Cuckoo for Marginalism

When I was a kid, I would ask my mother if she likes this cereal, that song, or this soft drink. 

She would often reply in her droll way: “I wouldn’t want a steady diet of it.”

I came to conclude that this really meant that she didn’t like it. 

I was wrong. She was thinking in terms of margins. She would perhaps like one experience but not three or four, much less a constant stream. It’s not whether we are for or against something. It’s how much we like a thing in its incremental consumable unit. 

Hence, when you decline the second piece of pie, you aren’t saying you don’t like the pie. You are saying that you liked one piece but not two. 

So it is when the girl breaks up with the guy, saying “I think you are fun, funny, cute, charming, and wonderful in so many ways; I’m just not ready for a big relationship right now,” this is not code for “take a hike, I don’t like you.” This means that she likes you but on the margin wants something else even more in the future, such as independence, more alone time, or whatever it could be. It’s not you; it’s her. 

If we could learn to take the margin more seriously, we would all learn to think more clearly and carefully about a number of life issues. What was previously mysterious now seems rather obvious. What had previously baffled you now seems perfectly clear. The marginalist way of thinking becomes, in the most colloquial use of the phrase, “common sense,” in the marvelous phrase of Phillip Wicksteed. 

I’m thinking about all of this following a masterful presentation by Phil Magness at the American Institute for Economic Research. He was explaining the history of economic ideas for some visiting students. He noted the special role that Carl Menger’s 1871 book Principles of Economics played in the rediscovery of marginalism as a core principle of the theory of choice, following centuries of confusion. 

The discovery of marginal utility was to this generation as significant as the discovery of flight, electricity, and the theory of evolution. It was a paradigm shift, an insight that changed everything. You can read a first-hand account of what it was like from the pen of Frederic Weiser. 

Menger is great but Wicksteed’s analysis is my favorite exposition of the marginalist point of view. Wicksteed writes with the passion of a hobbyist (he was actually a Unitarian minister in “real life”), but with a precision that exceeded all the professional economists of his time. His masterwork still stands as the most elaborate, detailed, and extensive explanation of the idea ever written.

His book opens with the perfect quotation from Goethe: “We are all doing it; very few of us understand what we are doing.”

Quite so.

If you stick with his argument from beginning to end, your thinking will be permanently affected. You will see marginal utility all around you, in every economic action. It will provide new ways of thinking of prices, resources, and human behavior. You will have an impenetrable edifice against the fallacy of thinking of the value of whole classes of goods and services, and instead will see value as exclusively attached to the incremental choice of the acting person.

What is marginalism? It is the notion that economic value extends from the incremental choice of one unit at a time.

Why does this matter?

Let’s say a friend invites you to his wedding. You say that you would love to go, but you have a work meeting you must attend that very day. You really want to go, but you can only do one thing at a time, and protecting your career at this point seems gigantically important.

Your friend understands. For now. But then the wedding comes, and you are not there. The picture album comes out, and you are nowhere to be seen. The memories are beautiful and exciting, yet you are not part of them. Over time, your friend begins to think: Hey, I thought he was a friend, but he ditched my wedding with some lame excuse. He must not be the friend I thought he was. I hate him.

This happens all the time. It happens because people do not think about marginal utility. It is not constantly in our minds. That’s hardly a surprise, because it took humanity one-hundred-thousand years to discover it. In scientific terms, it is a fairly recent discovery. It will probably take another few hundred years before the concept is emblazoned on our hearts. Meanwhile, those who get it are better at navigating life.

For example, I have a cup of coffee in front of me. I made it with my Keurig coffee maker. Each Keurig cup costs 50 cents. Is that too much or too little? On the one hand, it is crazy expensive. I could pay $4 for a full can of coffee and make probably 40 cups, paying only 10 cents per cup. 

Why don’t I do this? Because my choice is made at the margin. I’m not evaluating a whole stock of a good or consuming an entire pot much less the whole world’s coffee supply. So the lower price of the whole is of no matter. I’m making my value judgments on just the one cup of coffee that I want to drink right now. This is the relevant unit, not some abstraction concerning how much coffee is at the store or on the ships coming from Africa or the whole stock of coffee growing in plantations all over the world. What matters to me in making the choice of whether the coffee is “worth it” is the cup right in front of me.

The classic puzzle that marginal utility sought to solve was this: Why are diamonds so much more valuable in the market than water, even though water is obviously more necessary for life? Just on the face of it, shouldn’t it be the reverse? Marginalism solves the issue. The choice for one or the other is made on the incremental unit, not on anyone’s opinion on the value of the whole class of goods. 

From the point of view of human choice, water is usually far more plentiful and available than diamonds, whereas diamonds are much less so and, therefore, have a much higher value per unit. The situation could reverse itself in a different social context. A man dying of thirst in the desert will pay far more for water than diamonds. This is how prices come to be: The choice at the moment of decision-making for or against the increment of what is available right now.

Marginal utility theory solves many other seeming mysteries. Why are movies that cost tens of millions of dollars to make available for download for only a few bucks or even for free, while video games that might cost only a few thousand dollars to make priced $50 and $100? The answer is that the user is not making judgments based on the cost of production, but only on the use value of one unit to him or her at the point of decision making.

Marginalism helps explain wage puzzles too. Why do plumbers make so much more money than babysitters, even though babysitters are guarding and protecting human lives and plumbers are only unstopping drains? The babysitter might indeed have great total utility to society, but the market makes judgments on the margin. Babysitting services are much easier to come by, whereas plumbing services are relatively scarcer. Consumers do not care about total utility; they care about obtaining the service in the one instance in which they need it. That decision is what determines the price.

This insight further addresses wage issues that would otherwise mystify people. Why does a basketball star, who would seem to provide nothing necessary to human life, make so much more money than a reading teacher, who is teaching a crucial skill? Again, it is not the total utility of the task that matters for economics, but the utility of the incremental choice of the acting person.

Why, on holidays, are restaurants open but banks closed, when surely banking provides a more unique service to society and anyone can cook stuff at home anytime? The answer is that restaurants make higher profits on the margin on holidays, when people want to go out to eat, whereas the banks have discovered that their profit margins are best served by opening when people tend to do their banking, which is not on holidays.

Marginalism helps illuminate many other economic concepts, such as opportunity cost (the real cost of anything is the thing you give up to get it), subjective value (economic value resides in the human mind, not the physical good), diminishing marginal utility (the more of each additional unit you buy, the less you are willing to pay for it), and the relationship of cost and price (the cost of a good never dictates its market prices; indeed, the reverse is true). 

It provides insight into nearly every aspect of human behavior, provided we have maximum choice to express our preferences.

On the other hand, political democracy poses a serious problem for the reality of marginalism. When people vote, they seem to be making an absolute choice for someone to be a ruler. This is where the idea of a “mandate” comes from.

In reality, people are most often choosing on the margin: avoiding a worst fate, holding their noses to guess at the least bad, doing what they feel they must do under the circumstances, or maybe expressing a temper tantrum over one which issue among a million – same as the rest of life. Politics chews up all these complications and spits them out as your new overlord, as if marginalism doesn’t matter.

Markets, in contrast, are forever accommodating choices on the margin – a daily plebiscite in which every voter/consumer wins, as Ludwig von Mises says. 

Small and great evils in the world have come from absolutism, the belief that there is only one way forward, and that if that way is not what you choose, that makes you the evil enemy. Governments think this way. They don’t think on the margin. A world of billions of people acting and thinking based on marginal utility is too complicated a notion for them. So they decide to just ignore it all and divide the world between us and them.

On the other hand, if you think in terms of marginal utility, the scales truly do fall from your eyes. The world looks less black and white, good and evil, dark and light, and instead becomes much more colorful, interesting, complex, and subtle. The marginalist realizes that the whole world is built in tiny steps as an extension of a complex decision-making process that is ultimately rooted in the subjective, and that bringing people together can never come through force, but only through small acts of persuasion, one person at a time. In that way, too, marginalism can, on the margin, make you a happier, nicer, and more emphatic person. 

My mother was right: no one wants a steady diet of one thing only. But a steady diet of the theory of marginal utility? I’ll take that.

Related Articles – Economic Theory