CVA/FVA/DVA and Marginal Cost
In discrete manufacturing, we often thought about what will the next part cost and how to increase productivity to drop it. And along with this, makers thought of achieving market leadership by establishing a marginal cost pricing regime. As a result of this race the market became quite unstable.
It is not so easy to understand marginal cost. It does not include past development-, design-, set-up-, .. cost of the products and their manufacturing systems. Only the direct cost at risk of the next item. But what implications will this have to modernization, improvements, flexibility ..? Will fixed cost be only allowed if they fit into the marginal cost regime?
What will the next e-book cost, what the next digital copy of a John Coltrane concert, what the next use license of a piece of software?
What will the next financial instrument cost? Let us assume the calculation of the VAs are widely used to organize a prefect collateral management with counter parties, and the risk will be optimized in a way that the marginal cost are intuitively approaching zero.
In a competitive, undifferentiated market the price will generally be lowered until it is just above marginal cost. Especially in a market segment that promises "fair prices"?
So, if the regulators do not only force market participants to apply VA calculation in risk management, but to pricing, will this have similar effects as above? With the expectations of frozen counter party relations, counter-business clearing out to zero nettings, ..?
The only defense against the race to marginal cost is differentiation, products that have no substitute, ...
Industries thats intuitive marginal cost of their products may be zero are inherently unstable.
And if a few market participants figure out how to become the champion-in-all-arenas the effective marketing hypothesis is (definitely) broken.
This post is inspired by Seth Godin's post understanding marginal cost.
As a technology provider we will follow the rules - as I have outlined in CDA/FVA/DVA - Fairer Pricing or Accounting VODOO? - and do our best ...
Picture from sehfelder