All Terrain Thinking

A Compendium of things I think are Important

Economics: It's not just whats' in your wallet

Why are diamonds more expensive than water? This is a question that caused economists problems many years ago because water was essential for survival, but its price was lower than that for diamonds which we could easily do without. As a first step toward an understanding of the answer, we will look more closely at the consumers' choices which are reflected in the demand curves.

At the center of our analysis is the notion that individuals will make their choices in such a way as to increase their well being. Economists have developed rather elaborate models to explain the behavior of individuals and households? More specifically, to explain decisions regarding spending, working, and saving? When economists attempt to explain behavior of individuals, they start with the premise that people are rational - that they make choices in such a way as to move them toward their objective of greater satisfaction. Each choice is assumed to be made after a careful weighing the benefits and costs of the decision - the optimal choice being the result of the interaction of individual preferences and constraints.

This turns out to be a very flexible framework that will allow us to explain the behavior of individuals in the three major markets - output, capital, and labor - and with some modifications, it could also be used to explain non market activities such as marriage, divorce, and fertility. You also should be aware that not all economists support this framework. There tend to be four concerns with the model: that it does not adequately reflect the thought process, that individuals do not know what they want, that they do not know the array of prices, and that prices may affect individual's perceptions of the goods or services. Now let us move to our analysis of consumer choice in the output market.

We start with the premise that we are talking about 'goods' - that there is a positive relationship between the level of consumption and the sense of well being - what economists call utility. Baumol and Blinder define total utility of some bundle of goods to some consumer as the "largest sum of money that [a] person will voluntarily give up in exchange for those goods" But how much will someone pay for an additional unit of a good? We would call this marginal utility and we would expect that as your consumption of the good increases, you will not value the later unit as highly as the earlier ones. How much would you value one ice cream cone on a hot afternoon? How much would you value the fourth ice cream cone? I suspect you would pay more for the first than the fourth - and if you agree, then you have indicated that you believe in the concept of diminishing marginal utility.

If you accept this, is their any 'rule' that should guide you in your efforts to maximize your satisfaction (total utility)? As you would expect, there is such a rule - and it is fairly easy to see the logic. To better understand the rule, consider the situation faced by Chris who values another ice cream at #.00 and the price is $2.00. What should Chris do? It would seem as though Chris would buy the cone since the increase in value is greater than the cost. Following this logic, Chris would continue to buy extra cones as long as MU > P. This gap would be expected to close, however, as Chris bought more cones due to diminishing marginal utility. Eventually we would reach a point where MU = P, where the value added by consuming another cone just equals the price. If we went further and MU < P, we would cut back on our consumption since the additional value created would be less than the price. The optimal rule is then:

What does this mean for our analysis of demand? It means that we could expect an inverse relationship between price and demand. If we assume that an individual is consuming the optimal level of good X, then MUx = Px. As the price falls, however, consumers will find that MU > P and they will increase their consumption of X which will drive down MU (diminishing MU) and reestablish a balance between P and MU.

Before we leave let's return to our initial question. Water is less expensive than diamonds because of relative scarcity. A diamond is relatively scarce so the marginal utility of diamonds may be high, while because there is so much water available, the marginal utility of water is low because of the rule of diminishing marginal utility.

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