Econ 101
This post comes under the sub-section Econ 101. Under Econ 101, I try to cover some basic economics concepts that will come handy in public policy discussions. We won't cover economic theory exhaustively, there are many textbooks that can do this better. We will be focussed on developing an economic way of looking at the world.
Diamond-Water Paradox
There was a question that Adam Smith struggled with: Why is diamond more expensive than water? Clearly, water is more useful than diamonds! If you had to give up all diamonds or all water, what would you do? I guess the answer is obvious. Yet diamonds are more expensive. So why are people willing to pay more for diamonds than water when water is more useful?
This was called the diamond-water Paradox. This paradox was solved in the 1870s by three economists, and they ushered in the marginal revolution, which changed the direction of economic thought for the years to come.
To understand how this paradox was solved, first we need to understand the difference between total and marginal. Marginal in economics means having a little more or a little less of something. For example, the marginal utility of a diamond means the satisfaction given by one more diamond. On the other hand, total utility of diamond means the utility of all the diamonds. We know that the total utility of water exceeds that of diamonds. We would rather live in a world where there is no diamond than one in which there is no water. But almost all of us will prefer to be gifted with a diamond rather than an additional bucket of water. Why is that? This is because we are not thinking about whether diamonds or water have more value in total. Rather, we are asking ourselves if the value brought to us by one additional piece of diamond (marginal benefit of diamond) or one additional bucket of water (marginal benefit of water) is higher; and the answer depends on how much water or diamond we already have. In other words, we are "thinking at the margins". If we were in a desert, thirsty for a drop of water, we would obviously prefer water over diamond. But when we have enough water, the value brought to us by one additional unit of water is lower.
This is how the diamond-water paradox was solved. The price of a product is not determined by it's total usefulness or the work put behind it. It's determined by marginal utitliy.
Marginal Benefit & Marginal Cost
Marginal benefit or marginal utility is the added satisfaction from consuming a little more of a good or service, and marginal cost is the cost to produce another unit of a good or service.
Let's say a bus with a capacity to take 100 passengers is travelling with 60. The marginal cost of an additional passenger is nearly zero (since almost no extra money is spent by the bus owner to add one more passenger). The marginal utility of an additional passenger is the ticket price charged on the passenger. But if the bus was travelling with 100 passengers (full capacity), the marginal cost of an additional passenger would be the entire cost of adding another bus. But the marginal utility of an additional passenger is again only the ticker price. In the first scenario, marginal utility exceeds marginal cost. Hence, it is economically feasible to add one more passenger. In the second, the marginal cost of adding a new bus is much higher than the ticket price; hence, it is economically not feasible to add one more passenger.
Thinking at the margins is about making decisions based on marginal benefits and marginal costs, or the advantages and disadvantages of little more or slightly less.
Marginalism & Public Policy
In life, most of our decisions are made by weighing marginal utilities and marginal costs, even when it is done subconsciously. But when thinking about policy issues, we often miss this common-sense marginalism.
Let me illustrate this with a very interesting and controversial example: the maternity leave policy in India. The law allows mothers to take a 26-week paid leave for their first two children if they are working in a firm with more than 10 employees. When we look at maternity leave in totality, the law makes sense - maternity leave is a good thing.
But when we think at the margins, which policymakers need to do, we see a different picture. The maternity policy in India only benefits a small proportion of Indian women—women who are in the labour force, who are in the organised sector, who work in firms with more than 10 workers, etc. When we look at these numbers, the law only benefits around 2% of women.
But the law, like any other regulation, has some market-distorting effects, like, discouraging firms from having more than 10 employees, discouraging firms from hiring more women, etc. Such market distortions affect the growth of employment and the growth of economy, both of which could have been beneficial for everyone, including women. The marginal benefits from the law (gains to the economy through the extra money spent by firms in giving 26 days off - like improving women’s labour force participation) need to be weighed against the marginal costs (losses to the economy because of the extra money spent by firms in giving 26 weeks off) to assess its economic feasibility. Otherwise, a law that is intended to improve women's labour force participation rate might lead to the exact opposite.
Opportunity Cost & Trade-offs
Marginal costs can be confused with opportunity costs. While opportunity cost is an idea that expresses the relationship between scarcity and choice (the value of the next best alternative), marginal cost is the cost of producing an additional unit.
Also, marginal cost/benefit is related to the idea of trade-offs. In fact, marginalism is only a way to restate the idea of trade-offs. Trade-offs, like the idea of marginal, are about the choices that people make—choices about a little bit more or a little bit less.
Homework:
Read this article that explains the idea of marginalism using an interesting example.
Before marginalism became prominent, a concept called ‘Labour Theory of Value’ dominated economic thinking. Know more about LTV here.
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