Hey folks, new module today.   This is
going to be chapter 10 part 1, and I'm
actually going to give you a fair amount
of historical background on where modern
microeconomics comes from... and this is
going to go back to what was known as
the diamond water paradox.... and the
marginalist we've already mentioned in
this class these are the folks who end
up fixing the diamond water paradox... and
the way that they fix it is by refining
utility.  So we're going to talk quite a
bit today about the utility theory of
value, which is essentially modern
microeconomics answer for where prices
come from.  Let's go ahead and get started.
Okay, economics has got to explain where
prices come from.  A market society gets
everybody to allocate, produce, and
distribute based on price cues, so if the
economists can't tell you where prices
come from or why they are what they are, then
economists can't tell you very much.  Adam
Smith recognized early on that there
were two major options for explaining
prices.  There was utility and labor.   The
utility theory of value basically said
that objects were useful and brought
happiness; therefore, they held value.  So
really useful things that made you happy
should be really expensive and things
that were not particularly useful should
be cheap.  Smith recognized that this was
going to be a real problem for utility,
because water was free and things like
diamonds were expensive.   He looked at
this and said what's more useful than
water... it keeps you alive-- presumably that
also makes you happy.  Water should be
really expensive, but of course it wasn't.
Diamonds on the other hand were nothing
more than a trinket or a bauble, they
were a shiny thing, but they were hugely
expensive.  So
this seems like a massive counter
example for the utility theory of value,
and in fact it was so damning Smith
actually junked the utility theory value.
He didn't do much with it at all. 
The other option at the time was the
labor theory of value and the labor
theory of value said that objects were
worth the amount of labour required to
create all the tools and bring the
actual object into being.  So this was not
a paradox for labor, because water
required practically no labor.  That's why
it was free.  Diamonds on the other hand
required that you had all kinds of tools,
dug a mineshaft, brought it out of the
ground, cut it up, polished it, etc. 
Diamonds were expensive because they
represented a lot of embodied labour. 
This is why a lot of early theorists
like Malthus, Ricardo, and Marx preferred
the Labour theory of value.  Now if you're
paying attention,  you probably recognize
Marx name even if you don't recognize
Malthus and Ricardo, although you should
recognize Ricardo.   Marx basically was a
huge critic of capitalism and he
polished up the labor theory of value
and got to all kinds of conclusions
about how capitalism was going to cause
conflict, it was going to suffer from
crises, and it was essentially going to
exploit workers.  This was a huge problem
for anyone who still wanted to advocate
for markets,  and it became obvious that
if you were going to advocate for
markets you needed to be able to explain
markets with another theory other than
the labor theory of value.
They needed to fix the utility theory of
value. Whereas the labor theory
highlighted conflict and production and
crises, the utility theory of value
highlighted exchange and generally lent
itself to arguments about how a market
was an institution that produced
happiness.  It allowed people to get
better off through voluntary exchange. 
There were three independent theorists
Stanley Jevons, Carl Menger, and Leon Walras all who managed to fix the diamond
water paradox in the early... about 1870. 
Each one of these folks had recognized
that there's a difference between what
the last unit of the good gets you, in
terms of happiness or usefulness, and
what a whole set of good gets you.  Smith
had been focusing on the latter.  He was
thinking about what water was worth to
you, as in do I get water or do I not get
water-- period.   He was not thinking about
what the last cup of water was worth to you.  If you want to start talking about the
last cup of water, then you're talking
about the former.  You are now discussing
marginal utility.  What amount of
happiness is generated from the last
unit of water that you consume.  Jevons,
Menger, and Walras, to varying degrees, all
recognized that by separating out total
utility from marginal utility that you
would actually be able to generate a
theory of prices based on marginal
utility, not on total utility.  What we're
willing to pay for an object is based on
what the next unit is worth to us,  not on
what the entire set of those objects are
worth to us.  So this critical difference
basically unlocked the diamond water
paradox and launched what you could
think of as modern microeconomics at this  point
So let's revisit modern
micro and our golden rule and talk about
how this matches up with the marginalist
perspective.  Our golden rule is marginal
benefit equals marginal cost for our
last unit.   Well if you think about this
from the consumers perspective this is
nothing more than saying that you want
the marginal utility of your last unit
to equal the marginal cost (or price you
paid for that unit).  In other words it's
just a theme and variation on our golden
rule... And a later marginalists by the
name of Alfred Marshall
was actually quite good at describing
this process.  He described a little kid
who was harvesting blueberries and that
little kid would continue to harvest
more and more handfuls of blueberries as
long as the enjoyment of procuring and
eating those blueberries was greater
than the trouble or the cost of getting
the next handful of blueberries.  The kid
was going to stop when the last unit was
equal to the cost or the trouble of
acquiring that unit.   So in our context MU
is really just the marginal benefit and
the price you pay for the last unit is
the marginal cost... So just like that
little kid consumers,  if they're getting
a good deal and mu is bigger than P,  then
there's an incentive for them to keep
consuming.... and they're going to want to
stop when the last unit has a marginal
utility equal to the price (or MB equals
MC is the case).   Now a hidden assumption
here is that we are assuming that MU is
falling,  right??? and this probably slipped
right past you without even noticing. 
We're talking about the little kid
finding the blueberries less and less
interesting as they continued to harvest.
Why? why would we assume that?
The marginalist thought that you could
count on objects, goods, and services
generating less happiness for you the
more and more that you got of them.  If
you think about this
almost everything in life works this way.
The more that you get of it the less
that you tend to appreciate it.
So we can show this in a table and a
quick little example.   Suppose that you
like cheesecake and you start eating it...
as you start eating it you want to
generate happiness for yourself.... and
we're going to show that here with total
utility,  and of course total utility is
rising as we eat more and more units of
cheesecake..... but you can see that it's
rising by smaller and smaller amounts.
And when we start talking about how much
it's rising per unit we've drifted over
into a conversation about marginal
utility... and we can see that the first
unit here is generating us 20 utils 
of happiness.  Brief aside here we're going
to act like we can measure happiness, 
mostly just because it's easier to talk
about this.   If you want to see formal
solutions that can avoid actually having
to measure it you'll have to get a
little further into economics, but
there's a peek at how you could do it in
the appendix for chapter 10.  Okay, so as
we continue to consume cheesecake the
second unit is only going to generate 30
utils,  and that's good because it
actually has gone up... and they were okay
with it going up at first,  but what they
were going to insist is that the more
you got of something eventually it's
going to start producing less..... and at
this point right here,  we are going to
say that diminishing marginal returns
has set in,  because our third actually is
going to generate less for us than our
second.  Okay, and every unit after this is
going to generate less
and less and less.   If we went far enough
we could probably even talk about
negative marginal utility, but if you've
got rational folks they shouldn't be
looking to make themselves unhappy.  Keepin mind micro assumes you're rational,  so
this marginal utility was essential
because whether or not you were willing
to pay the price for a piece of
cheesecake was going to depend on what
the next piece of cheesecake was worth
to you. The only way you'd ever ask for 7
units is if it was free,  because
obviously it's not generating you any
real benefit.... so if you weren't going to
be willing to give up any price in order
to get it if it didn't generate anything. 
We can start to go ahead and graph total
utility,  and it's okay for total utility
to increase at an increasing rate for a
little bit,  but we're going to
essentially demand that it starts to
increase at a decreasing rate, this area
of the graph here once it flips over... and
if we go far enough and we actually
start causing our self harm then we're
going to see that total utility actually
declines.  We'd be talking about like a
unit number 8 over here,  where we
actually be enough cheesecake that we
make ourselves sick,  ok?  So we can graph
total utility and it kind of looks like
this mountain shape over here, and after
this second unit diminishing marginal
returns sets in,  so no longer are we
increasing at an increasing rate.  From
that point forward the graph is still
going up, but it's going up by smaller
and smaller amounts as we move out, and
of course the Q here is our
cheesecake,  right?  We're consuming more
and more units to get ourselves more and
more happiness.  Now total utility is not
really that important for understanding
prices.  It is what consumers are
interested in though, they are one is
going to want to maximize their total
utility.
But in order to start maximizing total
utility they actually are going to have
to pay attention to marginal utility.  So
if we want to map out and graph marginal
utility,  we're just going to graph these
numbers over Q,  so at unit number one
we're going to see that we have 20 utils, 
and at unit number two we're going to be
at 30 utils,  and then unit number
three we're going to fall to 15 utils,
and so on and so forth. 
Alright marginal utility is going to
look like this and by the time we get
out here to unit number seven marginal
utility is zero so this is what your
marginal utility curve is going to look
like.  We'll revisit this in a second, but
I want you to understand that these two
curves are directly related to each
other.  Okay margin utility hits zero when
total utility has maxed out.  Now let's go
ahead and move to our next phase.
Of course our whole point is we've been
trying to get to an understanding of
marginal utility, because we're trying to
explain consumer behavior and
essentially the demand curve-- why they're
willing to buy stuff ---why they're not
willing to buys stuff....  because if you think
about it our expression of prices is
based on equilibrium.... and equilibrium is
nothing more than the intersection of
supply and demand. 
So how do we get to these equilibrium
prices-- half of the discussion is based
on the demand curve.  Consumers demand
based on their marginal utilities,  so for
the sake of simplicity right now let's
say that you utils are equal to dollars, 
and if in fact you utils are equal to
dollars, then we can kind of
cheat and put price up here with
marginal utility.... and we could express it
in utils or dollars.   And if this is our
marginal utility curve,  it's downward
sloping... and the reason it's downward
sloping is because as we get more and
more of our cheesecake it's less
interesting to us,  so how do we decide
whether or not we want to buy cheesecake?
Let's impose a price, and if this price
--let's say that it's $4-- if cheesecake
costs us $4, then we would want to start
looking at each individual unit of
cheesecake that we could consume... and
that first one if you'll remember
generated twenty utils for us.   So you
could ask are you going to be interested
in cheesecake
if unit number one generates you 20
utils,  and the answer would of course be
yes, that's a great deal.  It's $20 worth
of happiness, but I only have to pay 4. 
Well as long as MU is greater than price,
you're going to buy.  You are going to
consume and you're going to consume all
the way up to the point where MU equals
P, and on our table Mu finally fell to
four at unit number five... So we can talk
about this as our Q star if you want.
It's the amount of cheesecake that this
person would buy if the price were four
dollars,  right?  Now obviously if we start
increasing the price of cheesecake and
we increase the price to ten bucks,  if
you look at the table from the last
slide our fourth unit of cheesecake
generated ten units of utility,  so if the
price was equal to ten we would have
stopped at unit number four....
so we can go ahead and show that here. 
With a higher price we actually would
back off and only request a smaller
amount of cheese
cake.  Of course prices rising and us
deciding to consume less cheesecake is
essentially the law of demand.  If price
goes up, quantity demanded is supposed to
go down.  This individual marginal utility
curve is an individual's demand curve.
And of course getting from the
individual to the market is nothing more
than summing up all of the quantity
demanded from all of your individual
consumers at any given price.  Essentially
you walk around and say cheese cakes
four dollars how many do you want?
This particular consumer, when it was
four bucks, wanted five units.  You ask the
next one how many do they want, and you
would start building up all of the
quantities that would actually be
demanded at four dollars,  all of the
quantity demanded at four bucks.
So really utility is quite happy because
they have an explanation of demand, and
they have got half of the explanation
for how we get to market prices.  Hence,
utility theory of value is on its way to
building a general theory of prices that
explains how we allocate, produce ,and
distribute within society.  Okay that'll
do it for this first portion.  We'll pick
up with other utility issues in our next
part.
