Some of you may be familiar with the diamond-water paradox: water is the liquid that sustains all life on Earth. Every living thing, humans included, need water. And yet diamonds are bought and sold for far higher prices than that of water. How can this be?
There are 2 parts to the answer: the utility (a term meaning “happiness” or “satisfaction” that economists use to sound smarter) we get from water exceeds the utility we get from diamonds. If we had to choose between living without water or living without diamonds, most people would easily choose the latter in a heartbeat. But let’s slightly change the question: would you prefer a diamond or a bucket of water as a gift?
The answer depends on whether one additional diamond gives greater utility than one additional bucket of water. This is known as marginal utility: the added satisfaction you get from consuming one more unit of a good, in this case being diamonds or water. If an additional diamond gives you 100 utils, but an additional bucket of water gives you 5 utils, you receive greater utility from that diamond and so that’s probably what you would choose.
On a quick side note, economists calculate utility based on the price of the good or service the consumer bought it at. If I buy a diamond for $100, this must mean that the diamond gives me at least 100 utils, otherwise why would I have bought it? If the diamond gave me only 50 utils, I’d only be willing to give $50 for it. Also be sure to keep in mind the term “at least” - it’s possible that the diamond gives me 1000 utils, but we don’t know that for sure. All we know is that it gives me at least 100 utils.
Say that you like to play video games (well there’s probably not a need to pretend), how much would someone have to pay you to not play video games? If a friend offers you $20 to stop playing and you accept it, video games are worth no more than $20 to you - they give you no more than 20 utils.
In contrast, total utility describes the aggregate amount of utility one receives from a good. Think back to the first question - people would rather do without diamonds than without water. Water provides a greater total utility than diamonds.
Marginal cost - what it costs to produce or consume one extra unit of whatever you’re producing or consuming - is also something that ties in with how people make decisions. Going back to our video game example, say that the marginal cost for playing video games is $5 but you still receive 20 utils. Continuing to play video games makes sense since the benefits (20 utils) outweigh the costs ($5). But if we increase the price to $25, it doesn’t make much sense to continue playing; the costs ($25) outweigh the benefits (20 utils).
Marginal analysis in economics can be traced back to the work of 3 economists in the 1860-70s:
William Stanley Jevons, England: first proposed the theory of marginal utility in his book A General Mathematical Theory of Political Economy, in which he emphasized that value depends entirely upon utility. If someone doesn’t obtain any utility from a good or service, it’s not valuable.
Carl Menger, Austria: in his book Principles of Economics, he argued that individuals should be expected to rank possible uses of resources and then use marginal utility to decide and determine if the trade-offs are worth it.
Say you have an hour of time and you can spend it either browsing YouTube, reading a book, or doodling. Each of these activities gives you 20, 10, and 5 utils, respectively. With this in mind, you’d go for browsing YouTube since that gives you the most utility and the costs of doing so (namely sacrificing either 10 or 5 utils) are worth it. This is what’s known as cardinal utility - giving different choices a quantitative utility value (i.e. choice A gives me 5 utils and choice B gives me 10 utils and we rank from there).
Léon Walras: furthered the ideas of Menger and Jevons in Éléments d'économie politique pure and also attempted to separate moral values from utility
“Whether a substance is searched for by a doctor to heal an ill person, or by an assassin to poison his family, this is an important question from other points of view, albeit totally indifferent from ours. The substance is useful, for us, in both cases, and may well be more useful in the second case than in the first one.”
A practical application
Marginalism is a rather flexible theory, one that can be applied to almost all decisions you make in real life. Here’s an example of how it would play out in the real world:
Say you’re in a pool and you record the total utility you receive from each lap you swim. You received 100 utils from your first lap and 300 utils from your last. The utility you received from each lap tripled. Seems pretty good right? But keep in mind that this is just total utility - it doesn’t tell us how “productive” each lap is at satisfying you. If we used the logic from the first table, it would make sense to swim hundreds of laps in order to maximize your utility. Something is missing here. Consider the second table:
Each additional lap you swam gave less and less utility - the marginal utility decreased. The way we calculated this was by subtracting the current lap’s total utility from the previous lap’s total utility (i.e. lap #2 156 utils - lap #1 100 utils = 56 utils). This tells us how much utility you receive from each additional lap. As you can see in the table above, the marginal utility decreases with every lap you swim.
This is diminishing marginal utility and it explains a lot of our seemingly contradictory behaviours and preferences. If you like having a can of soda every now and then, why would you not like 50 cans? If exercising for an hour makes you feel good, why not exercise for 24 hours straight? If you liked that book you just read, why not read it 100 times? The answer to all of these questions is diminishing marginal utility.
In our next article we’re going to look at even more practical applications of marginalism and how firms use it to maximize profits.