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In most academic disciplines, there is often a single idea or discovery which makes everything fall into place.
All of the things which didn’t make sense before suddenly do when looked through this new lens.
These eye-opening discoveries usually occur in the hard sciences, but one such advancement also took place in the field of economics.
Learn more about the Marginal Revolution and how it changed economic through on this episode of Everything Everywhere Daily.
There are certain ideas, discoveries, or theories which are fundamental to many scientific disciplines.
These are keystone theories through which you can analyze almost everything on that particular subject.
A good example is plate tectonics and geology. Once plate tectonics was understood, it explained earthquakes, volcanoes, and the movement of continents.
Understanding the structure of the atom made sense of the periodic table and most of chemistry.
Newtons’s theories made sense of gravity and motion. Maxwell’s equations made sense of electromagnetism.
The discovery of DNA made sense of biology and all living things.
Before these discoveries were made, the understanding of the various scientific disciplines was incomplete. Some things didn’t make sense or couldn’t be made consistent with other known facts.
Economics also had its moment when a theory was able to make things click into place and solved one of the field’s longest outstanding problems.
The statement of the problem is often attributed to Adam Smith, who wrote the Wealth of Nations in 1776, which is often considered to be the first real book on economics.
However, the problem actually dates back to Plato and was restated by other intellectuals such as Nicholas Copernicus and John Locke.
It is called the Diamond-Water Paradox.
Water is one of the most important substances there is. Without it, you’d probably die in a matter of days. We use water for a host of other important purposes, including cooking, sanitation, cleaning, and many others.
Water is really important.
Diamonds, on the other hand, are actually pretty useless. They are pretty, and there are some limited industrial uses for cutting hard surfaces like concrete or metal.
Yet, despite their limited use, diamonds are incredibly expensive. Certainly much more expensive than water.
Adam Smith stated the problem in the Wealth of Nations as follows:
The things which have the greatest value in use have frequently little or no value in exchange; on the contrary, those which have the greatest value in exchange have frequently little or no value in use. Nothing is more useful than water: but it will purchase scarcely anything; scarcely anything can be had in exchange for it. A diamond, on the contrary, has scarcely any use-value; but a very great quantity of other goods may frequently be had in exchange for it.
This puzzled philosophers for centuries. None of the great minds I mentioned earlier, including Adam Smith, were able to resolve the paradox.
Smith and other early economist such as David Ricardo and Karl Marx believed in what is called the labor theory of value.
The labor theory of value holds that the price of something reflects the amount of labor which goes into acquiring or creating the product.
At first glance, this sort of makes sense. Something which took a skilled craftsman a year to make would probably command a high price.
The problem was that it didn’t always hold. The amount of labor that goes into an expensive bottle of wine isn’t any more than the labor that goes into a cheap one. Yet, they are priced very differently.
Likewise, if you happen to randomly find a diamond on the ground, it would be worth just as much as one which was dug up from the ground.
Moreover, most buyers don’t care or don’t know how much labor goes into the creation of a product.
This puzzle was finally resolved in the latter half of the 19th century when a trio economists, William Stanley Jevons from England, Carl Menger from Austria, and Léon Walras from France, all came upon the answer at approximately the same time.
The solution had two parts.
The first was rejecting the labor theory of value and replacing it with the subjective theory of value.
The subjective theory of value is pretty straightforward. People want what they want. Some bottles of wine are valued higher than others because that is what people like. Some baseball cards are valued more than others because people like certain players.
So the subjective theory of value would just say that diamonds are priced more than water because people subjectively are willing to pay more for them.
However, that doesn’t really explain why people value diamonds more than water.
The insight into that comes from the concept of marginal utility.
Before I go further, I should explain the concepts of utility and of marginalism.
The term utility was coined by utilitarian philosophers, and the term originally meant happiness or pleasure. However, in an economic context, it has a broader meaning beyond happiness. It can also imply usefulness or anything that has some sort of value.
So, the utility you get from a screwdriver might be different from the utility you get from watching a movie and might be different from the utility you get from drinking water. However, they all fall under the general umbrella of utility.
When you talk about “the margin,” you are referring to an increment. The marginal amount of something in the next incremental unit of something.
Marginal utility is the incremental utility you get from something.
Why is this important?
Because the choice between water and diamonds isn’t between all water and all diamonds. If we had to make that choice, we’d choose water. The total utility of water is greater than that of diamonds.
The real question is the marginal utility of purchasing water or diamonds.
There is a lot of water. It is easy to get, and people consume it frequently. Diamonds are rare, and the average person will probably purchase one or none of them in their lives.
Why is this relevant? Because the marginal utility you get out of something decreases the more of it you have, or as it is called in economics, diminishing marginal utility.
Here is an example: A diamond is worth more than a glass of water, but is there any scenario you could imagine where you would exchange a diamond for a glass of water?
The answer is, yes. Imagine you were lost in the desert without water. You are parched and on the brink of dying of thirst.
As you crawl out of the desert, you encounter someone who offers you a glass of water in exchange for a diamond. Would you do it? Probably.
Now imagine you are offered a second glass of water. How would you value that? You’d still probably put a high value on that glass of water as you are still probably dehydrated, but not as much as that first glass that saved your life.
Now consider a third, fourth, fifth, and sixth glass of water. By this point, you are probably fully hydrated. Eventually, you don’t want any more water. You’re good. The marginal value you get from the 10th glass of water isn’t the same as what you get from the 1st glass of water.
In fact, you might get decreasing utility from drinking more water. It will actually harm you beyond a certain point.
So the reason why water is so cheap is that almost all of us are well along the marginal utility curve. We aren’t dying of thrist so what we are willing to pay for water is much less than someone who is desperate.
Likewise, we are closer to the dying of thirst part of the curve with diamonds. There aren’t a lot of diamonds, so most people are buying their first diamond, which means there is a very high marginal utility to the first one.
The reason why this way of thinking is called the Marginal Revolution is that it had implications for almost every part of economics.
One of the biggest ramifications of the marginal revolution is the law of supply and demand.
Because we all subjectively value things differently, we all have different amounts that we would be willing to pay for something. The aggregate of all our price points could be drawn on a curve with the price and the total quantity that would be purchased.
A small number of people would value something at a high price, and more people would buy it as the price goes down.
This is the demand curve which is downward sloping
The flip side of marginal utility for producers is marginal cost. Marginal costs are the incremental costs for the production of the next unit of the good. You can also plot out a supply cure based on marginal costs. The higher the price, the more of something will be produced. The lower the price, the less of it will be produced.
The supply curve is upward-sloping.
Where these two lines cross, you find an equilibrium point which will be the price set by the market.
The laws of supply and demand are determined through marginal analysis.
Marginal thinking permeates economic thought. It helps understand decisions made by producers as well as consumers.
You might have heard of something called the Sunk Cost Fallacy.
The Sunk Cost Fallacy basically says you shouldn’t throw good money after bad. The reason why the sunk cost fallacy is a fallacy has everything to do with the return on a marginal investment. No matter how much money you’ve already spent, if continued spending isn’t going to bring a return, it isn’t worth spending anymore.
One of my undergraduate majors in college was economics. Probably the biggest thing I came away with was marginal thinking.
For example, when I was doing travel photography, I would often submit my photos for awards. I would have to pay an entry fee for each photo I submitted.
I submitted quite frequently and was pretty successful. In one contest, I had won 46 different awards of various levels and in various categories over the years.
Eventually, I realized that there was little marginal benefit in winning a 47th award.
The first award had a lot of marginal value to me. I could say I was an award-winning photographer. Then I could say I won multiple awards. But eventually, it reached a point where there was no benefit anymore, and the money I was spending on entry fees was no longer worth it.
The marginal cost of entering was greater than the marginal value of winning.
Thinking on the margin can be very powerful. All of us do it all the time, even if we don’t consciously know we are doing it.
However, if you are aware of it, it can help you make better decisions, and you’ll understand why this method of thinking helped to revolutionize economics.
The Executive Producer of Everything Everywhere Daily is Charles Daniel.
The associate producers are Thor Thomsen and Peter Bennett.
If you’ve been following along, you might have realized that this podcast is very close to episode number 1000.
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If you have a story about listening to the podcast or a favorite episode, or anything you’d like to share, feel free to leave me a short voice message.
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