By M. Northrup Buechner

June 30, 2013

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

The standard interpretation of the diminishing marginal value of money (DMVM) is that, as we get additional money, we work our way down our hierarchy of economic values, buying things of less and less value, and that is why the value of additional dollars declines. This represents an enormous misunderstanding.

We do not spend our economic lives buying things of less and less value—working for an increase in salary so we can buy things of less value than what we bought with the last increase. This conception represents an attack on economic progress as such. It says that for human beings, a rising standard of living is nothing more than acquiring items of continually diminishing importance—so that if we make it big and hit the jackpot, we can buy things of no importance at all.

The flaw in this argument is that it focuses on adding first one dollar and then another dollar, that is, on adding almost nothing. In today’s economy, neither a dollar nor a penny can raise one’s standard of living. If you won at bingo, one dollar on Friday and then another dollar on Saturday, each successive item you bought with each additional dollar would indeed be ranked lower and lower, but nothing you bought would matter to you.

To grasp the truth about the value of additional amounts of money, we need to think in terms of larger amounts, amounts that could conceivably make a difference to someone’s standard of living. Suppose a young man has a part-time job making a hundred dollars a week; with that income, he has to live with his parents and take the subway or walk to his job. Now suppose he finds a real full-time job making a thousand dollars a week; with that income, he can buy a used car, stop taking the subway, and move into a little place of his own. If and when he advances to making ten thousand dollars a week, he can buy a house in the suburbs with a swimming pool, join the local country club, take tennis lessons, and go to the theater.

This is how increases in income work. With every increase, you are able to buy goods and services of greater and greater value. We can observe that, when people’s income rises, a significant proportion of their additional expenditures go for better versions of things they were already consuming: a TV with a bigger screen, a new Lexus instead of a used Ford, better food at home and eating-out more often, etc. We can also observe that in the advanced exchange economies of the modern world, there is virtually no limit to how high the values can be. But if that is so, why does the marginal value of money decrease? If with more and more money, we can buy things that are worth more and more, it seems that the marginal value of money should rise, not fall.

Let us remind ourselves of what the issue is here. As I said last time, of course more money is worth more than less money. We did not need economists to  point that out to us. That is not what the DMVM is about. The DMVM is about the value of a specific sum of money (such as a thousand dollars) to people who have alternative total amounts of money (or income levels or wealth). The DVMV says that if your total income is ten thousand dollars a year, a thousand dollars will be worth more to you than if your income is one hundred thousand dollars a year and much more than if your income is a million dollars a year. If we look at it in terms of adding money, an additional thousand dollars is worth more to the man with ten thousand dollars than to the man with a hundred thousand dollars.

This explanation strongly suggests that the DMVM is true. But why? Because, as we acquire more and more money, any specific sum (such as a thousand dollars) represents a smaller and smaller proportion of the total. Thus, a thousand dollars is ten percent (10%) of ten thousand dollars, one percent (1%) of one hundred thousand dollars, and one tenth of one percent (0.1%) of a million dollars. This is why one thousand dollars is much more important to a man with an income of ten thousand dollars a year than to a man with an income of one million dollars a year. The man with ten thousand dollars only has ten such sums while the man with a million dollars has a thousand such sums.

(The preceding words are my own, but I learned this explanation of the DMVM from Harry Binswanger (“Philosophic Issues in Economics” OCON, June 2008). Possibly, some other economist in the history of economics also has offered this explanation, but until I read Dr. Binswanger’s lectures, the only explanation I had ever heard was the one given in the first paragraph of this blog.)

Now we can take up the issue of consumer choice and why people buy what they buy and why an understanding of that is important.