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Pricing and Marginal Utility

Each individual judges the usefulness — the utility — of things they have or might acquire based upon the particular circumstances of their lives. No two people are in identical circumstances, so no two people make identical valuations of the things around them. It is this inequality that gives rise to trade.

The fundamental characteristic of economic trade is that it is voluntary. Each participant trades because they judge what they receive to be more valuable than what they give up. This is why people say "thank you" when concluding a trade. (The nice ones, anyway…)

The change in utility resulting from having one more (or one fewer) unit is fundamentally important to understanding trade. This unit is called the marginal unit and its utility is the marginal utility. A person who hasn't eaten in days will value their first unit of food very highly (it has a high marginal utility), while a person with a fully-stocked kitchen will not place much value on acquiring an additional unit of food (it has a low marginal utility). The fact that additional quantities of a good have a lower marginal utility than earlier quantities of a good is known as the law of diminishing marginal utility.

People trade when they can obtain things of higher marginal utility in exchange for things of lower marginal utility. It must be stressed that the judgment of utility is individual and based on that person's circumstances: different people will have different preferences.

A price is the ratio between two things (or bundles of things) in a trade: A shovel for an axe, two apples for an orange, three dollars for a gallon of milk, or ten dollars for an hour's work.

Prices are always between the marginal utilities of the seller (at the low end) and the buyer (at the high end). This satisfies the condition that both people must gain from a voluntary trade. These marginal utilities may be far apart, creating a wide range of prices that would be acceptable to both buyer and seller.

Consider the exchange of two apples for an orange. Let us arbitrarily call the owner of the apples the "seller" and the owner of oranges the "buyer". The change in the seller's utility would be (-2 apples, +1 orange) and the change in the buyer's (+2 apples, -1 orange). If both these quantities are positive, which depends on the utility valuations of the individuals involved, the trade will go through and the price would be 2 apples per orange.

Let us make the situation more complex through the introduction of a third person, offering a pair of shoes for the two apples. The possible outcomes for trade are:

  1. no trade, keep the 2 apples
  2. -2 apples, +1 orange
  3. -2 apples, +1 pair of shoes

Eliminating the negative (-2 apples) may make the analysis easier. If the seller imagines the apples as not his own, but available for free, the three alternatives become:

  1. +2 apples
  2. +1 orange
  3. +1 pair of shoes

The seller would choose the alternative judged by himself to have the highest utility. (#1 is equivalent to not trading.)

The introduction of money — a universal medium of exchange — greatly simplifies trade because it makes the alternatives directly comparable without the need for thinking in terms of oranges or shoes. With money, the seller must consider only two alternatives: Not trading, or trading with the buyer offering the greatest quantity of money.

Money also simplifies complex bartering situations, such as needing to temporarily obtain a good or goods purely in order to trade them for the goods one really wants. (If you want an orange but the seller wants a pear, you would need to trade your apples to someone else for a pear in order to finally get the orange.) Like such intermediate goods, money is not desired for its own sake. The utility of money is derived from its expected use in future trade. The universality of money means that it is the only intermediate good needed because everyone will accept it.

Future articles will assume money prices, not bartering, and will introduce many other factors besides marginal utility involved in the setting of market prices.

Tiny Island