Everything Everywhere Daily: History, Science, Geography & More - The Marginal Revolution (Encore)

Starting point is 00:00:00 The following is an encore presentation of Everything Everywhere Daily. In most academic disciplines, there is often a single idea or discovery which makes everything fall into place. All the things that didn't make sense before suddenly do when looked at through this new lens. These eye-opening discoveries usually occur in the hard sciences, but one such advancement also took place in the field of economics. Learn more about the marginal revolution and how it changed economic thought on this episode of Everything Everywhere Daily. What if your perceptions about the past were wrong? ThruLine is a podcast that takes you back in time to uncover the parts of the story that may have gone unnoticed. It effectively turned day into night.

Starting point is 00:00:59 And how it shaped the world now. Time travel with us every week on the ThruLine podcast from NPR. As I mentioned in the introduction, there are certain ideas, discoveries, or theories which are fundamental to many scientific disciplines. These are keystone theories through which you can analyze most everything else on that particular subject. A good example is plate tectonics and geology. Once plate tectonics was understood, it suddenly explained earthquakes, volcanoes, and the movement of the continents. Understanding the structure of the atom made sense of the periodic table and of chemistry. Newton's theories made sense of gravity and motion. Maxwell's equations made sense of electromagnetism. The discovery of DNA made sense of biology and all living things.

Starting point is 00:01:49 Before these discoveries were made, the understanding of various scientific disciplines was incomplete. Some things didn't make sense or couldn't be made consistent with other known facts. Economics also had its moment when a theory was able to make things click into place and solved one of the field's longest outstanding problems. The statement of the problem is often attributed to Adam Smith, who wrote the wealth of nations in 17, which is often considered to be the first real book on economics. However, the problem actually dates back to Plato and was restated by other intellectuals such as Nicholas Copernicus and John Locke. It's called the Diamond Water Paradox.

Starting point is 00:02:30 Water is one of the most important substances there is. Without it, you'd probably die in a matter of days. We use water for a host of other important purposes, including cooking, sanitation, cleaning, and many others. So, water, as I'm sure you're all aware, is really important. Diamonds, on the other hand, are actually pretty useless. I mean, they're pretty, and there are some limited industrial uses for cutting hard surfaces like concrete or metal. Yet, despite their limited use, diamonds are incredibly expensive, certainly much more expensive than water. Adam Smith himself stated the problem in the wealth of nations as follows. Quote, the things which have the greatest value in use have frequently little or no value in exchange.

Starting point is 00:03:14 On the contrary, those which have the greatest value in exchange have frequently little or no value in use. Nothing is more useful than water, but it will purchase scarcely anything. Scarcely anything can be had in exchange for it. A diamond, on the contrary, has scarcely any use value, but it has a great quantity of other goods which may frequently be had in exchange for it. end quote. This puzzled philosophers for centuries. None of the great minds I mentioned earlier, including Adam Smith, were able to resolve the paradox. Smith and other early economists, such as David Ricardo and Karl Marx, all believed in what is called the labor theory of value. The labor theory of value holds that the price of something reflects the amount of labor which

Starting point is 00:03:59 goes into acquiring or creating the product. At first glance, this sort of makes sense, something which took a skilled craftsman a year to make would probably command a high price. The problem was, is that it didn't always hold. The amount of labor that goes into an expensive bottle of wine isn't any more than the labor that goes into a cheap one. Yet, they're priced differently. Likewise, if you happen to find a diamond on the ground, it would be worth just as much as one which was dug up from a diamond mine. Moreover, most buyers don't really care or know how much labor goes into the creation of a product. This puzzle was finally resolved in the later half of the 19th century when a trio of economists,

Starting point is 00:04:41 William Stanley Jevons from England, Carl Minger from Austria, and Leon Walrus from France, all came upon the answer at approximately the same time. The solution had two parts. The first was rejecting the labor theory of value and replacing it with the subjective theory of value. The subjective theory of value is pretty straightforward. People want what they want. Some bottles of wine are valued higher than others because that's what people like. Some baseball cards are valued more than others because people like certain players.

Starting point is 00:05:13 So the subjective theory of value would say that diamonds are priced more than water because people subjectively are willing to pay more for them. However, that really doesn't explain why people value diamonds more than water. The insight into that comes from the concept of marginal utility. And before I go any further, I should explain the concept of the concept of marginal utility. of both utility and of marginalism. The term utility was coined by utilitarian philosophers, and the term originally meant happiness or pleasure. However, in an economic context, it has a broader meaning beyond happiness. It can also imply usefulness or anything that has some

Starting point is 00:05:50 sort of value. So the utility you get from a screwdriver would be different from the utility you get from watching a movie and might be different from the utility you get from drinking water. However, they all fall under the general umbrella of utility. When you talk about the margin, you're referring to an increment. The marginal amount of something is the next incremental unit of something. So marginal utility is the incremental utility you get from something. Now, why is this important? Because the choice between water and diamonds isn't between all water and all diamonds.

Starting point is 00:06:28 If we had to make that choice, we'd choose water. The total utility of water is greater than that of diamonds. The real question is the marginal utility of purchasing water or diamonds. There's a lot of water. It's easy to get, and people consume it frequently. Diamonds, however, are rare, and the average person will probably purchase only one or none in their lives. Why is this relevant? Because the marginal utility you get out of something decreases the more of it you have.

Starting point is 00:06:58 or, as it's called in economics, diminishing marginal utility. Here's an example. A diamond is worth more than a glass of water. But is there any scenario you could imagine where you would exchange a diamond for a glass of water? And the answer is, yes. Imagine that you were lost in a desert without water. You're parched and on the brink of dying of thirst. As you crawl out of the desert, you encounter someone who offers you a glass of water in exchange for a diamond.

Starting point is 00:07:24 Would you do it? Probably. Now imagine you're offered a second glass of water. How do you value that? You'd still probably put a high value on that glass of water as you're still probably dehydrated, but not as much as the first glass of water that saved your life. Now consider a third, fourth, fifth, and sixth glass of water. By this point, you're probably fully hydrated. Eventually, you'll reach a point where you don't want any more water. You're good. The marginal value you get from the 10th glass, of water isn't the same as what you got from the first glass of water. In fact, you might get

Starting point is 00:08:02 decreasing utility from drinking more water. It will actually harm you beyond a certain point. So the reason why water is so cheap is that almost all of us are well along the marginal utility curve. We aren't dying of thirst, so what we're willing to pay for water is much less than someone who is desperate. Likewise, we are closer to the dying of thirst part of the curve with diamonds. There aren't a lot of diamonds, so most people are buying their first diamond, which means there's a very high marginal utility to the first purchase. The reason why this way of thinking is called the Marginal Revolution is that it had implications for almost every part of economics.

Starting point is 00:08:42 One of the biggest ramifications of the marginal revolution is the law of supply and demand. Because we all subjectively value things differently, we all have different amounts that we would be willing to pay for something. The aggregate of all of our price points could be drawn on a curve, with the price and total quantity that would be purchased. A small number of people would value something at a high price, and more people would buy it as the price goes down. This is called the demand curve, which is downward sloping. The flip side of marginal utility for producers is marginal cost. The marginal costs are incremental costs for the production of the next unit of the good.

Starting point is 00:09:19 You can also plot out a supply curve based on marginal cost. costs. The higher the price, the more of something will be produced, and the lower the price, the less of it will be produced. The supply curve is upward sloping. When these two lines cross, you'll find an equilibrium point, which will be the price set by the market. The laws of supply and demand are determined through marginal analysis. Marginal thinking permeates economic thought. It helps us understand decisions made by producers as well as consumers. You might have heard something called the sunk cost fallacy. The sunk cost fallacy basically says you shouldn't throw good money after bad. The reason why the sunk cost fallacy is a fallacy has everything to do with the

Starting point is 00:10:03 return on a marginal investment. No matter how much money you've already spent, if continued spending isn't going to bring a return, it isn't worth spending anymore. One of my undergraduate majors in college was economics. Probably the biggest thing I came away with was marginal thinking. For example, when I was doing travel photography, I would often submit my photos for awards. I would have to pay an entry fee for each photo I submitted. I submitted quite frequently, and was pretty successful. In one particular contest, I had won 46 different awards at various levels and various categories over the years. But eventually, I realized there was little marginal benefit in winning a 47th award. The first award had a lot of value to me.

Starting point is 00:10:50 I could say I was an award-winning photographer. Then I could say I won multiple awards. But eventually it reached a point where there was no benefit anymore, and the money I was spending on entry fees was no longer worth it. The marginal cost of entering was greater than the marginal value of winning. Thinking on the margin can be very powerful. All of us do it all the time, even if we don't consciously know that we're doing it. However, if you are aware of it, it can help you make better decisions,

Starting point is 00:11:18 and you'll come to understand why this method of thinking help to revolutionize the field of economics. The executive producer of Everything Everywhere Daily is Charles Daniel. The associate producers are Benji Long and Cameron Kiever. I want to give a big shout out to everyone who supports the show over on Patreon, including the show's producers. Your support helps me put out a show every single day. And also, Patreon is currently the only place where Everything Everywhere or Daily merchandise is available to the top tier of supporters.

Starting point is 00:11:51 If you'd like to talk to other listeners of the show and members of the Completionist Club, you can join the Everything Everywhere Daily Facebook group or Discord server. Links to everything are in the show notes.

Everything Everywhere Daily: History, Science, Geography & More - The Marginal Revolution (Encore)

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