The first issue I wish to take up in this blog is that of
diminishing marginal utility and its application to money. At a glance, it is a
simple, almost trivial exercise in microeconomic theory. In fact, I just
explained the connection to my grandmother and she was fascinated by its
simplicity. So lets jump right in!
The concept of diminishing marginal utility, that the
utility gained from acquiring one additional unit of an economic good is less
than the utility gained from the same economic good that was acquired prior, is
a wonderful tool for understanding the limits of human desire for a number of
homogenous commodities. To put it simply, it explains why most people do not
want an endless amount of the same stuff.
Let us take delicious Bavarian beer as our example. It is a
warm, sunny day and you decide to go out to the Biergarten with your friends.
According to the law of diminishing marginal utility, you will enjoy the first
beer the most. With each successive beer that you drink, the pleasure you
derive from consuming another beer will diminish. That is, you will enjoy the
first beer more than the second, the second more than the third and the third
more than the fourth.
Take any economic good you can think of and apply this
thought experiment. Couches, TVs, bacon, pants, houses, ovens, glasses and even
drinking water are all subject to the law of diminishing marginal utility – and
don’t forget to assume ceteris paribus!
Now, what is unique about the application of this theorem to
money? According to Professor Fekete, the acknowledged father of what is now
termed the “New Austrian School of Economics,” money has the “slowest rate of
declining marginal utility.” This means that in comparison to any other
economic good, you will get sick of or satiated by accumulating more money more
slowly than any other good.
Why? The answer is simple. Money has the unique quality of
being desired by all participants in a given market economy for the same reason
– it can be used to buy other things.
Thus, the rate at which the utility of each additional monetary unit will
decline is less than the rate at which the marginal utility any other good will
decline.
While this explanation is simple, it leads to far more interesting
historically based question. Is a given item classified as money because it has the “slowest rate of
declining marginal utility” or vice
versa? At present, the most informed answer I can offer to this question is
the case of the latter – that an item has the slowest rate of declining
marginal utility and therefore becomes money.
In a market economy, can't everything be used to barter for other things? And won't everyone swap all goods such that their marginal utilities balance?
ReplyDeleteI'd have thought that the issues of non-perishability, non-corrosion, divisibility and a high value-weight ratio would have been the key qualities for currency. If you accumulate money rather than other goods, it must be because you want the liquidity to spend for later, and those are therefore the most important qualities. But perhaps that's just taking gold and silver and thinking backwards.
-Peter
Hi Peter, let me try to answer:
ReplyDeleteIn a barter economy, goods used to be traded by other goods, as you say, in order to balance their marginal utilities. I have a chicken farm, so the marginal utility of another chicken for me is very low; what I want rather is eggs. So, I have to find someone who is willing to trade his eggs, which have a high utility for me, in exchange for my chickens. However, the utility of those eggs for me will decline rapidly once I have enough eggs to feed my family.
Barter seems to work fine, but it depends on finding someone who has those goods, and also wants the goods that I am selling; and then make a deal with him. This is not always possible and is time consuming. A more efficient way, and the way traders started to act, was to exchange their goods for an item that they were willing to accept even if they had no urgent need for it, an item which they could later use to buy other things, as it will always be accepted: money.
The characteristics for money that you listed are absolutely right. Alex pointed out the liquidity of money: since it has the slowest declining marginal utility, you can use it to buy other goods that are perishable, corrosive, non-divisible or weighty, or that you might not need now but you will need in the future. The rest of the characteristics are the reason why gold (and silver) were the chosen item to become money, historically. But that is another story, and I'm sure Alex will address it!
Ana
I guess the question comes up, then: Do gold and silver have slowly declining marginal utilities because of their inherent properties? Or because they are widely used as currencies? If the first is true, then the historical hypothesis is plausible. If the second, then not, and the choice of currency must have been made on other grounds.
ReplyDeleteNotice, Peter, that I never used gold or silver in my discussion. I actually put money in parenthesis because my intent was not to address the historical process in detail, but merely the theoretical implications of money in light of what we know about marginal utility. Money is simply defined as the medium of exchange, whatever that medium may be.
ReplyDeleteHistorically, I think that it is a two-way street so to say. Once a medium, say gold (the best example), becomes money, there is probably an additional demand gold for indirect exchange. Their inherent properties reinforce this development and explain why gold might have remained a medium of exchange over a longer period of time.
Again, I address a purely theoretical issue and attempt to pull out some kind of explanatory power from the the conclusions for historical understanding.
I apologise for my belated comment, Mr Goodyear. The Cakes parading your blog made me famished everytime!
ReplyDeleteI wonder whether with money its marginal utility increases with the first quid/dollar and keeps increasing until some threshold from where our basic needs are satisfied. And then begins its slow decline. But that decline gathers speed as our wants our met. Then we look for interpersonal goods like pride, trust and so forth that money cannot buy!
Additionally, Gold and other shiny precious metals serve this purpose of exchange perhaps also due to their intergenerational properties. Since the barter economies of primitive villages till the 1970s Gold and Silver anchored and maintained those properties. Whereas Fiat Money is still in an ongoing experiment in Monetary Economics! Not quite sure as to how far one can maintain the second derivative of marginal utility on 1 million italian lira, as it was known, comparable to a few pounds.
Just a thought
Money is not desired simply for its ability to be traded for any number of items; it is traded because this ability removes a great deal of uncertainty for the actor. The "purpose" of money is a removal of uncertainty - this is its foremost function. In an ERE, money is devoid of meaning and could never arise (this constitutes one of the paradoxes of the ERE that Mises speaks of). The marginal utility of money is therefore not so much dependent on the ability to get any item, but it is its wide salability which removes uncertainty. An increase in the demand for money corresponds to an increase in the perception of uncertainty.
ReplyDelete