the economist and the engineer
Let’s say we have two companies, A and B, that both produce widgets. Widgets are very labour-intensive to produce, so company A has decided to move its production facilities overseas. As a result, company A is paying much much less in salaries but much more in shipping costs – with overall cost savings. As a result, company A can now make its widgets for cheaper than company B can; so it can undercut the prices of company B and win market share.
According to an economist, company A is a better company because it’s producing the same product for cheaper. However, to an engineer, company A is being ridiculously inefficient. Company A is accomplishing the same thing as company B, but a lot of extra work must be done in company A’s supply chain, including:
- Extract the oil from the Earth
- Ship the oil to the refinery, and refine it into gasoline
- Ship the gasoline to the harbour
- Build a shipping fleet
- Operate and maintain the shipping fleet in both directions (full one way, empty the other)
Overall, company A is spending less money to build each widget, but they’re consuming more man-power and more natural resources.
So who is right; the economist or the engineer? Which company is better?
Filed under: economics | 3 Comments
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Speaking as an engineer/mathematician, I would say that the answer to “Who is right” depends entirely on the utility function that is being optimized. Both companies are trying to maximize their profit (sales minus costs). As you said, Company A has “cost savings” even though its method requires all of the extra shipping and infrastructure. This inherently implies that the “utility function” under consideration has lower weights on these externalities than on the salaries and sales terms. For this utility function, the economist is correct. If another utility function is considered, where the shipping/infrastructure/environmental terms are weighted higher, the optimum value for this utility function would be obtained by Company B, thereby proving the engineer right.
In other words, with a properly defined utility function, both the economist and engineer would come to exactly the same conclusion about which company is more efficient.
I guess an important point in all this is that defining the utility function plays a critical role in determining optimality and behavior. For example, the weights on the terms in the utility function are defined by government regulations (e.g., higher tariffs, shipping restrictions and carbon taxes). Of course, in practice, there are multiple entities all with their own (hidden/unknown) utility functions that must be simultaneously optimized — finding how to do this is the trick. If you follow the economics/game theory literature, this is known as “Pareto optimality” or social optimality.
Interesting topic and interesting blog. Keep up the great posts.
Thanks for your comments Shreyas.
I think your argument that “it just depends on the utility function” is very value-neutral, and it implies that every utility function is equally valid. For instance, someone’s utility function could be to cause human suffering, but I don’t think anyone would say that’s “right” or “better”.
My question can be rephrased to: whose utility function is better?
The concept of utility function needs to be understood in terms of worthwhile benefits. Causing harm to others cannot be a utility, just as any antisocial behavior lacks utility. One could argue that if you make the same widgets in a developed nation by paying higher wages to workers, they will indulge in conspicuous consumption by using their excess earnings and the potential savings resulting from improved logistics may not result in net savings in terms of the desired utility or value. The various utility functions could be ranked on a totem pole, with some functions ranking higher on the hierarchy than do the others. But the hierarchy is defined and created by each entity and it might be difficult to find common ground as to which utility function needs to be pursued to the detriment of all others.