor vice versa. One can empathise with succumbing to the temptation to extract so much from so many, especially in a world where others do it and get away with it. But not respect or admire the decision. It is wrong, no matter how understandable, and those who make it are not intellectual gods.
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