I'm Shrijith Venkatrama, the founder of Hexmos. Presently, I am building LiveAPI, a super-convenient engineering productivity tool. LiveAPI processes your code repositories at scale and automatically produces beautiful API docs in minutes.
As I build LiveAPI, I am also making an effort to learn about various economic matters & share it here with you.
I am reading Adam Smith's - Wealth of Nations to understand economics better.
I'd rather read someone like Smith, with the original words of original thinkers, rather than dry "summaries" or more hodge-podge collations of higher quality works.
I may not understand everything, or I may not even understand most things, but the spark of vigorous thinking is of great value to experience.
For that purpose alone - it is worth making the effort.
Price is a fundamental concept in economics, and Smith explains it in simple terms as the sum of three key components: Wage, Profit, and Rent.
I've simplified Smith's original exposition into an oversimplified representation like so:
Price = Wage + Profit + Rent
This post explores these components in depth, drawing on Adam Smith's principles and applying them to modern examples.
From Raw Materials to Product: The Role of Labour
Every product starts as raw materials. To transform these raw materials into something valuable, businesses need labour and often some form of infrastructure. The equation is straightforward:
Labour + Raw Materials = Product
As more processes are applied to a product, it becomes increasingly refined or sophisticated. These added processes generally increase labour costs relative to rent costs. For example, consider a relatively sophisticated product like the MacBook, (hypothetically) priced at $1,000.
A MacBook represents the culmination of immense skill across diverse and challenging fields such as engineering, design, marketing, sales, and manufacturing. The quality of labour drives the product's value, far outweighing the contribution of rent. Apple, the producer, operates on a roughly 40% gross margin for the MacBook. Assuming labour costs also take up 40%, the remaining 20% can be attributed to rent, covering physical stores, offices, and operational licenses.
So, the price of a MacBook breaks down as:
MacBook Price ($1,000) = Wage ($400) + Profit ($400) + Rent ($200)
This distribution emphasizes how insight, expertise, and know-how dominate the cost structure of sophisticated products like the MacBook.
People, Profits, Infrastructure: Another View of Price
Product pricing can also be analyzed by splitting it into three broad categories:
- People: The more refined and sophisticated the product, the higher the cost related to people (labour). Products requiring specialized skills and expertise reflect this in their pricing.
- Profits: For complex and competitive markets, businesses aim for higher profits to justify the challenges of bringing such products to market. Competitive edges often allow companies to command premium prices.
- Rent: Simpler products, closer to raw materials, often see a larger share of costs attributed to rent. For highly sophisticated products, rent typically forms a smaller proportion—around 20% in the case of products like the MacBook.
Conclusion
Smith's way of looking at enterprise is helpful even today.
For an entrepreneur aiming and trying to do something valuable - it is very important to focus on skill and capability building.
The most valuable products are far from raw materials - they take up many transformations.
Intellectual capital is quite valuable; quality of know-how is super important.
With these, the ideal high value company is excellent people, plus high gross margins, and relatively lower infra costs.
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