Link between costs and prices

[cmadevarajan]

Friends,

I practice as a Cost Accountant based in India. My job involves correct allocation of expenses to products/services to arrive at the cost of the product/service. This facilitates better cost management practices in companies. This is also subject to audit and we also submit a cost report to the management. Such a Cost Report is also submitted to the government in the case of select companies in select industries for select products.

Can this input on company cost structures and thereby industry cost structures and its drift over a period of time linked with price movement provide necessary inputs to the regulators signalling the begining of asset bubbles.

I am looking for inputs, feedback, advice, resources on the above subject.

Many thanks and kind regards,

Devarajan

[liberty_student]

It’s a pretty complicated topic.

Is it a question about the capacity of regulators to spot market trends? Is it a question about what trends in cost drift can tell us? Is it a question about common methods to determine the creation of bubbles?

[ClaytonB]

No. First of all, costs and revenue are only weakly linked and that only by competition. If I purchase an RV for $250,000 and then realize I need to sell it to pay off my mortgage before I die, I may have to accept a paltry $100,000 just to get it off my hands . Businesses run into this sort of situation all the time where they ordered too much inventory and only later realized their mistake. But the market is unyielding, you cannot raise the price people are willing to pay on account of your own folly. “I paid $250,000 for it, it’s worth $250,000” “Yeah, but I can buy the same thing new for $150,000 now … goodbye!”

On the flip side, if I buy land in a remote place where nobody wants land and then suddenly there is a new rush to build retirement communities right where I bought the land due to the good climate or whatever, I can be in a situation where I paid pennies on the dollar for the land. I stand to earn 10x, 100x, 1000x profits. Again, costs and revenues are only weakly linked.

Now, most of the time, in competitive markets, we know that marginal revenue is driven down until it is equal to marginal cost. But this marginal analysis is only applicable to the “evenly rotating economy” as Mises called it or “perfect competition” as mainstream economists call it. The real world differs in important ways (specifically: (a) people’s desires are constantly changing (b) no one can see very far into the future, even in areas where they are expert).

For all these reasons, the answer to your question is “no”. Regulators cannot see asset bubbles forming - not by any means - until it is too late. Regulators have no special powers of observation that participants in the wider market do not have. The only way regulators can have special knowledge is if they are corrupt and colluding to manipulate the market.

Clayton -

[liberty_student]

@Clayton

For all these reasons, the answer to your question is “no”. Regulators cannot see asset bubbles forming - not by any means - until it is too late. Regulators have no special powers of observation that participants in the wider market do not have. The only way regulators can have special knowledge is if they are corrupt and colluding to manipulate the market.

Hedge funds are market place regulators, and I can assure you, many of them can indeed see asset bubbles forming early because they bet their capital on those observations.

[Smiling_Dave]

Fascinating question.

The first requirement of an asset bubble is credit expansion, meaning the govt printing money, and/or lowering interest rates, so that there is plenty of new money looking for a place to be invested. Without this requisite, where will the money come from to blow up the bubble? Answer: from nowhere, so there won’t be a bubble.

Next is to look for, not a rise in costs, but a rise in PRICES, of some asset. Then the question arises, why has the price of this thing or group of things gone up so suddenly? Do more people really need it [= plan to keep it], or do they think they will make money buying it now and selling it later at a huge profit? If the latter, watch out, a bubble is being blown up.

An important clue is if you hear people saying “Prices of Thing X ALWAYS go up.”

[ClaytonB]

No, hedge funds are not market regulators. A regulator has some coercive power - the power to levy fines or fees or to imprison.

Clayton -

[liberty_student]

@Clayton

No, hedge funds are not market regulators.

Of course they are.

@Clayton

A regulator has some coercive power - the power to levy fines or fees or to imprison.

That is completely irrelevant to my response. Of course any human has the potential to detect the early stages of an asset bubble.

[ClaytonB]

@Clayton

No, hedge funds are not market regulators.

Of course they are.

Name a hedge fund with the power to levy fines and fees on other market participants or to imprison them (or exclude them from the market).

@Clayton

A regulator has some coercive power - the power to levy fines or fees or to imprison.

That is completely irrelevant to my response. Of course any human has the potential to detect the early stages of an asset bubble.

I denied that regulators can systematically detect bubbles any better than the wider market. It goes without saying that specialists in any particular market can detect asset bubbles. In fact, this is one half of speculation, the other half being the detection of excess asset depreciation (and buying into it). However, no one can specialize in everything and that includes regulators. So, no, regulators cannot detect bubbles until it is too late.

The issue you’re discussing is whether Alan Greenspan or Ben Bernanke can detect inflationary bubbles and the answer is: of course they can because they’re the ones doing the inflating. They know that injecting cash into the economy will cause asset bubbles and they know that with well-aimed, yet subtle, adjustments to the regulatory structure, this inflationary cash can be “guided” into specific asset classes where the corrupt, central-bank insiders can buy early, sell at the peak and then do one better by shorting the market as it crashes, making a killing on both the upside and downside.

Sickening.

Clayton -

[liberty_student]

Clayton, you continue to misunderstand my post, which is probably why your responses are not relevant at all.

I said market place regulators. Not state regulators. Not bureaucratic regulators. I said market place regulators. They regulate firms naturally through the price system. You do not need coercion to manipulate the price system, you only need lots of your own capital. This is capital markets 101.

Now understanding the brilliant point I had made, go back and re-read what I wrote.

[ClaytonB]

@liberty: OK, well, the OP was asking about government regulators of the market. Is there anyone other than yourself who uses the terminology you are using?

Clayton -

[cmadevarajan]

Thanks for your reply.

It is about what drift in the cost structure over a period of time when compared with the movement in prices can tell us.

It cannot be seen in isolation.

Costs are certain because it is an expense/expenditure INCURRED, unlike prices.

Moreover what are prices for a seller are actually costs for the buyer on actually buying a product or a service.

[cmadevarajan]

Thanks Dave for the reply.

What/who determines the price. Many refer to market as if markets are someone/thing tangible. Mr.Market sets the price tone. Really??

Credit expansion and availability of excessive capital in the hands of few / many may create want which may not have existed prior. But if this basic premise does not exist there wont be manufacturing innovation, there wont be customer segments and there may not be luxury items only value for money items.

Would you like to elaborate your point on price a little more?

Thanks once again for your time.

[cmadevarajan]

Many thanks Clayton for your reply.

I will soon revert on your above point of view.

thanks.

[Lilburne]

“Costs are certain because it is an expense/expenditure INCURRED, unlike prices.”

Costs are determined by prices, and thus ex ante are uncertain. Costs are only certain ex post, but then so are prices.

[wolfman]

I think I have a very good answer. As an accountant & economics major myself I can be of help.

Asset bubbles become obvious when ROA (at market price not book basis) ratio decreases faster than changes in income. This is even more detectable in booming times where income is increases but asset values increases way faster; therefore droping the real ROA ratio.

I hope that helps my friend.

[Smiling_Dave]

@CMA.Devarajan Swaminathan

Thanks Dave for the reply.

Your very welcome.

What/who determines the price. Many refer to market as if markets are someone/thing tangible. Mr.Market sets the price tone. Really??

The price is determined by the law of supply and demand. Meaning that, at any given moment in time, every single person has in his mind, however vaguely, the following thought. “I am willing to buy a plasma TV [or whatever product we are talking about] if it was being sold for $300 or less.” [Of course, the number varies from person to person. One may be willing to spend only $300, another may be willing to go as far as $700, for the exact same product]. And every seller of plasma TV’s has decided “I am willing to sell it for X dollars or more, but not for a penny less.”

The seller tries to estimate the highest price he can get away with that will at the same time give him plenty of customers. He tries it, and if it doesn’t work, lowers his price until he gets nearer to what he wants, plenty of money and customers. Traditionally, the LOWEST prices that still turn a profit are the most profitable, since they get so many more customers. Strange but true.

So in a sense the market is someone tangible. It is all the people who have the product for sale and all the people who have an interest in [and ability to pay for] the product, engaging in either overt or covert haggling. And yes, that is what sets the price.

Credit expansion and availability of excessive capital in the hands of few / many may create want which may not have existed prior. But if this basic premise does not exist there wont be manufacturing innovation, there wont be customer segments and there may not be luxury items only value for money items.

I’m not sure what you mean here. What is “this basic premise”?

Manufacturing innovation is driven by the desire to make money, also known as greed and, more politely, the desire to improve ones lot in life and support ones family. Because if one can innovate something, either in reducing costs of production or making the product more desirable to consumers, they will buy your thing instead of the competition’s.

But as I said in the earlier post, a bubble, which means an increase in prices that is doomed in advance to drop right back again, is not caused by increased desire because of an improved or cheaper product. By definition almost, a bubble is an increase in desire for a product not because one intends to keep it, but to sell it on eventually to the next fool.

Even luxury items need not be objects of a bubble. If people are richer and more of them want to buy yachts to keep and sail the seven seas, that will increase prices of yachts, but it will not be a bubble.

The difference between candidates for a bubble and legitimate price increases [created either by less supply and/or greater demand] is what they buying it for? To keep, or to sell later on for a profit?

And let me point out that even in the latter case, it may not be a bubble. Say some speculator does his research and concludes correctly that copper will be in great demand in two years. He himself has no use for copper, but intends to sell it two years from now. So his buying copper, even thousands of people buying copper for the same reason as him, is not creating a bubble. Because he is right. Prices WILL go up, and stay up, because people really will need copper and will be willing to pay for it.

Only if many many people MISTAKENLY think prices will go up long term [usually the mistake involves thinking they will go up forever] and buy it with intent to sell at a profit later, will they be disappointed. That will be the bubble, the temporary increase in prices, and the bubble will burst when prices drop. This can happen for various reasons, usually when the last sucker willing to buy it for a high price has run out of money. So with no one to buy, prices will have to drop to get the things sold.

There is also a similar kind of bubble, the business cycle as described by Mises, too intricate to go into here. It too, has to begin with credit expansion.

May I suggest you avail yourself of the free books here, that will introduce you to the Austrian [i.e true] understanding of economics. If you feel like spending money, you could do worse than one of Peter Schiff’s books, like Crashproof, or How an Economy Grows.

Would you like to elaborate your point on price a little more?

Thanks once again for your time.

YW, and good luck.

[cmadevarajan]

Grayson says “Costs are determined by prices”

If that is true then no organization would suffer losses. Would they?

If you look at costs as input points and prices as output points. Then costs are certain as you have already incurred them in anticipation of selling the product/service at a particular price point, which may be realised or not.

To that extent the above statement is not true.

[cmadevarajan]

I agree Wolf (wish I could refer you with your real name )

“Asset bubbles become obvious when ROA (at market price not book basis) ratio decreases faster than changes in income. This is even more detectable in booming times where income is increases but asset values increases way faster; therefore droping the real ROA ratio.”

In principle yes. However, accounting returns have a lot of mumbo jumbo in it which does not make its way into the cost structure of a product or service.

[liberty_student]

@CMA.Devarajan Swaminathan

Grayson says “Costs are determined by prices”

If that is true then no organization would suffer losses. Would they?

All entrepreneurial activity entails risk bearing. Grayson’s point (I believe) was that cost is just one half of transaction. To the seller it is a price, to the buyer it is a cost. So if your firm resells Widget A, and you buy them from my factory, it is your cost to acquire Widget A from my factory. But it is my price that I am selling them to you. And my price, is also based on my costs, which are the prices of land, labor, capital for my factory, as well as raw materials.

At the end of the day, the process starts with an entrepreneur challenging uncertainty, and establishing the beginnings of a price structure which cascades through development and delivery of goods to the final consumer.

So again, costs are not determined necessarily by you at the time you buy Widget A. They are already somewhat established (and vulnerable to changes) earlier in the chain of production.

@CMA.Devarajan Swaminathan

If you look at costs as input points and prices as output points. Then costs are certain as you have already incurred them in anticipation of selling the product/service at a particular price point, which may be realised or not.

Even if you contract for delivery of Widget A, that doesn’t guarantee you delivery of Widget A. Without Widget A at our contracted price (your cost) your price structure may no longer be viable.

This is more than an exercise as prices are constantly changing throughout the economy, reflecting real resource availability, demand and even the amount of currency available to facilitate exchange.

If we’re talking about the firm qua firm in isolation, your points assume rational expectations. If we’re talking about cost/price in the greater economy, and their effect on the firm, then rational expectations are not useful to us, in my opinion.

[Lilburne]

What liberty student wrote was spot on.

Mr. Swaminathan, if you are talking about such macroeconomic matters as predicting asset bubbles, it makes no sense to refer to such a microeconomic notion as costs. Like liberty said, one firm’s cost is another firm’s earnings. From the perspective of the whole economy (and not an individual or an individual firm), there is no meaningful standard according which you can divide exchange ratios into “prices” on one hand and non-price “costs” on the other.