Marginalism
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In economics, marginalism is the theory that economic value results from marginal utility and marginal cost (the marginal concepts). Marginalism is the notion that what is most important for decision making is the marginal or last unit of consumption or production. For example, one automobile is very useful for getting around. An additional automobile might be useful in case the first is being repaired, or for spare parts, but it is not as useful as the first. A third automobile has even less utility than the first two. Given the price of cars, one would not expect many people to own three cars because the benefit they receive on the third car would be unlikely to exceed the price.
The theory of marginal utility was independently developed around 1870 by William Stanley Jevons in England, Carl Menger in Austria and Leon Walras in Switzerland. During discussions of which of those three had been the first to formulate the theory, a colleague of Jevons discovered a copy of Prussian economist H. H. Gossen's Die Entwicklung (1854). Gossen was recognised as the original author, and his work was reformulated in a less mathematical way, to make it more intelligible to the public. Gossen's posited connection between value in exchange and marginal utility was ultimately popularised by the three other European economists.
These advances in economic thought are known as the Neoclassical Revolution (or Marginal Revolution).
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Theories of value
Diamond-water paradox
The diamond-water paradox is the observation that even though water is essential to human life, the price of water is relatively low. Diamonds are frivolous and unimportant for human existence, yet the price of diamonds is substantially higher. Adam Smith, the esteemed and perhaps most famous economist, described the paradox in his seminal work An Inquiry into the Nature and Causes of the Wealth of Nations.
Cost of production
Adam Smith and David Ricardo both theorised that value is a result of the cost of production. Smith concluded that the economic value of a good is dependent on the amount of labor required to attain it. It followed that diamonds are expensive because it requires a lot of labor to find and mine them (labor theory of value). In long-run equilibrium, prices reflect costs per unit produced and a rate of profit that is equalized between sectors. Some economists, particularly many classical economists still believe this. However, this does not explain why emeralds, which are harder to find and more expensive to extract than diamonds, are not valued as highly, nor why large, easily extracted and easily found diamonds are worth much more than small, hard to extract ones.
The origins of marginalism come from Ricardo's theory of land-rent, in which the price of land depends on the productivity of the least productive land in cultivation—the marginal land. Thus, all else equal, as the demand for agricultural crops increases, the price of land rises as farmers move to less productive land.
Subjective value
Anne Robert Jacques Turgot proposed an innovative solution to the diamond-water paradox. He saw that value is subjective — it is in the eye of the beholder. That is, things do not have inherent value, but have value only insofar as people desire them: "Comparison of value, this evaluation of different objects, changes continually with the need of the person." Template:Ref Where water is plentiful, people value diamonds highly. A person stranded in a desert, however, would value water over diamonds.
Those who endorse subjective value theory (including mainstream modern economists) believe it is a refutation of intrinsicist value theories, such as the labor theory of value, which is a cornerstone of Marxism. Behavioral economics theorists explicitly seek to research and model how subjective framing of decisions affects the value an individual places on goods and outcomes.
Carl Menger and Eugen von Böhm-Bawerk, members of the Austrian School of economics, took subjective value further, developing the theory of marginalism.
Marginal utility
Marginal utility, or marginal benefit, is the additional utility (satisfaction or benefit) that a consumer derives from an additional unit of a commodity or service (output). The concept grew out of attempts by 19th-century economists to explain the fundamental economic reality of price. Austrian economist Friedrich von Wieser coined the term.
The Austrian economist Eugen von Böhm-Bawerk gave probably the most memorable description of the marginal theory of value, one often used by economics textbooks. Loosely translated it is:
A pioneer farmer had five sacks of grain, with no way of selling them or buying more. He had five possible uses: as basic feed for himself, food to build strength, food for his chickens for dietary variation, an ingredient for making whisky and feed for his parrots to amuse him. Then the farmer lost one sack of grain. Instead of reducing every activity by a fifth, the farmer simply starved the parrots as they were of less utility than the other four uses; in other words they were on the margin. And it is on the margin, and not with a view to the big picture, that we make economic decisions.
The law of diminishing marginal utility refers to the marginal utility of each additional unit of a good having less value than the previous unit. For example, the marginal utility of an additional slice of bread to a person with few slices will be great. But the marginal utility of an extra slice of bread to a person with many slices will be small.
Diminishing marginal utility is a very common assumption in economics, but it is not universally assumed. It corresponds to convexity of the indifference curves.
Note: On the indifference curve it is the good along the x-axis whose marginal utility starts to diminish with an increase of every unit, whereas the marginal utility of the good along y-axis keeps increasing with loss of every 'y' unit, which makes the customer less willing to trade-off 'y' for 'x' as he accumulates more of 'x' and is left with less of 'y'.
Marginalism and schools of economic thought
Neoclassical economics
Neoclassical economists derive demand curves from indifference curves, of which one assumption is diminishing marginal utility. Although the scarcity of factors of production is still thought to be important, individual demand and the marginal benefits that they would obtain from a good is seen as the driver of the whole process and the ultimate source of economic value.
Austrian School
The Austrian School accepts marginalism more completely, making a clear break from the factor-input theories of value. They used marginal utility as a starting point: for example, the supply of labor reflects the subjective marginal utility of leisure (and the marginal disutility of work).
Austrian economists formulated the law of marginal utility in a period when psychologists were much interested in the Weber-Fechner law of sensation. The Weber-Fechner law states that in order that the intensity of a sensation may achieve an arithmetic progression, the stimulus itself must achieve a geometric progression. For example, in a quiet environment, humans will notice even a small increase in noise level, but when the given noise level is already loud, humans will need a much larger increase in order to perceive a difference.
Friedrich von Wieser's seminal essay on "Natural Value" appeared in 1889. In 1890, the American psychologist William James wrote his Principles of Psychology and offered an interpretation of the Weber-Fechner law that may also shed a lot of light on marginal utility in von Weiser's sense. James saw the Weber-Fechner law as a rough generalization as to the friction in the neural machinery.
If our feelings [of weight, sight, sound, etc.] resulted from a condition of the nerve molecules which it grew ever more difficult for the stimulus to increase, our feelings would naturally grow at a slower rate than the stimulus itself," he wrote. "An ever larger part of the latter's work would go to overcoming the resistances, and an ever smaller part to the realization of the feeling-bringing state.
Whatever the neurological basis, the result of diminishing marginal utility is that rather than having a lot of one good or a lot of another one, one prefers having some of both. In the case of perfect substitutes this result does not apply (since the two products are essentially the same); in the case of perfect complements it applies most.
Marxist School
Karl Marx died before marginalism became the accepted interpretation of economic value and neoclassical economics replaced classical political economy. His theories were based on the labor theory of value, which distinguishes between exchange value and use value.
Some economists strongly influenced by the Marxian tradition such as Oskar Lange, Wlodzimierz Brus, and Michal Kalecki have attempted to integrate the insights of classical political economy and neoclassical economics. They believed that Marx lacked a sophisticated theory of prices, and neoclassical economics lacked a theory of the social frameworks of economic activity.
Marxists often criticise capitalism for its "commodity fetishism" or the "illusions created by competition" arguing that capitalists dominate the working class and exploit them. They argue that although individual economic visions and decision-making play a role in Marx's theory, he thought that it was necessary to understand the totality of capitalist social relations (in volume I of his Das Kapital) before it was possible to understand this consciousness and action (in volume III of that book). Some Marxists argue that on one level there is no conflict between marginalism and Marxism: one could employ a marginalist theory of supply and demand within the context of a "big picture" understanding of capitalist exploitation of labor.
Criticism of marginalism
Marginalism has been criticised for being extremely abstract, with the concept of "marginal utility" being described as "unobservable, unmeasurable and untestable".[1] While utility (in the sense of usefulness) has some objectivity, vital substances such as air, water, and staple foods are free or inexpensive, and marginal utility is somewhat subjective as the "value" of an additional unit of consumption would seem to be based on the individual's circumstances.
According to its critics, marginalism is individualistic and focuses too much on the market rather than production.[2] The theory is attacked for downplaying the role of cost of production in price determination in favor of a focus on individual's tastes and preferences. In its most extreme Austrian version, marginalism denies that an objective, cost-based, component exists at all. Rather the Austrians argue that costs of production are merely just the manifestations of individual's preferences over labor vs. leisure and saving vs. consumption.
Furthermore, despite its emphasis on logical rigor, the theory is charged with being circular: for consumers to evaluate utility they need to know the relative prices of goods, yet prices are presumed to be based on utility. For example, the "utility" that people derive from diamonds is inseparable from their knowledge that diamonds are expensive. Ludwig von Mises provided an answer to this with the Theory of Money Regression.
External links
- http://www.econlib.org/library/Enc/Marginalism.html
- Excerpts from Austrian Economists on the Subjective theory of value
- http://cepa.newschool.edu/het/essays/margrev/phases.htm
- Theory of Money Regression