Marginalism II

By M. Northrup Buechner

April 23, 2013

Another in a series of essays elaborating Objective Economics: How Ayn Rand’s Philosophy Changes Everything about Economics by the author.

The best way to convey the meaning of marginalism is to tell the story of its discovery in economics.

In The Wealth of Nations, Adam Smith (the father of economics) introduced his analysis of prices by pointing out a paradox in the prices of goods (1776, 28): Those goods which have the greatest importance for human life, such as water, often have very low prices, while goods which are relatively unimportant in supporting human life often have very high prices (for example, diamonds). This came to be called the diamond/water paradox.

Adam Smith drew a huge conclusion from this paradox. He concluded that the prices of goods are independent of people’s evaluation of goods. Since the things that people value the most often have low prices, while the things that are frivolous and unimportant frequently have the highest prices, prices must be caused by something other than what people want and how much they want it.

If the value people placed on goods was the cause of their prices, water would be expensive and diamonds would be cheap. Since they are not, some other factor must be at work. Adam Smith and his followers (the classical school of economics) broadly settled on the cost of production as the explanation of price. (This explanation does not work because the cost of every good is composed of prices, the prices of the factors of production which produce it.)

The paradox was solved by three different economists writing in different languages in different countries at almost the same time—an amazing, unprecedented coincidence, explained, perhaps, by the logical hierarchy of ideas—because it is not so unusual for two men to make the same discovery at about the same time in other scientific fields.

In economics, the three men who independently reached the same solution to the diamond/water paradox were Jevons (writing in English, 1871), Walras (writing in French, 1874), and Menger (writing in German, 1871). Smith’s error, each of them said, was that when he compared water to diamonds, he thought of both goods as a class or a category or a group, whereas in everyday life, people do not value goods as classes, they value goods the same way they acquire them, that is one by one.

Suppose we were conquered by space aliens who gave us this choice: they will take all the earth’s diamonds or all its water. Which would we chose? Of course, we would tell them to take the diamonds, because if they take the water, we would all be dead in a week, whereas we would hardly miss the diamonds. This is not Adam Smith’s example, but it is consistent with the underlying context he was assuming when he implied that water is inherently more valuable than diamonds. As a class, water is more valuable than diamonds, but nobody chooses between water and diamonds as classes.

The key to marginalism and the solution to the diamond/water paradox is called the Law of Diminishing Marginal Utility (which we will call the law of utility). In economics, utility means the feeling of satisfaction or enjoyment one gets from buying, using, and consuming a consumer good or service—for example, the utility one gets from eating a banana or driving one’s car or going to the movies.

Marginal utility is the additional utility one gets from buying, using, and consuming one more unit of a consumer good or service, for example, a second banana, another trip in one’s car, or going to a second movie. The marginal unit is the additional unit.

The law of utility says that the value of a good varies inversely with the quantity which one has available. The greater the quantity of any specific good that a man has, the lower the value he places on one more.

Suppose you are throwing a party, and you have asked guests to bring snacks. If the last guest shows up with a pound of Buffalo chicken wings, those wings will be worth more to you if you have no wings, less if you already have a pound, and much less if you have ten pounds. A new pair of socks is worth more to you if you have no socks than if you have a dozen. A fondue set may be a nice wedding present, but five fondue sets certainly are not.

The solution to the diamond/water paradox follows directly from the law of utility: Since in a modern industrial civilization there is a great abundance of water, we put a very low value on an additional gallon (perhaps to spray the leaves off the sidewalk) and we are willing to pay a correspondingly low price. By comparison, there are very few diamonds in the world—an infinitesimal fraction of  the number of gallons of water—so one diamond has great value to whomever can afford it and he is willing to pay a high price.

Marginalism can be defined as the principle that people value things at the margin; they value one more or one less. They do not value the entire quantity that they own or that they buy, unless the entire quantity is at stake. If you are deciding between buying two pounds or three pounds of cheese, you have already decided to buy two pounds. The value you put on the third pound determines what you do. If you value the third pound more than the price, you buy, and you go home with three pounds of cheese. If you value the third pound less than the price, you do not buy, and you go home with two pounds of cheese.

The discovery of marginalism constituted a revolution in economic thought, a major part of which was to entrench subjectivism at its base. We will take that up next time.