Marginalism

Marginalism is the use of marginal concepts within economics. Marginal concepts include marginal cost, marginal productivity and marginal utility, the law of diminishing rates of substitution, and the law of diminishing marginal utility. "Marginal" here implies that economists look at what happens when "a small change" is made to the subject under study.

Important marginal concepts

Marginalism in price determination

In neoclassical economics the price of a good on a free competitive market is thought to be determined by the forces of supply and demand. However, what marginalism seeks to explain is relative differences in prices. It is not necessarily an explanation of prices in monetary terms, but simply the price of anything as it exchanges for anything else, whether money, goods, or units of labor. The labor theory of value, which is no longer believed to be true by virtually all modern economists, held that relative prices in a market are proportional to the amount of labor required for the production of those goods. In contrast, neoclassical theorists say that it is the "marginal rate of substitution" of a good that determines the price of one good relative to another in market. The marginal utility of an object, whether manufactured or natural, is the least urgent use of an object - in other words, the use that is in the "margin." Marginal utility is subjective, because it depends on each person's wants and tastes. The same object may have different marginal utilities for different people.

For example, if someone had 5 gallons of water and he loses one, he will not choose to sacrifice his highest priority want which is to sustain his life but will choose to not water his roses. In other words, if he has 5 gallons of water, the least valuable use in satisfying his wants for any given one of those gallons is the watering of his roses. This is the use that is on the "margin." So the "marginal utility" of one gallon of water for him is the benefit he receives by watering his roses. In terms of applying this to prices, he will not be willing to sell one of his 5 gallons of water unless what he receives in return satisfies a greater want than the satisfaction he receives by watering his roses. If he had 10 gallons of water, naturally the marginal utility of water would be lower and he would be willing to sell it at a cheaper price. If he had an unlimited amount of water and kept it all to himself, any given gallon of water would have absolutely no usefulness to him. He is only able to drink so much water, and his roses can only handle so much water. So, he is willing to trade a gallon of water for things that are of any usefulness at all in order to increase the satisfaction of his wants. If money is in use, he would be willing to sell his water for any price that is above zero that others offer, so that he can purchase other things that satisfy still unmet wants; his water needs are already more than satified. Of course, the price that actually resolves also depends on the demand side. Demand is also determined by marginal utility. If an individual is wanting to buy one gallon of water, he will not trade something for a gallon unless the least satisfaction he receives from keeping that thing is lower than the satisfaction he will receive by having the gallon of water (note that he does not have to have a possession to trade, for he can trade one unit of his labor). If another object is substitued for water, such as gasoline, it would have a different marginal utility and thus a different price. The higher the marginal utility for all market participants as a whole, the higher the price.

The assumption is that people seek to increase the satisfaction of their wants when they trade (rather than seek to increase the satisfaction of the other parties wants at the expense of becoming less satisfied themselves - to be altruistic). The implication, then, is that both sides benefit by trade by satisfying more wants than they could have if they kept what they had to themselves. This is also a justification for middlemen, because they make a trade possible that would have not occurred and therefore increase the satisfaction of wants in the world.

Marginal rate of substitution

The marginal rate of substitution (MRS) between two goods, A and B is the amount of good A a consumer is willing to give up to get an amount of good B. It depends on the amount of the goods the consumer is consuming to start with and it also differs between different consumers, even when they are consuming the same thing.

An example: Assume Lisa's current consumption is 3 bananas and 4 ice creams per day. Now take one ice cream away from her. If you have to give her two bananas as compensation to keep her just as happy as before Lisas MRS between ice creams and bananas is 2. Note that if Lisa had started with only one ice cream it would probably have taken more than two bananas to compensate Lisa and her marginal rate of substitution would have been different to begin with. With competitive markets the marginal rate of substitution between two goods should be the same for all consumers that are consuming something of both of the goods and this marginal rate of substitution should equal the ratio of the price between the goods.

Unlike marginal utilty, marginal rates of substitutions are in principle measurable.

Marginal cost

Marginal cost is a quantity defined for producers. It is the amount of money it would take to increase production one unit. (Frequently, both marginal cost and marginal rates of substitution are defined by derivatives.)

Application of marginalism to value theory

Predictions of marginalism

If you combine the principle of marginalism with the theory of free competition you get predictions about the price of goods on markets. The most prominent of these predictions are that the price of a good will equal its marginal cost of production and that the marginal rate of substitution of two goods will equal the ratio of their prices. In the long-run equilibrium prices will also equal its average costs of production and thus there will be no profits. Note that a compensation to capital owners for the use of their capitals is included in the costs so that profits are zero does not mean that the owners of companies are uncompensated.

What is then the difference between neoclassical thought and classical thought if both think that in the long run price will equal the average cost of production? One major difference is that in neoclassical economics the average cost of production is not independent of the quantity produced. Because of economies or diseconomies of scale the average cost of producing a 1000 cars might differ from the average cost of producing 10 cars. Thus the statement that price will equal average cost does not suffice to determine the price if you do not know how much is produced.

The above discussion applies to products that can be produced. The analysis of the pricing of products that cannot not be produced, like new paintings by Rembrandt is different but still applies the basic principles of marginalism.

Diamond-water paradox

Main article: Paradox of value

The diamond-water paradox is the observation that even though water is essential to human life, the price of water is relatively low. Diamonds (apart from industrial diamonds) are frivolous and unimportant for human existence, yet the price of diamonds is substantially higher. Adam Smith, the esteemed and perhaps most famous economist, described the paradox in his seminal work An Inquiry into the Nature and Causes of the Wealth of Nations.

The marginalist theory of value explains the "paradox" by arguing that it is not the usefulness of water as a whole that affects price (not necessarily monetary), but the usefulness of one unit of water, not total utility but marginal utility. If a man has ten gallons of water, then the usefulness of any particular gallon is lower to him than it would be if only one gallon was available. Another way of saying this is that because water is in large supply, the marginal utility is low and therefore the price is proportionally low. On the other hand, because diamonds are useful but scarcer, each diamond is more useful in satisfying human wants than each gallon of water. The benefit a man forfeits by losing one gallon of water when he has ten gallons is less than the benefit lost if he loses one diamond out of ten diamonds. The marginal utility of water is lower than that of diamonds. This corresponds with water having a lower price than diamonds, because people are willing to pay less for things they value the least (whether it be payment with money, goods, or their own labor).

Cost of production

Adam Smith and David Ricardo both theorised that value is a result of the cost of production. Smith concluded that the economic value of a good is dependent on the amount of labor required to attain it. It followed that diamonds are expensive because it requires a lot of labor to find and mine them (labor theory of value). In long-run equilibrium, prices reflect costs per unit produced and a rate of profit that is equalized between sectors. Some economists, particularly many classical economists still believe this. However, this does not explain why emeralds, which are harder to find and more expensive to extract than diamonds, are not valued as highly, nor why large, easily extracted and easily found diamonds are worth much more than small, hard to extract ones.

The origins of marginalism come from Ricardo's theory of land-rent, in which the price of land depends on the productivity of the least productive land in cultivation—the marginal land. Thus, all else equal, as the demand for agricultural crops increases, the price of land rises as farmers move to less productive land.

Subjective value

Anne Robert Jacques Turgot proposed an innovative solution to the diamond-water paradox. He argued that value is subjective — it is in the eye of the beholder: "Comparison of value, this evaluation of different objects, changes continually with the need of the person." Where water is plentiful, people value diamonds highly. A person stranded in a desert, however, would value water over diamonds.

Those who endorse subjective value theory (including mainstream modern economists) believe it is a refutation of "intrinsicist" value theories, such as the labor theory of value, which is a cornerstone of Marxism. Behavioral economics theorists explicitly seek to research and model how subjective framing of decisions affects the value an individual places on goods and outcomes.

Carl Menger and Eugen von Böhm-Bawerk, members of the Austrian School of economics, took subjective value further, developing the theory of marginalism.

Marginal utility

An example of diminishing marginal utility

The marginal utility of an object, whether manufactured or natural, is least urgent use of an object in satisfying the wants of a person - in other words, the use that is in the "margin." Marginal utility is subjective, because it depends on each person's wants and tastes. The same object may have different marginal utilities for different people. The concept grew out of attempts by 19th-century economists to explain the fundamental economic reality of price. Austrian economist Friedrich von Wieser coined the term.

The Austrian economist Eugen von Böhm-Bawerk gave probably the most memorable description of the marginal theory of value, one often used by economics textbooks, which neatly encapsulates this confusion between the natural economy and the market economy. Loosely translated it is:

"A pioneer farmer had five sacks of grain, with no way of selling them or buying more. He had five possible uses: as basic feed for himself, food to build strength, food for his chickens for dietary variation, an ingredient for making whisky and feed for his parrots to amuse him. Then the farmer lost one sack of grain. Instead of reducing every activity by a fifth, the farmer simply starved the parrots as they were of less utility than the other four uses; in other words they were on the margin. And it is on the margin, and not with a view to the big picture, that we make economic decisions." Positive Theory of Capital (1889)p143 [1]

Bohm-Bawerk describes a mechanism for price formation, in a situation where prices are not formed, the farmer can neither buy nor sell his output. If the farmer produced within a capitalist economy it would be the price of his output, not its use, i.e. its exchange value not its use value which determined whether he sold it or consumed it. If he could sell his grain for a higher price than the cost of food, chickens, whiskey or parrots, he would sell the grain and buy the food, chickens, whiskey and parrots. The price that the farmer receives for his output would be something entirely separate from its utility for him, consequently its utility for him cannot determine its price.

Further the vast bulk of production in a modern market economy is by capitalists employing workers, not by simple commodity producers like small farmers. Capitalists produce not to consume their output but to sell it, the utility of the commodities they produce is immaterial to them, all that matters is the amount of profit it yields on their investment. Workers do not own the production they produce for the capitalist as they have already alienated their labour power in the act of employment. In neither case does the choice Bohm Bawerk describes apply.

The law of diminishing marginal utility refers to the marginal utility of each additional unit of a good having less value than the previous unit. For example, the marginal utility of an additional slice of bread to a person with few slices will be great. But the marginal utility of an extra slice of bread to a person with many slices will be small.

Diminishing marginal utility is a very common assumption in economics, but it is not universally assumed. It corresponds to convexity of the indifference curves.

Note: On the indifference curve it is the good along the x-axis whose marginal utility starts to diminish with an increase of every unit, whereas the marginal utility of the good along y-axis keeps increasing with loss of every 'y' unit, which makes the customer less willing to trade-off 'y' for 'x' as he accumulates more of 'x' and is left with less of 'y'.

Marginalism and schools of economic thought

Neoclassical economics

Neoclassical economists derive demand curves from indifference curves, of which one assumption is diminishing marginal utility. Although the scarcity of factors of production is still thought to be important, individual demand and the marginal benefits that they would obtain from a good is seen as the driver of the whole process and the ultimate source of economic value.

Austrian School

The Austrian School accepts marginalism more completely, making a clear break from the factor-input theories of value. They used marginal utility as a starting point: for example, the supply of labor reflects the subjective marginal utility of leisure (and the marginal disutility of work).

Austrian economists formulated the law of marginal utility in a period when psychologists were much interested in the Weber-Fechner law of sensation. The Weber-Fechner law states that in order that the intensity of a sensation may achieve an arithmetic progression, the stimulus itself must achieve a geometric progression. For example, in a quiet environment, humans will notice even a small increase in noise level, but when the given noise level is already loud, humans will need a much larger increase in order to perceive a difference.

Friedrich von Wieser's seminal essay on "Natural Value" appeared in 1889. In 1890, the American psychologist William James wrote his Principles of Psychology and offered an interpretation of the Weber-Fechner law that may also shed a lot of light on marginal utility in von Weiser's sense. James saw the Weber-Fechner law as a rough generalization as to the friction in the neural machinery.

If our feelings [of weight, sight, sound, etc.] resulted from a condition of the nerve molecules which it grew ever more difficult for the stimulus to increase, our feelings would naturally grow at a slower rate than the stimulus itself," he wrote. "An ever larger part of the latter's work would go to overcoming the resistances, and an ever smaller part to the realization of the feeling-bringing state.

Whatever the neurological basis, the result of diminishing marginal utility is that rather than having a lot of one good or a lot of another one, one prefers having some of both. In the case of perfect substitutes this result does not apply (since the two products are essentially the same); in the case of perfect complements it applies most.

Marxist School

Main article: Marxism

Karl Marx died before marginalism became the accepted interpretation of economic value and neoclassical economics replaced classical political economy. His theories were based on the labor theory of value, which distinguishes between exchange value and use value. In his Capital however, Marx had already developed a critique of the confusion between the use value or 'utility' of an object and its 'exchange value' which forms the basis for marginal utility theory, this is demonstrated very clearly for example in Marx's discussion around the effect of supply and demand on prices [2]:

"Nothing is easier than to realize the inconsistencies of demand and supply, and the resulting deviation of market-prices from market-values. The real difficulty consists in determining what is meant by the equation of supply and demand.....If supply equals demand, they cease to act, and for this very reason commodities are sold at their market-values. Whenever two forces operate equally in opposite directions, they balance one another, exert no outside influence, and any phenomena taking place in these circumstances must be explained by causes other than the effect of these two forces. If supply and demand balance one another, they cease to explain anything, do not affect market-values, and therefore leave us so much more in the dark about the reasons why the market-value is expressed in just this sum of money and no other." [3]

Therefore to really explain the price of a commodity, it is necessary to consider some other factor, for Marx the labour time necessary for a commodities production, other than supply and demand.

Marginalism and the relations of distribution

Maurice Dobb, a Marxist at Cambridge University writing in his 1973 "Theories of value and Distribution", provided further critique of marginal utility theory. Dobbs pointed out that prices derived through marginal utility theory assume a pre-existing distribution of value. Consumers with different amounts of money have vastly divergent abilities to express their different preferences. A different distribution of income would produce different prices. As marginal utility theory asserts that prices arise in the act of exchange it is unable to explain how the distribution of income effects prices and consequently it cannot explain prices.

The idelogical purpose of Marginalism

Dobbs also criticized the ideological purpose of marginal utility theory. Jevons, one of its key originators alongside Marshall and Walras, wrote for example "so far as is consistent with the inequality of wealth in every community, all commodities are distributed by exchange so as to produce the maximum social benefit." Dobbs and other Marxist critics contend that this statement (and other similar formulations) indicate that marginalism is intended to logically insulate market economics from criticism by making prices the natural and optimal result of a given income distribution.

Other Marxist influence economists

Some economists strongly influenced by the Marxian tradition such as Oskar Lange, Wlodzimierz Brus, and Michal Kalecki have attempted to integrate the insights of classical political economy and neoclassical economics. They believed that Marx lacked a sophisticated theory of prices, and neoclassical economics lacked a theory of the social frameworks of economic activity. Some other Marxists have also argued that on one level there is no conflict between marginalism and Marxism: one could employ a marginalist theory of supply and demand within the context of a "big picture" understanding of capitalist exploitation of labor.

Criticism of marginalism

Marginalism has been criticised for being extremely abstract, with even supporters of the concept describing "marginal utility" as "unobservable, unmeasurable and untestable". [4] While utility (i.e. usefulness) has some objectivity, vital substances such as air, water, and staple foods are free or inexpensive. Marginal utility is somewhat subjective, as the "value" of an additional unit of consumption would seem to be based on the individual's circumstances. According to its Marxists critics, such as Ernest Mandel, marginalism is individualistic and focuses too much on the market rather than production.[5] The theory is attacked for downplaying the role of cost of production in price determination in favor of a focus on individual's tastes and preferences. In its most extreme Austrian version, marginalism denies that an objective, cost-based component exists at all. Rather, the Austrians argue that costs of production are merely the manifestations of individual preferences for labor vs. leisure and saving vs. consumption.

Proponents of behavioral economics argue that people often follow simple rules of thumb instead of engaging in a mental process of maximizing some function. The reply from some neoclassical economists is that these rules of thumb have been shaped by experience so that they give the same result as maximizing.

External links

• http://www.econlib.org/library/Enc/Marginalism.html
• Excerpts from Austrian Economists on the Subjective theory of value
• http://cepa.newschool.edu/het/essays/margrev/phases.htm
• http://www.introecon.com An online textbook in microeconomics that discusses marginalism