The price of everything

“Do you have common sense?” my seven-year old daughter once asked me. Obviously, I replied “Yes, I suppose so”. “Then, answer this question” she continued “a man goes to a car showroom to buy a car. He sees a car made of silver and another car made of gold. Why did he buy the golden car?” she asked (she is well aware that gold costs more than silver). “Maybe, because he liked the golden color” I said. “You’re wrong” she said “he bought the golden car because he had more money”.

She had a point. A car of any make, size or color would serve the purpose of transporting the man from one point to another. That is its ‘utility value’. But a ‘perceived value’ may be quite different from utility value of a car. Perceived value comes from factors like travel comfort, safety or style. The same is true for any product or service we buy.

Have you ever wondered as to how everything is priced? In an ideal world (all things being equal), the branded pizza that I ordered last week should have cost exactly the same as it would cost, if I made it in my kitchen.

If I was a die-hard believer on making a pizza myself from end-to-end, I will have to grow the wheat, grind it into flour to make the pizza base, rear a cow to give me milk to make cheese and butter; and grow the vegetables in my garden (I may take a few months to make one pizza). This choice is of course not available to most of us. The bottom line is that the cost of my pizza will be substantially lower than the branded one (not counting the cost of my time). I may take an alternate route - buy the basic ingredients and just “assemble” the pizza in my kitchen. It will definitely cost more than the “do-it-all-yourself” approach, but still less than the branded pizza.

Then, why should I be ready to shell out more money for a branded pizza, knowing that I was being robbed blind (with my eyes wide open)?

When you think about it, for the branded pizza outlet, the cost of making a pizza is the aggregate of four factors of production – men (cost of labor), material (cost of the ingredients, rent, electricity, advertisement and the like), capital (interest on loans) and enterprise (everything else that you can think of).

As is most often the case, the pizza outlet may have bought most of the ingredients and services from vendors and will have paid more than what it would cost it in a ‘do-it-all-yourself” model. Those vendors, in turn, will have sourced much of their wares from someone else. All this has a cascading effect on costs. But even with the cascading costs, economies of scale and bargaining power should drive down the real cost for the pizza outlet to even lower than what it will cost me to make in my kitchen.

We are back to the same question – why do we pay more for everything we buy? Is it because we have more money than we need, like the man who bought the golden car? Think about it.

Money matters

From barters, we have for long become accustomed to using money in our trades. Many things changed with the advent of money.

If you think about it, we are still using the barter system. The only difference is that money has become an intermediary; the means to complete an exchange. If you don’t agree, then answer this question – do you consume money? Of course not – you consume goods and services bought with money. And how do you make money - by exchanging something, like your labor. So effectively, you are exchanging your labor to buy something you wanted.

Money decoupled the barter transaction. In a barter trade, you knew exactly what you were giving up in exchange for something that you wanted. In the example of my previous post, you knew that spending half a day’s labor will get you one stomach full of food in exchange. If your neighbor asked you to spend a full day’s labor in exchange for one meal, you may disagree and demand that you need two meals in a day to survive. Today, if you buy yourself an expensive piece of clothing, it may never occur to you that you are bartering a day’s labor (for example) in exchange for your dress.

With money, came the disease of “poverty”. A simple definition of poverty is “the state of being poor”. A poor person is the one who lacks the means to access goods and services to meet his basic needs. The reference here is to absolute poverty and not relative poverty.

In the Stone Age, no one may have been ‘poor’ as natural resources were available in abundance to meet the needs of a tiny human population. Even today, Earth has sufficient resources to support the ever growing human race. Then why do we have the ‘poor’? The answer is clear – our economic systems have denied the poor access to basic necessities. Unlike in the Stone Age, our civilized society attaches a cost to every natural resource and consequently, to every human activity. In simple terms, for a poor person, there is a mismatch between his purchasing power and the cost of satisfying his basic needs like food, water, shelter, clothing, sanitation, education and healthcare.

As we shall see in future posts, the way we control access to natural resources, the way we price everything and the way we have arranged our economic affairs are largely responsible for creating conditions of absolute poverty for a large number of people.