MARGINALISM VII

MARGINALISM VII

By M. Northrup Buechner

June 24, 2013

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

I concluded my last post with: “next time we will take up what I think is the truth about why and how people decide what to buy.” That subject is still on my agenda, but I have thought of some other issues that should be covered first.

In previous posts, I have identified a small number of products that satisfy the necessary condition to validly apply the law of utility. That condition can be called the uniformity requirement. It means that the additional units of each product that consumers choose to buy, use, and consume are identical—that they are uniform in nature, structure, composition, performance, and any other attribute that consumers want to possess. If this is not true, then the second unit acquired may be better than the first, and the consumer would get more utility from the second unit than from the first unit.

Products meeting the uniformity requirement are gasoline, electricity, water, heating oil, natural gas, and perhaps some food staples such as butter, eggs, and milk. (If there are others, I am unable to think of them.) The point is that only a very tiny fraction of the millions of consumer goods individuals buy in a free economy are uniform and therefore governed by the law of diminishing marginal utility. In addition, people value those goods that are uniform at their price. If this were the whole story, the status of the law of utility in economics would be as the solution to the diamond/water paradox, and otherwise, as an irrelevant, historical curiosity (which is the way I treated it in my book, with the following exception).

However, that is not the whole story. There is a huge, enormous, towering exception to the preceding view of the law of utility. That exception is money. Money is uniform. Each dollar or hundred dollars is identical to every other dollar or hundred dollars. Consequently, money satisfies the uniformity requirement for the law of utility. But what exactly does the law of utility mean in relation to money?

First, let us dispense with the word “utility.” In economics, utility has no definite meaning. Sometimes it is interpreted as a synonym for “usefulness,” such as the utility of a hammer to pound nails. Sometimes it is used to mean a feeling or emotion, such as the enjoyment derived from buying a new TV set. In the first case, economists have found it impossible to explain the utility of all those activities that have no physical product (which includes the whole entertainment industry). In the second case, it is impossible to identify a unit of psychic utility (a util), and therefore economists view the feeling of utility as nonobjective.

In economics, application of the law of utility to money is called “the diminishing marginal utility of income.” Since we are dispensing with “utility,” and one can acquire money in forms other than income, we will call this principle “the diminishing marginal value of money (DMVM).” The marginal value is the additional value. Thus, this principle means that as you acquire more and more money, you value any given sum less and less. Obviously, more money is always worth more. The issue here is the value you place on a given sum (say one hundred dollars), now and after you win the lottery.

Because the DMVM is defined in terms of the margin (marginal utility in the original version), and the marginal unit is almost always interpreted as one more or one less, economists typically take the relevant sum of money as one dollar. Thus, the meaning of the DMVM is that as one acquires additional dollars, one values each additional dollar less and less. Why? The standard answer is that as we acquire additional dollars, we use them to buy things that we value less and less.

Thus, whatever the amount of money you have at your disposal, you spend it on the goods and services that you value most. Suppose there is a lamp in a store window that you walk by every day. You love the lamp, but the price is a hundred dollars, and you have decided that you cannot afford it. You estimate that you would have to eat spaghetti every meal for two months in order to save an extra hundred dollars and variety in your diet is worth more to you than the lamp.

Then suppose that you win a hundred dollars at the racetrack. The additional hundred dollars is worth less to you than the lamp, and you buy the lamp. But before you won the hundred dollars, the lamp had less value to you than any of the other things that you were buying. If that were not true, you would not have needed to win one hundred dollars in order to buy the lamp. That is the argument, and in the context created here, it is unanswerable.

The implication of this interpretation of the DMVM is that, as we get more and more money, we work our way down our hierarchy of economic values, buying things of less and less value, of lower and lower importance, until, if we have a lot of money, we buy things which have no value to us at all and without which we would be no worse off. (One may observe that this is exactly the view held by the Left of consumption spending by the “one percent”—that is, the one percent of the population with the most wealth.)

The preceding paragraph pushes the argument a little further than it is usually pushed in order to make a point—that there is something horribly wrong with this thinking. This interpretation of the DMVM obliterates the value to people of more money. It is impossible to reconcile with the scramble to buy lottery tickets for one chance in twenty-six million to win a lot of money. Next time, we will see in detail where it goes wrong.

 

Marginalism VI

Marginalism VI

By M. Northrup Buechner

June 8, 2013

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

Last time we saw that the law of utility is limited by the fact that most of the things that people acquire are not identical. We went through a standard explanation, seeing how a farmer would value his buckets if one were lost or another was added. But we ignored how the farmer acquired his buckets, which also is standard in explaining the law of utility.

Goods do not magically appear and disappear. They do not fall like manna from heaven only to be snatched away by the devil. In an economy governed by a price system, such as the one in which we live, when people want to possess goods, they BUY them at a PRICE. When they want to dispose of goods, they SELL them at a PRICE. This fact, that prices are almost always involved in both the acquisition and the disposal of goods, is the second fact about the economy that nullifies the law of utility.

In the normal course of events, people value goods at the prices they have to pay for them. This is normal, natural, and unavoidable. The extent to which price automatically affects our evaluations is quite remarkable. For example:

“Girls, girls, look at this ring. I got engaged last night. Billy asked me to marry him and gave me this ring. He paid $20,000 for it.”

“Oh my Gawd! Look at that rock!”

“It is so big. And the sparkle is almost blinding!”

“That is the most beautiful thing I have ever seen.”

“Where did Billy get $20,000?”

“$20,000? Billy? Oh, I was just kidding. He paid $20 for it. It’s just a piece of glass. But he promised to buy me a real ring as soon as he can.”

In the blink of an eye, the ring is transformed from a big, blinding diamond into an uninteresting piece of glass.

What is the point? In an exchange economy, price is value—price measures the value—not to everybody, not all the time, not if you keep your wits about you (as did the girlfriend who asked where Billy got the money)—but as a first impression, and for the things one routinely buys every week or month, people take price as the value.

Price as a measure of value is a variation on, and perhaps an extension of, the principle identified by Böhm-Bawerk, that people value goods that are easily replaced at the price it costs to replace them. This principle applies to all consumer goods that are for sale in the market. It excludes items like photographs, family heirlooms, keepsakes, and other such items, perhaps of enormous value to an individual, which cannot be replaced.

Consider, for example, a standard 26 ounce container of table salt or a five-pound bag of sugar. Both are very inexpensive and no one has reason to think much about them or to consider what their objective value might be. But if salt or sugar were rare and hard to get and each container cost $500 or $1000, people would value both salt and sugar in accordance with their prices. They would be thought of as precious commodities like caviar, saffron, or platinum.

Alternatively, suppose you have one roll of Bounty paper towels left in your kitchen, so you buy a package of fifteen Bounty towels on your next shopping trip. If storage is not a problem, the fact that you now have sixteen rather than one does not change the value to you of an individual roll. This contradicts the law of utility, but it is true nevertheless.

The proof is introspection—that is, each of us can imagine ourselves in these circumstances and grasp that we would still value a roll of Bounty towels the same as before. The reason is that, since we can buy more Bounty towels whenever we need them, we have no reason to value them at anything other than their price.

Evaluation is more variable with some expensive items. Consider a house, for example. Normally, when one buys a house, one values it at the price one paid. But, if the buyer thinks he got a bargain, he will value the house at more than he paid. Over time, as the housing market goes up or down, the value of the house goes up or down, and the owner revises the value in his mind, depending on what may be more or less reliable sources of information. However, a change in circumstances can change the value of a house to its owner, independently of its market value, such as an increase or decrease in the number of occupants or a change in the neighborhood.

In general, people value exchangeable items, that is items that can be bought or sold, at what they can be bought or sold for. For the most part, this includes even the most expensive things. If this is true, the law of utility is irrelevant.

The preceding discussion applies to consumer goods and services in an exchange economy. Things are different with producer goods. However, the law of utility does not apply to producer goods; it has always been applied only to consumption items. In the context of consumer goods, it is hard to think of cases where the law of utility helps us understand what people buy and what they pay. Additional units are not identical, and if they are, such as gasoline, we value them by what they cost, not according to an alleged diminishing utility.

Next time we will take up what I think is the truth about why and how people decide what to buy.

 

Marginalism V

Marginalism V

By M. Northrup Buechner

June 1, 2013

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

[Apologies for the long hiatus. I have been out of the country giving a paper at an economics conference.]

Marginalism and subjectivism are completely integrated and mutually interdependent in modern economics. Marginalism is the idea that the value people place on things is the value of the last one acquired, and subjectivism is the idea that the prices of things are determined by the value people place on them. Subjectivist economics gives priority and causal power to people’s preferences, but those preferences rule the economy in a definite pattern defined by the law of utility—that as one acquires additional units of a good, each additional unit is worth less and less. This is what keeps subjective preferences from being completely arbitrary. It is also what allows economists to say something more about the economy than “Who knows?”

Without marginalism, economic subjectivism would have nothing to say. People’s preferences could take any form whatever. They might want more when the price went up and still more if it came down, and there would be no limit on how much they wanted. Or, they might want less when the price fell and more when the price went up and everyone might be satisfied with the bare minimum possible or be happy to die of starvation in a week. Marginalism and subjectivism entered economics together in the solution to the diamond/water paradox, and they exist together in roles of mutual support. In the field of economics, neither could survive without the other.

Last time, we saw what is wrong with the subjectivism of modern economics. Now we will look at the marginalism of modern economics.

There was some truth in the discovery of Jevons, Walras, and Menger. Certainly, the explanation for the relative prices of water and diamonds has something to do with the value people place on them, and that in turn has something to do with their relative scarcity. As a broad generalization, it is true that people tend to put greater value on things that are scarce than on things that are abundant. But there is no specific relationship of the kind projected by the law of utility that applies to everything, and that can be taken as the basis for the whole economy.

The first problem with the law of utility is that, in order for it to hold, all the units under consideration must be identical. This point is well recognized. Suppose a farmer has three identical buckets for work around the farm. If he loses one, he will value each of the two remaining buckets more highly than before. Alternatively, if he acquires another bucket identical to the first three, the farmer will value each of the four buckets less than before. The fourth bucket is worth less to him, but so are each of the first three because they are all the same.

This analysis is completely dependent on the buckets being identical. Since they are all the same, the farmer values each of them the same, and that value goes down if he gains buckets and up if he loses buckets. But what if the buckets are not the same? What if he has three identical wooden buckets and then he gets a steel pail?

Sometimes we buy additional units that are identical to the previous units we have purchased. This is not the norm, but also it is not unusual. Everybody does it when they buy gasoline, heating oil, electricity, water, natural gas, and perhaps some food items like butter and milk. For almost everything else we buy, however, including most food items, the units are not identical—and usually we do not want more than one at a time. Examples are legion: a house, a car, an ipad, a shirt, a skirt, a steak, a bunch of bananas, a lamp, a rug, a TV set, a CD player, a computer, a movie ticket, a restaurant meal, and so forth. The complete list would embrace virtually the entire realm of the millions of consumer goods and services.

If additional units are not identical, the second unit is not a unit. It is something else. Or, to put it a little differently, if the additional units are not identical, the second unit may have more value than the first, and the law of utility is irrelevant. If you buy a 36-inch TV set and then you buy a 50-inch TV set, what does the law of utility tell us? Nothing! There is no law governing the relationship between the values people place on two different products, even if the products are very closely related. Only if they are the same can we say that the second unit will have less value than the first.

Next time we will see additional limitations in applying the law of utility to consumer goods and services.