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Published in:
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2011 | OriginalPaper | Chapter

1. Introduction

Author : Dr. Roger L. Conkling

Published in: Energy Pricing

Publisher: Springer Berlin Heidelberg

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Abstract

This chapter adopts the mundane activities of a lowly baker to portray one of the most fundamental functions of the economy—the determination of cost and price. The baker computes his costs as the sum of the prices he pays for his ingredients and other inputs. He sets his prices to recover these costs plus a profit. This is simple in broad concept, but becomes elusive in the real world. The baker produces a variety of products—doughnuts, pies, and cakes, as well as bread—to each of which he must assign a portion of his costs, a process called cost allocation. This process in most cases is involved and subjective. And, finally, the baker may be faced with competition. He must then adjust his several prices to meet the prices of his competitors, either directly or by distinguishing his product from theirs (product differentiation).

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next chapter The Cost Approach to Pricing: The Direction of Cost
Footnotes
1
Saint John’s Gospel, Chapter 18, 37–38.
 
2
Webster does little to clarify the distinction between the two terms. The primary definition of cost makes that term equivalent to price: “1. (a) the amount of money or the like asked or paid for a thing; price.” The secondary definition is completely different “1. (b) the amount spent in producing or manufacturing a commodity.” Broader definitions are “2. (a) the amount of money, time, effort, etc. required to achieve an end; 2. (b) loss, sacrifice, detriment.”
The primary definition of price also makes that term equivalent to cost: “1. the amount of money, etc. asked or given for something; charge.” Again, the secondary definition is different: “2. value; worth,” synonyms are charge, cost, expense, expenditure, outlay, value, and worth.
At the level of “our daily vocabulary,” economics texts also give little clarification. The texts tend to give too much rather than too little. Paul A. Samuelson’s Economics, perhaps the most widely read of all texts, lists in its index under COST (S): accounting; average (fixed, long-run, marginal, minimum, short-run, variable); constant; decreasing; increasing; least; and total, together with other subdivisions. His index under PRICE is even longer.
 
3
The seller may attach a price to an item which is too high, in which event the item will not sell. The item must be priced at an amount which buyers are willing to pay. This is why we define price in a twofold sense: the amount offered by the seller and accepted by the buyer.
 
4
This definition does not include societal or externality costs, which represent detriments to the economy as a whole resulting from the manufacturing or marketing of the item, but which are not compensated for by the seller either as a payment or a tax. A current controversy in utility regulation is whether the utility and/or its customers should be required to compensate society for such costs through its rates.
 
5
An apology to Thomas Bowdler, pioneer in sanitizing our language, and to Random House’s new Webster’s College Dictionary. When the writer drafted his first pencil version of the adventures in cost-land of our baker, he wondered if the baker should be a he or she, and the bakery his or hers. Revealing a cowardly streak, that first draft was neutral on the matter. It was him or her making decisions, etc. Even for a coward, a few paragraphs proved gender-neutralism to be too much of a good thing. Therefore, this chapter returns to the old Webster on the subject of gender. “His” bakery refers to ownership by “Mr.” Baker, “Mrs.” Baker, or “Ms.” Baker, without differentiation to whether his or her birth certificate notes “M” or “F” under “sex.”
 
6
Return on equity often is referred to rather loosely as “profit.” This is unfortunate for it leads to the erroneous conclusion that cost does not include a return on invested capital, as if capital were free: thus, we hear the phrase, “cost plus profit.” There is a cost of capital: if one doubts this, try to acquire an interest free loan. The uncertainty lies in trying to pin down just what that cost is for an enterprise having its own unique circumstances and degree of risk. Cost-based utility regulation attempts to determine a rate or return which is appropriate to the circumstances and risk of the given utility, which rate is then applied to the depreciated equity investment.
 
7
In the real world of utility regulation, broad estimates of direct costs normally would not be acceptable. “Refined measurement” would be the rule not the exception.
 
8
There are differences between these terms when used on a more stringent analytical basis, as is done in later chapters.
 
9
We regard this as only a basis for estimation, short of a yardstick for allocation.
 
10
In effect, this is a yardstick or allocation method for the assignment of investment costs: purpose of the investment.
 
11
For balance, we now reverse gender and adopt the feminine for our example.
 
12
We beg the question as to whether the discount incentive to the buyer in our examples is sufficient to overcome the buyer’s aversion to buying more than is immediately needed, a weeks supply at one time rather than from day to day. That is a question which only trial-and-error discounts of varying amounts will answer.
 
13
For an earlier but brilliant discussion of this subject, see J. Maurice Clark, “Studies in the Economics of Overhead Costs,” 1923.
 
14
Assuming constant dollars; i.e., disregarding any changes in the value of money due to inflation.
 
15
From the seller’s point of view, this cost rationale has an opposite side. Discounts lower the price for current sales as well as for induced added sales. Therefore, the revenue from current sales declines as a certainty, while the additional revenue from added sales is speculative. Discounts place the future cost-to-revenue balance at risk.
 
16
It is safe to say that quantity-discount pricing by the electric and gas utilities has a solid economic basis since the utilities normally operate under conditions of declining unit costs. We develop this basis in chapter 2 on the Cost Approach to Pricing, so we mention only the highlights here.
 
17
Similarly, energy conservation objectives have pointed to the substitution of energy saving devices (such as double glazing of windows in homes) for added capacity which otherwise would have to be installed by utilities.
 
18
See Faludi, S.C., “Judge Orders Bank of America to Slash Fee Charged Firms for Bounced Checks,” The Wall Street Journal, July 9, 1991.
 
19
Samuelson and other economists might disagree with the above. In his Economics, Samuelson states categorically: “Competitive price and quantity are determined by supply and demand,” noting that this declaration says little about “competitive price being determined by cost of production.” He asks and responds as follows: “Should not this be listed as a third factor in addition to supply and demand? Our answer is firmly, ‘No.’ ” (Samuelson, Paul A., Economics, Eleventh Edition, p. 366).
 
20
On this point, at least, Samuelson would agree. WG: Energy Pricing/Conkling/text in word/Chapter1
 
Metadata
Title
Introduction
Author
Dr. Roger L. Conkling
Copyright Year
2011
Publisher
Springer Berlin Heidelberg
Book
Energy Pricing

Print ISBN: 978-3-642-15490-4

Electronic ISBN: 978-3-642-15491-1

Copyright Year: 2011

DOI
https://doi.org/10.1007/978-3-642-15491-1_1