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danieldwilliamToday’s excursion into the Ten Pillars of Economic Wisdom takes us to Pillar number 3.
Economic thinking is thinking on the margin.
How does behaviour change as people have slightly more or slightly less of a thing? Or the opportunity to have slightly more or less of thing? What decisions do I make when looking at my current position and deciding whether to move to a different position?
On the consumption side of the equation the general position is that the more I have of something the less use one more of it is. I really value my first litre of water of the day, not so fussed about my hundred and twenty first.
Concepts of marginality are key to understanding economic behaviours. Here we are looking at things like the marginal cost to a firm of producing one extra item of a good, the marginal utility to a consumer of consuming one extra unit of a good, and what is the marginal rate of substitution, (how many of good X will I swap for a unit of good Y and still consider myself just as satisfied.)
I like beer. If I go out I like to have a beer. I’m really thirsty. I quite enjoy a second beer. One beer is tasty and refreshing but I can really savour my second beer, so it’s pretty good. A third beer, combining the garrulous effect of slight inebriation with the retention of my razor sharp wit and polymathic range of knowledge makes me a conversational god amongst men. I can’t actually taste much of the beer now but I’m enjoying the mind altering effect the alcohol is having. By beer 4 I am not restrained by my modesty any longer. I may start dancing. Or maybe even singing. I’m a little drunker than after beer 3, not so sharp but generally a little merrier. Tipsy but still able to operate my own trouser zipper best out of three.
Each beer from 1 to 4 increases my total utility but as I move from refreshed to inebriated I enjoy each additional beer slightly less than before. I’m no longer quenching my thirst and increasing my social lubrication. I’m filling my bladder and becoming too drunk to look after myself.
Should I have a fifth beer? That depends. If I have a fifth beer I won’t enjoy it as much as my fourth beer. I’ll start bumping into the furniture but with nothing else to spend my money on a five beers is better than four beers. However, if I have the choice of spending the money I save on a fish supper then I’d be better off with four beers and fish supper than I would be with 5 beers. My marginality utility for a fifth beer is lower than my marginal utility for my first fish supper.
Assuming I do stay in the pub and have a fifth beer should I have a sixth? A seventh? No. Bitter experience tells me after five beers in an evening any more beers will render me approaching incoherent and likely to fall over whilst executing complex gymnastic manoeuvres, such as going to the loo. A sixth beer actually makes me worse off compared to five beers.
It’s useful to remember that I’m making a series of decisions to have another beer not a decision to have 4 or 5 beers. I’m dealing with a series of marginal decisions not one big aggregation and averaging decision.
This begins to inform my demand curve. I’ll pay quite a lot for one beer, less for the second and in order to get me to drink eight or nine beers you are going to have to pay me. It informs my indifference curve which shows the trade offs from one good to another I’ll be willing to make given a fixed amount of money. (1) If you are a brewer and you want me to drink five beers rather than four you have to change my indifference curve, you need to price the fifth beer you are selling me so it’s more attractive than a fish supper, given that I’ve had four beers already.(2)
This same logic can be applied to production. Understanding the cost of moving from 1 unit to 2 units and from 2 units to 3 units is a more useful exercise than knowing the average cost of 3 units. Producing one bottle of beer requires a whole brewery, a bottle and ingredients. The second beer only requires the bottle and the ingredients. Once I’ve built the factory I would be happy to sell a second bottle of beer for any price higher than the cost of the bottle and the ingredients. The marginal cost of one beer is $1m plus 50p worth of barley and hops. The marginal cost of beers 2 and 3 is a handful of ingredients each. So on up until my brewery reaches capacity and in order to produce the next bottle of beer I need a second brewery.
Consumers will consume a good up to the point where the marginal utility from consuming it is lower than the marginal utility of the other goods and services they could have instead. Producers will produce goods up to the point where the marginal revenue from an extra unit of production is less than the marginal cost. This general behaviour informs demand and supply curves.
What’s the bigger picture with marginality? When people are making decisions about what to do next they usually do so from a position they already occupy. They are often constrained in their ability to change some of the conditions in the position they are in. Having built my brewery I can’t un-build it in a month, not can I build a second one. I’m changing my brewing or drinking behaviour at the margin of where I already am. I don’t rebuild my life every time I make a decision. I can’t.
Concepts of marginality help to explain behaviour we see in daily life(4). Why do rich people buy art and poor people buy potatoes? The answer is not that rich people have more money. That would explain why rich people bought more potatoes than poor people. It’s not that rich people like art more than poor people. Attendance at public galleries suggests this isn’t the case. What is it about the quality of having more money that makes people alter the proportion of their income that they spend on different goods. (5) Marginality is our friend here. The marginal utility of potatoes changes as you have more of them and changes steeply at a certain point. If you have only enough money to feed yourself you are likely to spend every penny of it on food. An extra potato in the pot might be the difference between going to bed hungry or not. People clearly value not being hungry very highly.(6) But there is a physical limit to the number of potatoes you can eat. As your income increases you reach the point where you have sufficient potatoes in your pot. Once you are fully fed, once you reach the point where an extra potato isn’t attractive, what do you do with your additional income? Go shopping for art.(7)
So, for the student of economics or the economist studying behaviour in the wild a useful question is, starting from where we are how do people behave next? How does that change in behaviour change as we change the variables? How quickly do marginal preferences change? What are the tipping points when people move from wanting a little of something to wanting lots of something. (8). Or vice versa?
If you see economic behaviour you don’t understand when you look at it on average ask yourself what is happening at the margin. If the current selling price is well below what you think the long term average cost of production is what time or structure constraints are operating to make selling something below its long term cost better than not selling it. Is the seller in a market suffering from structural over supply? Or is the seller a new entrant trying to gain volume in order to change their own long term production costs?
Why do changes in income change people’s behaviours? Not just the volumes of stuff they consume but the proportions and qualities.
What small changes in input variables translate into large changes in outcomes?
(1) generally if I have all beer I’ll swap a lot of beer for 1 fish supper. If I have all fish suppers I’ll swap a lot of fish suppers for my first beer. If I’ve got a mixture of tasty fried haddock and beer my exchanges will be less extreme. (3)
(2) Generally this is done by hiring bar-staff who become more beautiful the more the patrons of the bar have had to drink or by including a free gift along with the marginal unit of beer of a pair of special novelty eyewear called beer-goggles.
(3) perhaps mainly as a result of the chips soaking up some of the alcohol.
(4) At least, better than the classical economics of the Enlightenment that preceded. Theory didn’t fit the evidence, so the theory was revised.
(5) Quantity have a quality all of its own.
(6) But they don’t, evidentially, value being feed above concepts like self-actualisation. So the evidence of sieges and Antarctic exploration suggests to me. I think Maslow’s Hierarchy of Need could do with a revision to include the concept of marginality.
(7) Actually, what people do is go shopping for meat, which is one of the reasons why potatoes are Giffen goods.
(8) Turns out the head of IBM was right about the number of computers the world wanted, if you were pricing them at $60m each. At $250 I’ll have a dozen thanks, and so will my wife.
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no subject
Date: 2012-06-08 10:02 am (UTC)(Unless, of course, you count the XBox, PS3, and Wii, and the Virgin box, and the router, and the one inside the washing machine.)
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Date: 2012-06-08 11:02 am (UTC)Which I was in my own count - mindful of an article on the death of the PC pointing out not that people would have fewer PC's but that they would have proportionately more non-PC computing internet connected devices.
I’ve got a PC at work, a laptop at home, a smart phone, a wii, a playstation, there is probably sufficient processing power in the tivo thing I’m about to buy to qualify, the washing machine, the stereo.
That’s 8.
I can think of a few other things I’d like to have some processing power – mainly something to manage my energy consumption.
9 – the controls in the boiler perhaps.
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Date: 2012-06-08 12:21 pm (UTC)no subject
Date: 2012-06-08 01:16 pm (UTC)Does there comes a point where you don't have any time in the day to read more books or use more yarn?
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Date: 2012-06-08 02:47 pm (UTC)no subject
Date: 2012-06-08 02:49 pm (UTC)no subject
Date: 2012-06-08 03:10 pm (UTC)I certainly see why it would be easier to buy too much of both in a way it isn’t for beer and fish suppers.
The substitution of goods for each other I find fascinating. I’m very interested in concepts like value engineering where you try to break a product down into its various attributes (taste, bubbles, consistency of flavour, friendliness of barstaff etc) and work out how much people value each attribute individually. The ultimate aim being to compare the price people are prepared to pay for an attribute with the cost of providing it. Alan Sugar used to be very good at this.
I have recently started swapping fish suppers for Kindle books.
When I first started working here I would get lunch in the canteen. This typically included chips.
For health reasons chips must be reduced. (My marginal utility curve for chips just got steeper after the results of my recent cholesterol test. Chips once a month is okay, chips daily is not okay.)
When I did a review of how much that was costing me each month compared to the slightly lower prices of books if bought on a Kindle I realised if I cut down on the number of full lunches I bought from the canteen I could afford an extra Kindle book every week and still save money.
There is something about books being useful in the future. I have a habit of buying interesting books when I see them because I might never see them again. Again, Kindle has changed this. (I now need a better way to record books that I would like to buy at some point in the future.)
Not all beers are the same. For me at least. I tend to quite enjoy variety in beer. I generally go to one of two pubs. One is a nice, old-fashioned pub with a decent selection of beers and often one I’ve not seen for a while. The other is a specialist beer variety pub which is almost guaranteed to have one or two beers I’ve never heard of before.
If I had more money and fewer Captains (and the two are linked in some way) I would probably visit the first pub once a month more than I do. The specialist pub I might visit much more often. I can envisage myself as a pension popping in their every night for one or two beers. Each night a different beer.
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Date: 2012-06-08 03:53 pm (UTC)I think I probably have fewer books in a TBR pile because of the kindle, though I know I have done a lot more impulse buying at midnight and have consequently done a lot less re-reading than I used to, so I do have a lot more books than I otherwise would.
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Date: 2012-06-08 04:16 pm (UTC)This is the same impulse that has me buying games on the cheap on Steam, because some day I might break both legs and get a chance to play all of them!
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Date: 2012-06-08 04:26 pm (UTC)That's part of it.