Marginalism

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Marginalism

• 4 March 2008

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The Economic Way of Thinking

• There is no free lunch.
• The cost of an action is the alternative that is
  sacrificed. 
  
• The relevant costs and benefits are the marginal
  (or incremental) ones.
  
• People respond to incentives.

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Thinking at the Margin

• In making choices, individuals weigh the
  additional costs against the additional benefits
  of their decisionsto themselves, but not
  necessarily to others.
• As the cost of an action rises, people will
  substitute relatively cheaper activities for the
  more costly activity.
  
• Few decisions are all-or-nothing.
•  

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Economic Way of Thinking

• One of the most useful economic concepts is
  marginalismthe effect of incremental, or small,
  changes (in relative prices).
  
• Marginal means additional.
• We make decisions based on expected marginal
  benefits and expected marginal costs.

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Power of Marginal Thinking

• The power of economics is in fundamental
  concepts.
  
• The power of marginalism can be seen in answers
  to such questions as
  
• Why are diamonds more valuable than water?
• Why do professional athletes earn more than
  school teachers?
  
• Why do price ceilings raise the price to buyers?
• Why dont college students study more?

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Diamond-Water Paradox

• Adam Smith struggled with what came to be called
  the paradox of "value in use" versus "value in
  exchange."
  
• Water is necessary to existence and of enormous
  value in use.
  
• Diamonds are frivolous and clearly not essential,
  but valuable in exchange.

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Adam Smith WN Book I, Chapter IV

• The things which have the greatest value in use
  have frequently little or no value in exchange
  and 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 scarce any thing. A diamond has
  scarce any value in use but a very great
  quantity of other goods may frequently be had in
  exchange for it.

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Solving the Paradox

• In 1870s the Austrian economist Carl Menger and
  the British economist William Jevons
  independently recognized the difference between
  marginal value and total value.
• The first gallons of water are used to satisfy
  the most important uses, and successive gallons
  are used for less important (less valuable)
  purposes.

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Total vs. Marginal Values

• Price reflects the value people place on one more
  unit of something (its marginal value), not the
  value of all of it (its total value).
  
• Because water is so plentiful (except in unusual
  circumstances), the amount people are willing to
  pay for one more gallon is close to zerothe
  marginal value of water is low.
• Diamonds are so rare that people are willing to
  pay thousands of dollars for one more.

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Total and Marginal Value of Water
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Total and Marginal Value of Diamonds
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Other Examples

• We have all heard arguments like these Something
  is wrong with the economy when professional
  athletes are paid a lot more than teachers.
  
• Food is far more important than golf, so we are
  making a big mistake by converting so much prime
  agricultural land to golf courses.

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Other Examples, contd

• Health care is certainly more important than
  recreation.
  
• If you are going to do a job, do it as well as
  you possibly can.
  
• Some things, such as human life, are simply too
  valuable to put a price on.

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How Economists Think

• Each of these sounds plausible.
• But all of them are flawed because they ignore
  the importance of marginal considerations.
  
• Failing to distinguish between marginal value and
  total value is all too common.

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Baseball Players vs. Teachers

• Price reflects the value people place on one more
  unit of something (its marginal value), not the
  value of all of it (its total value).
  
• Baseball players earn high salaries because one
  more baseball playerbecause they are so
  scarceis more valuable than one more teacher,
  because they are not as scarce.

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Teachers Ave. Salary 44,367

• Median annual earnings of kindergarten,
  elementary, middle, and secondary school teachers
  ranged from 39,810 to 44,340 in 2002 the
  lowest 10 percent earned 24,960 to 29,850 the
  top 10 percent earned 62,890 to 68,530.
• According to the American Federation of Teachers,
  beginning teachers with a bachelors degree
  earned an average of 30,719 in the 200102
  school year.
• The estimated average salary of all public
  elementary and secondary school teachers in the
  200102 school year was 44,367.

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3.8 Million Teachers

• Preschool, kindergarten, elementary school,
  middle school, and secondary school teachers held
  about 3.8 million jobs in 2002.
  
• Of the teachers in those jobs, about 1.5 million
  were elementary school teachers, 1.1 million were
  secondary school teachers, 602,000 were middle
  school teachers, 424,000 were preschool teachers,
  and 168,000 were kindergarten teachers.

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Teachers Earn Significantly More

• 3.8 million teachers
• Estimated average salary of school teachers in
  the 200102 school year was 44,367
  
• 168.6 Billion
• 800 MLB players
• Ave. 2,486,609 Median 1,570,600
• 2 billion

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Its No Contest
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Without the Surplus
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Decision Making

• Economists believe that sensible choice requires
  comparing marginal values and marginal costs.
  
• We also think that most people apply the
  marginalism concept regularly, even if
  subconsciously, in their private decisions.

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Snow Shovels

• In southern states, for example, a much lower
  fraction of people buy snow shovels than in
  northern states.
  
• The reason is that although snow shovels cost
  about the same from state to state, the marginal
  benefit of a snow shovel is much higher in
  northern states.

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Food Golf

• During the 1990s more than 10 million acres of
  farmland went to development.
  
• Farmland has been paved over for shopping centers
  and highways, converted into suburban housing
  tracts, and developed into golf courses.
  
• Sowhy would consumers willingly sacrifice food
  for golf courses, shopping centers, and parking
  lots? Isnt food more valuable than golf?

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Of Course it isin Total Value

• The choice is not between eating and golfing.
• The choice is a little more food or a little more
  golf.
  
• At the margin a little more golf is more valuable
  than a little more food.
  
• Developers have been able to outbid farmers for
  the land because the value of golf has risen
  relative to the value of food.
  

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Health Care vs. Recreation

• What is more important, health care or
  recreation?
  
• If forced to choose, everyone would find health
  care more important than recreation.
  
• But marginalism suggests that our real concern
  should be with proportion, not rank.
  

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Total Thinking Masks Tradeoffs

• Finding health care in total to be more important
  than recreation in total does not imply that all
  diving boards should be removed just because a
  few people die in diving accidents.
• The appeal of total value and intrinsic worth as
  the basis for decisions can mask the insights of
  marginalism.

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If a job is worth doing, its worth doing
right.

• People sometimes suggest that if a job is worth
  doing, its worth doing perfectly.
  
• But no matter how much time is spent on a job it
  can always be done better.
  
• At some point the value of doing the job a little
  bit better is less than the value of a little
  more time doing some other activity.
  
• Even if perfection were possible, it would be too
  costly.
  

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Equating at the Margin

• How long should you study for a test?
• You should equate at the margin
• Allocate your time over several activities so
  that the marginal value created from more time on
  each is the same for all.
  
• Trying to get straight Asa worthy goalmay mean
  foregoing valuable time looking for a job or
  looking for a spouse.
  

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Econ Professors UnderstandReally!

• Professors often complain that students are not
  taking their course work seriously.
  
• I often join in these complaints.
• We believe that our students would get more out
  of our courses if they never missed class, read
  the assignments carefully, and actually attempted
  their homework.

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Students Equate at the Margin?

• Being a good student can be important in
  achieving ones objectives, but so are lots of
  other things, such as working part-time, making
  friends, developing social skills, or just having
  fun.
• Long before a student has done the best job
  possible in his or her course work, the marginal
  value of time spent studying will have fallen
  below the marginal opportunity costthe marginal
  value sacrificed in other activities.

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The (Marginal) Value of Human Life

• All of us put a price on our own lives every day
  with the choices we make and the actions we
  take.
  
• We stay up too late, eat and drink too much, fail
  to exercise enough, and drive too fast.
  
• The total value we put on human life is extremely
  high, but the marginal value is pretty low.

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Price Controls Marginalism

• The 1970s price ceiling on gasoline caused
  consumers to pay far more for gas than they would
  have paid without it.
  
• That's right The price ceiling that was billed
  as a way to protect consumers against high gas
  prices increased the cost of gas.
  
• Because consumers wanted more gas than was
  available with the price ceiling, the marginal
  value of gas to them was greater than the
  controlled price.

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Price Controls on Gasoline

• With price controls, people commonly compete by
  waiting in line.
  
• They will wait until the cost per gallon (the
  controlled price plus the opportunity cost of
  their time) is equal to its marginal value to
  them.
• Since the price ceiling increased the marginal
  value of gas, the cost of gas ended up higher
  than it would have been without the ceiling.
  

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How Much Higher?

• During the 1979 gasoline shortage, David
  Henderson calculated that the 80-cent-per-gallon
  price control caused consumers to spend about
  1.10 a gallon (30 cents per gallon in lost time)
  and that if the price controls had been removed,
  the market-clearing price of gasoline would have
  been 1.00.
• Consumers actually paid more than they would have
  without price controls, and producers made 20
  cents less. Both lost.

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Price Ceiling Raising the Cost
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Failure to Apply Marginal Thinking

• In 1974 the biggest bank failure in the nation's
  history occurred (up until that time).
  
• The Franklin National Bank, once the 20th
  largest commercial bank in the United States, was
  declared insolvent by the U.S. Treasury.
  
• Franklin generally approved a loan if the rate of
  interest charged was at least 1 percent above the
  average cost of the funds lent.

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Calculating Average Cost

• Franklin could easily calculate its average cost
  of borrowing money in the following way
  
• demand deposits (2 billion at 2.25)
• passbook savings (1 billion at 4)
• federal funds (1.7 billion at 10)
• total funds (4.7 billion)
• 5.42 percent average cost of money

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Average Cost Pricing

• When other banks charged a prime rate of more
  than 10 percent, Franklin made loans at 6.5
  percent.
  
• It is no wonder that Franklin was swamped with
  loan applications.
  
• On the loans it made of funds acquired in the
  federal funds market, it actually lost 3.5
  percent (6.5 percent - 10.0 percent) on the 1.7
  billion it borrowed for this purpose, or over 59
  million a year.

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Making Bad Loans

• If Franklin had followed marginal cost pricing,
  it would not have made new loans that didn't
  cover the additional cost (marginal cost) of
  obtaining the funds.
• Instead of losing 59 million on its additional
  loans, Franklin could have loaned all of its
  deposits to other banks in the federal funds
  market, and made 300 million a year on its 3
  billion in deposits while the federal funds rate
  was 10 percent.

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Wives and Mistresses

• Lets get back to spouses. Happily, economic
  analysis allows one to acquire insights into
  activities without needing first-hand
  experience.
• After a few years of marriage a husband may not
  find his wife very valuable at the margin.
  
• In contrast, the woman he meets at work or on a
  business trip seems far more interesting. (e.g.,
  Brad Pitt and Angelina Jolie)
  
• Also, he likely sees her in more interesting
  situations than in a messy kitchen with screaming
  kids.
  

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Wives Mistresses, contd

• If she becomes his mistress, with occasional
  liaisons in romantic settings, he can find
  himself exhilarated at the thought of the next
  encounter. His mistress is more valuable to him
  than his wife at the margin.
• The husband may think about leaving his wife for
  his mistress.
  
• But leaving his wife involves a different
  calculus from comparing the value of a little
  more time with his wife with that of a little
  more time with his mistress.

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Moving Away from the Margin

• A divorce is not a decision made at the margin
  but one that forces the husband to confront
  competing total values.
  
• Here the advantage can easily shift to the wife.
  
  
• Her marginal value may be small, but her total
  value can be very large.
  
• The husbands relationship with his children, his
  parents, and many of his friends his standing in
  the community and his financial prospects are
  all inextricably connected with his wife and
  marriage.

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Diamonds and Water

• The wife is like water and the mistress like
  diamonds.
  
• Given a marginal choice between the two, the
  husband readily spends a little less time with
  the wife for a little more time with the
  mistress.
• But when the choice is between the total value of
  the wife and the total value of the mistress, the
  wife often wins.

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Additional Reading

• Dwight Lee, Its the Margin that Counts, The
  Freeman Ideas on Liberty, June 2000.
  
• Dwight Lee, "Running Out of Agricultural Land,"
  The Freeman Ideas on Liberty - July 2000.
  
• Dwight Lee, Marriages, Mistresses, and
  Marginalism, The Freeman Ideas on Liberty,
  August 2000.
  
• Steven E. Rhoads, The Economists View of the
  World Government, Markets, Public Policy,
  Chapter 3. 1985.
  
• David R. Henderson, Price Controls on Gasoline?
  Bad Idea, Hoover Weekly Essays, June 23, 2004
  http//www.hoover.stanford.edu/pubaffairs/we/2004/
  henderson06.html