Armed with the powerfully obvious truth that economic behavior is about satisfying human desires, economists came up with a term that means "the amount of human desire that a thing will satisfy, at a certain place and time". That term is "utility". My measure of the utility of something is how much I am willing to pay for it.
One might be tempted, at this point, to say, "Duh." But let's remember that none of this would be the least bit interesting if our analysis were limited to our own family or small circle of friends. We can observe and (more or less) predict their behavior, without all those fancy terms and concepts -- without needing to study "economics" at all. Economics only becomes useful when we want to understand aggregate behavior: the behavior of large groups of people. We certainly can't make money just selling widgets to our small group of family and friends, can we? We need to figure out how all the consumers, out there, will behave when given the opportunity to buy our widgets.
Utility is never static. The satisfaction we can get from one thing varies in comparison with the satisfaction we could get from other things we could choose. And, it varies with the amount of that thing we've consumed already. This leads us to explore the idea of marginal utility: the added satisfaction we get from consuming one more unit of something.
The notion of the margin -- the effect of adding or subtracting one more unit of something -- is very big in economics. When you think about it for a moment you'll see why that is so. What we're trying to do, as widget-sellers, or economic policymakers, is to predict the choices that people will make in the future. That's the only way we can have any idea whether to produce more widgets, or impose a tax on gasoline, or raise the minimum wage. In every case it is immensely important to understand the overall effect of adding the next unit of the thing in question.
Let's return to that hot dog stand we were operating a few lessons ago. We know from basic supply and demand analysis that if we lower the price, people will buy more. How long will that process go on? We notice that the lower price encourages many people to buy two dogs, where before they'd only buy one. So we lower the price further, but -- very few buyers want a third hot dog. Why is that? Well, they're full. The marginal utility of hot dogs is diminishing for them -- as it does for all goods. The more people consume of something, the less they will want the next unit if it. To get them to buy that third dog, we would have to set the price so low that we could no longer make a profit! So, by observing the principle of diminishing marginal utility, we've been able to determine how to make the most profit selling hot dogs in this market.
The idea of the margin is immensely useful in making all kinds of business decisions. Let's continue with our hot-dog stand example. We've been doing well, but we're selling all the hot dogs we can sell in this particular parking lot. And we have some profits to invest. What shall we do? Shall we introduce a new line of hamburgers to go along with our dogs? Or shall we open up a new stand in another parking lot across town?
Well, you gotta figure that once we get set up to produce burgers, or set up that other stand across town, it won't cost too much to produce more of them, in either case. It's the cost of that next one that matters: we have to consider the marginal cost of each option. To sell burgers won't cost so terribly much; we'll just have to buy the meat, buns and condiments, and paint a new line on our sign. To sell hot dogs across town, however, will cost more: we'll need a whole new stand, boiler, sign, an employee to run it, the whole nine yards.
So let's say we went ahead and added burgers to our product line. It seemed like a sensible thing to do. But -- alas -- it turns out that we failed to consider a very important factor. Rats! There is a restaurant that sells burgers, just a half-mile up the road. No wonder nobody was asking us for burgers at our stand.
Nevertheless, we have invested in $100 worth of meat, rolls, condiments and tools, to sell burgers that our customers don't want. We face a question. Should we try to find a way to sell those burgers that we've bought, even if it demands further investment? What are those burgers worth to us now?
The painful truth of the matter is that regardless of what the burger-capital cost us, there is no market for it. We miscalculated. So, it makes no sense for us to spend any more money or effort trying to sell the burgers. The $100 we spent on them is what economists call a sunk cost. In this case it is easy to see why it would be unwise to base any decisions on what we've paid for in the past. We have to look at what's going to happen in the future.
We need to compare the cost of adding that additional unit of output (a dollar's worth, let's say, of burger or dog) with the money that we'll get from selling it. (The economic term for that is marginal revenue.) Doing so, alas, shows our mistake in painful clarity. Lured by the low cost of adding burgers to our line, we neglected to consider the revenue side of the equation. The marginal revenue of a burger is, basically, nil. Even though it will cost more money to invest in new hot dog production, that will bring in much more revenue per dollar of investment.
We can't predict the future with certainly -- but by looking carefully at the margin, we can make our guesses a great deal more accurate.
Background Questions