Before we begin this lesson, and giving the fact that it refers to something called "Utility", it would be nice to know what it is that we are referring to.
In economics the term utility is extremely important. At its most basic, utility is why economics actually happen at all. We have said before that people act to diminish "uneasiness" and also that when we choose among different options to do so, we create a Scale of Values. We prefer one option over the remaining ones. This scale of value determines how much we prefer one scale over the other. But this is not the only way to look at the problem. We can also create the same Scale of Values by looking at how effective is each option in decreasing "uneasiness" or, in other words, how useful this option is when compared to the other options. Therefore, we are looking at the "utility" of something.
As every economic choice of every person is subjective and personal, so it is the "utility" of every option. This immediately leads to the conclusion that it is impossible to measure "utility" because every person has a different and personal utility scale. There is no such thing as a Utility Unit of Measure such as the Liter or the Meter. This is so because we would need to create a unit of measure that will hold true for all people at all times and situations, just like the liter or the meter. The length of a meter does not change because you are sad or happy, in a hurry or rich, tall or blonde. The length of the meter remains constant regardless of what we believe or feel and it can thus be used to measure things (i.e. compare against) all the time regardless of our situation.
Reality and Utility
Before we go any further, we must dis-ambiguate (i.e. make clear the difference) between an objective utility and what Praxeology calls Utility. In communism there is something known as use-value. This is the value that an item has to society regardless of what the value may be to a person. For example, if we are building a house we need concrete. This concrete is necessary regardless of its price. It has an objective and hence measurable use-value and this value is measured in units of itself. For example, if we need 10 tonnes of concrete per house, the use-value of concrete per house is 10 tonnes. This is not the definition that Praxeology uses.
Praxeology indicates that Utility is based on personal belief, not objective use.
For example, let's say that Fred needs 20 liters of gasoline to make it to the nearest city and back. This value is objective and it is based on the laws of physics. When Fred decides to go to the city, he won't be looking at the laws of physics to determine the use-value of the gasoline; he will be looking at his ends. Because Fred believes that 20 liters of gasoline will take him to the city and back, he will use 20 liters of gasoline. This seems confusing because Fred ends up using 20 liters of gasoline regardless. But there is a crucial difference.
A use-value is objective and therefore unique. If Fred wants to go to the city and back, he will need 20 liters of gasoline and not less. Fred cannot change the laws of physics, but Fred can change his belief. Fred may decide to use 19 liters of gasoline because he believes that 19 is enough. Therefore for Fred the utility of 19 liters of gasoline is 19 and not 20. Therefore the utility of any item under Praxeology can have infinite values.
The fact that something has a use-value means nothing in terms of utility. Utility has to do with human decisions as expressed in humans acting or human action. Use-value has to do with the laws of physics. Two completely different concepts. This is the reason why communists do not use the term utility but use-value; because communists do not believe in individual action, only in societal action. And in society it is possible to know the use-value of things. I we have 10 families and we need to build 10 houses we will need 100 tonnes of concrete regardless of what those 10 families may believe.
Use-value is technological or physical and objective.
Utility is personal and subjective.
Utility and error
Now that we understand what utility is, we need to emphasize that the value of a utility can be insufficient to achieve the desired goal; this is people make mistakes. In our previous example it is obvious that Fred won't have enough gasoline to make it back to his house. His goal to get to the city and back will remain unfulfilled. Yet, Fred believes otherwise. Fred is in error.
Utility and Uncertainty
As we discussed in a previous lesson, humans act within uncertainty. We have to do so because we never, ever have all the information at hand. We may have bits and pieces but never the whole picture. In our previous example perhaps Fred believed that 19 liters would be enough because he did the calculation for an average car, or perhaps he read it in the Internet. Thus Fred believed that he had sufficient information and acted accordingly.
But there is an extreme case of this scenario. What happens if we are not even aware that a given option exists? In our previous example, Fred may not even know that he needs 20 liters to go to the city and back. He simply jumps on the car assuming he will make it; he won't.
In this case as Fred does not know that he needs 20 liters, for Fred the utility of 20 liters of gasoline is value-less. It has no value. What this means is, again, that utility is totally unrelated to use-value even to the extreme of having no value at all! Which is the ultimate in subjectivity and yet, it is very common in real life. How many things you do not know which could be of use to you? There are infinite pieces of such information. This concept is very real and happens all the time non-stop.
Scales of utility
As we mentioned before, the concept of utility is simply a different way of looking at Scales of Value. Thus utility is also cardinal but not ordinal. This is, we can say what it is that a person prefers but we cannot say by how much. In our previous example, let's say that Fred wants to go to the city, but he also wants to go the neighbouring sports store. In observing what Fred does (goes to the city) we can say that Fred prefers to go to the city as opposed to go the neighbouring sports store. What we cannot say is that Fred prefers to go to the city 30% more than he prefers to go the neighbouring sports store.
In other words, at this point in time Fred's scale of utility is:
go to the city > go the neighbouring sports store
Now that we understand what it is that Utility means in Praxeology, we can move forward and look at a related phenomenon. We normally observe that people who have a lot of things don't value them. If Gill has a lot of shoes, he may be convinced quite easily to donate a par to charity. However, if Gill is poor and it only has two pairs of shoes, it is unlikely that he will donate any of them. This is so because Gill is looking at the utility of his shoes.
Rich Gill knows that he has so many shoes that giving one pair away won't increase his "uneasiness". He can wear other shoes. Poor Gill, on the other hand, knows that if he gives that pair away, his "uneasiness" will skyrocket because he will have to go barefoot. What this means is that for rich Gill, the utility of one pair is very low. However, for poor Gill the utility of the same pair is very high.
This poses a question: if we acquire many units of the same thing, what will their utility scale look like?
Let's take rich Gill. The first pair of shoes had very high utility because it prevented Gill to go barefoot. The second pair had less utility because it was a backup for when the first pair breaks. The third pair had even less utility because it was used only when the first and second pair are unusable… and so on. Every new pair of shoes that Gill bought removed less "uneasiness" (i.e. solved less problems) and therefore their utilities were progressively lower. And so our utility scale would look like:
Unit #1 > Unit #2 > Unit #3 and so on.
This means that Gill values each successive pair of shoes less and less. But what drives the "uneasiness" of each pair of shoes? Their urgency. Going barefoot is very uncomfortable and dangerous. Having to walk with broken shoes is only inconvenient. And so the first pair is far more useful (it has higher utility) than the second and the third and so on.
But what happens when the first pair of shoes is destroyed and the second takes its place while being replaced by the third and so on? The utility scale looks like:
Unit #2 > Unit #3 and so on.
In other words, we used whichever thing we had at hand to remove the most pressing uneasiness first. Then, once this one is removed, we try to remove the second most pressing issue and so on.
What we don't do is to use all the things to eliminate the most pressing uneasiness and leave the second alive and well. For example, rich Gill is not using all his shoes simultaneously not to walk barefoot leaving no shoes as backup.
Rich Gill is behaving in this manner because he does not have all the shoes in the world. He only has a few. As such he must decide which uneasiness to remove first, which second and so on. Rich Gill will act with economy because he only has so many shoes. In other words, shoes are scarce and he cannot afford to waste them using all of them every day taking the chance that they may all break at the same time.
What this means is that the utility of each shoe is determined not by looking at all the shoes Gill have, but at the uneasiness Gill is trying to prevent. Once the most pressing one is removed, the following one will be less pressing thus the utility of the next pair will be lower.
In economic terms this means that the utility of a thing is determined at the margin. When Gill is barefoot, his margin is to solve this problem. Once this problem is solved, his margin moves to make sure that if the first pair of shoes break, the second will be at hand. Once this is solved, his margin moves again to make sure that if the second pair breaks the third will be at hand and so on.
Gill is not looking at all his shoes and thinking that the utility of all of them is to avoid him walking barefoot. The utility of things is determined one thing at the time in a specific context and for a specific person.
The classic example is water. If you are thirsty, the first glass of water will be very satisfying. Once you drank it, the second will be less satisfying and so the third and the fourth and so forth. Every successive glass of water has a different -and decreasing- utility. This is so because they remove the most pressing uneasiness, one at the time.
This is called the:
Law of Diminishing Marginal Utility
And it is a very important law. As we have shown it derives directly and logically from the axiom of human action. We deduced it from said principles. As such it holds despite and before any empirical testing.
This law also tell us that at some point there may be no more utility and further consumption of a good or service will become dis-utilitarian. This is we won't want it any longer. For example, if rich Gill continues to buy shoes at some point his closet will be so full that he won't be able to find anything. At that point the marginal utility of buying another pair of shoes becomes undesirable or un-satisfactory. Same with water. At some point if we keep drinking it, we will become sick.
Diamonds versus Water
A classic example where this law help us explain why things are happening is the case of the utility of diamonds against the utility of water. Water is critical to sustain life and as such it is obviously far more valuable than diamonds but the market reflects just the opposite! How is this possible?
Simple. We measure the utility of water one glass of water at the time and the utility of diamonds one diamond at the time. But water is plentiful while diamonds are not. As such, we can have a glass of water anytime we want and the next one will be far less useful, this is, it will have lower utility because it will be easy to get and so forth. Diamonds on the other hand, are in short supply. The first diamond will satisfy our initial desire to have it, but the second (because it is scarce) will also be hard to get. Which means that it will have a slightly lower utility than the first, but a much, much higher utility than the second glass of water. Therefore comparing the marginal utilities of diamonds versus water it becomes clear that the utility of diamonds is much higher than the utility of water.
But this example reverts itself if we are in a place where water is scarce. If we are in the desert of South Africa where diamonds are plentiful, we would value far more water than diamonds. This is so because we will need scarce water to survive. In the desert every glass of water is critical for survival hence their marginal utility is far, far higher than the marginal utility of diamonds that do nothing for our survival.
One of the breakthroughs of the Law of Diminishing Marginal Utility is the understanding that supply and demand do not determine prices by themselves in a mechanical fashion. People determine prices through the process of seeking goals, and the marginal utility of goods and services is affected by supply and demand. But in the end the marginal utility of goods and services is what actually determines prices.
We can observe this in the everyday markets when a product X is plentiful (i.e. large supply) and it is also highly sought after. For example apples in a supermarket. This combination (high supply and high utility) will keep apple prices affordable but desirable.
On the other hand, simple iron nails are cheap and plentiful but not very desirable for the majority of people. This means that their utility is low despite their supply being high. This will keep their prices low.
We can also look at obsolete computers which are plentiful (high supply) but their utility is actually dis-utility because most people have no use for them and consider them garbage. Thus the price of obsolete computers is zero or less than zero (people want to get rid of them).
These are three examples of large supplies producing three different price levels precisely due to the marginal utility of each good.
Note: please see the Glossary if you are unfamiliar with certain words.