Personal Finance
Scott Wentland
[email protected]
434-395-2160
Longwood University
201 High Street
Farmville, VA 23901
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What Determines Value?
Part 1 – The Labor Theory of Value
and the Diamonds/Water Paradox
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What determines value?
• Why are some things more valuable than
others?
• How can “thinking on the margin” and costbenefit analysis help us understand value?
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What determines value?
• That’s easy. The stuff we need the most is the
most valuable.
– Houses are expensive
– Gas is expensive
– Medicine can be very expensive
• Is something really more valuable because we
need it more?
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Value = Need?
• Adam Smith wrote about this in 1776
– The Wealth of Nations (1776)
– Smith was the father of economics and The Wealth
of Nations is one of economics most important
books (more about Smith later…)
• Water/Diamonds Paradox
– Why are diamonds more valuable than water?
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Water/Diamonds Paradox
• Water is essential to human life
– Other than air, there is literally nothing more
important to our survival as water
– Humans need water
– But, water is cheap
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Water/Diamonds Paradox
• Diamonds are not essential to human life
– They are shiny stones, used in jewelry and a few
other uses (like cutting)
– Diamonds = bling  we don’t need bling.
– But, diamonds are expensive!
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If not need, what?
• If value doesn’t necessarily come from need,
then where does it come from?
• Adam Smith’s answer: how much work goes
into it
– “The real price of every thing, what every thing
really costs to the man who wants to acquire it, is
the toil and trouble of acquiring it.”
– Labor theory of value
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Labor Theory of Value
• Water is easy come by, in most places
– In the old days, pump water from a well
– Now, it comes out of the faucet
• Diamonds are hard to make
– Need to be mined from a far-away land
– Need to be precisely cut and polished
• If a diamond maker goes to the trouble of
making the diamond, he/she will want
something back in return
– Something of at least equal value
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Diamond/Water Paradox Solved?
• Diamonds are more valuable because it takes
more labor to make a diamond?
• This story is incomplete. Why?
• Does more labor always mean more value?
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Labor = value?
• Grandma spent a lot of time knitting this
sweater…is it valuable?
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Labor = value?
• Countless, highly skilled people helped make
these movies…
– Are these movies valuable to studios?
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If not labor, what?
• What have we learned?
• The labor theory of value is obviously
incomplete.
– Does not account for other costs
– Does not account for demand
– Not necessarily ‘thinking on the margin’
• Next part: Is there a better way to resolve this
diamonds/water paradox?
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What Determines Value?
Part 2 – Marginal Analysis and
Resolving the Diamonds/Water
Paradox
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Resolving the Paradox
• Where does value really come from?
– Individuals (the rest of this lecture)
• First look at how individuals determine value for
themselves
• Individuals think “on the margin”
– Markets (next lecture)
• Markets are made up of individuals (consumers and
producers) who trade with one another
• Markets can be best understood by understanding the
laws of supply and demand
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Value and the Individual
• Individuals have value for consuming
something, independent of what the price
actually is
– Consumption (or use) value is subjective
– Price of a can of Coca-Cola = $1
• I may buy it, because it is worth more than $1 to me
– I might be willing to pay $2 or $3.
• You may not buy it, because it is not worth $1 to you
– You might be willing to pay $0.50
– This value may vary from person to person
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Value and the Individual
• Does this mean you wouldn’t want a Coke if
you could buy it for, say, $0.75?
– Exchange value is not subjective
– You may buy the Coke for $0.75 and try to sell it
for $1.00
• People trade/exchange/buy/sell because they
either want to 1) consume it or 2) re-sell it
1) depends on your own value for it
2) depends on the market value for it
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Value, on the margin
• Individuals think (and make a lot of decisions,
like consumption decisions) on the margin
• In economics, “the margin” refers to the “next
increment” of whatever you are deciding to do
– Should I have one more drink?
• I was happy with the first cup of coffee, should I have a
second cup? A third? A forth?
– Should I study an additional hour?
– Should I take one more class this semester?
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Value, on the margin
• Example:
– Suppose you are studying for an exam at
Starbucks
• You plan to stay for several hours
• You drink energy drinks to give you an extra kick of
energy
– Do you order all of your energy drinks all at once?
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Value, on the margin
• You probably think on the margin:
– Buy the first when you get there
– Buy a second when you are getting a little tired
– Buy a third when the second one wears off…
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Cost-Benefit Analysis
• Why do you buy the first energy drink?
• Breaking it down:
– Cost of one energy drink = $3.00
– Benefit of one energy drink > $3.00
• You would be willing to pay as much as $4.00 for this
• You buy the energy drink because:
Benefit > Cost (for the first drink)
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Cost-Benefit Analysis
• Why do you buy the first energy drink?
• Marginal cost
– The additional cost for one additional unit
– $3.00
• Marginal benefit
– The additional benefit for one additional unit
– $4.00 for the second unit
Marginal Benefit > Marginal Cost
$4.00 > $3.00
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Cost-Benefit Analysis
• Individuals are always weighing costs and
benefits
– This is called cost-benefit analysis
– This can be either intentional or
unemotional/subconscious
• Economics’ prediction about human behavior:
If Marginal Benefit > Marginal Cost, DO IT!
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Cost-Benefit Analysis
• Why do you buy the second energy drink?
• Breaking it down:
– Marginal Cost of the second energy drink = $3.00
– Benefit of second energy drink > $3.00
• You would be willing to pay as much as $3.50 for this
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Cost-Benefit Analysis
• Why do you buy the second energy drink?
• Marginal cost
– The additional cost for one additional unit
– $3.00
• Marginal benefit
– The additional benefit for one additional unit
– $3.50 for the second unit
Marginal Benefit > Marginal Cost
$3.50 > $3.00
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Cost-Benefit Analysis
• Why do you buy the third energy drink?
• Marginal cost
– The additional cost for one additional unit
– $3.00
• Marginal benefit
– The additional benefit for one additional unit
– $3.05 for the second unit
Marginal Benefit > Marginal Cost
$3.05 > $3.00
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Diminishing Marginal Utility
• Why is my marginal benefit shrinking?
– I’m not as satisfied with the 3rd as I was the 2nd or 1st…
• I am less satisfied with “more of the same”
• I may be getting tired of drinking energy drinks
• It may not provide the same “kick”
• This idea is linked to diminishing marginal
utility
– As I consume more and more of the same thing, the
additional happiness (or marginal utility) diminishes
with each additional unit
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Cost-Benefit Analysis
Marginal Cost
1st
Marginal
Benefit
$4.00
2nd
$3.50
$3.00
3rd
$3.05
$3.00
4th
$2.50
$3.00
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$3.00
Cost-Benefit Analysis
Marginal Cost
1st
Marginal
Benefit
$4.00
2nd
$3.50
$3.00
3rd
$3.05
$3.00
4th
$2.50
$3.00
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$3.00
Cost-Benefit Analysis
Marginal Cost
1st
Marginal
Benefit
$4.00
2nd
$3.50
$3.00
3rd
$3.05
$3.00
4th
$2.50
$3.00
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$3.00
Cost-Benefit Analysis
Marginal Cost
1st
Marginal
Benefit
$4.00
2nd
$3.50
$3.00
3rd
$3.05
$3.00
4th
$2.50
$3.00
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$3.00
Cost-Benefit Analysis
Marginal Cost
1st
Marginal
Benefit
$4.00
2nd
$3.50
$3.00
3rd
$3.05
$3.00
4th
$2.50
$3.00
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$3.00
Cost-Benefit Analysis
• At some point, you choose not to buy any
more
– Why?
– Because the Marginal Cost > Marginal Benefit
• Second prediction about human behavior:
If Marginal Benefit < Marginal Cost,
Then DON’T DO IT!
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Cost-Benefit Analysis
• Cost-Benefit Analysis Conclusions:
Choose to do more of something if:
MB > MC
Choose NOT to do more of something if: MB < MC
Happiest when we have reached:
MB = MC
– The third can was closest to this optimal point
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Bulk Pricing
• Diminishing marginal utility and “bulk
pricing”
– Vendors know the consumers have diminishing
marginal utility, so they price accordingly:
– One for $3, Two for $5
• The marginal cost of 1st = $3
• The marginal cost of 2nd = $2
• This is different than average cost
– AC = Price / Quantity
– Average cost = $5 / 2 = $2.50
• Marginal cost may not always be constant
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Back to the Paradox
• How does marginal analysis (or “thinking at
the margin”) resolve our diamonds/water
paradox?
• Water is incredibly valuable to us, but not so
much at the margin
– When we want to buy a bottle of water, we’re
usually not completely dehydrated
– An additional bottle of water might make us less
thirsty, but is not usually a matter of life and death
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Back to the Paradox
• One more bottle of water usually means…I’m a
bit less thirsty
– How much is that worth to you? Maybe $1 or $2.
• The question is not usually a “lifetime of water” vs. “no
water”…it is usually choosing to buy water at the
margin
• One more diamond usually means…I am much,
much happier (or my significant other is much
happier!)
– How much is that worth to you? Hundreds?
Thousands?
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Back to the Paradox
• Each additional diamond is still worth a lot to
you…
– For consumption, who wouldn’t want more
diamonds?
• Each additional bottle of water…not so much.
– Always?
– Alone in the desert, you may be glad to trade a
diamond for a bottle of water!
• Most of the time, we’re not in a desert.
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Conclusions
• When we think on the margin, we can see how an
additional diamond > an additional bottle of water
– Consumption value is subjective
• Differs from person to person
• Differs from unit to unit (additional units are usually valued
less)
• When we think on the margin, we make good,
rational decisions (where MB > MC)
– We are happiest when we come to MB = MC
– This is sometimes called cost-benefit analysis or
marginal analysis
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Conclusions
• Marginal analysis or marginalism supplants the
labor theory of value
– Developed by 19th century economists after Smith,
called the “marginal revolution”
• Why is this important?
– Karl Marx’s theories depended on the labor theory
of value
– Relatively simple concept devastates a key tenant
of Marxist/Communist economic theory
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Conclusions
• What if I don’t like diamonds? And my
significant other doesn’t like diamonds?
– If I found one (or could buy one for cheap),
would I just throw it away (or not buy it)?
– No, you can always sell it (or exchange it for
something you do like)
• Exchange value is not subjective
– We can sell it on the market at some market price
• Later: what determines that market price? How
does the market value things?
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Thank You
For additional information see:
http://en.wikipedia.org/wiki/Paradox_of_value
http://en.wikipedia.org/wiki/Marginalism
http://en.wikipedia.org/wiki/Cost_benefit
http://en.wikipedia.org/wiki/Marginal_concepts
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