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Introduction to Price Theory, Part 2: Marginalism

February 3, 2012

The supply and demand graph is simple, but it holds a lot of insight and subtlety. One of those insights is that the market price is equal to the point where the marginal cost to supply an additional unit of a good is equal to the marginal benefit to consumers from consuming an additional unit of that good. Marginal cost means the difference between the cost of producing some amount of a good and a little more or a little less. So the marginal cost to a bakery of producing 7 loaves of bread is the difference between making 6 loaves and 7 loaves. Likewise, the marginal benefit of consumption is the difference between consuming some amount of a good and one unit more or less of that good.

A demand curve consists of a sorted list of values which people place on a good. At the far left is the value of one of the good for the person in society who values it the absolute most. Next is the person who values it second most, etc on down the curve. People can, of course, demand more than one unit of the good, though because of diminishing returns, ususally additional points are further right. Each additional unit along the demand curve is a little less valued than the one before it.

Diamonds and Water
Without water, people would die, and so they should be willing to pay anything for it. If you lived your entire life without a diamond, maybe you would be sad, but your life would not be significantly different. And yet, diamonds are far more expensive than water. Earlier economists thought that the discrepency could be resolved by examining the amount of labor required to produce various commodities, but there are many products which require far more labor to produce than diamonds, yet which cost less. In a sense, both diamonds and water are God-given resources, so should the price for both be 0?

The first liter of water in a day is very important. Most people would be willing to pay a lot, because without it they would be thirsty. However, after a few gallons, people start to use up the high value uses and move to lower valued uses. By the time you get to your hundredth gallon for the day, you’re really not willing to pay that much for additional water. Diamonds, because of their rarity, have very high marginal benefits. If you had a gallon bucket of diamonds, you really couldn’t put them to good use, except to sell them. On the margin though, people are willing to pay a lot of money for such a beautiful stone.

Some Examples
High average cost, but low marginal cost:
Computer programs – The first copy costs a ton of money to produce, but once a single copy of a program is made, it is basically free to make as many copies as you like. Pharmaceuticals work in much the same way. It costs tons of money to create and test a new drug, but once one is found that is effective, it is very cheap to create as many pills as you like. Recipes and ideas likewise follow this pattern.

Low average cost, high marginal cost:
Oil – The average price of getting oil out of the ground is quite low. Saudi Arabia can produce oil for around $6 a barrel, and yet they charge the same $100 a barrel price that everyone else does. Why? You can think of it in terms of opportunity cost. If someone says to them, “you’re charging too much”, the Saudis can say to them, fine, then buy it somewhere else. Their next best alternative is to buy it from a high cost producer, and they wind up spending $105 a barrel.

The Law of One Price
Even with firms with widely varying prices, consumers pay one price for an identical good. If a firm tries to charge a high price to one customer and a low price to another, the low price customer can buy several and resell them. This is especially true in thick markets, where the products are uniform and frequently traded. Additionally, if one firm tries to price higher than the others, customers will avoid that firm and go to its lower priced rivals. Because of competition, the market will one price. Sometimes firms specialize on providing good customer service, or more convenience, and so they will be able to charge a higher price, but in general for comparable goods, the price does not vary much in competitive environments.

Part 1 here.
Part 3 here.

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