Marginal Utility

In simplest terms, marginal utility is the variation of cost of a unit or good "at the margins." The initial cost of a unit is sure to be more expensive than subsequent ones and at the margins, although once enough units are available the unit cost will significantly diminish. Thus prices of goods and services are determined by the amount of production and its unitary demand, which create an economic equilibrium. This explains why prices tend to remain fairly static over time, absent other factors. Wikipedia quotes economist Philip Wicksteed: "Marginal considerations are considerations which concern a slight increase or diminution of the stock of anything which we possess or are considering."

Another way to illustrate at least part of the concept of marginal utility is by emphasizing the role that markets have to play in pricing. Visualize a lake on one hand and a desert on the other. In the middle is a glass of water. One shifts the glass of water toward the desert and it becomes marginally more expensive; one shifts the glass of water toward the lake and it becomes marginally less so. Of course it should be pointed out that this example focuses on supply-and-demand whereas marginal utility shows us that it is not raw supply-and-demand that determines cost but the amount of units available and the position of their creation.

It was this insight – that the market itself is responsible for even marginal fluctuations in prices – that sparked the neo-classical revolution in economics. Before marginal utility insights of the Austrian economics school became known, classical economic theory followed a far more static model. Such a model of fixed costs that recognized neither supply or demand or marginal utility led to some spectacularly unfortunate predictions.

Perhaps the most well-known classic economist, Thomas Malthus, predicted that all of England would starve by the late 1700s. He made the prediction based on food-growing trends (down) and population growth (up). It never occurred to Malthus that people who were faced with imminent starvation would try to grow MORE food. This they did, and the starvation never occurred. It is unfortunate, however, that classic economics remains with us in public policy and even in economics today despite the revolution of marginal utility and neo-classical insights.

Every time government passes a law or regulation based on predictive elements – where the market is now and where it is going – those legislators are practicing a form of Malthusian classic economics. In truth, each solution influences "human action" and thus as people adapt predictions go awry. Communism – Karl Marx's intricate philosophy – is also a classical analysis. Such proposals do not take into account what famous Austrian economist Ludwig von Mises called "human action."

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