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.


  1. The article in question was here for those who are looking for it.

    Your information is interesting, but I was simply talking about the idea that too many players focus on the selling end instead of the buying end of a market. They act like once the item is in their hands they should make a profit off it regardless of what they paid for it. To bring in opportunity cost is kind of a side discussion that just reinforces my point. I purposefully leave some angles of the conversation untapped so as to leave room for discussion (like your post here).

    Also, do not act like opportunity cost is this super easy thing to determine that remains constant at all times. It is always in flux and determined by supply and demand. Holding yourself to a set opportunity cost leaves you blind to the cycles of wow. Saying catch phrases like 'opportunity cost' sounds really intelligent, but they are not the kinds of phrases millionaires use in this game. We use terms like market pipelines and diversification, because opportunity cost is just too narrow minded.

    I'm curious what your opinions are on my overall economic theory article which can be found here:

    Markco-vian Economics

  2. I reread my comment and realized that it sounded kind of rude. You did a good job of explaining opportunity cost in this article and I hope my readers can find some value in your article. I'll tweet/facebook this as well.

  3. I did make my quotes into links to your article, Markco. Is there a more common way to do this that would be clearer?

    I agree with you that determining opportunity cost can be complex. And snowfall ink is a classic example of how it can be complex. At different times and different market conditions, you can profitably use all the snowfall you mill, and determining the best way to diversify it is an interesting problem.

    But for any high-volume material, you definitely can put a lower bound on your opportunity cost at 60-80% of standard market ah rates. Using anything less than that is foolish, because you can almost always unload as much as anybody can farm at those rates within roughly the same time frame as your crafted items might sell.

    And I've absolutely heard bloggers say they were making profit at 1g glyphs, but well, unless their server conditions were *extremely* unusual, then no, they weren't. They were making a big profit buying cheap ass herbs, and maybe making a profit milling them, but it's highly unlikely that 1g glyphs were ever profitable over just selling the inks, or only selling glyphs over, say 2-3g.

  4. This is Dale. I think perhaps I should clarify. I'm talking about specific situations in markets where you have established competition. Markco summed up what I was going for perfectly with "They act like once the item is in their hands they should make a profit off it regardless of what they paid for it"

    Buying cheap always applies, but as you said there are definitely cases where its a wiser choice to flip mats rather than convert them into an item and just because you crafted something doesn't mean you are selling against other people that crafted it.

    That being said I think Markco would agree that it is a rarer occurrence to face competition who is flipping finished goods against you when you are crafting them and if you do wind up in that situation then it means you weren't diligently "buying" those items to flip yourself. Someone else is making money on the buy you could have had.

  5. Take an example: a large server with many uncut gems on the market at all times and they go for around 100g.

    Person A buys an uncut gem
    Person B has a sick two-year-old or a broken leg and gets in lots of snatches and buys gems for 80g
    Person C gets a gem for essentially free - typo on AH; ex-roomate chooses weak passwords, etc.

    Opportunity costs say that all three of these people if rational should sell at the same price. If you argue that B could make a profit at selling the cut gem for 95g, then would you argue that C would and should make a profit selling it for 15g?

    I.e. if they were rational, then what they paid for it would not influence their sale price.

    In my example if cut gems go for 115 gold, then A, B, &C all make 15g from jewelcrafting it is just that B also made 20g in trading profit and C made 100g. So if someone is selling less than you, it may be that they are willing to do it for cheaper than you. I.e., they will get gem from AH and cut it for 5g where you need 10 to be worth the time. But if uncut gems sell for 95g, then none of A, B, or C should sell it for 95g, even though B & C are accounting profitable. ( I.e., you get a $50 gift certificate Visa good anywhere and you sell it for $15; that sale would be a $15 "accounting" profit and a $35 "economic" loss.) I.e., whether you paid 0, 80, or 100 for the 100g of mats did not influence whether a rational seller should sell the result for 95.

    And of course even Gevlon can delude himself into ignoring opportunity cost when it suits him.

  6. that example isn't ignoring opportunity cost, it's discussion the situation I talk about with snowfall ink -- something where you can produce an item at fairly low cost, but you can produce much more than you can sell as a raw material.

    I think this is probably what Markco is getting at with his "diversification" comment. You can only sell so much of most materials. If you have a way to make or acquire tons of them cheaply -- more than you can sell as a raw material, you make more profit selling a bunch of different things that use it, than by only selling the raw material, even if some of the things you sell would not be profitable buying the mats off the ah.

    Arctic fur is actually another good example. On my server, there's almost always a borean leather --> heavy leather --> arctic fur arbitrage. But at the standard arctic fur price or higher, I can usually only sell a couple furs a day. I can sell more only if the price is driven down to where the borean arb makes almost nothing. But I can also make leg armors with the fur, and it is worth doing that even when the fur goes really high, to the point where the mat price is around what the leg armors are selling at. Why? Because at those prices, I can't sell all the cheap arctic fur I can create by buying up borean leather -- so some of it can go into making leg armors.

    Same thing can be true of cut gems. The "market price" of uncut gems is usually a price at which you can sell only a few, and need to diversify, so it's worth selling cut gems for slightly below this price. The price that I consider my "opportunity cost" for gems is what I see advertised in trade for large quantities -- usually represents my highest buy price. I know I can unload a pile at that price, so I shouldn't cut anything I can't sell for more than that.

    But the headline auction house price is not a price at which I can sell 60 uncut cardinal rubies for instance. So it doesn't make sense to use that as my opportunity cost because I can sell 15-20 gems in an evening by listing 6 ea. of uncut, bold, delicate and brilliant, or only 4-5 by listing just uncut. I could list 20 uncut instead of 6, but chances are I'd still sell only 4-5 of them on average unless I cut the price to a wholesale rate (~80-85% of market), and then I'd eat the deposits.