Why is crafting so much more profitable than farming? Why will a crafter who could buy a gem for 130g and resell it for 190g accept a 10g tip? If crafting is so much more profitable, why do so many people still farm for mats? And why do people keep undercutting me constantly? It's all about managing risk.
Risk demands reward. I won't make the claim that we must reward risk-taking. That's a stupid claim to make. Risk isn't some special activity that we must throw piles of money at. That's the exact opposite way to look at risk. Instead of rewarding risk, add incentives. Some risk is necessary but if risk carries no more reward than non-risk, then who would choose risk? In other words, if risk is not sufficiently ore profitable than safe activities, it will be rejected. I'll come back to risk in a moment.
Don't just say they're stupid
If we assume people are rational in the ways they collect gold, we would expect that as farming or crafting or dailies became more profitable that people would shift to those activities. This would cause other activities to gain profit as supply falls and back and forth a bit until finally things settle on a certain potential gold per hour. The easy explanation is that people are too stupid to find the highest gold or that they are too stupid to figure out crafting. Well that's a lazy, stupid, useless explanation. It offers no practical solutions; short of massive education programs and/or eugenics, human intelligence is what it is.
Risk offers answers and solutions. Crafting is more profitable than farming because it takes on higher risk. If I could make 50g in a minute by farming, why would I buy a gem off the AH and cut it for the same profit? I'd be taking on risk for no reward. The risk has two effects. First, it sets minimum profits; so if I risk 150g on a raw gem I'm not going to settle for cutting and selling it for a 5g profit after the AH cut; that's too much risk for a small reward. Imagine the AH deposit as well; a few failed auctions can wipe out profit entirely. Furthermore, people have varying levels of aversion to risk. This means some people are driven away from crafting by the risk.
These two forces serve to lower the supply of crafters. If profit falls too low, people leave the market. If risk (and its relation to profit) gets too high, people leave the market. The net effect is to make it so that regardless of the rarity of recipe drops, there will be low numbers of crafters. This shouldn't be confused with people not taking crafting professions. Jewelcrafting and blacksmithing both have great bonuses for raiding, so there are many of them, but a large portion of them are not active in the market, so for this discussion they don't count as crafters.
Let's move on the risk moderation. In practice this can take many forms, but undercutting is one of them. While my earlier post came off as critical of undercutting, I do not regard it as a stupid practice. All people accept some ratio of risk to reward and this will influence their behavior. When people undercut, they lower their risk (increase chance of sale) along with their reward (sale price). There are other explanations such as impatience or ignorance of market demand, but risk is something we can objectively analyze, without the veneer of superiority.
Finally there are the situations of next to no risk, when we gamble none of our gold but also receive very low profit. Since we've been talking about crafting, let's start with that: tipping. As I've said before, gems can run 50g+ profits, but tips may be only a few gold. So why ever work for tips? There are two reasons and both involve risk. First off, there is no guarantee that the customer was planning on buying your more expensive gem off the AH; he might have bought a competitor's instead (let's avoid discussing the many reasons why your gem isn't the lowest). Your working for a tip brought in revenue that you would have not had otherwise. It also denied revenue to a competitor, effectively lowering his profit/risk, potentially to the exit point. I won't get into business ethics, but we can agree that it's much more profitable to not have competitors. The other side of the risk is that you take none: you don't have to buy a gem and risk that in addition to the deposit. Pure profit with no risk, nice, right?
On the customer's side, there is a taking on of risk. They may have bought the gem before finding the crafter (let's not ask why) and as such have taken on risk. As such, they demand greater profit. This profit takes the form of a lower payment for the conversion of raw->cut gems; 10g instead of 50g. That's a pretty nice profit, actually; perhaps us crafters should be charging more! People do tend to give more than that, but it might be from my elvish good looks.
Then there's farming. As my post earlier this week discussed and criticized (mostly for humor), there's no challenge or risk in farming. When there's no risk, people will work for lower profit. Farm for as long as you want, unless you go hunting those herbs in the middle of Scourge, there's almost no chance that you'll die and have to take a repair. Beyond the training and inexpensive tools, gathering requires very little investment/risk. Skinning is slightly more risky, but even then, very low when you consider the chance of death and compare a few gold for a death with an expensive gem, stack of herbs, bars, or whatever base material the crafter is using.
Solution to inequality?
Let's imagine that we're Blizzard and we want to make gathering more profitable. What could we do? Removing AH deposits might help. This would allow crafters to post their products at higher prices since they lose only some time (mostly offline) rather than gold from failed auctions. I believe gatherers would benefit more though. Their items move in the thousands of stacks per day. This would seem to make it easy to establish a market price, except that they cannot be sure of it and the lost deposit might not be worth it, so they undercut. If they lost nothing by a failed auction, they'd be more eager to try that slightly higher price and therefore greater profit. This has the effect of reducing risk, which could mean even more of a flood of gatherers. To compensate, let's raise the risk of crafting itself, bringing in more aggressive and dangerous mobs, though with higher resources as well; meaning that gatherers will take on more significant risk, to the point that some will leave the market and drive up prices while others may even go to crafting, lowering prices there and also increasing demand for gathered items.
Then there's the lowly daily grinding. The risk is even lower than farming because it doesn't even require interaction with other players. Do a quest, get gold. It's not a hard quest, but it gives gold anyway. It won't give gold as fast as farming or crafting, but what do you expect?
So there we have it, why we undercut, why crafting is so profitable, and why dailies are so incredibly boring. Okay not the last one, but surely you can agree with it anyway. You could get a more complete picture by adding in ignorance and stupidity and laziness, but why delve into the murky realm of subjective judgements if you're attempting to find reality?