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starbucks4ever (98.98)

Marginal utility vs LTV

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July 16, 2009 – Comments (26)

The beauty of the competitive free market is that in the absence of interference it makes it possible to dispose of "Marginal Utility" prices. This is why I have respect for competitive free markets in the first place.

Of course there is a disclaimer. Even a competitive free market is not a panacea. Too many things can still go wrong. It may happen that not enough information is available to consumers. Consumers could be gullible to a degree when fraud is more profitable than honest competition. There may be production bottlenecks or shortages of row materials. Markets participants could become locked in a negative-sum game, which the consumer must pay for. Or there could exist a monopolized market somewhere else, and its effects can spread like cancer, poisoning the otherwise healthy segments of the market. Not to mention the overhead when each producer has to employ its own clerical staff, and the possibility that having a large number of small competitors may destroy the economy of scale.  

Having said that, in those happy situations when none of these restrictions apply, a competitive free market can be surprisingly efficient. And then we enjoy the LTV price of goods and services (LTV stands for the Labor Theory of Value) that remains the Holy Grail of Marxists. There is, of course, some extra overhead in the amount of 5-10% to allow for a small profit margin, but let's get real: 10% is not something to get obsessed about. As far as economic theory is concerned, it is well within the margin of error.

The trouble starts when American enterpreneurs begin to explain why they should derive their prices from "Marginal Utility". Wikepedia defines the concept thus: "For example, a ration of water might be used to sustain oneself, a dog, or a rose bush. Say that a given person gives her own sustenance highest priority, that of the dog next highest priority, and lowest priority to saving the roses. In that case, if the individual has two rations of water, then the marginal utility of either of those rations is that of sustaining the dog. The marginal utility of a third unit would be that of watering the roses." 

So if you listen to this theory, then you have to recognize the constitutional right of businesses to charge $100,000, $1000, and $10 for the first, the second, and the third unit respectively. 

But unfortunately for the Marginal Utility hypothesis, the harsh reality of competition instantly destroys these rosy income projections. What will happen in reality is that the person will dispatch the neighbor's boy to the nearest well to bring the first, the second, and the third unit for a buck apiece. Poof go the dreams of our dedicated enterpreneurs! The LTV has put a ceiling above the price of water. Water doesn't cost more than $1 per unit because producing a unit requires only $1 worth of labor. If some ambitious individual tries to charge more, then someone else is aways ready to do it for a buck.

OK, water is realy a commodity, but the same idea still applies to other consumer goods, and to production goods as well. Replace water with a tractor, a computer, or some measuring instrument. As long as there are thousands of small factories that could take the order, the situation will not be any different. Those of us who remember paying $3000 for a lousy 486 computer with a flickering screen and a dial-up modem will agree that if they had to pay $3000 for the computer on their desk, they would accept that price. Luckily for us, we can always turn to AMD if Intel takes the Marginal Utility theory too seriously.

Does it mean that Marginal Utility has no legitimate role to play? Of course not! We can't avoid it when we consider some expensive project like taking a tourist to the Moon. After all, the expenses in such a project could well exceed the maximum price that anyone will pay. One can say that here LTV is currently greater than Marginal Utility, and so it's the marginal utility analysis that discourages us from launching this money-losing project.

Of course LTV also comes with its limitations. If everybody in the village is already employed on the nearest farm, then you'll have to offer them something like $7 an hour for the water. By the same token, if every factory is already busy with other orders, you may have to pay more than LTV price, though less than Marginal Utility price. You are competing with other consumers for the valuable factory resource. So one needs to have lots of factories in order to use LTV. If Karl Marx were appointed president of Afghanistan tomorrow, electricity would still be priced based on Marginal Utility until enough power plants are built.

But of course technology marches on, and eventually you have an overproduction of capital chasing ever diminishing returns. And then one day there comes a moment when the developed state of the economy well justifies LTV pricing of both consumption AND production goods, but the capitalists still feel nostalgic about those $100,000 units of water. And then you get a Marginal Utility Theory whose purpose is to discredit the idea of a buyer's market. 

 

26 Comments – Post Your Own

#1) On July 16, 2009 at 5:06 AM, whereaminow (42.76) wrote:

rec for the effort

So if you listen to this theory, then you have to recognize the constitutional right of businesses to charge $100,000, $1000, and $10 for the first, the second, and the third unit respectively.

Where is this company that can charge whatever if would like for any unit it produces?  I would like to invest in them.

Your analysis focuses on consumers and labor, but then just lumps all producers into the category of "would charge whatever they could if they could get away with it."

If so, their stock price would be infinite.  What would be the future cash flows of such a magical company?  Whatever it wanted.  Under those circumstances, the company couldn't even have a value, since no one could calculate its future returns.

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#2) On July 16, 2009 at 10:30 AM, starbucks4ever (98.98) wrote:

So you are now saying that it's competition that determines the price level, and not the marginal utility? 

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#3) On July 16, 2009 at 12:18 PM, whereaminow (42.76) wrote:

No sir! I was just pointing out that your example has little to do with marginal utility.  

Why do individuals pay much higher prices for some goods versus other goods?  It would help if we looked at the different understandings of maginal utility.  This article helps explain the two different camps:

Mainstream vs. Classical economists on Marginal Utility

Mainstream economists view marginal utility as a unit which can be measured quantitatively with nice supply and demand curves.  Notice that the shifts in the supply-demand curves never occur due to entrepreneurial action.  Mainstream economists, with all of the charts and data, can not explain entrepreneurs because they do not understand human action.

Humans act, economically speaking, in a purposeful manner.  (That doesn't mean that sneezing falls into our analysis or other reflexively human acts that do not represent any kind of conscious decision making.)  Austrian economists represent marginal utility in terms of valuation rankings that are qualitative in nature, not quantitative.  It is the valuation of the exchange of resources in order to fulfill desires that explains diminishing marginal utility.

David in Qatar

 

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#4) On July 16, 2009 at 11:36 PM, starbucks4ever (98.98) wrote:

Have read your link, but still don't see how it proves your point. 

Basically, Mises' "fair market price" is like that cannon that cannot fire for 8 different reasons, the first reason being the lack of powder. In your example, competition between bakers will put an end to spiraling prices long before the marginal utilitity price is reached.

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#5) On July 17, 2009 at 3:30 PM, nfactor13 (< 20) wrote:

Are you assuming that marginal utility price is a singular quantity?  That is, it's the same for anyone and everyone?  Even if the baker was the only baker in town, there is an upper limit on what he could charge because not everyone values baked goods as highly, and at some price, no one would view the purchase as worthwhile.

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#6) On July 17, 2009 at 3:39 PM, nfactor13 (< 20) wrote:

Reading through your explanation of entrepreneurs and competition again, I think you're heading down to the 'perfect competition' idea, though by a different route.  Perfect competition models also have no idea what to do with entrepreneurs, and they exclude such activity completely.  They do this through eliminating differentiation of product/service.  If you want to deliver water to people, and water is a singular product that will always be simply water, then yes, you will only be able to save on production/labor costs, and everyone will be driven to the same price eventually.  The role of entrepreneurs is not to trick people into paying $5 for a bottle of water that's the same as any other water producer could provide.  It's to provide value from other things along with the same product or to provide a new product that you might value more.  Ultimately, you can decide to reject any of those combinations, but by constantly adapting and innovating, the entrepreneur provides escape from a market where you only compete on price.

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#7) On July 17, 2009 at 3:40 PM, starbucks4ever (98.98) wrote:

More to the point, there is marginal utility for the buyer, and marginal utility for the seller. The two are not the same. The marginal seller will become happy with the price of baked goods long before it approaches the maximum buy-in price point of the marginal buyer.

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#8) On July 17, 2009 at 3:56 PM, nfactor13 (< 20) wrote:

Why would a seller of baked goods be happy with a price at which he/she can't actually sell them?

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#9) On July 17, 2009 at 3:57 PM, nfactor13 (< 20) wrote:

Related to my comments on entrepreneurship above, what does the LTV have to say about:

 Risk premiums (the compensation for taking a risk)

Different time horizons (valuing money differently based on whether you get it immediately or have to wait for it)

 

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#10) On July 17, 2009 at 5:20 PM, starbucks4ever (98.98) wrote:

"Why would a seller of baked goods be happy with a price at which he/she can't actually sell them?"

I mean, approaches from below. The customer would pay up to $10, but as soon as he produced a $5 bill, some baker was happy to take the order. 

"what does the LTV have to say about risk premiums"

This question relates to the issue of capital availability (which I mentioned when I said that LTV does not apply to Afghanistan). Sure if you have only $10,000 of savings, you can't set up a bakery and risk losing it all. On the other hand, when you have $10 M, and open a new bakery every month, your risk is very manegeable, plus your first bakery will give you experience that will make you more confident later on. The time value of money also decreases with the amount of capital. So yes, you can't take shortcuts and skip the capitalist stage. If you try to go directly from feudalism to socialism, that would be like an opening gap on the S&P chart - it will have to be filled eventually, possibly by reverting back to capitalism. Russia is a good case in point.

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#11) On July 17, 2009 at 5:25 PM, nfactor13 (< 20) wrote:

So you're arguing that entrepreneurs have no role in a socialist economy?

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#12) On July 17, 2009 at 5:59 PM, starbucks4ever (98.98) wrote:

This is a good question which has no single answer. First, note that I'm defending socialism as such, I'm only defending it from unjustified criticism by Mises. Secondly, there is a huge variety of interpretations of what Marx actually meant. Some people even say that "socialization of the means of production" should be understood as a system of state supervision over private enterprize. In that framework, the baker would still run his bakery as a private business, responding to market signals as usual, only the state would make sure that he never gets the wrong kind of market signals. You can see that this is not much different from the Federal Reserve system, so these theoreticians say that in fact, it is the Western word that has built a kind of socialism, whereas the Soviet experiment was only an exercise in state-run capitalism. There are many other interpretations, and there is also the Soviet practice. By and large, private enterpreneural activity was legal as long as you didn't use hired labor. But of course officials always tried to discourage it becuase they were afraid to be accused of "counterrevolution". Still, most fruits and vegetables were grown on those tiny family plots of 0.1-0.2 acre each; a personal car would easily become a taxi when you stood on the roadside and raised your hand; and you could give private lessons or receive patients at home. 

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#13) On July 17, 2009 at 6:00 PM, starbucks4ever (98.98) wrote:

Should read "that I'm not defending socialism as such". A Freudian slip, no doubt.

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#14) On July 17, 2009 at 6:07 PM, nfactor13 (< 20) wrote:

"In that framework, the baker would still run his bakery as a private business, responding to market signals as usual, only the state would make sure that he never gets the wrong kind of market signals."

I'm not an expert on Mises, but my understanding is that 'market signals' for Mises are grounded in the satisfaction of individual ends.  In that sense, consumer goods are a kind of production good to each consumer because they are utilized to satisfy some other purpose, even if that purpose is to avoid something from happening (like eating food to avoid hunger, though of course people also eat food for other reasons).

So if you accept that premise, how would you be able to trust any other entity to gather that information and utilize it?  Further, those preferences, grounded in actions taken to accomplish certain ends, are expressed in voluntary exchange.  Any interference with those voluntary exchanges either forces exchanges that are unwanted by at least one party or forbids exchanges that would be mutually satisfying.  Socialism cannot improve on this.

Perhaps I'm misrepresenting his criticism, though.  Do you see it differently?

"You can see that this is not much different from the Federal Reserve system, so these theoreticians say that in fact, it is the Western word that has built a kind of socialism, whereas the Soviet experiment was only an exercise in state-run capitalism."

Indeed, I agree with you there, though I would call state-run capitalism 'fascism,' and we have plenty of that in the West, too.

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#15) On July 17, 2009 at 6:32 PM, starbucks4ever (98.98) wrote:

Some more food for thought.

This is from "The Communist Manifesto". 

"10 Conditions For Transition To Communism

1) Abolition of property in land and application of all rents of land to public purposes.

2)A heavy progressive or graduated income tax.

3)Abolition of all right of inheritance.

4) Confiscation of the property of all emigrants and rebels.

5) Centralisation of credit in the hands of the State, by means of a national bank with State capital and an exclusive monopoly.

6) Centralisation of the means of communication and transport in the hands of the State.

7) Extension of factories and instruments of production owned by the State; the bringing into cultivation of waste-lands, and the improvement of the soil generally in accordance with a common plan.

8) Equal liability of all to labour. Establishment of industrial armies, especially for agriculture.

9) Combination of agriculture with manufacturing industries; gradual abolition of the distinction between town and country, by a more equaldistribution of the population over the country.

10) Free education for all children in public schools. Abolition of children's factory labour in its present form. Combination of education with industrial production.[7]"

Point 1: Property tax; regulation of land use by the Department of land, but propery is still private. Partial check.

Point 2. Progressive income tax. Check. 

Point 3. Inheritance tax. Partial check.

Point 4. NaN

Point 5. Check.

Point 6. Highway system, subways, airports, and Amtrack nationalized; cars and buses and planes still private. Partial check.

Point 7. Land use is entirely regulated by bureaucracy; some government-controlled non-governmental companies (Fannie, Freddie), but factories still mostly private. Partial check.

Point 8. Blank. 

Point 9. Essentially realized in America. Check.

Point 10. Check.

 

 

 

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#16) On July 17, 2009 at 6:38 PM, nfactor13 (< 20) wrote:

No argument with your list except I would say for #1, you can't truly own property if you must pay perpetual rent to maintain ownership and if that ownership could be revoked at any time (eminent domain) regardless.

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#17) On July 17, 2009 at 6:41 PM, starbucks4ever (98.98) wrote:

You are welcome, comrade :) 

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#18) On July 17, 2009 at 6:50 PM, nfactor13 (< 20) wrote:

When I say no argument with your list, I meant no argument that it's occurring or has occurred.  Not meaning that I like any of it. :-)

I take it that you do approve?

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#19) On July 17, 2009 at 6:58 PM, starbucks4ever (98.98) wrote:

Only points 6 and 10.

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#20) On July 17, 2009 at 7:35 PM, nfactor13 (< 20) wrote:

Going back to your original post, how do you view 6 and 10 in light of your first two paragraphs?

 You mention the "absence of interference," but all the things you mention in the 2nd paragraph are normal and opportunities for entrepreneurs to provide value.

If your sense of a 'normal' economy is the perfect competition model where information is free and widely available, there is a homogenized product, multiple producers/sellers, and low or no switching costs, then it's easy to characterize market processes as distortions or interference.

Consumers don't always have enough information.  This means that they would value someone providing that to them, and we have seen that in certain markets where this was a problem.  CarFax for one obvious example.

The existence of fraud is another opportunity for businesses to differentiate themselves by providing reasons to trust them.  Price is not the only factor in making a purchase.  Even the return policy, something the customer hopes never to need, can affect how much they're willing to pay.

Bottlenecks and shortages are a signal that there is opportunity in making up those shortages or in finding ways to circumvent or fix the bottlenecks.

Calling these interference assumes a sort of quiet-state economy that we'll make it back to somehow.

In regard to 6 and 10, if there is no competition in those areas, what assures either cost-effectiveness or high-quality?

 

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#21) On July 17, 2009 at 7:49 PM, starbucks4ever (98.98) wrote:

nfactor13,

How about his simple solution: leave the market alone when there is perfect competition, force a perfect competition by decree when capitalists try to subvert it?

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#22) On July 17, 2009 at 7:50 PM, starbucks4ever (98.98) wrote:

this simple solution

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#23) On July 17, 2009 at 8:38 PM, nfactor13 (< 20) wrote:

Perfect competition means no innovation.  Why would you want to force this?

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#24) On July 17, 2009 at 9:26 PM, EScroogeJr (< 20) wrote:

Couldn't disagree more. The urge to innovate does not arise spontaneously when you are sitting behind your moats raking in thusands per minute. No, you innovate when you rack your brain how to survive in this business for another year, that's when you develop your best ideas - under pressure. Why do we have good computers? Becuase they were designed by companies that knew that their only choice was to innovate or die. Why do you have this crisis? Becuase when fat cats like GS, BAC, WAMU, JPM, and Madoff Securities decided to innovate, their fat brains stupefied by 7-digit bonuses could no longer produce any ideas except new Ponzi scemes.  

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#25) On July 18, 2009 at 2:50 AM, starbucks4ever (98.98) wrote:

nfactor13,

There is no need for innovation. 90% of the time there is nothing wrong with the current technological process - only that the company practicing it has hidden behind its moat, and overchages you 100%-200%. We don't need to invent a revolutionary new sewage pipe, we only need to break the moat surrounding the local monopoly. Our healthcare is functionally broken, and it's not the lack of instruments that's causing the trouble. It's the lack of political will to remove that useless HMO that stands between you and your doctor, squeezing both of you. We haven't done the simplest things that are easily within our reach and yet we want some "innovation".

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#26) On July 20, 2009 at 1:13 AM, nfactor13 (< 20) wrote:

I'm not in favor of monopolies, of any kind.  I was simply pointing out that LTV only does well in describing markets with perfect competition:

http://en.wikipedia.org/wiki/Perfect_competition

And even there, it can turn into a tautology pretty easily.

I agree we should remove the political barriers, whether it's health care or anything else.  Just don't expect politicians to do so.  HMOs are only what they are because of government interference in health care.  Same goes for insurance being tied to the employer, the shortage of doctors, and the restrictions on access to various drugs and medical procedures.

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