Thursday, April 28, 2011

Visible Variable Costs Uber Alles!

When figuring out what measures will reduce costs people love to fixate on variable costs. They doubly love to fixate on variable costs that are highly visible. They tend to downplay fixed costs, and anything hidden.

Witness, for instance, the hype about Hybrids and electric cars. This is the principle taken to the extreme. Petrol is a visible variable cost for the environment. The more you drive, the more you use. And since you think of it every time you fill up your car, it's highly salient to you.

Now, when you buy a Prius, there is also the fixed cost of the manufacture of a second motor and the battery. This second battery and motor also require more services and replacement parts. None of this comes for free, either in terms of money or resources used. But that's not salient to people, so they ignore it.

With electric cars, the comparison is even more extreme. The car produces no greenhouse gas emissions, because it uses no petrol at all!

Unless you count the emissions from the power plant that makes the electricity. If that's a hydro power plant like in the Pacific Northwest, great! If it's a coal-fired power plant like in the Midwest, it's not clear you're helping at all.

But as long as it's not my emissions, it's okay. It's the evil power plant!

I'm not saying that these types of cars are necessarily not a good deal, or a net benefit to the environment. I'm just saying that the vast majority of the people who bought them probably never stopped to consider these costs properly. 'Lower petrol consumption' is my rough guess at how sophisticated the average thought process is.

I think this is part of the fixation with solar and wind power. People have the idea that since the sun will always shine and the wind will always blow, once you pay a fixed cost then it's free forever! Surely that makes it a bargain, no?

Well, first of all there's maintenance. Solar and wind power sources degrade, get broken, and need to be repaired.

But even if they didn't, the average person doesn't understand the value of a perpetuity. In other words, suppose the interest rate is 10%. How much should you be willing to pay for $20 per year, forever? It must be, like, an infinite amount of money! Or at least a huge amount of money!

No. You should be willing to pay $200. That's all.

Even if solar power pays off until infinity, if the payoffs are small and the upfront costs are high, you still don't want to do it. Matter of fact, "the payoffs are small and the upfront costs are high" is not a bad description of the whole solar power industry at this point of its development.

This isn't just an environmental thing. I remember a childhood friend of mine talking about a lottery in Scotland where the tickets were a couple of hundred bucks to buy, and they held a lottery that paid off a certain amount every week, forever. You could even resell your ticket to whoever you wanted! Surely this was the best deal in the universe. To the young Shylock, this deal sounded so awesome that it couldn't possibly be right.

As I grew up, I figured out this was a simple case of selling an overpriced perpetuity, but in the form of a lottery. You've got to admit, it's a great scheme.

Shylock says learn how to calculate a present value, or you'll end up giving away your money to hucksters and frauds.

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