5.5. Marginal Utility & the Law of Diminishing Marginal Utility

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With the water-diamond paradox on the run, we can delve into the demand side of market life. Why does the demand curve slope downwards? Why do people buy what they buy? Why does Maria buy three gallons of gas, why does Bayla buy a box of chocolates as a gift for her mother, Rodney a diamond for his ear, Paul a ton of soybeans for his firm? And, come to think of it, why are they not buying more—or less?

You can answer such “why” questions in various ways, all of them acceptable for what they want to accomplish. A psychologist might focus on Maria’s psyche to figure out why she is not filling up her whole tank with gasoline, or why she refuses to pedal her bicycle to Pilsen instead of driving. A sociologist might speak of the status value of driving a car versus riding a bike.

Without denying that many questions are best answered in other ways, an economist takes a more “behavioral” and price-oriented approach. An economist talks in fact as though she were looking simply at the behavior of the demanders from the outside, with no knowledge of what’s going on inside their minds. That’s why it’s called “behavioral,” in honor of a once-popular psychological theory called “behaviorism.” Behaviorism said that psychologists should look only at how peoples and rats actually behave, not inquire into their mental states. The economist following behaviorism simply asks how the demanders respond to the stimulus of market prices, as though the demanders were analogous to mice in a soda-drinking experiment. In other words, the economist uses an experimental metaphor to talk about the quantity demanded: “What would happen if Maria were faced with a price of as much as $15 for a gallon of gasoline. $3.05? What if only 50 cents?”

Understand, economists won’t necessarily do the literal experiment before they talk about demand curves; often they rely on “thought experiments.”

Bayla: But are thought experiments scientific? They sound pretty subjective to me.
McCloskey: Yes, they most certainly are scientific. Every science, from physics to history, uses them. They are not a perfect substitute for empirical research, but they can help to solve certain kinds of empirical problems. The most famous examples are Einstein’s various theories. Einstein was not an experimenter. But he was a thought-experimenter. By thinking through, say, what would theoretically happen to light as it passed by our Sun on the way to our eyes he completely changed physics.

The thought experiment about Maria and her gasoline clearly has two sides, her subjective feelings about the gasoline (and its use value for driving to Pilsen) on the one hand and her objective constraints on the other. Remember the discussion in Chapter 2 of choice and constraints. Maria would like to buy gasoline, but also two other things: dinner and a get-well card for Alan. Those are her feelings — the subjective side of her choice. But she is constrained by her budget and the costs of the things she wants, as we said in Chapter 2.
Why does Maria want to buy X-number of gallons of gasoline, while Alan would prefer to use the money to buy part of a concert ticket? Why did you want a course in economics above a course in physics or dance? Maria demonstrates by her choices what things give her satisfaction, or happiness, or, in Jevons’s terminology, “utility.” By buying gasoline Maria adds to her total utility. The neoclassical theory of demand supposes that people buy gasoline, or any other commodity, because they add to their total utility.

Utility is the pleasure or satisfaction that consuming or doing something provides.

That seems obvious. What’s the big deal?

The big deal comes with the notion of marginal utility where marginal here does not mean “minor” or “beside the point,” but its literal Latin meaning of “additional” or “extra.”

Marginal utility is the last unit of total utility received, the extra utility from an extra unit of the product.

The notion is simple. Consider the situation of Maria at the gasoline station buying three gallons of gasoline. Buying the first gallon adds a lot to her total utility. It gets her to Midway Airport tonight for work on time. If she didn’t buy even this one gallon she’d be out of gasoline in a couple of miles, and therefore out of a job. True, she’ll want to buy another, second gallon tomorrow if she only buys one now. But the one gallon is obviously an improvement over an empty tank. The second gallon is a convenience, worth less in utility than the first gallon, but still worth a lot. It means she won’t have to worry about gasoline for a couple of days. The third gallon makes her still less worried about accidentally running out — a convenience, but not as much of a convenience as the second gallon.

And so on. Each additional gallon up to the capacity of the tank is an additional convenience, but it is very reasonable to suppose, as economists do, that the marginal (that is, extra) convenience gets lower and lower. This insight has proven to be a critical ingredient in the neoclassical theory of demand. It’s named the Law of Diminishing Marginal Utility.

The Law of Diminishing Marginal Utility: As a consumer buys additional units of some good the marginal utility of the last unit will eventually go down.

Concept Check 2: The classic examples of marginal utility getting lower and lower are foods. Argue the case for eating successive numbers of donuts, one at a time. Take the argument to extremes. (Check answer at the end of the chapter).

A wild and crazy example of the Law of Diminishing Marginal Utility is given in The Guinness Book of World Records. Tom Nall once held the world record in tortilla-eating — 74 tortillas at a sitting in Marciano’s Mexican Restaurant in Dallas on October 16, 1973. As he ate the 74th tortilla Tom probably said to himself “Man, this doesn’t taste anywhere near as good as the first.” Even the champion devourer of tortillas feels diminishing marginal utility for tortillas. So does everyone, for nearly everything.

The Law applies to most things: gasoline, sodas, tortillas, shelter (the 21st room in the Hollywood mansion is not as valuable as the earlier ones), clothing (the 3000th pair of shoes does not give Sarah Jessica Parker as much pleasure as her first, or even her 50th), and so forth. And yes, the Law of Diminishing Marginal Utility even applies to Homer J. Simpson and his tasty donuts. “Mmmm … enough donuts.” The next step in the argument takes us from Maria’s marginal utility to the price she would want to pay for any amount of gasoline. Think of the price as an opportunity cost — the utility of the other goods Maria could have bought with the cash she spent. Suppose Maria pays $4.00 for the four gallons of gasoline (for sake of easy arithmetical computation, we’re going to assume from now on the bargain basement price of gasoline to be $1.00 a gallon!). She forsakes the utility of $4.00 worth of ice cream, compact disks, or whatever other desirable things she would have bought buy for the money has she not spent it on gasoline.

When Maria has no gasoline at all she values the first gallon at quite a lot, say $10.00. We’re talking now about value in use. That is, if she could only buy one gallon, and there was only one place to buy it, and the one place charged $10.00, she would be just willing to enter the deal. A cent more and she rides her bike or takes the subway. She would be willing if she had to forsake the utility of other things worth $10 in total for that first gallon. Now of course she doesn’t have to pay $10, her value in use. She only has to pay $1.00, the value in exchange — that is, the going price at the pump. Take it now, in your mind’s gasoline tank, to the extreme. If she had 100 gallons of gasoline (don’t ask how she would store it), another gallon would have a very, very low marginal utility to her.

The money-valued satisfaction, the value in use, that an extra gallon of gasoline provides is called “the marginal utility in dollars” of the gasoline. To repeat: it is the dollar value of an extra gallon of gasoline to Maria. It is subjective, internal to Maria’s head. Calling it “Maria’s” is not merely a cutesy label. It really is not the same for Maria as it is for, say, her friend Alan. It is personal and in the short run it is stable, what each person values the gasoline at. In a phrase, it is the marginal value in use.

Notice that marginal utility is not an unchanging amount. This is crucial to grasp. Marginal utility is not a constant number, like 3.14159 or $3.00. It is a “schedule” of numbers, as economists sometimes put, or as mathematicians out it a “function” of the amount of gasoline Maria in fact buys. Marginal utility goes down as the consumer acquires more and more of the good in question. In other words, the amount of marginal utility of gasoline depends on how many gallons of gasoline Maria already has. It falls with more gallons. As Maria gets more gasoline, the extra utility she gains out of another gallon of it goes down. So she is less and less willing to forsake other goods. As Maria gets more gasoline her willingness to pay for an additional (or “marginal”) gallon gets lower. It’s shown in Table 5.1.

Table 5.1 Diminishing marginal utility and willingness to pay
When Maria has purchased this many gallons of gasoline She’ll be willing to pay this much for one more gallon
0 $10.00 for the first gallon
1 $5.00 for the second gallon
2 $1.00 for the third gallon
3 $0.90 for the fourth gallon
4 $0.80 for the fifth gallon
5 $0.60 for the sixth gallon
6 $0.5 for the seventh gallon
… 10,000 $0.0001 for the 10,001st gallon
Figure 5.3 Maria’s diminishing marginal utility of gasoline
The graph translates Table 5.1 into numbers. The vertical axis indicates how many dollars Maria is willing to give up to acquire each extra gallon of gasoline. The curve tells you that she is willing to give up $5.00 (the number on the vertical axis) to acquire an additional gallon when she already has one gallon (the number on the horizontal axis).

Table 5.1 exhibits the Law of Diminishing Marginal Utility. For each additional gallon Maria is willing to sacrifice less money, indicating that in each step the marginal utility goes down. You can see this trend even better when you plot the numbers from the table in a graph. Figure 5.3 shows this result.

Exceptions to the Law of Diminishing Marginal utility are few. Crack, the cheap derivative of cocaine, is one example. Having never smoked crack, you are, like the authors, likely to put a zero or even negative value on “a little bit more.” But once someone starts using the stuff, he or she, if addicted, would be willing to steal to get the money to get a little more. (If you find yourself dreaming about it, we recommend you watch a film called “MacArthur Park,” starring Thomas Jefferson Byrd. It will kill your fantasy—and save you.) The problem with addictive drugs is that marginal utility rises instead of falling with more use. So you can’t get enough. (Contrast the tortilla-eating contest: it’s difficult to imagine anyone so addicted to tortillas that the seventy-sixth one at a sitting would be tastier than the first.)

Cigarettes, also addictive, are a more common example of an exception to the law of diminishing marginal utility. Controlled experiments show that the amount of nicotine that cigarette smokers need per day varies from person to person—marginal utility is the same amount for everyone. But the fact of the addiction does not vary. Smokers in laboratory experiments tied up to an intravenous drip will stop smoking as soon as they have been given without their knowing it their daily fix of nicotine. The addiction means that until you reach your daily nicotine fix the marginal utility of another smoke is higher for each additional cigarette. After the daily fix the marginal utility drops to zero. Sets and collections are another minor exception. If I have an almost complete set of baseball cards of the 1952 Dodgers, for example, I am willing to pay a lot of money to complete it. The last card is worth more to me than the first one I bought. But even the exceptions do not violate the Law of Diminishing Marginal Utility entirely. The Law would still hold for additional sets of the 1952 Dodgers. If I had two sets the second one would be less valuable to me than the first.

These examples make the earlier point sharply: “Utility” in modern economics is not a matter of ethical good. It is merely a matter of wanting. The Law of Diminishing Marginal Utility is that the wanting rarely goes up as you get more. Come to think of it, even a crack addict can use only so much of the stuff before they pass out or die. The Law holds, with minor amendments, essentially everywhere.

The Law sounds deeply psychological, and in a way it is. It fits how we feel about most things. That’s what the thought experiment is about. But you can believe it for external reasons, too. For one thing, it works in actual experiments with people and with rats.

For another—and this is an economic argument, not a psychological one—it follows logically from the very idea of thoughtful choice. The first thing chosen will of course be the most valuable. If the person choosing is being thoughtful she will choose the most valuable first, of course. It would be silly to choose the least desirable first. The next thing chosen will be less valuable. The last will be least valuable. And that’s the Law of Diminishing Marginal Utility.

Ranked projects lead to diminishing marginal utility

Think of all the investment projects available to a society — opening a bagel store, say, or replacing the giant Ferris Wheel near Piccadilly Circus or building a swimming pool for the idle rich or repairing the Picasso sculpture at Daley Plaza. Each project has a net profit attached to it, which can be expressed as the return per dollar of investment. What would a well functioning society do if there were very few resources for investment? Obviously, it would do only the most valuable projects, that is, the ones with the highest return per dollar of investment. As the amount of resources for investment increased it would undertake more projects, going further down what amounts to the curve of the “social marginal utility of projects.” The society has a marginal utility curve for projects, like Maria’s marginal utility curve for gasoline.

Your mother gives you money “for a mini-refrigerator.” She does not want you to use it to buy CDs. Can she stop you from using the money for CDs? Not really, even if she checks your apartment for a refrigerator. She ranks the desires as “refrigerator then CDs.” You rank them the other way around. You buy the refrigerator, sure, but since you now have more money in total her gift actually makes it possible to buy more CDs — if you were going to buy some sort of refrigerator anyway. The point is that the gift of money loosens your budget constraint. You then decide how far down the list of desires—CDs, refrigerator, hanging plants, etc.-you want to go. Mom doesn’t.

Speaking economics: “Utilitarianism”

The word utility means “usefulness.” To economists, revealingly, it has come to mean all of happiness. It entered the conversation of economics a little before the time of Adam Smith’s discussion of markets. Smith good friend David Hume used it, for example. “Utility” became especially prominent in the writings of an English philosopher named Jeremy Bentham (1748-1832). Bentham was an astonishing man. By age five he read Latin and French, played the violin, and read lengthy books on history. He went to college when he was 13, graduating at 15. He invented the design of modern prisons, with their central lookout towers. He proposed the Suez and Panama canals decades before the projects were taken seriously. And he specified in his will that his body be dissected in the presence of his friends and his skeleton be kept in a box in University College, London. To this day the skeleton, fully dressed, is displayed in a glass case in the administration building of the College. They put a wax head on his body.

Trained as a lawyer, Bentham came to detest the usual law of England, built up over centuries case by case. He wanted to replace it with a “rational” system, designed anew, which at age 41 he presented to the world in his Principles of Morals and Legislation (1789). The word “utility” in his thinking meant the utility of all members of the whole society taken together: “An action may be said to [conform] to the principle of utility . . . when the tendency it has to augment the happiness of the community is greater than any it has to diminish it” (Vol. 1, p. iii). On this he erected what he himself called “a new religion” – utilitarianism – which dominated social thinking in Europe for a century and more. Utilitarian philosophers such as Bentham did a lot for the expansion of liberty and justice. For example, the University College-London, which Bentham helped found, was the first university in England to admit students regardless of creed, race, gender, or nationality.

The main dogma of utilitarianism is simple. Maria gets a certain amount of happiness from buying three gallons of gasoline, her total value in use from the purchases. If the buying does not diminish someone else’s happiness more than hers is increased, then allowing her to buy the two gallons is a good idea for society. In such a way the society will achieve “the greatest happiness of the greatest number.”

For society as a whole, however, utilitarianism has serious, even fatal, logical difficulties. The difficulty is to know how to weigh Maria’s utility together with Paul’s. In dollars it looks easy. But Maria might value the dollars more than does Paul – she might for instance get more joy from living than he does; or she might be poorer, and therefore value each dollar more. So adding up my utility and thine doesn’t make a lot of sense.

Yet willingness to pay is still used by economists to decide social issues by “cost-benefit analysis.” A road generating $5,000,000 of value in use should not be built if its opportunity cost is $6,000,000. Though the technique produces useful numbers, it is deeply controversial if used as the only guide. As the conservative economist Henry Simon said in 1938, the utility of two different people added together is “something which no one has ever known, or will ever know, anything about.”

Concept Check 3: The World Bank in Washington makes loans to poor countries. But naturally it doesn’t want the countries to use the money “for” useless, low marginal-utility projects. So it has a rule saying that the loan can be used only for high marginal-utility projects. Question: Do you imagine the rule works? That is, does it prevent countries from engaging in low value projects? (Compare the case to your mother and the money “for” a refrigerator.)

5.4. From Marginal Utility to the Demand Curve

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The influence of price on demand

Back to Maria’s choice of gasoline. If the price of gasoline is $3.00 per gallon, then Maria can be viewed as facing this problem: “How many gallons do I want to own, considering the price is $3.00?” Notice how the question has been turned around. So far our discussion has asked what she would be willing to pay for the Nth gallon of gasoline (the first, the second, and so on). The turned-around question looks at the same table of marginal utilities but starts with the second (value) column and moves back to the first (quantity). The same table and same diagram apply (refer to Table 5.1 and Figure 5.3).

Figure 5.4. A rational person chooses the quantity that brings marginal utility down to price
This is the same graph as in Figure 5.3. The vertical axis measures the marginal utility in dollar terms. The price is given at $3.00. Maria chooses to buy the number of gallons where the marginal utility (of the last gallon bought) equals or just barely exceeds the price.

Maria buys four gallons of gasoline because (as shown in Table 5.1) the last, fourth gallon is worth (in utility to Maria) $1.10, which just exceeds the going price. What is being applied here is the Rule of Rational Life:

Do what’s best – and you can do it by equalizing marginal benefit and marginal cost.

When Maria buys her first gallon, she adds $10.00 in utility to her total utility, because $10.00 is the value in use of the first gallon. She has to give up only $3.00 to acquire the $10.00-worth of utility. A good deal. In total her utility goes up by the difference ($10.00 – $3.00 = $7.00). On balance she feels better. And so it goes until that third gallon, which nets her only ***$0.10 on the deal. To go further, and buy five gallons, would give her a marginal benefit of $0.90 but would have a marginal cost, still, of $3.00. Not a good idea. Stop at four gallons.

The step from here to the demand curve is simple. Translate the marginal utility curve into dollar values—as we’ve already done so in the example. That’s called the marginal valuation curve. You might as well call it the “marginal value in use” curve. It’s just Maria’s demand curve. It says that at $3.00 she buys a certain number of gallons of gasoline, namely three. But it also says that at a lower price she would buy more. Try it out. If the Going Price in the diagram were lower, it would obviously cross the Marginal Utility curve at some larger quantity. But buying more at a lower price is merely the Law of Demand, familiar from Chapter 3. In other words, the Law of Demand can be derived from thinking about diminishing marginal utility. If you believe that the 74th tortilla at a sitting would not be quite so tasty as the first, then you also believe in the Law of Demand.

Figure 5.5. The buyer’s marginal utility curve is also a marginal valuation (demand) curve
The graph is the same as the graph in Figure 5.4 with one difference: now you read “price” on the vertical axis instead of “marginal utility expressed in dollars.” At a lower price she buys more gallons because it will take more gallons to get marginal utility equal to that lower price.

Now we’re getting somewhere. The Law of Diminishing Marginal Utility links the Law of Demand to sensible behavior by individuals. If Maria has a demand for gasoline, so does Alan, and so do millions of other people. Taken together their little demand curves make up the Market Demand Curve. The market demand curve depends on how individuals value the next gallon of gasoline or carat of diamonds they are thinking of buying.

Figure 5.6. Individual demand curves add up to the total (market) demand curve
At each separate price determine the quantity of chocolate gallons that individuals demand for that price. Add those quantities up horizontally and you get the total market demand for the price. Do so for each price and you have derived the total demand for gallons of gasoline.

A solution to the water-diamond paradox

The analysis of marginal utility thoroughly resolves the water-diamond paradox. True, the total utility that a person gets from having all the water he or she uses is greater than the total utility he or she gets from having diamonds. Without water the person would be dead; without diamonds he or she would be a little less ornamented. It’s not the total utility, though, but the marginal utility that matters for markets. The marginal valuation of the last ounce of water is what figures in the demand curve, not the earlier marginal valuations. Fresh water is so abundant that its marginal utility is low, and so it is priced low, and so it is used a lot, for watering lawns and flushing toilets. Diamonds are so rare that they are reserved for high-value, high-marginal-utility uses, as for instance tokens of marital affection. Their total utility is probably quite small beside the total utility of water. But marginal utility runs the markets.

Concept Check 4: What is the addition to Maria’s utility from the first gallon of gasoline she buys? The second? The third? The fourth? Make a two columned table. Contrast successive subtotals with the marginal utility she gets from each gallon (1st, 2nd, 3rd, and so on). What is the total utility she gets from her purchase of the 3 gallons as a whole?

Technical workshop: Consumer surplus

The logic of Concept Check 4 can be extended a long way. It’s one of the premier tools of applied economics, used for evaluating road projects, for example, and for showing the costs and benefits of price and wage controls. The total value in use is just the area under the marginal valuation:

Figure 5.7 Measuring total utility and the consumer surplus

Total utility is the summation of marginal utilities. The area of each rectangle measures the marginal utility of the last item demanded. Adding up the rectangles gives you total utility. This total is, by approximation, equal to the surface below the curve, namely the shaded areas Cost plus Surplus.

The area Cost under the price line measures the total opportunity cost of buying four gallons at the going price. It’s of course just the value in exchange (namely, $4.00). The value in use exceeds the value in exchange by the red colored triangle Surplus. It’s called consumer surplus. Formally, consumer surplus is the excess of value in use over value in exchange for the amount purchased.

You can also think of the total value in use as the most that Maria would be willing to pay for all gallons of gasoline if she had to. For the first gallon she would be willing to pay $3, $2 for the second, and so on. But she actually pays only $1. Accordingly, Maria the consumer gains when she buys four gallons of gasoline. The area Surplus is her “gain from trade” (which is still another name for the concept). It is the “profit” or surplus of happiness Maria the consumer got on all the gallons she actually bought.

It is obvious, actually, that there is a consumer surplus. When you buy anything you always pay less than the maximum amount you would be willing to pay. Why? Because otherwise you would not buy it! You are certainly not going to pay more than what you are, at most, willing to pay. So you pay less if you buy at all.

Notice that the point picked out by the Rule of Rational Life is the point of maximum consumer surplus. One could say “choose the point of maximum surplus” or “choose the point where marginal utility equals the cost of the next gallon.” They lead to the same answer. If Maria bought too few gallons she would not get the whole Surplus. Or if she bought too many, say five, she would again be giving up surplus, because the area of loss on the additional purchases, Loss, would have to be subtracted from the area Surplus.

Heterdox Box: Conspicuous Consumption

Not every economist is impressed by the law of demand. In 1899 Thorstein B. Veblen published an unusual book, The Theory of the Leisure Class, arguing among other things that emulation, status, envy, the desire to make “invidious distinctions,” not price, were the big drivers of demand. He coined a term—”conspicuous consumption”—to describe what the rich do when they go to market. Buying more when the price is high, especially for items that signal your status, such as bright trophies, green lawns, and even mistresses, said Veblen, makes sense. What better way to show off your great wealth and status? Veblen, and especially Veblen’s many followers, such as John Kenneth Galbraith (1908-2006), thought that social pressures like status and advertising were more important than price.
Neoclassical economists don’t believe that Veblen’s critique of the law of demand cuts very deeply. For example, there are substitutes for everything, they say, including status and other forms of invidious distinction, and people economize on them just as they do bread and beer. A stranger or best friend will not be able to tell that your Prada purse came from T. J. Maxx in Peoria and not from Prada in Paris. But the contents of your purse prove the point. Fake status goods can be bought at a low price, and the lower the price, the higher the quantity demanded. Do all those wearers of Louis Vuiton handbags pay full retail price?
And does advertising really do what its critics think—”manipulate” consumers? That’s you. The neoclassical economists doubt it. One among several warrants for their doubt is that if advertising were so powerful then advertiser would be rich. It’s the $100 Bill Theorem again.
Economists subscribing to a school of thought called “Institutionalism”—to which Veblen largely contributed—persist in their disagreement with neoclassical economists. The status good in question will lose its status at a high volume of circulation, they reply, turning the neoclassical response on its head. Fake Vuiton’s will cause people to shift to other signals of status and wealth. And on advertising, the institutionalists, and many others, claim to the contrary that advertising is essential for late capitalism. And so on. Science, you see again, is a conversation about exactly where we agree and disagree.

5.3. Supply and Demand

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The supply/demand theory solves the paradox of inessential-but-expensive diamonds and cheap-but-essential water. The supply-and-demand theory tells us that diamonds are highly priced because they are scarce. There are objectively few of them—relative to demand. If diamonds were as common as gravel we would use them to pave our garden walks. More precisely, the equilibrium point in the market for diamonds is reached at a high price per ounce. Recall that at the equilibrium point the supply and demand curves intersect and the quantity demanded equals quantity supplied. See Figure 5.1.

Figure 5.1 The demand of and supply for diamonds

Diamonds become more costly to produce as more are produced. Consequently, the supply curve slopes up: producers want a higher price (to cover their increasing cost) if they have to produce more. The price is in equilibrium determined at the intersection of supply and demand. Given the unique supply/demand circumstances in this market (people badly want diamonds and diamonds are costly to produce) the intersection occurs at a high price. If the demand curve were to fall back towards the origin, the price would fall.

The diagram shows that supply and demand determine the value of diamonds in unison. Like the two blades of a pair of scissors, both are necessary. If for example the poets and moralists suddenly made numerous converts and people started thinking of a diamond as no more desirable per ounce than the lump of coal it came from (geologically speaking), then clearly the demand curve fall (that is, move to the left). And so, moving along an unchanged supply curve, the price would drop.

Why then in developed countries is the price of tap water almost zero? Again, a supply and demand diagram explains why (see Figure 5.2). The price of water is not of course exactly zero. We still have to pay a nominal sum for the water we consume at home or work or school. But the price is very low per ounce because plenty of water is supplied, relative to demand.

Figure 5.2 The supply and demand curves for water

The Demand Curve and Usual S Curve are positioned so that their intersection is at a very low price. But note the high price that the buyers of water would be willing to pay at the second supply curve, the “Desert Supply Curve.” If water were rare enough (on the moon, say) it would be more valuable than diamonds. On the moon, at least.

The diagram does not entirely resolve the paradox. Nineteenth-century economists distinguished value in exchange from value in use. The distinction is still intelligent. The value in exchange is merely the market price, what water and diamonds actually sell for per ounce. Value in use is the subjective value to demanders, that is, the maximum amount a consumer would pay for one ounce of water if she had to. (“Consumer,” by the way, is the economist’s work for “demander” or “buyer,” especially when the buyer in question is a person or a family or, as economists say, a “household” rather than a business.)

She actually pays the market price, the value in exchange, always lower than what she values it at—or else she wouldn’t deal. But if she were dying of thirst in the Sahara she would be willing to pay much, much more. That “more,” whether in usual circumstances where it is low or in the desert where it is high, is the value in use. The value in exchange is determined by the market. But the value in use is personal, varying from one individual to another. Maria may love diamonds and attach a high value in use to them, and hence be willing to pay a high price. Klamer, by contrast, has little use for diamonds–except to resell them at the value in exchange. He would never buy a diamond, since his value in use for diamonds is below their going price, the value in exchange. If he inherited a diamond he would sell it. The demand curve in Figure 5.2 indicates how the value in use for water declines as more and more water is consumed. When water is scarce, as it is in the middle of the desert, we would we willing to give up a lot to get one thermos full. With fresh water all around we would not even be willing to pay one dollar—unless for fancy bottled water, of course.

Rodney: I don’t see where all this is going. Why have all this complicated vocabulary of objective/subjective, value in exchange and value in use?
McCloskey: It’s going towards a crucial idea—also one of Alfred Marshall’s inventions—of “consumer surplus.” Consumer surplus is how much higher total value in use is than value in exchange.
Rodney: And it’s crucial because . . . ?
McCloskey: Because it shows—and we’ll show later—why market exchange is good for you and everyone else involved.
Rodney: That does sound crucial.

5.2. From Moral to Amoral Theories of Value

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One opinion, often heard on the streets, is that things have “natural” prices. In Russia the government dictates the “natural” price for bread. The French government does the same for French bread, and has for centuries. Why? Because that is how it should be, they say. The set price reflects what the bread is worth, its “value.” Any talk like this of the essential, internal, “natural” worth of something is a moral theory of value. The value of a good is whatever it is “really” worth.

The moral theory of value came first. Aristotle, one of the very first economists (so to speak), wrote in the fourth century before Christ that merchants should charge a fair, natural, or “just” price. For twenty centuries or so after Aristotle the philosophers for the most part followed his moral emphasis, urging merchants to charge the just price, and recommending that the government enforce it with punishments.

Idealized painting, by Raphael, of Aristotle (384-322 BC), whose theory of value could not resolve the water/diamond paradox.

But why would 10 florins for a young horse be a “just” price? And what about 10 pennies for a loaf of bread? The Spanish scholastic philosophers in the 16th century, and then the Scottish moral philosophers in the 18th century, reopened the question. Adam Smith in 1776 suggested that the amount of labor used in the production of a good was a measure of its value. “If among a nation of hunters, for example, it usually costs twice the labor to kill a beaver which it does to kill a deer, one beaver should naturally exchange for or be worth two deer.” Smith’s theory was called the labor theory of value. It pointed to an objective determinant of the value of a commodity, namely the amount of labor that went into its production. It’s trying to find something inside a deer or a diamond that makes them “really” worth so many dollars.

Smith’s labor theory of value immediately started running into logical difficulties, as even Smith realized. For starters, one hour spent hunting by a good hunter is clearly worth more than an hour spent by a slow hunter with poor aim. So you have to adjust somehow for the quality of the labor hours. Furthermore, and more troubling, how do you account for the use of the tools, called in economics the “capital”? Often a hunter with a modern gun will be more effective than a hunter with a bow-and-arrow. The capital of the gun is apparently worth something. Hunting costs hours of labor, yes, true. But the tools used have to figure in the cost, too.

In the early nineteenth century David Ricardo and then Karl Marx — himself inspired by a now little-known thinker and writer for The Economist magazine, Thomas Hodgskin (1787-1869) — elaborated on Smith’s labor theory of value and tried to answer the doubts. They argued that the hunter’s gun, his capital, is itself produced in turn by labor and hence “embodies” it. And the machine that helped make the gun-making machine is also produced by labor. And so on back to the beginning. The value of the gun reflects all the embodied labor, they said. They thought they had saved the labor theory of labor. Ricardo and Marx and Hodgskin still have followers among some economists, who find the source of value on the supply/cost side of the market — in the amount of labor expended, whether directly in time hunting or indirectly in the time used to make the gun.

Most later economists, however, have abandoned the labor theory of value. At first they proposed something like the opposite of the labor theory. The best way to think about value, the economists started thinking in the 1870s, is a subjective theory. “Subjective” in this context means “having to do with people’s feelings,” as against the “objective” fact that hunting a beaver takes more hours than hunting a deer. Accordingly, the value of a commodity is determined by those who want to consume it, and not by what labor or capital went into its production. In the case of beavers and deer the point would be that beavers had uses in making hats for gentlemen while deer were only a source of meat.

This idea of subjective value occurred in the 1870s to many people. That many economists thought of it independently more or less at the same time suggests that it is correct. Simultaneous discovery is quite common in science — the most famous example is that Alfred Wallace, another British naturalist, came up with the theory of evolution independently of Charles Darwin. In economics in the 1870s the time was ripe for the next step in value theory. William Stanley Jevons, for example, a British physicist, philosopher, meteorologist, and economist — a most amazing man — wrote in 1871: “Repeated reflection and inquiry have led me to the somewhat novel opinion, that value depends entirely upon utility.” “Utility” is merely a fancy word for the use, or subjective feelings, that people have for things.

But modern thinking puts the two — the “what it costs” and the “how people feel about it” — into a single, unified argument. Alfred Marshall, as we’ve noted, pointed the way in the 1880s with his supply/demand diagram. Economists had long realized that something like “supply and demand” fixed marketed prices, but until Marshall they waffled between the two in confusion. Marshall’s diagram cleared it up. He argued correctly that both resource-cost and subjective value figure — those “two blades of a scissors” we quoted earlier. It would be silly to say that “the top blade of a scissors does all the work.” You need both to cut a sheet of paper. Likewise, labor value alone, or even subjective value alone, are not enough. The supply/demand theory alerts us to the two sides of the issue: the household demand side with the assigning of subjective utility to desired commodities, and the company supply side with the seemingly objective factors that go into the production of the commodity.

Maria: Why did you say “subjective” when referring to the values of household demand and “seemingly objective” when referring to the company supply?
Ziliak: It’s an advanced point, Maria. Economists wanted to be known as objective and scientific so they adopted the so-called “positivist” vocabulary. They came to believe that things you can look at, such as “capital input,” were “objective,” like the chair you’re sitting on. Non-observable entities, such as “expectations” or “tastes,” were “subjective,” such as your taste for ice cream But nowadays most economists understand that the supply side is just as subjective as the demand side -and, for that matter, the demand side just as objective. Producers desire profits and expect sales and guess at costs just like a supposedly “subjective” household. And more deeply the “objective” costs are determined ultimately by the subjective value of what you had to give up to incur them. It is known as an “Austrian” argument, dating from Karl Menger of Vienna (1840-1921; his major work the Grundsätze, the Principles, appeared in that banner year of 1871), but all economists admit it is true. Economics is subjective, about mental states, all the way down. And it’s objective, too, about seeable prices. Both.

As a result of Marshall’s solution, nowadays economists tend not think in terms of “value” at all. They think only about price, a price determined by supply and demand, Marshall’s scissors. The modern theory of supply and is part of neoclassical economics.

The neoclassical theory of supply and demand combines the objective and the subjective theories of value into one – with the conclusion that value equals price.

Concept Check 1: Maria complains about the high salaries of doctors. Paul replies that doctors deserve every penny they earn because they work hard for it. What theory of value is implied by Paul’s answer? And what would an economist say in response?

5.1. The problem of value: the water-diamond paradox

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Water is clearly important. We literally can’t live without it. Yet you can get water in your apartment in New York without paying for it. On modern Roman streets you can wash your hands or bathe your dog at any old fire hydrant. In the office and in the dorm you can drink water from the fountain in the hall.

Diamonds are different. You can live without diamonds. Yet they are very expensive, valued extremely highly per ounce in the marketplace.

Notice how strange this is — how a good such as a diamond, which is beautiful but inessential, could be so much more expensive per ounce than an essential and not necessarily beautiful good, such as water. The case is called “the water/diamond paradox.” It is the first and the deepest question of value. What, after all, determines the value of things?

Chapter 5. To Buy or Not To Buy

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Graham: What is a cynic?
Darlington: A man who knows the price of everything. . . and the value of nothing.

Oscar Wilde (1854-1900), Lady Windermere’s Fan, Act III

PREVIEW

The economic words for buyer and seller are, as you know, “demander” and “supplier.” The two flow together in markets. To understand markets you need to understand each of these-supply and demand-more deeply.

Begin with demand. Why do people buy the amounts they do? In particular, why are they willing to pay only a little for an essential item like water and so very much for an unnecessary item like diamonds? One answer comes from the economist’s “Rule of Rational Life.”

Chapter 4. Exercises and Problems

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EXERCISES AND PROBLEMS

  1. Describe in detail how the economic life of a family might be governed by a visible hand. Endow the children with a certain amount of money.
  2. Does your college have “market power”? Defend your answer, paying particular attention to the degree of “exit” that students can exercise, in the short run and in the long.
  3. How are problems of public goods settled among friends – that is, a society of “loyalty”? Consider for example how it is decided who will provide the car and gasoline for a trip among friends. Once the car is provided, the extra seats in it are public goods. The driver could exclude his friends from riding, but it would be socially inefficient: a commodity (namely, a ride) would be thrown away if it were empty. How is it actually done? Can this apply to larger groups?

ESSAY AND DISCUSSION QUESTIONS

  1. Explain, using specific examples from your own country, why there is no such thing as pure capitalism (that is, a purely free market economy).
  2. “Pure capitalism may be impossible because governments always find ways to intervene in their economies. But, in a perfect world, pure capitalism would rule!” Do you agree or disagree? Why?
  3. “The optimal amount of pollution is of course zero.” Why would an economist disagree with such a statement?
  4. “The economically best solution to pollution is the creation of a market.” Discuss. What is the alternative to paying people not to pollute?
  5. When prices are inflexible, markets do not work as well as when they are flexible. Prove it. Use a diagram to underscore your argument. Imagine a fixed price with fluctuating demand and supply curves.
  6. In recent years the Romanian economy has been in poor shape. As a result of the policies by the communist government of earlier times to increase population, the orphanages of the country are filled with healthy but unclaimed infants and children.
    • A. Make the case for allowing Americans to purchase orphan children from Romania.
    • B. Now make the case against it.
  7. “Market societies are terribly unjust.”
    • A. Make three convincing arguments in favor of this proposition.
    • B. Now turn the tables: “But so are non-market societies.” Distinguish sharply between ideal societies and actually existing ones.

ANSWERS TO CONCEPT CHECKS

  1. The price is fixed, and in some views that is a “failure” of markets. Even though there is an excess demand for the “consumption of Irish pubs”, the price for getting in does not go up. You have to pay instead by literally wasting your time in the line. Somehow the scarce places in the pub have to be allocated. But as the Chicago-School supplement suggests, it’s not really a “failure.” It’s costly to keep changing menus, for example.
  2. Bayla’s implicit argument is that the market for underwriters is unfair because of discrimination against her mother. The question remains why insurance companies would sustain their discriminatory practice. After all, the relatively low wages should make women like Bayla’s mother more attractive as employees; a greater demand for them would pull up their wages.
  3. Since marijuana can sprout up in one’s own backyard, or in a ditch, or anywhere, the supply curve would shift radically to the right, and the market price before state intervention would drop to nearly zero (non-zero but still very low prices would obtain for unusually high quality and for coffee house or pub house services). Some students want to shift the demand curve up and to the right. But that makes little sense. Robitussin® is legal but you don’t see people flocking toward it, or missing work in droves because of it. Likewise tequila or rum or airplane glue, in truth, more dangerous. The first and obvious benefit of legalization is gangs and drug lords would lose a major profit source, and therefore power. The War on Drugs is very expensive. Lives and money would be saved (question: we wonder how much?). Another non-trivial benefit would be conferred to medical marijuana users, such as people with stomach cancer who struggle to find an appetite. With state and local regulation and taxation the benefits would be similar to those associated with beer and liquor and tobacco: “sin taxes” mean more money for government programs, such as better roads and schools. In the next two chapters you will learn how to shift and interpret the supply and/or demand curves when a tax is imposed.
  4. Likening the university to a business firm, some might favor exit as the solution to disputes. If students do not like the way freshman English is handled, they can leave. Using the analogy of a political community or a family, on the other hand, if the students do not like something going on at the university, they can also complain – stage a sit-in at the dean’s office, perhaps, or write to the trustees. And using the analogy of an army, the students and staff can choose to stick to the university out of a sense of loyalty, even if things do not work out exactly as they want. Disagreements about university policy often arise from choosing different analogies. One’s approach depends on whether one sees the university as a business company (exit) or a city-state (voice) or an army (loyalty).

Chapter 4. Summary and Conclusion

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CONCLUSION

The ideal picture of markets presented in the last chapter has now been balanced with some awareness of their possible flaws. We can’t assume that markets always work well, or that the unintended consequences of buyers’ and sellers’ actions will always serve the public interest. Even so, the consensus among contemporary economists, regardless of political conviction, is that an imperfect market system is far better than none at all. We do not live in a world that can be made perfect. Our task is to choose among the imperfect alternatives, the achievable worlds.

The basic contours of the economic argument have been laid out. You have seen the beginnings of what economists have to say about choice, the accounting of budget constraints under which people make choices, the market as the coordinator of individual choices, and now some critical questions about the role and effectiveness of the market. These notions constitute the basic vocabulary of economics, the materials for its conversation. As the British Prime Minister, Winston Churchill, said after an air victory early in their struggle against Hitler: “This is not the end. It is not even the beginning of the end. But it is, perhaps, the end of the beginning.”

SUMMARY

Not all markets work perfectly well, and at times they fail to work at all.

  1. The main market failures are a) price inflexibility, b) market power c) unequal distribution of information, d) and instability. Markets for public goods and bads are often absent and in any case markets can be considered unfair or unethical.
  2. When markets are failing, absent, or unfair the government may consider wielding its visible hand by taxing, regulating, or spending.
  3. Not all economic behavior is market behavior. Besides the exit option, which characterizes market behavior, people can talk and negotiate – the voice option – or respect the norm or an authority – the loyalty option.
  4. There are many different economic systems. By definition all economies are mixed economy, with roles for both markets and the government.

4.7. Alternative Economic Systems

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When the communist system in the Eastern bloc fell apart at the end of the eighties the free marketeers all over the world cried “Victory,” exclaiming that capitalism had won over communism. They claimed that Adam Smith had been proven right and Karl Marx was wrong after all.

Some think the celebration was a little premature. As Masha testified at the start of this chapter, the transition from a communist society to a capitalist society has been painful, especially in the 1990s. Many Russians even now want a return to strong government involvement.

Here are the definitions in play:

Capitalism is an economic system based on private property and voluntary exchange in markets.

Communism is an economic system based on workers’ ownership of the means of production and, in many cases, the centrally planned allocation of work and commodities.

In Hirschman’s terms you could say that capitalism is based on the exit option whereas communism is based on voice if it is democratic and on loyalty if it is authoritarian. Some communists will deny that central planning is necessary in their ideal world, where the state would “wither away.” True, it didn’t when it was tried. And many Marxists define capitalism as a system based on “wage labor,” that is, working for a boss rather than for oneself or one’s community. True, if we exchange at all we work “for” others.

No pure capitalistic system exists; neither does pure communism. The former Soviet Union was not purely communistic because a massive state, not the workers, owned everything; the workers were employees of the state. Very reluctant employees, usually. The joke among ordinary Poles or Russians was, “We pretend to work. And the state pretends to pay us.” That is why some on the left in the West called the system “state capitalism,” the state merely taking over where the capitalist bosses left off. Western economists pointed out that even in the centrally planned economy of the Soviet Union an extensive market economy was operating on the sly. So in parts of a supposedly communist system there was an exit option.

The U.S. is not purely capitalistic either. It is not all exit. There is plenty of opportunity for voice. And a big chunk of life in the U.S. is ruled by loyalty, in the family most prominently, but also in armies and clubs. There is also a good deal of central planning in the U.S. – though located in the big corporations and not so much in Washington. As in the former Soviet Union, corporations do not rely much on markets in the arrangement of their internal affairs. If a middle manager at Kraft Foods is told to hire more chemists, she does so. She’s not presented with a price and asked to choose. The big—and small—companies rely on management methods to determine who does what and how much.

Economically the two kinds of planning, Soviet central and General Motors central, do look quite similar. Politically they are very, very different. Someone trying to exercise the “exit” option in General Motors might possibly be wished well as he leaves, and if while employed he tries to exercise the “voice” option he is sometimes listened to. But anyone trying to exercise either option in the old Soviet bloc of countries, or today in places like (still) Communist (though very market-oriented) China, or in North Korea or Cuba, is jailed or shot. In the times of Stalin in Russia (1779-1953, ruled 1922-1953) or Mao in China (1893-1976, ruled 1949-1976) his friends and relatives would be shot along with him.

The resulting difference in economic behavior is great. A worker on the line in General Motors may feel put upon by the bosses, and call himself a “slave” and call the bosses “tyrants.” But he’s not going to shot if he tries to leave. He’s not a real slave and the company is not a real tyranny. And in its markets for sales General Motors, unlike an all-encompassing socialist state, faces other car makers, who can hire the engineer fired for exercising voice, or supply the customer who exercises exit.

There have been sizable communist experiments in capitalistic U.S., dozens of them in the last century, as for example the Amana colonies:

Amana refrigerators, air-conditioners, and other kitchen appliances are made by the Amana Company in Eastern Iowa—it’s now owned by another Iowa firm, Maytag, which in turn is now owned by Whirlpool. Strangely, this highly successful capitalist enterprise originated in the largest communist experiment in America. Like dozens of other communities in America from the Plymouth Puritans onwards, the Amana Colonies were settled in 1855 as a religious community, by the pietistic Community of True Inspiration, dating from 1714 in southwestern Germany. The colonists in Iowa owned their clothes and other personal odds and ends. But all other possessions were common property, including the factories, the schools, the houses, and even the kitchens. In imitation of what they imagined very early Christian communities to have been like, they shared tasks, each according to his or her ability, and ate together in communal dining halls. Internally the community relied on voice—a German voice, since until recently the religious service and schools were conducted only in the old language. Externally, the Colony dealt in a market, with exit. But internally the community was held together with loyalty. The colonists had, and retain, a reputation for hard work and craftsmanship—and yet also a reputation for a certain lack of initative.

After fifty years of strict socialism the pressures to enter the market more thoroughly became too strong to resist. The young, especially, were attracted to the moneyed glitter of the market. The official web site tells a story that has been played out in many centralized societies, from your own home to Soviet Russia: “By the 1930s, the communal system in Amana had generated stresses which it could not resolve. Many community members found the rules associated with communal living to be petty and overly restrictive. Regulations governed most aspects of daily life including dining, dress and leisure activities. Many young people wanted to be free to play baseball, to own musical instruments or to bob their hair in the new style. Families wanted to eat together at home rather than in the communal kitchen dining rooms.”

In 1932 the community, in “the Great Change,” adopted a capitalistic, corporate form. The Amanians became stockholders. Workers got paid an ordinary wage and households began to cook their own meals. Many bought or built houses in private. The Amana Refrigeration Plant was owned by the stockholders until sold to Raytheon in 1965. The economic and social change was not so simple as the legal change. Amana, through which Interstate 80 now cuts, with gift shops galore at the exits, continues to be a community with a special character, where loyalty and voice often can alter the market outcome.

Mixed Economies

There is no market economy without significant involvement of the government. After all, rights to private property need to be enforced somehow—which brings in governmental courts. The government at a minimum must see to it that force and fraud is punished, or else the market will break down in violence.

Once upon a time the government was small, so small that it is difficult for modern people to believe. U.S. governmental expenditures as a share of all economic activity are nowadays around 35 percent. In 1900 they were a mere 7 percent. An the power of government extends far beyond its direct expenditures, by way of regulations from local building codes, which barely existed in 1900, to national immigration laws, also barely existing in 1900. The government now spends or heavily regulates about half of national income, even in a market-oriented country like the United States. The share is higher in places like The Netherlands or Sweden.

The British colony of Hong Kong — handed back to Communist China in 1997 by the terms of a 99-year lease — is perhaps the closest modern approximation to pure market capitalism. Little Hong Kong and gigantic Communist China now make a very odd couple. Hong Kong has Western standards of living, for example, and wants at least its local government to be elected. Big China has been adopting capitalism with enthusiasm, unlike the reluctant, uneven move to capitalism in Russia. But the Communist Party still makes the rules, without free speech or opposition parties, and with still a system of imprisonment for political “crimes.”

The United States is plainly the leader of capitalism, however much mixed with socialism in the form of governmental regulation and subsidies. It does for example have the lowest share of government expenditure of any large poor country.

A mixed economy is ruled by markets as well as a government.

With such a definition, of course, any economy short of extreme anarchy is “mixed.” Some economies, as the map suggests, lean towards the socialist side of the mix, some towards the capitalistic.

Some Western and especially English-speaking economists believe that a world with a radically smaller government would be better.

McCloskey: Sign me up! As Milton Friedman says, “The glad you don’t get the government you pay for”! He and I want it to shrink drastically—back to that 7% in 1900, for example, would be a good target. In other cultures the option of minimal government is not taken as seriously.
Klamer: For example in my home country, the Netherlands. When I first met McCloskey I was amazed that anyone could propose to cut government so sharply.

By historical accident the early Americans were lightly governed. English people at home in England were taxed heavily, and vigorously governed. But their theory of their governing was “libertarian,” whatever the realities. The least of them felt himself to be a “free-born Englishman.” Englishwomen, too, though in fact having less economic power than women in, say, the Netherlands, felt free. The governments of Continental Europe by contrasts had populations unaccustomed to asserting their “freedom,” and the rulers believed themselves, often on not very good grounds, to be competent to intervene in the economy. An English-speaking criticism of economic policy was therefore likely to be a criticism of interventionist government, and so it was.

Northern European countries have more intrusive governments than the U.S. and even the U.K. Their welfare states take the form of comprehensive, and often astonishingly generous, programs for the least advantaged, such as the unemployed, disabled, and poor. The citizens of welfare states are guaranteed a minimum level of existence. Of course, they pay for this security in the form of high taxes. And they pay in high levels of idleness. Many Swedes nowadays find their country’s programs to pay for disabled people too lax— healthy people in large numbers claim to be disabled, and get nearly full salaries for life. In German companies workers have a real voice on the governing boards of corporations. In Holland until recently most wages were negotiated among unions, employers, and the government in a cozy meeting. Market forces were thus circumvented, at least in part.

It is usually and correctly presumed that the invisible hand can take care of most matters of efficiency – that is, what things are produced and how. That’s a tall order. It’s why even a socialistic mixed economy like Sweden can be called “capitalistic.” Sweden lets the market decide what color the raincoats will be, who will make them, how many will be produced, who will sell them, what they will be made of, and so forth. By contrast, in fully socialist economies such as the Amana Colonies or the old Soviet Union the government attempted to decide everything—and most of the raincoats were decreed to be green.

Rodney: So I just don’t see why economists make such a big deal of markets. They don’t seem to work.
Ziliak: How do you know?
Rodney: Well, look at what you’ve been saying about the imperfections and unfairness of markets. The discussion of loyalty and voice even says that markets are unethical. Now we see why we need governments.
Klamer: No. You’re mistaking some critical comments for a total rejection of markets. That’s not our intention. Markets are a crucial component of any modern economy – even the Chinese government, the last large outpost of communism, has introduced markets on a giant scale.
McCloskey: Exactly right. The chapter is just adding a dose realism to the ideal story we told in Chapter 3. In the ideal story the market is more efficient than any other conceivable system. Like you, Steve and Arjo, I don’t think it makes much sense to compare ideal systems. We need to compare real with real. You know what I think: really, the market works best!
Bayla: What I get from this is that it’s not good to compare ideal systems. We have to think about actual, realistic worlds, and not compare a theoretically perfect capitalism with an actual socialist economy, or the other way around.
McCloskey: You’ve got it.
Maria: Even so, real-life markets seem cold to me, nothing like a family.
McCloskey: You hit on a crucial point. People, especially young people, like what the conceive of as “socialism” because it sounds like an ideal family. I know I did when I was young and a socialist. Your mom puts the meal on the table out of love, not because she’s paid each time to do it! The realistic question, though, is whether what works in your own family can work also with 300,000,000 people. I don’t think so.
Ziliak: But elements of love can be socialized.
McCloskey: Maybe. Yes the critics of markets and corporations tend to underestimate how much warmth there is in such institutions.
Ziliak: Granted. The office is not always a field for Dilbert bad actors.
McCloskey: And voice and loyalty, which sound so warm and fuzzy, have their ugly sides, too, compelling people to talk or to obey. Hitler’s Germany ran on loyalty. Gang-banger culture does, too.
Ziliak: But there are plenty of reasons to be skeptical about extending markets indefinitely. As Nancy Folbre says in title of a book, there is an “invisible heart” to market life, namely, the love that supports it in families. Today’s feminists do not want “caring”-that is, the heart-to be solely in the province of women’s labor. And lots of men, feminist or not, agree. Markets are tough. That’s our post-Eden reality. Fortunately we have other institutions-like lotteries for public schools and first-come, first-served options for fishing licenses-to soften the edges.
McCloskey: But the three of us agree, as do most economists, that we all benefit from good markets – when they are good.

4.6. Exit, Voice, and Loyalty

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So far we have talked about markets and governments intervening in markets as though all economic life takes place in markets. But it doesn’t. Mom doesn’t charge her kids for lunch, but that’s “economic” by any definition—allocating scarce resources (bread, sliced ham, mayonnaise, Coke). You do not charge your friend for a ride to the airport. If you do, it kills the friendship instantly. Suppose you think that you do more for him than he does for you. You won’t “exit,” as a market demander would if the prices at Macy’s looked too high—”doing more for Macy’s than Macy’s does for you.” You’ll talk about it, work it out, as friends do.

In other words the market is not always the natural way to do things. When Paul and Rodney send out for a pizza they naturally intend to share it equally, and share the costs, too. The market intrudes a little in their dividing it – if Rodney paid for all of it this time, then Paul is perhaps expected to ask permission to eat, and to offer thanks in exchange. But after it has been established that Rodney is paying the bill this time, Paul does not offer money. In a strict market for pizza what matters is how much money you are willing to give up. In a relationship among friends what matters are such feelings as love, status, duty, envy, and generosity. In such a relationship a market arrangement is often considered offensive, and even unethical. Prices should not rule friendships. That doesn’t mean that considerations of money and prudence go by the boards in families and friendships. It just means that virtues other than prudence rule, too.

Similarly, your father does not conduct a market negotiation when he wants you to get up in the morning; he just wakes you up, and shouts at you if he thinks you need it. The slave-holder often used the whip, not always money, as the incentive to get his slaves to work. (Though slave owners in America and Africa and Russia often used money, too.) Your boss “bribes” you to come to work. That’s straight pay. But a well-functioning store or office also depends on non-market persuasion. She may make use, for example, her superior standing — she may be older and wiser or able in some other way to persuade you to grant her loyalty without making a direct market deal.

The difference between what happens inside and outside the marketplace was well captured by the economist Albert Hirschman (1915- ) in a famous trio of ideas: “exit, voice, and loyalty.” Suppose you quarrel about dividing the pizza. You can exit, which is to say, get up and leave. Markets operate in large part through exit. There’s no point in quarreling with the local grocery store if you think his price of milk is too high. You don’t have to put up with a dry cleaner who insults you. You exit, going to a different grocer or a different dry cleaner.

Exit is the market response: you leave the shop or the job when you expect to find a better deal elsewhere.

But, Hirschman noted, can also exercise your voice. You can argue with your roommates about dividing the pizza; you can complain to your alderman about the uncollected garbage. Voice dominates in politics. If you don’t like, say, the current foreign policy of the United States you will not easily exit to another country. That’s a bigger deal than shifting where you buy your milk. Instead you vote, agitate, write letters to the newspaper editor, join a political party, lobby Congress. The same is true in a family, or even in a business. As long as the family has decided to stay together, it has decided not to resolve disputes by exit. That is, a family – or a family-like business – resolves internal disputes by voice, quietly or loudly as their customs dictate.

Voice is an alternative to the exit response; you exercise voice when you communicate your response, negotiating or arguing.

When your father is deathly ill and needs you at home, you go without argument, even if you had planned to go a rock concert that night. Why? It’s a matter, to use Hirschman’s third term, of loyalty. Another word for it would be love. You go for the same reason that Scottish highlanders stuck to their chief despite his arrogance, or workers stick with a company even when they have somewhat better chances elsewhere.

Loyalty may be a matter of love and respect, but the news is not all good. It also can be enforced by intimidation and other psychological and physical tricks. Military dictators, for example, tend to secure loyalty from their subordinates through fear. Some radical economists argue that the relationship between workers and their bosses has similarities to the relationship between a people and its dictator.

Loyalty impels you to avoid exit and forsake the opportunity of using voice: you stick to your father, boss, or country because you are loyal.

According to the stereotypes, the merchant exercises exit, the politician voice, the soldier loyalty. Most institutions, though, run on all three, in varying amounts.

Concept Check 5: College course requirements are different dependent upon whether you stress the exit, voice or loyalty options. Try out each as a description.

Heterodox Box: Albert O. Hirschman (1915- )

A. O. Hirschman is one of a rather common paradox at the higher reaches of academic life: he is both greatly celebrated and greatly ignored. Born in Berlin and educated in Paris, London, and Trieste (Ph.D. 1938), he taught at Berkeley, Columbia, and Harvard, and was then for three decades professor at the famous (“Einstein”) and select Institute for Advanced Study in Princeton, New Jersey (not a part of the University there, by the way). In the 1950s and 1960s he was very influential in thinking about poor countries. Mainstream economists are willing to discuss the ideas of his 1970 book, Exit, Voice, and Loyalty, as we just did. But since then his cultivated yet down-to-earth thinking in the wider social sciences has been passed over by economists, though admired greatly by many other social scientists. Samuelsonian opinion of his methodological forays (such as Essays in Trespassing [1981]) can be summed up by one of Hirschman’s own ideas: exit.