F-Bombs + Marginal Consumption and Production

by JT McGee

marginal cost, marginal cost consumption, marginal profit, marginal production“I’m offering you a subscription to the Daily News at a substantially reduced price,” says a refreshed newspaper salesman, earlier rejected by the same potential customer still on the line.

“We’re trying to reach to people who have never had home delivery before,” he continues.

“Right. So basically you’re saying that everybody else who already has a subscription is getting f***ed on this one?”

“Yeah…uh, I guess so.”

“Alright, well I can handle that.”

The above is a classic conversation from the movie Boiler Room, a film about a young man who works his way up in a less than ideal brokerage firm. Boiler Room is a move everyone should see, if not for the laughs along the way, but for this single conversation between a newspaper salesman and the main character, Seth Davis.

Marginal Cost Consumption

The prevailing lesson to be learned here is that not everyone can be a marginal cost consumer all the time. For Seth Davis to receive a discount on home delivery of the Daily News, everyone else who also subscribes pays a higher price.

The Daily News can offer a lower price because it overprints each issue. A newspaper sold to Davis is purely profit at any price, since the paper would otherwise be thrown away.

There are several personal finance-related products or actions that exemplify the idea of marginal cost consumption:

  1. Couponing – You need not look much further than couponing to find people who really believe that everyone can be a marginal cost consumer. When the television show Extreme Couponing first aired, people took to the internet to join the coupon craze. (See the summer 2011 jump in “coupon” search volume.) It wasn’t much longer that major retailers started calling back coupons, and food producers reduced the value of single coupons. When everyone gets the discount, coupons go out the window. The last thing any business wants to do is turn ordinary customers into discounted customers.
  2. Bread stores – Same thing. Bread stores sell overproduced product at huge discounts. Spoiled food is lost money. Generating revenues of any amount is again pure profit as the product is otherwise thrown away.
  3. Netflix – Somehow people are still of the belief that Netflix can and will displace cable, making access to television far less expensive. Netflix was originally welcomed by content producers because it provided a means to sell content to people who would not pay full price. Today, television content producers and cable companies want more and more money because Netflix is cutting into their cable subscribers. Netflix can certainly grow further by attracting new people to the service, but the price will have to go up for all members. Cannibalizing high margin cable customers for low-margin Netflix members isn’t a good trade-off for cable companies.
  4. Medical Goods and Services – The rest of the world enjoys marginal cost consumption in medical technology on the backs of American patients. Socialized health care operations around the world become marginal consumers of already researched pharmaceuticals and medical technologies. If a pill required $2 in research per pill but only cost $.10 to produce the physical form, a country’s medical system can easily offer to pay only $.15 per pill to enjoy the benefits of marginal cost consumption. Americans, who do not live in a system where costs are negotiated, pay not only for the research required to produce their medications, but also the research required to pay for the medications of everyone around the world. Insurance companies have little reason not to approve any drug at any cost. Each new dollar that passes through health insurance companies to medical companies is a few more pennies of profit. To date, we still hear how the US has the highest health care costs because we do not have a socialistic system. The US doesn’t need socialized medicine in the full form to reduce costs, it just needs the ability to negotiate so that other world citizens also bear a proportionate percentage of research costs.
  5. Community Colleges – Community colleges are the best thing going for individuals. As a community college student, you are a marginal cost consumer who benefits from the subsidies of state and local governments. If everyone were to attend a community college for the first two years of a four-year education, tuition prices would necessarily explode. Granted, community colleges certainly save money from a lack of research. However, smaller class sizes and other benefits are quite costly. There’s nothing inherently less expensive about a community college that would make it fractions of the cost of other universities. Many community colleges take advantage of low-cost real estate in odd corners of a city for lower operational costs. There’s only so much cheap real estate, and state and federal subsidies.
  6. Index funds – Index funds cater to the marginal cost consumer who wants low fees in exchange for less active participation in the markets. The belief is that index funds benefit from a so-called Efficient Market Hypothesis. However, if EVERYONE were to stick their capital in index funds, the markets would be horribly inefficient. Since the S&P500 seems to be the preferred index, imagine the distortions that would arise if funds were invested only in 500 companies of the more than 5000 publicly-traded firms. You can’t have an efficient market unless others work to actively make markets more efficient.

Marginal Cost Production

Just as not everyone can be a marginal cost consumer, not everyone can be a marginal cost producer. I never had an interest in continuing into marginal cost production (this article is already too long!) before I read an article about blaming the economy over at LifeAndMyFinances. You can thank Derrick for not allowing this article to end here!

Here’s a few examples where an individual can enjoy the status as a marginal cost producer:

  1. College – Even if everyone in the United States were to have a college degree, there is no way to say that employment would fall in the aggregate. Certainly, people will degrees do enjoy a lower unemployment rate, and one individual can make the leap from one side to another, but if everyone were to have a degree there’s simply no way that the aggregate unemployment level would fall to that of the unemployment level for people with college degrees.
  2. Blogging – For whatever reason, blogging seems to be the new killer way to make money. I have my own conflicts with that; it’s very difficult to make money when you can’t possibly be a marginal cost producer. I, for one, would continue to write posts that no one reads whether or not I were to be rewarded with a single dime. If your model is for-profit, and someone is willing to operate without profit, it makes it difficult to carve out a business model.
  3. Preparing for interviews – If everyone were to use my interview tips, every tip would lose all value. You can prepare for an interview all you want, and bust your chops as much as you’d like, but you are part of the new normal – the 100%!

The simple fact of personal finance is that any savings you accumulate is most likely to come from marginal cost consumption, and income from marginal cost production. There is nothing that inherently makes one choice less expensive than the next, and to say that EVERYONE can do this, that, or the other to save money is patently false. Hence, marginal.

Likewise, to say that EVERYONE can do this, that, or the other to make money is equally false, though for whatever reason, almost always accepted as truth.

{ 6 comments… read them below or add one }

TheDailyThinker February 15, 2012 at 16:12

Interesting post. I’ve thought about that stuff a fair bit, but failed to use the same terminology. If I understand what you’re saying by “marginal consumption”, two big ones would be cable providers and cell phone companies.

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JT McGee February 15, 2012 at 16:33

Right. Media is a great example. If I make a TV show for $100,000 and sell it to 50,000 people for $3, I generate $150,000 in revenues, and $50,000 in profit.

However, if I make that same TV show and sell it to 50,000 people for $3, and 20,000 people for $1, I now generate $170,000 in revenues and $70,000 of profit. I dropped the price by 66% to attract those additional 20,000 buyers, but I still increase my profit by 40% from $50,000 to $70,000.

If everyone paid $1 for my TV show, I would lose money. I would generate $70,000 in revenues at the $1 cost, and lose $30,000 given my $100,000 cost of production.

In almost every case, the people who save money on particular products save this cash at the cost of the people they belittle – the people who are “dumb” to pay $50, for example, when I pay only $10.

This happens all the time in tech. Early adopters (who value the time value of tech product X at Y price) pay substantially more than the late adopter who gets the same product X at Y-$50 price. We can say the early adopters are irrational, but clearly it’s just the case that having this particular product in hand earlier was worth the additional expense. Naturally, the early adopters pay for the substantial amount of research costs and other fixed expenses, with late adopters paying far less of the fixed costs to produce the product.

As for the terminology – who cares!?

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Dividend Monk February 17, 2012 at 23:03

I’ve seen marketers argue that you should never discount your products.

If you sell customer A a widget for $100, and then put it on sale for $80 to customer B, then you piss off customer A. Maybe that’s ok if the business owner doesn’t really care about relationships and making customer A a repeat customer, but in the long run, it’s probably a bad move.

Examples:

-JCPenney apparently recently decided to eliminate coupons and just provide all-around lower prices.

-Back in Nov ’09, Coca Cola and Costco battled over pricing for Coke products at Costco, and it resulted in a temporary cessation of Costco ordering Coke’s products for their shelves. The reason was that Costco wanted to get Coke at a really great discount, but Coke didn’t want to dilute the power of its brand by selling its products so cheaply. It was likely less about the money, and more about the image. They don’t want to set a low precedent for the prices of their branded drinks. Coke and Pepsi run into the same problem with those soda machines in fast food places- they sell their syrup for such a low cost, and it makes their expensive and basically identical bottled products look like a rip off, so then they try to market their expensive bottled products in those restaurants instead.

So as a consumer, it’s good to find marginal value as long as the time-value of finding that value doesn’t exceed the amount for which you value your time. From a production standpoint, it could be preferable to not discount, or to at least be strategic about discounting and think in the long term.

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JT February 18, 2012 at 15:41

As a marketer – YES! Discounts are the worst way to go. As an investor, I hate to see brands dilute their image by selling through product at a discounted price.

I worked with a jewelry company to improve their online sales funnel. The owner told me of the absolutely horrible returning customer numbers they had. Over the course of a few months, he had discounted aggressively his products at every turn. The customers in this particular funnel were waiting for the right discount to make any purchase.

Long story short, we created a new funnel to split test. The new funnel never discounted, and instead offered only a modest non-price discount on shipping only when it was absolutely required for competitiveness. What we found was that the second funnel was not only more responsive at full price, but more likely to spend several times more than the average order to get free shipping. Whereas he might have discounted his jewelry at 30% around Christmas to his first sales funnel, we offered only free shipping (which amounted to a few percentage points, at best) for larger orders.

(Sidebar: Discounting jewelry at a percentage rate consistently is the worst idea ever! Don’t tell your customers your profit margin – they already know they’re overpaying.)

Christmas rolls around. The original sales process yields a few purchases of mostly single items. The second funnel brings in multiples of the repurchases. Later, we discovered that women in funnel #2 were buying 3 or even 4 different sterling silver sets to give to friends. The original list was horrendously unresponsive, and when they were, they purchased only 1 item at a discounted price, likely the item they were waiting to buy at a discount they had come to expect.

The guy later split his business into two, selling his “odds and ends” at irregularly large discounts to customers to sell discontinued product wasting space and generating carrying costs. The second funnel became standard business practice for the main brand.

I also learned a very valuable lesson here – work on commission, not on a flat-rate. I could have KILLED IT with this client. Instead, I made a (very nice, but not amazing) hourly figure on retainer when I could have likely made tens of thousands of dollars on a sales split. At least I have a great case study and story to remember for a long time. The more you know… ???

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Dividend Monk February 19, 2012 at 11:07

Nice, classic move.

Discounting upwards (via free shipping on larger orders) instead of discounting downwards (via price cuts) seems to almost always be the way to go.

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HowMuchIsIt February 24, 2012 at 16:20

Man, speaking of bread stores. Back in the day, my Dad used to take us to the Hostess Outlet store. You could seriously get bread for $0.25, Twinkies for $0.25 and so much more. It was great! The only downfall is that we had to eat it within 2 days most of the time :/

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