ECON1401 Marginal Analysis What is value? In the classical school of economic thought embodied by thinkers like Adam Smith, Karl Marx and David Ricardo, the worth of a good or service was seen to derive from the labour value of that good. How much was the value of the labour that had gone into producing it? Some distinctions were drawn between value in use and value in exchange, where value in use could be calculated as the amount of labour saved by the user when using the good. While exchange value brought in the connection of a good's value to its worth to another person, apart from the initial user, there was no full reckoning by classical economists of value in relation only to the entire marketplace on which the good traded. Alfred Marshall, together with other economists who collectively contributed to what we now call the marginalist revolution, turned in his search for an alternative measure of the economic value of a good to its price. The price of a good is a signal of its value on the market as a whole rather than being specific and personalised like value to the individual user, or reflective of the amount of resources used to produce it, or that would be saved by its use. Price is ruthlessly and narrowly a judgment upon the worth of the good to the market right now - regardless of how costly it was to produce, or how much any individual person or even society collectively might value it now or at another time. Marshall applied marginal analysis to both sides of the market - supply and demand. On the demand side, consumers buy according to a rule that compares the price of a good to the marginal utility they obtain from it. On the supply side, producers are willing to sell a good in the short run as long as they can recoup their marginal cost of producing that one additional good (i.e., as long as price is at least as great as marginal cost). The supply and demand curves that are generated by these decision processes, occurring on both sides of the market across consumers and firms that are heterogeneous in their preferences and their production costs, give rise to the familiar equilibrium price for a good - also, according to Marshall and all of the ensuing neoclassical economists, the value of that good - where those two curves intersect. The idea of decision making on the margin has given rise to the indifference curve, to the notion of firms deciding on input mix by considering the marginal rate of technical substitution between those inputs, and to the notion of diminishing returns. Marshall also pioneered the analysis of consumer and producer surplus (arguably another form of value) and the impacts of taxation on surplus on both sides of the market. He also was the first great economist to draw many of the graphs that we see today as standard in neoclassical economics. A picture of the economy is worth a thousand words, and the graphical expository techniques that Marshall popularised likely saved the economists who came after him hundreds of thousands of words. Opportunity Cost Students often struggle to understand the concept of opportunity cost, and this is partly because the way we calculate opportunity cost is not by figuring out how much something costs, but rather by figuring out how much we benefit from something. Opportunity cost is the value - the benefit - of the next best alternative action foregone by the decision maker when he takes a particular action. It is in fact a cost, but an unseen one, of taking the chosen action. Frédéric Bastiat's parable of the broken window published in 1850 in "Ce qu'on voit et ce qu'on ne voit pas" is a striking illustration of opportunity cost. Essentially he tells the parable of a boy who breaks a window through throwing a ball through it and then people, the onlookers, say, "oh, you know, it's not so bad because the whole economy will benefit since the glazier will be employed to fix that window. There is a benefit from this destruction." But in fact, Bastiat argues that's not the best way to use the money. That money could have been spent on something else. Let's take a modern and more personal example. Suppose you make an impulse purchase while waiting in the checkout queue at the grocery store. Say you buy five dollars' worth of lollies. By making that purchase, you are foregoing the value that you would obtain by spending that five dollars on another good or service. If across all possible alternative uses of the five dollars, you would most value the lollies, then an economist would not quibble with the optimality of your choice, but your choice would still carry an opportunity cost, equal to the value of the next-best most favoured thing you could have bought - for example, the value to you of five dollars worth of beer, or chips, or cherries. If in fact you get more value from buying something other than lollies with your five dollars, then an economist, using the Homo Economicus model to predict your behaviour, would be very confused by your choice to buy the lollies. In the broken window parable, Bastiat alleges that even though repairing the broken window does give work to a glazier, breaking windows on purpose in order to ensure that glaziers don't go unemployed would be a sub-optimal decision for the economy. To support this claim, he compares the benefit of the repair work to glaziers - one segment of the economy to the benefit of using the resources spent in repairing windows on other things instead, that support the economy in other ways, providing employment to other workers in different sectors, or even funding investment into innovation and hence further future growth of the economy. A big part of thinking like an economist is thinking about what is given up when a choice is made in a world where resources are scarce. Trade-offs are implicit in every resource allocation decision, and the concept of opportunity cost embodies that pillar of economic thought better than any other concept. Externalities My son is studying to play piano at Boston University and when he used to live in the home, and be playing and practicing all the time, I would come home from work and have a lovely evening with my husband, cooking dinner while we heard piano music in the background. This was an example of a positive externality: Neil's playing, which was beneficial for him, was also beneficial for us because it gave a nice ambiance to the environment in the home. However, his playing often continued after dinner and up until the point when we wanted to go to bed, and then even after that point. At that stage in the evening, his piano playing was then generating negative externalities: although he was enjoying it, it was impacting negatively on other people in the household. Ronald Coase, who won the Nobel Prize in Economic Sciences in 1991, famously analysed the situation of externalities and put forward a proposition that if there are no transaction costs, then allocating the right to some property that's relevant in the creation of externalities to one party or the other will enable those parties to come to a traded solution which optimises the level of production of the good that generates the externalities. In the example of the piano playing, if you imagine that the property right being allocated is the right to create noise in the home, then that allocated right could be given first to our son, for example, and then we, the parents, could bargain with him and say, "Look, if we pay you a bit of money, would you be willing to not play as much in the late evening?" Alternatively, that property could be allocated to us, in which case he would then come to us, offering us money to be able to play a bit more than nothing in the late evening. Either way that the initial property right is allocated would generate, according to the Coase theorem, the same solution in terms of the amount of piano playing done. The problem, of course, in the real world is that there are transaction costs associated with this sort of bargaining. Also, of course, the individuals involved really do care about the initial allocation of property rights, because that impacts their ultimate wealth level. In the example of the piano playing, the transaction cost might be that I don't really feel comfortable taking money or giving money to my son in relation to his piano playing. I actually, as a mother, just want him to do lots of that and I'm willing to sacrifice and take the cost of the fact that he's playing. Maybe that could be a barrier in real life. In families, often times it's not money that's exchanged but other sorts of in-kind favours. So, for example, he might say, "Well, if I play a little bit tonight, how about I walk the dog tomorrow or do the dishes?", and then we might agree to that. That's still a form of bargaining, and that kind of bargaining happens in families all the time. Comparative Advantage So the concept of comparative advantage is often attributed to David Ricardo, and he spoke in terms of comparative advantage between countries. But let's work through an example that considers production in the home. So let's assume that you have a set of inputs that we'll call time (like maybe one hour of time), flour, sugar, fruit, and water. With that set of inputs, you might be able to make a number of different things. And there are often two householders in a given household, so let's imagine that we want to look at the productivity of each of those two householders in producing two different things that you could make with that same input set. So let's imagine we have Mom and we have Dad. We have two things we could make. We could make kids' snacks, and we could make pies. So typically when we look at comparative advantage, we make a table. And often times the classical depiction of opportunity cost and comparative advantage uses a different formula than what I'm doing here. This is a more general way of describing it, which hopefully you'll find illuminating. So, you take this set of inputs... If you're Mom, you can, with those inputs, make eight kiddie snacks. And you can also, alternatively, make two pies. If you're Dad, let's say you can make six kiddie snacks or one pie. Now when you look at that, first off, you think "Well, obviously Mom should be doing everything because she has an absolute advantage over Dad in the production of both of these things." But as we'll see, actually there is a difference between the two of these people in their relative productivities across the two different possible uses of the inputs. And that gives rise to comparative advantage of one person in one production and the other person in the other production. And then it's optimal for the household to have that sort of specialisation according to their comparative advantage. So let's look at that over here. So, for Mom, what is the opportunity cost of making the eight snacks? Well, the opportunity cost is what she could have made with the same inputs, if she didn't make the snacks. And that's two pies. So the opportunity cost for Mom of making the eight snacks is equal to two pies. Now for Dad, the opportunity cost of making the six snacks that he makes with those inputs is one pie. And we can do the same thing in reverse: we can say the opportunity cost of making these two pies, for mom, is eight snacks And for Dad, the opportunity cost of making one pie is six snacks. Now what we can do to figure out who has a comparative advantage in what is take the ratio of the opportunity costs. So, for Mom, the ratio of the opportunity cost of making the pies over the opportunity cost of making snacks is equal to eight snacks over two pies, or four. For Dad, on the other hand, the opportunity cost of making pies over the opportunity cost of making snacks is equal to six snacks over one pie, or six. So who has the lower ratio of opportunity costs? This person. So what that means is that Mom should specialise in making pies. The relative opportunity cost for her of making pies, relative to making snacks, when compared with Dad, is lower. Dad, alternatively, as the opposite, should be specialising in making snacks. And you can think about that as simply reversing these ratios, so his opportunity cost of making snacks, relative to the opportunity cost of making pies, is onesixth, whereas Mom's is two-eighths, or one-fourth. And one-sixth is smaller than one-fourth, so again, smaller relative opportunity cost for Dad of making snacks relative to pies. So, we end up that Mom specialises in making pies, dad specialises in making snacks, and so the whole household gets six snacks and two pies from each parent spending one hour of their time and all of these other inputs making something. Now, you might argue, "How about Mom just does both of those things." Again, because if she spends two hours she gets more stuff than what we get if each parent spends the one hour. And often times, households will specialise more broadly in terms of household labour versus labour at work, and sometimes that's because of these kinds of comparative advantage arguments. I will also say that of course, like any other example of comparative advantage, such as David Ricardo's example of Portugal and England making wine and cloth, respectively, there is an assumption built in that the market is going to value each of these goods. So the analysis here is all predicated upon the notion that the household really wants snacks and also really wants pies, and it sort of wants them both all the time. There's no consideration of changes and market scenarios. Remember, comparative advantage is a classical sort of concept that came up before the Marginalist Revolution. It was inspired by, and reflects very much, the labour theory of value of goods. Behavioural Economics When I was a child growing up in Pittsburgh, Pennsylvania, my mother worked at Carnegie Mellon University and that happened to be where Herbert Simon also worked, and we went to a church where he also attended, and I remember after the sermons, we'd have coffee hour and my mother and Herb Simon would spend an hour talking about ideas in relation to human decision making and motivation and psychology. My mom was herself a cognitive therapist and so it was the most wonderful look on her face that I would see, every Sunday, when she was able to have a conversation with Herb Simon. Herb Simon was an economist and a cognitive scientist and a pioneer of the notion that cognitive limitations - what he called bounded rationality - fundamentally impacts human decision making. We might like to think that decision makers always select the best outcome via a comprehensive consideration of all the alternative actions available at any given decision point, and that's what the standard Homo Economicus model asserts. But Simon bluntly rejected this as impossible. His work on decision making in administrative organizations and rational decision making in general earned him a Nobel Prize in 1978. Since that time, a raft of economists have joined the chorus of voices claiming that some, if not all, of the core assumptions about economic decision making maintained by mainstream economic theory are simply not valid. These critiques, which often come together with toy models and empirical evidence from the experimental laboratory or the field, claim to illustrate the inaccuracy of traditional assumptions and are seen by the profession to be part of the relatively new sub-field of behavioral economics. In the academic literature, we've seen models in empirical work and behavioral economics focusing on cognitive constraints of many flavours, as well as attempts to build into models of human decision making notions like identity, altruism and social norms that are entirely omitted from the Homo Economicus model. Some economists have made lots of money on popular science books arguing for their particular favourite wrong assumption. Two famous examples are Thinking Fast and Slow by Daniel Kahneman and Nudge by Cass Sunstein and Richard Thaler. (Note that Kahneman and Thaler are both winners of the Nobel Prize in economic sciences.) Far deeper work is required before economists will be in a position to deliver a renovated theory of individual decision making that retains the simplicity and tractability of the Homo Economicus model yet captures more realistically the constraints and objectives, both seen and unseen, faced by human decision makers.
