In the previous lesson we defined Utility from a Praxeological point of view, which is simply the capacity to diminish uneasiness. We also showed that the utility of a good or service for a person is always determined one item at the time and it depends of the circumstance in which that determination is made. In other words, it is subjective. The Law of Diminishing Marginal Utility simply says that people will choose to satisfy their most pressing needs first, whatever they may be. As such, once the first need is satisfied, people will target the second pressing need and so forth. Which means that for every need that was solved, the subsequent one will be less pressing (i.e. will have lower uneasiness) and therefore its resolution will be done by a good or service with has less utility than its predecessor. This law operates for users, but what about producers?
Consumer and Producer Goods
In economics there is a handy classification of goods. Consumer goods are those goods that can be used directly to diminish our uneasiness; this is, to satisfy a need. For example a sandwich if we are hungry or a pair of sneakers if we are barefoot.
Producer goods are those goods that can diminish our uneasiness but only indirectly. Alternatively, producer goods are those goods that are used to create consumer goods. For example the oven to bake the bread from which our sandwich is made or a mould injection machine to manufacture the sole from which our sneakers are made.
There is another differential characteristic between consumer and producer goods. Producer goods cannot be used alone. If a producer good can be used alone to manufacture consumer goods, this would mean that the producer good is itself a consumer good. Therefore, a producer good must always be used combined with at least another producer good in order to be classified as such.
This classification and the knowledge of the existence of the Law of Decreasing Marginal Utility leads us to ask the following question: Is there some equivalent law for producer goods?
Utility of producer goods
Before we embark in an answer, we need to determine or define what Utility is for a producer's good. But we already defined what utility is for consumers. Can we have two utility definitions? We could, but that would complicate things enormously. It is far better to see if the existing definition works.
A producer good makes sense only if it is producing consumer goods. It would make no sense to create a factory to purposely manufacture a gadget that nobody wants (i.e. the gadget has zero utility). What this means is that economically speaking producer and consumer goods are tied together by the utility of the latter. Which means that the utility of a producer good can only be assessed from a consumer point of view.
But we already know how a consumer would assess the utility of a consumer good; this would reflect the capacity of the good to remove uneasiness. But if we now trace back the origin of this consumer good, we will find that it was created through a producer good. Therefore from a consumer's point of view the utility of a producer good is the same as the consumer good it produced because it has the same capacity to remove consumer's uneasiness.
In our previous example, the utility of the oven that produced the bread of our sandwich is the same as the utility of the bread in our sandwich because the oven cannot decrease our uneasiness beyond what the bread can do.
In other words:
The utility of a producer good (or marginal productivity) is determined by the marginal utility of its contribution to the consumer good it creates.
Things that produce unlimited supplies are not goods. The typical example are ideas. An idea does not wear out and does not run out. An idea can be used and re-used an infinite amount of times. When we are taught how to paint a wall, that information can also be taught to an infinite number of people. If we decide to paint a wall, we may run out of brushes or paint, but not the information about how to do it.
Although it is true that ideas depend on physical media, their informational quantity does not decrease as it is taught to other people. If we have 10 marbles and we give them away one by one, every time we do we have one marble less until we have zero. With ideas this is not the case. Every time that we teach an idea to somebody, we still retain the whole idea.
We know that things are scarce and therefore we must economize them; this is, we use them to satisfy our more pressing needs first. This is how we determine utility. Utility only makes sense in scarcity. But if consumer goods are scarce and they are manufactured by producer goods, this also means that producer goods are scarce.
Producer goods and marginal productivity
Let's take a very simple example. Let's say that we have two producer goods: clay and paint. We use them to manufacture standard sized painted bricks. If we vary their quantities we have the following possible scenarios:
- Less clay than paint: in this case we can only manufacture as many pained bricks as clay we have available. As we have extra paint, this paint is a waste.
- Right amount of clay and paint: in this case we produce all the pained bricks we can an neither clay nor paint go to waste.
- More clay than paint: in this case we can only produce as many painted bricks as paint we have. The reminder of the clay goes to waste.
As clay and paint is scarce, we must have at least one optimum combination which maximizes the amount of painted bricks we can produce leaving no waste.
This is known as the Law of Returns and it states that:
For every combination of producer goods there exists an optimum.
But as we know that marginal productivity is determined by marginal utility, we can re-state this law by saying that:
For every combination of producer goods, there is a maximum in marginal utility or marginal productivity.
There is another way to state this law, it is:
In a set of producer goods required to manufacture a consumer good, if we keep all producer goods constant but one and we keep increasing this one, it will reach a point at which any further increment will not increase the marginal productivity.
We can see this last description in our brick & paint example. We started with insufficient clay and kept increasing it. By doing so we went from few painted bricks to a maximum and then we stayed there but with increasing amounts of wasted clay.
The Law of Returns does not provide all the information we would ideally like to have. For example, it cannot:
- Tell us if there is only one optimum capable of producing the desired goal (there may be more than one optimum)
- Tell us if once achieved our goal, there is a way to enhance it by increasing the quantity of a given producer good (there may be a way to improve on our goal)
- Tell us what is the relationship between an increase in the quantity of a given producer good and the progression of the process towards its optimum (the relationship may be proportional or non-proportional)
All this information must be obtained by experience, this is, by manufacturing the consumer good.
Note: please see the Glossary if you are unfamiliar with certain words.