The preceding examples, which were intended to give us some idea of the tasks of economics, have turned our attention from the narrow confines of our personal experiences to a consideration of the larger fabric of society with which they are mysteriously interwoven. It is as if, all this time, we had been unconcernedly and thoughtlessly drawing water from a brook for our own private needs when, of a sudden, we look up and perceive that our brook is, in reality, a broad and majestic river stretching away upstream into illimitable distances. A recognition of the existence of the great social problems is a long step forward on the road to an understanding of economics.
But we would be traveling, ultimately, in a wrong direction were we not to consider another circumstance which leads us back to ourselves and to our own individual experiences. For it is imperative that we keep clearly in mind that the economic system is not an objective mechanical thing which functions whether we will or no, but a process to which we all contribute in the totality of our reflections and our decisions. At bottom, it is the millions upon millions of subjective events taking place in the mind of each individual which form the substrata of economic phenomena. It is the feelings, judgments, hopes and fears of men which are manifested objectively in such things as prices, money, interest, prosperity and depression. But around what axis do these movements of the human psyche revolve? An answer to this question will provide us with the key to an understanding of all the objective events of economic life—to an understanding, in brief, of the “phenomena of the market.”
The meaning of all economic decisions and actions can be summed up in the word economize. When we have only a limited quantity of an important or useful commodity, we invariably tend to husband the inadequate supply. When we cannot have as much as we would like of a thing, there must be a certain order in our use of it if “waste” is to be avoided—if we wish, that is, to forestall our acting in an uneconomic manner. Unhappily, we do not live in Cockaigne; there are only a few goods of which there is an inexhaustible supply (free goods). Under normal circumstances, the air of our atmosphere is a free good, though it is at the same time the most essential commodity we know. A calisthenics addict may fill his lungs to bursting with air and no one will label him a glutton. But if he continues his exercise too long, a glance at the gymnasium clock and his own increasing fatigue will soon alert him to the fact that at least two things do not exist in unlimited quantities: time and physical strength. These things must be husbanded. However important and useful breathing exercises are, they cannot be kept up indefinitely without neglecting even more important things. Because time and physical strength are limited in quantity, they are not free goods, but economic goods. We are forced to economize them no matter how little importance we attach to life’s other activities.
Economic goods and not free goods determine our behavior. Our whole life is made up of decisions which seek to establish a satisfactory balance between our unlimited wants and the limited means at hand to satisfy them. To say that economic goods are limited in quantity is simply to say that the existing stocks of such goods are unable to satisfy the total subjective demand for them. It is important to note that this is not the same thing as objective scarcity. Rotten eggs are, happily, scarce, but even so, there are too many of them, economically speaking (Robbins). Not only do we not want them, but energetic efforts are made to see that as few as possible come into existence. They have no value for us, indeed, they are an inconvenience, which is to say that they have a negative value. On the other hand, an economic good which is not objectively scarce can increase infinitely in value, if life itself depends upon its possession. So the sorely-beset hero of Shakespeare’s Richard III feels compelled to offer his kingdom for a horse. The scale of values of things encompasses, then, all values from minus (negative value) through zero (free goods), through a range of finite values (economic goods) to infinite values (meta-economic goods). The place of any good in this scale of values is determined ultimately by the strength of the subjective demand for it.
Air and water are ordinarily ranked very low on our scale of values, though they are essential to life. On the other hand, a diamond is valued very highly, though it is not in the least an object of vital importance. This circumstance leads us to a further important concept which is indispensable for an understanding of the subjective foundations of economic life. Our preceding discussion has made tacit use of this concept; it behooves us now to give it the most careful scrutiny.
When it comes to assigning a good its place on the scale of values, the determining factor is utility—not a general utility based on the degree of the good’s vital importance, but the specific, concrete utility of a definite quantity of the good. The larger the supply of a good at our disposal, the smaller is the amount of satisfaction procured by its individual units, and hence the lower is such a good ranked on our scale of values. The reason for this is that with increasing satisfaction of a want, the utility (satisfaction or enjoyment) furnished by each successive dose diminishes. Moreover, take away any one of a number of identical units and the loss of utility or satisfaction will be the same as if any other had been taken away. It follows that the minimum utility of the last dose or increment determines the utility of every other unit of the supply and therefore the utility of the whole supply. The value we attach to water is not determined by the infinite utility of the single glass of water needed to save us from perishing of thirst; it is determined by the utility of the last dose used to bathe ourselves or to sprinkle the flowers. We call the utility of this last dose final or marginal utility.
We may now affirm the following theses: (1) marginal utility diminishes with increasing supply, that is, with the increasing possibility of satisfying a want; (2) marginal utility determines the utility of all other units of the supply; (3) as the quantity of a good is increased, there is a corresponding fall in its place on our scale of values, providing our taste (scale of preferences) has not changed in the meantime; (4) the utility of the whole supply (total utility) increases as quantity increases, but at a decreasing rate due to the absolute decline of marginal utility. In fact, if marginal utility diminishes faster than quantity increases, total utility may decline absolutely.
Now it is readily apparent that marginal utility will fall at a different rate for different commodities. Oddly enough, the rate of fall is greater the more vital the commodity. Let us reconsider the example of water. Each of us can remember a long walk on a hot summer’s day when we had only one thought in mind: water. We at least reach a spring and, consumed by thirst, fling ourselves down to drink. The first mouthful of water is swallowed greedily, but with the second there is an abrupt lessening of satisfaction. Finally, we bathe our faces, we refill our canteens, and then forget both thirst and water to stretch out on the grass in leisurely contemplation of the countryside of which “we can’t get enough.” We will observe that as the result of the extremely rapid fall in the marginal utility of water, its total utility can easily become negative. Those unfortunates who, during the Middle Ages, were tortured by forceful infusions of water, could have furnished convincing proof on this point. Or consider the proverbial discontent of the farmer with the weather. He complains as often that it rains too much as that it rains too little—a further proof that water is characterized as much by the urgent need we have for it, as by the extremely rapid fall in its marginal utility.
From the concept of diminishing marginal utility may be deduced still another: elasticity of demand. In general, the elasticity of demand for a good varies inversely with the urgency (intensity) of the demand for it. Later, we shall see how this principle underlies important phenomena of the price structure, especially on the markets for agricultural goods. With low elasticity of demand (rapid rate of fall in marginal utility), the total utility of a supply may decrease absolutely, as illustrated in the well-known fact that the income derived from grain production in a given year may be smaller for an abundant harvest than for a lean one.
The meaning of “rapidity of fall in marginal utility” and of “elasticity of demand” will become clearer if we apply these concepts to certain considerations of a practical nature.
Remembering that elasticity of demand varies for different commodities, it is obvious that individuals will tend to consume more nearly the same amounts of a given commodity the less elastic is the demand for it—and this despite differences in income. And inelasticity of demand, we will recall, is the greater, the more essential to life is the commodity in question. Another outcome of these relationships is this: the smaller is one’s income, the larger is the share of it which is expended on foodstuffs. This fact was first demonstrated by the Prussian statistician Engel in 1857 (Engel’s law). Somewhat later, another statistician, Schwabe, arrived at identical conclusions for housing expenditures (Schwabe’s law). We may conclude, therefore, that taxes on basic consumption goods hit the poor more severely than the rich.
A closer scrutiny of the expenditures of the rich will show that the notion of the rich gluttonously stuffing themselves is inexact, the stomach capacity of most individuals being approximately the same. Of course, the larger is a man’s income, the greater will be his consumption of luxury goods, such goods having a high elasticity of demand (slow fall in marginal utility). But even such luxury wants are not sufficiently elastic to absorb the whole of a very large income. The result is that the unspent portion of the very large income is saved. This gives us an inkling as to how important is the function of the rich in the formation of capital. It follows that very little can be expected from a redistribution of the large incomes among the poorer classes. For if the rich spend for their vital needs but little more than the poor, the poor will hardly be benefited by such redistribution. Moreover, the amount of money which the rich spend on luxuries is relatively insignificant, in spite of what the lay mind imagines. The rich are so few in number that the amount they expend on luxuries is trifling in comparison with the total expenditures of the rest of the citizens. (For example, of the 58,701,000 individual income tax returns filed in 1958 in the United States, only 236 showed incomes of $1,000,000 or more; only 115,000 income units earned $50,000 or more [Statistical Abstract of the United States for 1961]). As for that part of the large income which is saved, it cannot figure in any scheme for the redistribution of the wealth since the cessation of saving will invite general economic decline. It should be remembered that the wealth of a Henry Ford consisted not of money but of factories which were built with his savings, factories which even a Communist state would have built had it the necessary means. Looked at in this light, people like Henry Ford are really public servants who administer our productive resources after the manner of trustees and who, if their trusteeship is bad, undergo the immediate and heavy punishment of financial loss. The problem, then, is not whether the fate of the poor will be appreciably better in a society where there are no rich. The problem is, rather, whether it is preferable to put state functionaries in the place of private entrepreneurs and to convert private enterprises into state enterprises; and further, whether the economic, social, and political power wielded by the rich is such as to result in economic evil or social injustice.
Let us clarify this point by still another illustration. Let us suppose that a poor street cleaner wins first prize in a lottery. How will he dispose of his sudden wealth? We see at once that it is the elasticity of his wants which will play the decisive role. Obviously, he will first satisfy his pressing needs for food, clothing, and shelter. But it is soon apparent that for these inelastic needs the point of satiety is quickly reached. The larger the winnings from the lottery and the richer the individual before his winnings, the smaller will be the percentage of his total income expended on inelastic or vital needs. However, while it is certain that all men will spend a part of their incomes for the basic subsistence goods, we cannot predict how they will distribute the remainder of their incomes among other wants. People will consume more nearly the same amounts of a given commodity the more inelastic is the demand for it. The more elastic is the demand for a commodity, the more probably will its consumption vary with the fluctuations of individual taste. It has been shown, for instance, that during the years 1926-27 the percentage of national income spent for food in Canada, Switzerland, and England was, surprisingly, the same (30-31 per cent), while expenditures on other items varied considerably among the three countries.
If it is now the whole population instead of the street cleaner which is enriched, the same sequence of cause and effect will be operative. The percentage of income expended on food (inlastic demand) diminishes, while other needs assume increasing importance. This means that the relative importance of agriculture will ultimately diminish, and that within the agricultural domain itself grain production will become relatively less important than the production of more highly valued foods (milk products, meat, eggs, fowl, vegetables and fruit). Similarly, non-agricultural branches of production satisfying ‘luxury” wants of a still higher type (“tertiary production”) will increase in importance as the general standard of living rises. Trade, transportation, tourism, motion pictures, radio, television, the legitimate theatre, books, art works, concerts, etc. absorb an ever-larger share of the national income as the standard of living rises. Otherwise expressed, rises in living standards go hand in hand with increased production, in the agricultural domain, of butter, meat, fruit, etc. As incomes rise still further, the ultimate stages in the developmental process—urbanization and industrialization—are attained. Our own age clearly reflects this evolution.
Thus far we have sketched the broad outlines of the principle of marginal utility, a clear apprehension of which will show it to be almost a commonplace. But as the above examples indicate, it is a commonplace which is indispensable to an understanding of economics. Indeed, it is upon this principle that the whole edifice of modern economic theory has been built. It is to a group of economists who initiated their researches within the last fifty years that we must assign the credit for this accomplishment.