Wednesday, November 24, 2010

The perils of making your money on the buy side*

*Everything you always wanted to know about opportunity cost but were afraid to ask.

Markco has an article today reposting a letter from one of his readers which contains an important truth about playing the gold game:
"It is at the time of buying when you set yourself up for future profits. But the profit potential that you control is 100% related to your buying decision."

But there is one thing that bothers me when many gold bloggers talk about this, and Dale, the letter writer, repeats the possible fallacy when he says:
"That person that is selling below "your" cost is very likely still making a profit if you are basing cost on auction house prices. This means they are getting their materials cheaper than you."

Perhaps they are making a profit. But they might not be making a profit on *crafting*.

One thing Gevlon consistently harps on that is crucial to understanding how to play this game is opportunity cost. The appropriate cost of an item is not what you paid for it. It's what you could get for that item if you sold it, or used it another way.

Ignoring the market for an item is the basic fallacy behind "I farmed it, so it was free". Leather is not free. Ore is not free. Herbs are not free. You may not have paid any gold for them, or you may have bought them for much lower than market price, but if you post current high-demand trade goods at 70-80% of the standard market price, they are going to sell and sell fast. Probably no matter how many you have, they will all sell, and if you have a moderate amount, you should be able to get 90-110% of standard market within a few days.

Let's suppose some fool just sold me a few bags full of borean leather for 1g/stack. (market range on my server runs 50-90s per leather, or 10-18g/stack).

I look at the auction house and see that borean armor kits are selling for 1g. Here's the crucial question: Am I making a profit if I craft some and sell them for 99s? NO, I am not. Making those destroys value. I know that leather will sell in quantity for 50s a piece minimum and often up to 75s ea, so somewhere in that range is how I should count the cost when deciding whether to craft something with it.

Remember the crucial line about buying: I made my money when I bought the item. That's absolutely true. As soon as that leather came into my hands, my net worth increased by at least 9g per stack that I bought.

Now, when I craft, I am making a separate decision about what to do with my leather. And in this step, I can either add value, or destroy it. If I craft borean armor kits for only 99s value, I am destroying value. If I craft heavy leather, I'm probably adding value (usually sells for at least 4.50-5g ea.), and I may add even more value converting to furs and crafting leg armors (currently 150-175g) or by crafting some of the leveling or basic pvp pieces

If someone else is consistently selling at or below my cost and the components are items with a strong high-volume market -- I don't need to wrack my brain about how to buy the stuff cheaper to get back in that market. I don't need to craft that item, they can have their zero/negative-profit market, and if I find the mats cheaply, I will sell the raw materials instead.

The only time it makes sense to ignore auction house price for materials is when the raw material market is too low-volume to compete with the crafted market as an opportunity to sell my stuff.

A good example would be snowfall inks versus runescrolls or off-hands during wrath. I spent some time in the ink business -- I'd mill craploads of herbs for ink of the sea, and creating snowfall ink at the same time. Now, there was a sweet spot with people going for insane before the shattering that let me sell piles of snowfall ink, but go back to the summer -- a typical ah price for snowfall ink was 8-10g ea. And people would buy it, but rarely in huge quantities. I would post 5 singles and a couple 5 stacks every 2 days, and sometimes they'd all come back to me, only rarely did they all get bought, most of the time I'd sell a few. I was generating far more than I could sell at that price. But the problem wasn't a high price. If I listed my snowfall for 5g, I would sell a little more, but still not enough to get rid of it all.

So it made sense to craft scrolls and offhands instead. And even if the price of those dropped to where costing snowfall at 8g ea (standard market price at which I sold it) made them break even or a small loss, it still made sense to craft them, as long as they were profitable with a minimal/zero cost for snowfall, because I would never get rid of all the snowfall otherwise.

So the crucial rule is:

  1. if you can reliably move the raw material on the auction house for market price, then the cost of using that item is the market price, no matter how you acquired it, or for what price.

  2. If you cannot reliably move the raw material in quantity for market price, then cost is whatever profit you could make from some alternate use of the item that would let you get rid of it all. If runescrolls are flying off the shelves at prices making you 5g per snowfall after other items are accounted, then you probably shouldn't craft offhands unless you can get at least 5g per snowfall from those as well. It's legitimate to treat your snowfall ink as a waste product and consider it as "free" only if every feasible way to get some value out of it won't use it all up.

I've seen a lot of glyph sellers boast about how they could make a profit selling glyphs for some very low amount (like 1.5g before glyphmas), because they had a connection to get their herbs for very very cheap. But this is a mistake if between your herb market and your ink market, you can support big sales at levels significantly higher than 1.5g/ink or 10g/stack of herbs. Even if you buy your herbs for 5g a stack, you should just sell herbs or ink rather than go to all the trouble of making and posting glyphs that you can't sell for more than 1.5g ea.

This is the #1 basic economic fallacy: a failure to understand opportunity cost. It's the same thing you see with the many people who will equip, rather than sell, an expensive twink item if they get a lucky drop or find it on the ah cheap, but would *never* dream of paying something near market price for it. Somehow gold in their bag seems more valuable than gold they could get for something -- even if the sale really is a sure thing.

I've seen it with poker players as well. I used to read regularly. A number of posters would always play satellites in an effort to win a seat in the WSOP main event. They would treat it as getting to play in the WSOP if they won a satellite. They would *never* pay the 10k to play if they didn't win a satellite. But even though you could sell those entries for 95-99c on the dollar, they never even considered doing that if they won a seat.

But this is the same principle. Cashing that event ticket costs you the same 10k whether you won it in a satellite or pay it out of your own pocket. Either it's worth wagering 10k to play the event or it isn't. If it isn't, then you should sell your ticket when you win it as long as you can get fair value. If it *is* then you should be willing to play whether or not you win a satellite.

The general take is this: judge your crafting profit by the opportunity cost of the items you use, not by your actual cost.