Thinking at the Margin
Why are diamonds more expensive than water? Prof. Mario Villarreal-Diaz answers this question using what economists call marginal analysis. Essentially, the marginal utility of water decreases faster than the marginal utility of diamonds. Put another way, people face decisions in a particular context and time. In modern economies, people have ready access to water on the margin, but do not have the same level of access to diamonds.
- Margins and Thinking at the Margin [Article]: EconLib explains the concept of marginal thinking and provides the history its development.
- Marriages, Mistresses, and Marginalsim [Article]: Dwight R. Lee demonstrates the concept of marginalism through marriages and mistresses.
- More on Marginalism [Article]: Dwight R. Lee emphasizes the importance of marginal analysis in economics and demonstrates the concept through a couple simple examples.
- What Does Marginality Mean? [Article]: Roberty P. Murphy explains marginal analysis and uses it to solve the water-diamond paradox.
Individuals make choices and tradeoffs based on comparisons. When they are trying to decide what is the best choice, it depends on those comparisons. One alternative versus the other. Let’s think about ordering some fast food. If you go to a restaurant and they have the combo number one and the combo number one includes a hamburger and some french fries and the price is $10, you can take a look at the combo number two. And the combo number two includes the hamburger and the fries and a milkshake, and it’s $13. So immediately when you think about it you say, well, what am I going to get from those extra $3? A milkshake. So that extra unit of food is going to cost me $3. So the question you’re trying to answer is, is that milkshake worth $3 for me or not? And then you make your choice. You make your decision of combo number one versus combo number two. That’s thinking at the margin.
At the margin means to think about the next increment, the next unit, that relatively small change, the net additional subtraction when I make a choice. Marginal thinking helps us understand puzzles such as why diamonds are so much more expensive than water given that water is indispensible and essential for life. And the answer is that the marginal utility of water compared to the marginal utility of diamonds decreases way faster. Think about the first glass of water if you’re thirsty—very satisfying. Think about the second one. Think about the 20th or 50th glass of water. Maybe you will be not that happy getting that 50th glass of water. Think about diamonds. What is the marginal utility of that extra unit of diamonds? It probably will not decrease at all. It probably will even increase. What I’m trying to say here is if you compare the value of the extra unit of water versus the value of the extra unit of diamonds, it is obvious why diamonds are much more expensive than water.
Individuals make choices at the margin all the time. This is part of the way we think, even though we don’t notice. But not only individual decisions such as buying combo number one or combo number two are made thinking at the margin. Businesses also make decisions with this way of thinking.
For example, if a business wants to hire an extra employee, they think exactly the same way. How much is that extra employee going to cost me? Well it’s going to cost me his or her salary. Well now I need to compare it versus what, how much he’s going to produce. What is going to be the value added for having an extra employee? What is his or her marginal production? And then, of course, if his or her marginal production is larger than how much I’m going to pay his or her marginal cost, then it’s a good business decision to hire that extra person.
These basic tools, such as incentives matter, opportunity costs, and thinking at the margin are not substitutes. They complement each other. They are intertwined in the way economists see the world. Thus, when somebody’s deciding about the combo one versus the combo two and thinking should I get the milkshake that is worth for me three more dollars, she is not only thinking about that extra pleasure that the milkshake is going to give her, but about the opportunity cost of using those $3 to buy that milkshake and what is the alternative use of those $3. Maybe some popcorn at the movies, maybe candy at the movies or what have you.
So at the same time, that is thinking at the margin, it’s thinking at the opportunity cost of that money, how to allocate those resources. So we do that all the time. For a public official, it might be the case that marginal analysis doesn’t come that naturally because there is not that attachment. However, it should, because still there is an alternative use of those public funds. So a public official should think, if I allocate these resources in this project, how much am I going to get out of it? Maybe I’m not going to get enough, and I should invest that money somewhere else.