Components of Price
We all studied basic economics about price, supply, demand etc. But here is an equation that tells you the different components of prices.
Zero is also a price!
- Ajay Dwivedi
I once sat in a discussion room where the question was, we know the value of a company, but what will be the price of that company's stock when Ajay Dwivedi made this statement that has since stuck with me.
Price is a different animal.
Yes, it is governed by supply and demand. Yes, it depends on utility, replacement cost, etc. But there are other elements to consider as well. As you think about the price of various things, a toy, a car, a patent, a stock, a company, gold, money, a baseball card (or Pokemon card), etc., you realise the other components of price.
The price equation
Price = Utility Value + Rarity Premium + Monetary Premium + FOMO premium -erosion costs - storage and handling cost + Reference adjustment
Utility Value incorporates the manufacturing cost and replacement cost. However, the utility value may be lower than the manufacturing cost. It also includes Brand premium, etc.
Rarity Premium is the extra price paid for rare items—e.g. classic cars.
Monetary Premium refers to the higher value paid for an item if you can easily use it or convert it into money. Gold, silver and Platinum enjoy a decent monetary premium. Lawful (white) money fetches a premium over black money.
FOMO Premium can also be termed as herd safety premium. It is the extra price paid to be seen to be part of the crowd.
Erosion costs are losses that result from the passage of time without actually using the thing. Thus, oil evaporates, iron rusts, perishables rot, etc.
Storage and Handling Costs refer to how easy or difficult it is to transport and store the stuff. At one point in 2020, there was no storage available for crude oil, and the price of crude oil became negative.
Reference Adjustment accounts for inflation. All of the above components are measured in terms of money. The value of that money itself changes, and that leads to a change in the price of the goods. But I deliberately did not call it inflation adjustment. That is because, since 2005-06, the value of money has reduced a lot more than what inflation figures suggest.
So what?
I was trying to think of reasons why financial markets have strayed so far away from the norm. I think the reasons lie in two variables - Reference Adjustments and FOMO premiums.
As mentioned earlier, since 2005-06, the money supply growth and economic growth have diverged, and the excess money has stepped into assets (far, far) more than consumption items. This money could hold prices a lot higher and for a lot longer than the time horizon for my trades. I had sort of understood this, though I underestimated how higher and how long this could go on.
What I ignored was the FOMO premiums. FOMO premiums have expanded, and they move in sync. The classic case was how smaller traders using the Robinhood platform chased and held the price of Gamestop stock. But FOMO is affecting hedge funds, money market funds and other large investors too.
So, hold tight and enjoy the view.
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