Wednesday, February 9, 2011

On Utillity, Price, and Cost

The goal of this post is to differentiate between utility, price and cost.

There is a philosophy called utilitarianism which states that the goal of human life is to maximize the utility of human life. The problem has been that, since the inception of this philosophy, there has been no way to quantify this term 'utility.' Some people say that utility is pleasure, some say that utility is knowledge, while others say that utility is money.
So, what's the point of a philosophy if we can't even define what we're trying to maximize?

Simply put, there is no point in having a philosophy if we can't define what we're trying to maximize. Though, what's important about utilitarianism is that it gets us thinking about what we are doing here on Earth. What is the goal of life?  What is it that we are trying to maximize? Or perhaps instead, are we trying to minimize something, like pain or poverty?
Utilitarianism is a form of consequentialism, which states that the moral worth of an action is determined by its outcome.

So, there are quite a few similarity between utilitarianism and the "philosophy" of maximizing the rate of return on work invested. In both cases, the goal is to maximize a certain quantity. In both cases, the moral worth of an action is determined by its outcome (as opposed to the intention.) In both cases, the quantity being maximized is impossible to calculate accurately. (utility is impossible to calculate because it's ill-defined  & rate of return on investment is impossible to calculate because we can't predict the future.)

So, now with this background, I'd like to discuss the difference between utility, price and cost. Sometimes, I'll use the unit of kW-hr instead of $ because we can always assume that we live in a country with an electricity-backed-currency. (Check out the previous post on Electricity Backed Currency for more details.)

Utility is the amount of value for the customer who buys a product. Value can mean a lot of different things to different people. For some people, value can mean pleasure, for some it means spirituality. For other people, the value of a product is equal to its capability to produce a return on investment. For these people, they can try to estimate how much return on investment they would get by buying the product, and from that calculation, they could estimate the maximium amount that they would be willing to pay. For them, utility is the amount that they would pay at which their rate of return is exactly zero.

Similarly, but from the other side, cost is amount of work (kW-hr) required to build the product with zero profit. A company can roughly estimate how expensive it will be to manufacture a product at a given rate (# of products per time). The cost to make the product does not include the profit that the company makes when they sell the product above the cost.

So, this leaves the price of the product. For some people, the utility of the product is larger than the cost of the product, and therefore it's possible for the buyer and seller to find an intermediate price that is beneficial to both people. For others, the utility is less than the cost, and there is no price that is mutually beneficial. (check out the previous post on Comparison between Supply & Demand Curves)
In the end, the company will try to maximize their total profits, and they can do that by estimating the cost as a function of the # of products per time as well as the number of people who will buy the products as function of the utility.
Interestingly, both of these functions can be graphed. (One axis has the units of kW-hr... i.e. $,  and the other axis is # of products per time.)
The company should graph the two curves, and the location where the two curves meet. At this price, the company can maximize its profits, and the buyers can maximize their eventual return on investment. A win-win for all parties, i.e. the price is the kW-hr ($) for the product that gives the greatest 'return on investment' for the most people. And so we return back to utilitarianism. The price of a product is not the utility and its not the cost. The price is the amount of work (kW-hr) exchanged in order to maximize the greatest good for the greatest number of people.

So, in summary:

utility = the kW-hr of work exchanged such that the customer will obtain a zero rate of return on investment. (Any price below this leads to a positive rate of return on investment for the customer.)

cost = the amount of work (kW-hr) required to build the product with zero profit. (For any price above the cost leads to profit for the company.)
price = the exchange of work (kW-hr / $) that creates the maximize good for the greatest number of people.

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