Monday, August 13, 2012

Goods Are Valued Unit by Unit - Robert P. Murphy

Goods Are Valued Unit by Unit

One of the most important advances in economic theory was the realization that people valued goods unit by unit, rather than comparing entire classes of goods against each other. Using their jargon, economists now say that people evaluate goods based on marginal utility.

The classic illustration of this new way of thinking is the so-called “water-diamond paradox.” At first glance, it seems odd that the price of water should be so low—restaurants will serve it for free!—while the price of diamonds should be so high. (Try asking your waiter for a complimentary glass filled with diamonds.) If economists think that the value of goods is ultimately related to humans trying to satisfy their subjective goals, how can diamonds possibly be more valuable than water? After all, you can’t satisfy too many goals if you die of thirst.

In the early 1870s, three different economists independently worked out the solution to this problem: Yes, it’s true that the way to explain the value of an object, is to get inside the head of the person who values it and understand his goals. But when this person makes actual choices in the real world, he never faces the tradeoff of “all the water” versus “all the diamonds.” If that really were the choice, then the person would most probably pick the water. But in normal life, there is so much water available that any particular gallon of it, has a very low value. In contrast, there aren’t enough diamonds to go around to satisfy all the uses people have for diamonds. That’s why any particular diamond is still quite valuable. Economists would say that diamonds are scarcer than water.

This principle of valuing goods by individual units applies in Robinson Crusoe’s world. For example, suppose one night Crusoe is careless and falls asleep while his campfire is still sending out embers. The wind carries one right onto Crusoe’s humble shelter (constructed out of vines, branches, and leaves). By the time Crusoe wakes up, the whole building is ablaze.

Crusoe realizes he has to hurry outside before the shelter collapses on him, and he has time to grab just one thing to rescue from the inferno. The only objects in the shelter are a fresh coconut and a watch that he was wearing at the time of his original shipwreck. What object should he choose to grab as he runs from the fire?

A superficial guess would say, “Crusoe should take the coconut, assuming that the goal of avoiding starvation is more important to him than keeping a useless memento from civilization.”
But that answer is wrong. That particular coconut will not mean the difference between starvation and nourishment. Indeed, Crusoe still has a stockpile of 99 more coconuts that are not near the fire. At the very worst, all the sacrifice means is that Crusoe will have to settle for eating only 19 coconuts on some particular day (not even necessarily the next day), rather than his normal 20. In fact, Crusoe may simply decide to work an extra 12 minutes at some point11 to knock down 21 coconuts and replace the one lost to the fire.

The general principle is that Crusoe will evaluate goods unit by unit. When he is deciding how valuable a particular coconut is, compared to a particular watch, he considers how his goals will be affected by those particular items. It is completely irrelevant to Crusoe that 100 coconuts are more valuable to him than 100 watches; that’s not the decision he faces as he runs out of the burning hut. No, he has to decide if one coconut is more valuable than one watch. And as we’ve seen, the loss of one particular coconut isn’t devastating at all. It simply means that Crusoe will have to eat a little less at some point, or that he’ll have to work a little more. Economists would say that on the margin the loss of a coconut is fairly insignificant. That’s why it’s perfectly sensible for Crusoe to grab the watch, which he values for sentimental reasons.

Lessons for the Young Economist

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