Definition of 'Marginalism' The study of marginal theories and relationships within economics.

The key focus of marginalism is how much extra use is gained from incremental increases in the quantity of goods created, sold, etc. and how those measures relate to consumer choice and demand. Marginalism covers such topics as marginal utility, marginal gain, marginal rates of substitution, and opportunity costs, within the context of consumers making rational choices in a market with known prices. Investopedia Says Investopedia explains 'Marginalism' The idea of marginalism, and its value in establishing market prices as well as supply and demand patterns, was popularized by British economist Alfred Marshall in a publication dating back to 1890. Marginalism is sometimes criticized as one of the "fuzzier" areas of economics, as much of what is proposed is hard to accurately measure, such as an individual consumers' marginal utility. Also, marginalism relies on the assumption of (near) perfect markets, which do not exist in the practical world. Still, the core ideas of marginalism are generally accepted by most economic schools of thought, and are still used by businesses and consumers to make choices and substitute goods.

Title: Marginalism 1 Marginalism

4 March 2008

2 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.

3 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.

4 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.

5 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

6 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.

7 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.

8 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.

9 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.

10 Total and Marginal Value of Water 11 Total and Marginal Value of Diamonds 12 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.

13 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.

14 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.

15 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.

16 Teachers Ave. Salary 44367

Median annual earnings of kindergarten elementary middle and secondary school teachers ranged from 39810 to 44340 in 2002 the lowest 10 percent earned 24960 to 29850 the top 10 percent earned 62890 to 68530. According to the American Federation of Teachers beginning teachers with a bachelors degree earned an average of 30719 in the 200102 school year. The estimated average salary of all public elementary and secondary school teachers in the 200102 school year was 44367.

17 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 602000 were middle school teachers 424000 were preschool teachers and 168000 were kindergarten teachers.

18 Teachers Earn Significantly More

3.8 million teachers Estimated average salary of school teachers in the 200102 school year was 44367 168.6 Billion 800 MLB players Ave. 2486609 Median 1570600 2 billion

19 Its No Contest 20 Without the Surplus 21 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.

22 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.

23 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

24 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.

25 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.

26 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.

27 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.

28 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.

29 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.

30 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.

31 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.

32 Price Controls Marginalism

The 1970s price ceiling on gasoline caused consumers to pay far more for gas than they would have paid without it. Thats 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.

33 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.

34 (No Transcript) 35 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.

36 Price Ceiling Raising the Cost 37 Failure to Apply Marginal Thinking

In 1974 the biggest bank failure in the nations 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.

38 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

39 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.

40 Making Bad Loans

If Franklin had followed marginal cost pricing it would not have made new loans that didnt 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.

41 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.

42 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.

43 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.

44 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.

45 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 BadIdea Hoover Weekly Essays June 23 2004 http//www.hoover.stanford.edu/pubaffairs/we/2004/ henderson06.html