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In economics, marginalism is the theory that economic value results from marginal utility and marginal cost. The theory of marginal utility was around 1870 being independently developed on somewhat similar lines by William Stanley Jevons in England, Carl Menger in Austria and Leon Walras in Switzerland . HH Gossen had also discovered of the connection between value in exchange and marginal utility, but it was ultimately forced into notice by the three European economists. These advances in economic thought are known as the Neoclassical Revolution (or Marginal Revolution).
Marginal utility is the idea that we don't consider classes of goods, such as all the automobiles in the world versus all the hot dogs in the world. Instead, we consider each unit at the margin. 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. And a third automobile has even less utility than the first two.
Theories of Value
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 frivilous 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 The Wealth of Nations.
Cost of Production
Adam Smith and David Ricardo both theorized 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.
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.
Anne Robert Jacques Turgot brilliantly solved 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." 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 intrincisist 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.
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. 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.
Diminishing marginal utility refers to how 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.
Marginalism and Schools of Economic Thought
Neo-classical 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.
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.
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.
Marxism criticises capitalism of "commodity fetishism" or the "illusions created by competition" arguing that capitalists dominate the working class and exploit them. Though 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 possible to understand this consciousness and action (in volume III of that book). Thus, some 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.
- Excerpts from Austrian Economists on the Subjective theory of value
- Marginal Revolution, an economics weblog
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