Production Cost and Price

When determining the price of something, one factor that you may take into consideration is the cost required to produce it. Keep in mind that the production cost by no means determines the price, as production cost is simply a limitation on new supply. The level of demand for the product is just as important, and changes in demand can even cause price to drop below production cost!

Branded products especially can have considerable margins between cost and price, as these are effective monopolies. Apple is not the only smartphone producer, but they are the only seller of iPhones, and iPhones have their own internal supply/demand that is relative to the overall demand of smartphones. Apple can leverage this by charging a premium for their reputation and marketing, which are not necessarily production costs.

Even unbranded commoditized products can have their price moved away from the production cost if the supply is controlled by a small group; the OPEC cartel controlling oil prices is a good example of this.

However, in a competitive free market, deviations on price away from the production cost are very often due to over/under investment, and so the market incentivizes participants to push the price back toward its production cost. Some examples:

• A sudden unexpected demand for milk causes prices to increase. Because the actual cost to product milk has not changed, dairy farmers have larger margins and therefore greater cash flow to re-invest to expanding production. As production increases, prices begin to fall back down toward the break-even point.
• A company anticipates there will be a large demand for apples next year and so invests a large amount of capital expanding their farm production. The next year comes and the expected demand increase never arrives, and the company is stuck with a large amount of apples. The company is incentivized to sell their apples below the production cost (at a loss). The company scales down their production for next year, increasing the price of apples back upwards toward production cost.
• Demand for bitcoin suddenly drops, bringing the price below the mining production cost. The most inefficient miners go bankrupt until production cost drops below the new lower price.

In general: the most competitive free markets have the smallest profit margins; price and production cost trend towards eachother.

Note also that a lack of [[ Elasticity ]] on either the supply or demand side can cause price to temporarily deviate away from the production cost. These time delays are one of the major causes of commodity price oscillations.