Thursday, March 3, 2011

Sunk Costs & Investment

Take a moment to muse on the following thought experiment:

Yesterday there was 10 stacks of Whiptail for 60g/stack and 5 stacks of Cinderbloom for 55g/stack. You bought them all for 875g and made 100 Mythical Mana Potions using all of the herbs, with the intention of selling them for 25g apiece. Today, the price of Whiptail is 110g/stack and Cinderbloom is 90g/stack.

Question: Is there a difference in profit between a sold Mana Potion yesterday and a sold Mana Potion today?

I find this thought experiment fascinating because A) it's based on true events, and B) my answer oscillates wildly even when I bring in no new information. To save you the time of mathing it out, Mana Potions made at yesterday's herb prices cost 8.75g each to create while potions at today's prices cost 15.5g. So if I sold 10 yesterday and 10 today at 25g apiece, how much profit did I make? 308g (16.25 * 20 - 5%) or 247g (16.25 * 10 + 9.5 * 10 - 5%)? What would be your answer?

The answer you choose largely has to do with how you view investing and opportunity cost. I think a lot of people would choose 308g because it "makes sense" in a static investment scenario, especially if you made all the potions yesterday. What does it matter the price of herbs today if you used them all up the day before? Well... it matters quite a lot, actually. If I had resold the herbs the next day instead of making potions, I would have gained 6.75g worth of profit per "potion" compared with the 9.5g profit of today. In other words, 70% of the profit for 0% of the effort (since you don't even need Alchemy to warehouse herbs for a day), and probably 0% of the risk (the market for herbs > market for mana potions).

Passing on the cost to the customer frequently does not work because, rightfully so, the customer doesn't care about your costs. I sold 20 potions at 25g apiece over two days; what possible expectation do I have that even 20 more will sell at 31.75g? Well, I could be optimistic and perhaps post during server raid days, relying on cyclical desperation.

One of the most fascinating Wikipedia pages I have come across is the one on Sunk Costs. It is fascinating precisely because it does not make any sense... until it does... and then the sense that it makes slips your mind even as you are thinking about it. No, seriously, go read it.

Buying cheap herbs are not considered "sunk costs" because the herbs can be resold. Once the potions are made however, the herbs can be considered sunk as you cannot un-potion them. I bring it up at all because, conceptually, I largely consider my own investments as sunk costs as soon as I make them. In terms of the thought experiment, then, my answer is (usually) the surprise third one: 500g.

This is not to say that opportunity cost is zero or that I do not make strategic purchases with an eye on profit margins; obviously I care about these things. Rather, I endeavor to not let past investments (unduly) influence future investment and/or the prices I set today*. This mindset is made easier by default as I have no real way of tracking the returns of each individual gold piece (there are addons which will do this though) invested. All I have is Auditor, which keeps the bottom line in plain view - as long as the number keeps going up, I am content with letting experiments like making Mythical Mana Potions potentially run at a loss. It would be miles easier (and more profitable) to have simply milled and inked those 15 stacks of herbs, for example.

It would have been easier, but way less fun.

*Incidentally, that is precisely the reason I stopped using Auctioneer and it's GetAll and historical pricing features: they are largely useless trivia. Obsidium Ore went for 75g/stack two weeks ago? Who cares? It is either a good price today or it isn't. What is a "good price?" Can you buy it now and turn it into something that will sell for more now? Good price! Things get fuzzier once the time horizon shifts further back, like buying the Bracer Enchant patterns in anticipation for cheaper Maelstrom Crystals in 4.1 (and subsequent demand spikes). Then again, how is the historical price supposed to help you there?


  1. Some great points here, Azuriel. In the wikipedia article, when they were talking about a pharmaceutical company spending money on R&D, powerleveling a profession immediately came to my mind.

    I suppose a more accurate view of wealth would include both liquid gold and current market value of all available assets. If you have a guild bank full of whiptail and the price drops one day, your wealth takes a hit. If the prices comes back up, great. If you turn that whiptail into something that has more value, great.

    The view of investing within the game should likely look something like this: If you spend 1K on something at 50% of its current market value, you might have 1K less liquid gold, but you have something worth 2K, so you actually gained 1K in your overall wealth.

    Also, I believe that the "Big Picture" addon does precisely this - totals your liquid gold, your inventory, and the sum of all the auctions you have up. Maybe I will go grab it tonight....

    Thanks again for such an excellent post.

  2. I dont really get what you are trying to say here. Maybe I am just not reading what you are saying correctly but if you have bought your items and turned them into Mana have your cost of mana potions. Your profit will be what you will realize when you sell them. Regardless if you sell them today or tomorrow. If you leave them as herbs...then your issue is what gets you the most value for your mats. Its a different question. It doesnt change your profit from mana potions but it may mean it is better to resell the herbs than it is to make mana pots.

    Anything else is dealing with an assessment of net worth given fluctuating market conditions. No different than the stock market.

    As to say your point on Obsidium Ore. If it sold for 75g 2 weeks ago the question today is what is happening with supply. Did something happen to bring the price down permanently or is it just a temporary decline. Obsidium ore should have a floor price of 54gold. People still sell it for 40g a stack on my server. At times it will sell for 100gold a stack. It is just a function of supply and demand. I buy when it is low and sell it when it is higher. My profit will not materialize until I sell it or transform it into another item that I sell.

    This is all crystal clear to me as my background is accounting. I know what you are getting at but I think I get lost in your post some where as to the point. Many people do not understand the concepts of sunk costs, net worth today, and realized net worth.

  3. Hey Azuriel,

    Awesome job, love the blog!

    My comments on today's post, food for thought:

  4. @Brent: First, my apologies for the confusion. I felt even as I was writing the post that I was not quite expressing the idea as clearly as I would like. Hopefully this attempt will be a bit better.

    The first part is that I am genuinely curious as to how other people would look at this sort of scenario, e.g. buying cheap herbs and making mana potions out of them, then finding out herb prices went way up the next day.

    The answer you gave - the cost being set when you make the potion - makes intellectual sense to me, but I find myself almost never operating under that mind-set. What I routinely find myself operating under is the "IRL gasoline" pricing model.

    Two weeks ago, I saw the price of gas in my town literally increase $0.30/gallon overnight. Did the cost of drilling oil out of the ground go up overnight? I'm guessing no, but I could be wrong. What probably happened is that people were suddenly willing to pay more for oil, which would in turn make restocking gasoline more expensive. The cost of turning the oil into gasoline was already sunk, but we see gas prices pegged at fluctuating oil prices all the time.

    Obviously the Whiptail::Mana Potion relationship is not directly analogous to Oil::Gasoline for various reasons, but hopefully it makes a bit more sense as to how/why a person could view a Mana Pot's profit as being pegged to daily herb values.

    As for the point of it all... there isn't one per se. I wanted to provoke some thoughts and kind of work out through words my own thought process, which is somewhat contradictory if you haven't noticed. :P I "solve" the discrepancy between what I know intellectually and how I feel emotionally by going a third way, which... I could have probably left out of the post since it's not particularly relevant to anything, and confusing besides.