On Beer and Fish Suppers - The Third Pillar of Economic Wisdom

[danieldwilliam]

Today’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.

Comments

[andrewducker]

I suspect that the reason people buy more yarn is that while they already have more yarn than they will ever use, they don't have any that's this particular shade of yellow and purple, and thus might come in useful some day.

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!

[rosathome.livejournal.com]

*eyes up all the hot pink yarn in my stash*

That's part of it.