Diamonds or Water? Which do you value more?
For a student of economics, it is strange that water is cheap and a diamond is expensive. After all, water is necessary to survival and extremely useful while diamonds are rare and have little use at all. How is one to determine the value of a given good?
There is a value in use and a value in exchange. It appears that goods that have the greatest value in use, have little value in exchange; while goods that have the least value in use, have great value in exchange. The paradox of value was proposed by Adam Smith and it wasn't resolved until about 100 years later by Eugen Bohm von Bawerk. (If that is any indication of how slowly economic theory has developed.) Thus, the subjective theory of value and the concept of marginal utility was born. It was argued that the total utility did not determine value, but the marginal utility did. The focus is directed at each additional unit of water. A man dying of thirst in the desert would have a greater marginal utility for water and would exchange more for each unit than for a diamond. Each additional unit supplied would have a diminishing marginal utility as he became less thirsty. It may sound trivial but this concept is actually the key to success in business and in life. Everything that is important occurs at the margin. It is essentially, "the straw that broke the camel’s back.”
Which is what calls forward the Law of Diminishing Marginal Returns. (Sometimes referred to as the Law of Diminishing Marginal Productivity or Law of Variable Proportions) The law holds that when working with a fixed resource (scarcity), each additional input produces a declining quantity of outputs, on the margin. (What do I mean by "on the margin". . . it means on the next additional unit added)
Thinking like a good economist requires you to train your mind to conceptualize decision making "on the margin." Ask yourself if the benefit of one more additional unit of something is greater than its cost.
For example, a small restaurant has a fixed number of tables and each additional waiter the owner hires produces a declining amount of return until eventually, the owner is operating at a loss. I just recently read an article discussing the construction of the 2nd Avenue subway line in NYC which is contracted through the MTA using a labor union. The tunnel digging project uses 25 workers due to labor union rules for the same project that Spain requires 9 workers for. Not only has this project taken much longer than most it is also the world’s most expensive tunnel digging project. Perhaps it is worth considering that those looking to eliminate labor union power are not seeking to take advantage of the working class, rather seeking to keep the powerful lobby from taking advantage of the taxpayer. Whatever you are evaluating in life, love, business; remember diamonds and water.
Just a few Things That Matter.