Capitalism Level 3: Light your Cigar

Capitalism Level 3: Light your Cigar


Applications of the Law of Diminishing Marginal
Utility The law of diminishing marginal utility has
important applications. It is appropriate to consider several of them
here, both because they shed light on the rationality of
economic activity and because, in one case at least, they
provide positive confirmation of the fact that man’s need
for wealth is limitless. Resolution of the Value Paradox
As explained in the Introduction, the law of diminishing
marginal utility makes possible a resolution of the
classical economists’ paradox of value—the seeming
paradox constituted by the fact that goods of apparently
the lowest utility, such as diamonds, are normally more
valuable in exchange than goods of apparently the highest
utility, such as water. This apparent paradox was, of
course what prevented the classical economists from
being able to ground their theory of exchange value and
prices in utility. When people regard water as more useful than
diamonds, what they have in mind is that if one had
to choose between having no water or no diamonds,
one would obviously choose to have no diamonds. Up to a
considerable point, units of water are vastly more important
than units of diamonds. But because of the operation
of the law of diminishing marginal utility, a point is
reached at which the utility of the marginal unit of water
falls below the utility of the marginal unit of diamonds. The first gallon of water, the hundred and
first, or probably even the thousand and first gallon of water,
is more important than the first carat of diamonds
or even the first ten or a hundred carats of diamonds taken
together. But
at some point, after one has all the water necessary for
drinking, cooking, washing, irrigating, and so forth, the
marginal utility of water falls below the marginal utility
of diamonds. The extremity of the abundance with which
nature provides water and the extremity of the scarcity
with which it provides diamonds jointly operate to establish
a far higher marginal utility of diamonds than of
water in normal circumstances. Thus the fact that in the normal circumstances
of civilized life people value diamonds above
water is not at all paradoxical or irrational. It is perfectly consistent
with considerations of genuine utility, provided the latter
are properly understood—that is, in the light of the
principle of diminishing marginal utility. By the same token, the fact that people nowadays
desire to possess such things as power windows on their
automobiles, and are willing to pay substantial sums for
what many may regard as relatively modest improvements
in fashion or style, is also perfectly consistent with
rational principles of behavior. It is a question of the
context of how much wealth or income one has available
and thus of the marginal utility to the individual of a unit
of wealth or income. If one has sufficient wealth or
income so that one is already able to provide for a very
full satisfaction of such needs as those for food, clothing,
and shelter, then, indeed, the most important use for the
price of power windows or the price of a relatively modest improvement in fashion or style may
well be the purchase of the power windows or the improvement
in fashion or style. One must always consider what the
individual’s choices are in the context confronting him. If the choice is, for example, the power windows
or an improvement in his hi-fi equipment, because
all wants of greater importance are already provided for,
then the purchase of the power windows may very well
be the most important use for the money in question.

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