Wednesday, September 24, 2014

Opportunity Costs

I have always made the assumption that the concept of opportunity costs was one that people inherently understood and incorporated in their behavior. Playing online games has disabused me of that notion.

Now, most people understand the concept on an intellectual level even if they have not seen a definition. Formally opportunity cost is, in economic terms, the opportunities forgone in the choice of one expenditure over others. Informally, it is the cost of not being able to do A if you choose to do B instead.

Now why has online gaming made me think that people do not in fact apply this to their behavior? Well, it started back when I played WoW right after Lich King came out. My main was a blacksmith and I was looking to make some extra gold with that skill. Since the expansion had just come out there was a high demand for the crafted starter plate PvP gear. By comparison, not many people had advanced their blacksmithing skill high enough to craft said gear. So, the price was rather high in the marketplace. I made a tidy profit by buying raw ore from miners sending it over to my alt that could smelt ore and getting the refined metal bars over to my blacksmith to craft the gear where I could easily sell at a 100% markup. At some point, as more blacksmiths entered the market and more people were moving beyond the starter PvP gear, the price dropped but I was still making a profit. Eventually, the price of the gear became less than the price of the metal bars it took to create the gear. Considerably less. Complaining about this in guild chat, one guildmate replied "Well, they might be mining the ore themselves and that is why they can still make a profit."

This is where opportunity cost comes in. Sure, by mining their own ore and refining it then crafting gear they are not strictly losing gold like I would have if I had continued crafting those items. However, the idea that the ore they mined was free is quite false. At that point in the marketplace they could have just sold the ore/metal bars for more than they were selling the PvP gear. In fact, they were actually destroying the wealth they could have been making by crafting. As a big believer in rational markets this drove me crazy.

Fast forward many years to me starting to play EVE. Naturally, as a person that professionally deals with markets and business on a financial level, I was drawn to the rather deep and extensive player run economy of EVE Online. Looking to make some ISK doing manufacturing, since I like the concept of building things, I started to run the numbers on various manufactured goods. I found that many of the popular ships and modules were being made at a loss. This is even calculating with perfect material efficiency.

It turns out that EVE has a similar saying to WoW in that "The minerals I mine are free." This idea is still false in EVE for the same reasons I gave in my WoW example. It doesn't matter how much the raw materials cost you to acquire. The only way to determine profitability is to value them at the price you could sell them at. If more people take that mindset we would be well on our way to a more rational market place.

(As an aside, Eve Cost, is a fantastic tool to gauge profitability of all your industry activities. I highly recommend it.)

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