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The law the diminishing marginal utility


15 February 2020


 
Jeep Grand Cherokee
Jeep Grand Cherokee
 

Imagine that you are very fond of pizza and also very hungry. If I offer you a pizza, you will be very grateful. If after you have finished eating your pizza I offer you a second pizza, you will not decline the offer but you will be a bit less grateful. If I offer you a third you might still eat it in order not to offend me. The fourth pizza you would decline. Perhaps you would come up with some lame excuse like nausea to explain your peculiar behaviour. Before the fifth pizza is offered, you may already have left my home in a hurry.

Welcome to the law of diminishing marginal utility. It is an important law in economics. It states that the more you have of something the less useful an extra unit is to you.

This law can be expressed in terms of money. If you are at a pizza restaurant, you might be willing to pay € 12 for the first pizza. After eating it you are not so hungry anymore and you might not be willing to pay € 12 for a second pizza. But if the restaurant owner offers you a discount of € 6 on the second pizza, you might accept the offer. A third pizza you may only eat if it is on the house. A fourth pizza you won't eat unless the restaurant owner offers you € 6 to eat it. Eating a fifth pizza might cost the restaurant owner € 12.

What might strike you is that the fourth and fifth pizza have a negative value to you. You are not willing to eat them unless you are paid for it.

The law comes with another consequence. If you have enough now, you may think about the future and save money for unexpected expenses and retirement. As we get wealthier, getting more stuff becomes less important to most of us while certainty about the future becomes more important. At some point we do not want more stuff and the law of diminishing marginal utility becomes an obstacle to economic growth.

If you are happy with what you have and care about the future, you may save too much for the economy to grow and capitalists won't make enough money because they must at least make the interest rate. The law of diminishing marginal utility is therefore a grave threat to capitalism. And so is interest. This is where the advertisement industry comes in. The trick of advertising is to make us unhappy with what we have and to make us desire more. Buying this or that will make us happier, advertisements promise us.

Fashionable items with a limited life-span are part of the solution too. It is not always possible to make us desire more stuff, but it is still possible to make us desire new stuff. The dress you bought last year is out of fashion now. In order not to look stupid you have to buy a new one. And then there is technological development. Next year there will be a newer model, and by the way, the software on the old model won't be supported any more. And of course, luxury items do their bit. Why go for a Volkswagen Polo if you can afford a car with a low marginal sports utility value like the Jeep Grand Cherokee?

Yes, the Jeep Grand Cherokee is an ugly monster, but it is bigger than the Volkswagen Polo and if you can afford to drive it, why not? There is a reason why not.

We humans use far more resources than our planet can offer. That's why capitalism is a grave threat to humanity. Capitalism nowadays is like making us eat the fifth pizza and pay extra for it even though that creates a health hazard while many people are hungry. And there may be no food tomorrow because we have eaten too much today. The Jeep Grand Cherokee is like the fifth pizza. We work hard to buy stuff we do not need. This is how humanity is committing suicide. This can't go on. There is one obstacle. Businesses must make at least the interest rate, and interest rates below zero are still unthinkable.

In other words, we must learn to care about the future and interest rates may need to go below zero. We must learn to be happy with what we have and settle for less when possible. This may be a grave threat to capitalism for what will happen if we stop spending on excesses? Economists fear that the economy will collapse and that we will be without jobs when business profits decline and interest on debts can't be paid. That doesn't have to happen when interest rates are negative. In that case debts don't have to be repaid and businesses with little or no profits can survive.

That may seem strange but it is already happening. The law of diminishing marginal utility is kicking in, and it is kicking in big time.

This law affects capital too. If there is only one pizza factory that can supply every pizza addict with one pizza per day, it would almost certainly make a profit. A second factory might make a profit but it might not. And what is more, if the second factory comes into operation, the supply of pizza increases, and according to the law of supply and demand, the price of pizza would drop. That would also cut into the profits of the first factory.

A third factory would almost certainly be loss-making and it would make the other factories loss-making too. At some point there is little use for more capital. That causes the demand for capital to drop and interest rates to go negative. Traditional economics would consider this unhealthy or temporary. 

That doesn't need to be and it can be desirable. Three pizza factories fiercely competing and without profits might be better for consumers than one that is profitable if we assume that pizza is a necessity. Everyone must eat something. There could be an ample supply of investment capital at negative interest rates so profits may not be needed for pizza factories to stay in business.

A problem is that excess investment capital can go to businesses that suicide humanity by using scarce resources to produce stuff we do not need. Negative interest rates can help to make the economy sustainable but only if the excesses do not happen. This would require governments to ban or tax excesses or to regulate their production so that these products don't have a harmful impact. That would make them a lot more expensive.

But the fun of driving a Jeep Grand Cherokee, apart from giving environmentalists the middle finger, comes from the fact that you can afford it, so the fun will even be greater when it is three times as expensive.

When people start saving more and businesses hardly make profits then where does the money go? It can be used to make the economy sustainable. It can go to people in need who still have use for money. The money can help to reduce poverty and it can be used to address pressing needs in society. And we could have far more leisure time. What's the point of working so hard for things we do not need? We may only have to work for twenty hours per week and still have a good life. It seems possible that humanity will survive capitalism and that capitalism will be transformed into an economic model that can endure for the foreseeable future.