In my last blog post, I examined what I called the “flaw of marginal cost.” I used the famous example of the price differences between diamonds and water to explain why pricing an item based on its abundance and ease of availability may not be ideal. I particularly pointed out the California drought as an example of the distortion inherent in the premise of marginal cost.
Some may have read the post and thought, “Gee, this guy is a moron. The diamond/water example is explained by marginal utility, not marginal cost.” True, but I focused on marginal cost because, considering the total utility of water, the reason it is so relatively inexpensive is because it is abundant and cheap to make each additional unit available for consumption. In other words, it has extremely low marginal costs as a resource in general.
Consider that if water was far less abundant, it would be far more expensive. The same holds true if water was abundant but extremely difficult to make available for consumption. Why? Because its total utility is extremely high. Only the air we breathe has greater total utility.
The thinking goes that a diamond has greater marginal utility than water and is, thus, more expensive. In other words, the value derived from an additional diamond is greater than the value derived from an additional gallon of water.
I’ve never really understood this. First, for what are diamonds used? At least for general consumption, diamonds are used almost exclusively in jewelry. The total utility of a diamond is practically nil. As for its “marginal utility,” it definitely has more meaning to give your fiance a diamond engagement ring than a bucket of water. In that respect, a diamond definitely has greater “marginal utility” than a gallon of water.
But this is all a distortion. The high price of gem-quality diamonds is almost entirely a product of cartel-like control by diamond suppliers and brilliant marketing. In other words, the “marginal utility” of diamonds is completely arbitrary. A more accurate reason a diamond is more expensive than water is its perceived value in combination with contrived scarcity and relatively high marginal costs.
Is that to say that marginal utility is a useless concept? Let’s look at the example of mobile phones. Most people find value in having at least one, a few in having even two. But the marginal utility of a third mobile phone is pretty low and gets lower for every mobile phone a person chooses to own. In that respect, marginal utility as a concept makes sense.
But, going back to the diamond/water example, it’s said that the marginal utility of water decreases for every glass you drink such that the combination of its abundance, its low marginal cost, and the limit any one person can consume at any given time gives it a naturally low price, especially in relation to diamonds.
Can you identify the flaws in this reasoning?
One, how abundant is water actually, particularly in a world of seven billion people? Sure, the planet is covered with water but, if everyone had equal access to a modern water infrastructure, the need for conservation would be apparent. At the very least, the need for advanced methods for water reclamation would be apparent. The abundance of water, particularly given the state of modern water infrastructure, is very much an illusion.
As for water’s low marginal cost, that’s indisputable. Once the pipes are in place, it’s relatively easy to get it from one spot to another. But then again, many countries, particularly those labeled as “developing,” do not have access to modern water infrastructures.
Now what about water’s marginal utility? The notion that you can only drink so much of it at any given moment? This particularly doesn’t make sense to me because water must be consumed every day. And this doesn’t even include its agricultural uses. There is always someone who is thirsty or requires water somewhere. So while the next glass of water may not be important to any particular person at any given time, it is important to someone always, in far greater proportion than the next diamond. So, even by the standard of marginal utility, water is far more important than diamonds but still a lot cheaper.
This is all a way of saying that the concept of marginal utility as it relates to water and its pricing is also flawed, which is I why I didn’t consider it in my previous post.
It’s said that humans have infinite wants and needs. That may or may not be true. But our basic needs are relatively simple: shelter, warmth, water, and food. Have we gotten to the point where these basic necessities are available for everyone on the planet in a secure, reliable and dignified way?
While technology has made it possible for these things to reach everyone, Capitalism has not kept up. If Greece is any indication, the possibility now exists for a significant regression.
My thinking on the concept of marginal utility is that it is a simplification that leads to distorted thinking on economic matters. It’s a simple quantification of a complex set of conditions that presents the illusion of understanding as it relates to certain economic matters. In my opinion, it’s value in economic understanding is both overrated and misleading.