Scott Wentland wentlandsa@longwood.edu 434-395-2160 Longwood University 201 High Street Farmville, VA 23901

1. Scott Wentland wentlandsa@longwood.edu 434-395-2160 Longwood University201 High StreetFarmville, VA 23901

2. What Determines Value? Part 1 – The Labor Theory of Value and the Diamonds/Water Paradox

3. Why are some things more valuable than others? • How can “thinking on the margin” and cost-benefit analysis help us understand value?

4. That’s easy. The stuff we needthe most is the most valuable. • Houses are expensive • Gas is expensive • Medicine can be very expensive • Is something really more valuable because we need it more?

5. Adam Smith wrote about this in 1776 • The Wealth of Nations (1776) • Smith was the father of economics and The Wealth of Nations is one of economics most important books (more about Smith later…) • Water/Diamonds Paradox • Why are diamonds more valuable than water?

6. Water is essential to human life • Other than air, there is literally nothing more important to our survival as water • Humansneed water • But, water is cheap

7. Diamonds are not essential to human life • They are shiny stones, used in jewelry and a few other uses (like cutting) • Diamonds = bling  we don’t need bling. • But, diamonds are expensive!

8. If value doesn’t necessarily come from need, then where does it come from? • Adam Smith’s answer: how much work goes into it • “The real price of every thing, what every thing really costs to the man who wants to acquire it, is the toil and trouble of acquiring it.” • Labor theory of value

9. Water is easy come by, in most places • In the old days, pump water from a well • Now, it comes out of the faucet • Diamonds are hard to make • Need to be mined from a far-away land • Need to be precisely cut and polished • If a diamond maker goes to the trouble of making the diamond, he/she will want something back in return • Something of at least equal value

10. Diamonds are more valuable because it takes more labor to make a diamond? • This story is incomplete. Why? • Does more labor always mean more value?

11. Grandma spent a lot of time knitting this sweater…is it valuable?

12. Countless, highly skilled people helped make these movies… • Are these movies valuable to studios?

13. What have we learned? • The labor theory of value is obviously incomplete. • Does not account for other costs • Does not account for demand • Not necessarily ‘thinking on the margin’ • Next part: Is there a better way to resolve this diamonds/water paradox?

14. What Determines Value? Part 2 – Marginal Analysis and Resolving the Diamonds/Water Paradox

15. Where does value really come from? • Individuals(the rest of this lecture) • First look at how individuals determine value for themselves • Individuals think “on the margin” • Markets(next lecture) • Markets are made up of individuals (consumers and producers) who trade with one another • Markets can be best understood by understanding the laws of supply and demand

16. Individuals have value for consuming something, independent of what the price actually is • Consumption (or use) value is subjective • Price of a can of Coca-Cola = $1 • I may buy it, because it is worth more than $1 to me • I might be willing to pay $2 or $3. • You may not buy it, because it is not worth $1 to you • You might be willing to pay $0.50 • This value may vary from person to person

17. Does this mean you wouldn’t want a Coke if you could buy it for, say, $0.75? • Exchangevalue is not subjective • You may buy the Coke for $0.75 and try to sell it for $1.00 • People trade/exchange/buy/sell because they either want to 1) consume it or 2) re-sell it 1) depends on your own value for it 2) depends on the market value for it

18. Individuals think (and make a lot of decisions, like consumption decisions) on the margin • In economics, “the margin” refers to the “next increment” of whatever you are deciding to do • Should I have one more drink? • I was happy with the first cup of coffee, should I have a second cup? A third? A forth? • Should I study an additional hour? • Should I take one more class this semester?

19. Example: • Suppose you are studying for an exam at Starbucks • You plan to stay for several hours • You drink energy drinks to give you an extra kick of energy • Do you order all of your energy drinks all at once?

20. You probably think on the margin: • Buy the first when you get there • Buy a second when you are getting a little tired • Buy a third when the second one wears off…

21. Why do you buy the first energy drink? • Breaking it down: • Cost of one energy drink = $3.00 • Benefit of one energy drink > $3.00 • You would be willing to pay as much as $4.00 for this • You buy the energy drink because: Benefit > Cost (for the first drink)

22. Why do you buy the first energy drink? • Marginal cost • The additional cost for one additional unit • $3.00 • Marginal benefit • The additional benefit for one additional unit • $4.00 for the second unit Marginal Benefit > Marginal Cost $4.00 > $3.00

23. Individuals are always weighing costs and benefits • This is called cost-benefit analysis • This can be either intentional or unemotional/subconscious • Economics’ prediction about human behavior: If Marginal Benefit > Marginal Cost, DO IT!

24. Why do you buy the second energy drink? • Breaking it down: • Marginal Cost of the second energy drink = $3.00 • Benefit of second energy drink > $3.00 • You would be willing to pay as much as $3.50 for this

25. Why do you buy the second energy drink? • Marginal cost • The additional cost for one additional unit • $3.00 • Marginal benefit • The additional benefit for one additional unit • $3.50 for the second unit Marginal Benefit > Marginal Cost $3.50 > $3.00

26. Why do you buy the third energy drink? • Marginal cost • The additional cost for one additional unit • $3.00 • Marginal benefit • The additional benefit for one additional unit • $3.05 for the second unit Marginal Benefit > Marginal Cost $3.05 > $3.00

27. Why is my marginal benefit shrinking? • I’m not as satisfied with the 3rd as I was the 2nd or 1st… • I am less satisfied with “more of the same” • I may be getting tired of drinking energy drinks • It may not provide the same “kick” • This idea is linked to diminishing marginal utility • As I consume more and more of the same thing, the additional happiness (or marginal utility) diminishes with each additional unit

33. At some point, you choose not to buy any more • Why? • Because the Marginal Cost > Marginal Benefit • Second prediction about human behavior: If Marginal Benefit < Marginal Cost, Then DON’T DO IT!

34. Cost-Benefit Analysis Conclusions: Choose to do more of something if: MB > MC Choose NOT to do more of something if: MB < MC Happiest when we have reached: MB = MC • The third can was closest to this optimal point

35. Diminishing marginal utility and “bulk pricing” • Vendors know the consumers have diminishing marginal utility, so they price accordingly: • One for $3, Two for $5 • The marginal cost of 1st = $3 • The marginal cost of 2nd= $2 • This is different than average cost • AC = Price / Quantity • Average cost = $5 / 2 = $2.50 • Marginal cost may not always be constant

36. How does marginal analysis (or “thinking at the margin”) resolve our diamonds/water paradox? • Water is incredibly valuable to us, but not so muchat the margin • When we want to buy a bottle of water, we’re usually not completely dehydrated • An additional bottle of water might make us less thirsty, but is not usually a matter of life and death

37. One more bottle of water usually means…I’m a bit less thirsty • How much is that worth to you? Maybe $1 or $2. • The question is not usually a “lifetime of water” vs. “no water”…it is usually choosing to buy water at the margin • One more diamond usually means…I am much, much happier (or my significant other is much happier!) • How much is that worth to you? Hundreds? Thousands?

38. Each additional diamond is still worth a lot to you… • For consumption, who wouldn’t want more diamonds? • Each additional bottle of water…not so much. • Always? • Alone in the desert, you may be glad to trade a diamond for a bottle of water! • Most of the time, we’re not in a desert.

39. When we think on the margin, we can see how an additional diamond > an additional bottle of water • Consumption value is subjective • Differs from person to person • Differs from unit to unit (additional units are usually valued less) • When we think on the margin, we make good, rational decisions (where MB > MC) • We are happiest when we come to MB = MC • This is sometimes called cost-benefit analysis or marginal analysis

40. Marginal analysis or marginalism supplants the labor theory of value • Developed by 19th century economists after Smith, called the “marginal revolution” • Why is this important? • Karl Marx’s theories depended on the labor theory of value • Relatively simple concept devastates a key tenant of Marxist/Communist economic theory

41. What if I don’t like diamonds? And my significant other doesn’t like diamonds? • If I found one (or could buy one for cheap), would I just throw it away (or not buy it)? • No, you can always sell it (or exchange it for something you do like) • Exchange value is not subjective • We can sell it on the market at some market price • Later: what determines that market price? How does the market value things?

42. For additional information see: http://en.wikipedia.org/wiki/Paradox_of_value http://en.wikipedia.org/wiki/Marginalism http://en.wikipedia.org/wiki/Cost_benefit http://en.wikipedia.org/wiki/Marginal_concepts