01b_Gains

01b_Gains - GAINS FROM TRADE Consumer Surplus and Seller...

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Unformatted text preview: GAINS FROM TRADE Consumer Surplus and Seller Surplus MARGINAL UTILITY If consumers have constant marginal utility for one good, like money, and can con- sume divisible (continuous) numbers of units of the other goods, then in competitive equilibrium, the price of each non-money good will be equal to everybody&s marginal utility. The market discovers this "consensus" marginal utility, and transmits it to the public via the price. In doing so it also directs agents to reallocate the goods in a way which maximizes total utility or surplus. For the great classical economists Smith, Ricardo, and Marx, the price of a com- modity was determined by its cost of production. If a deer took twice as long to &nd as a beaver, then its price would be twice as high. Since the main element in the cost was thought to be labor (including the labor used to produce the good and the labor ¡congealed¢in the machinery, i.e., the labor that was used to produce the machines that are used to produce the good), the classical economists formulated the so-called labor theory of value. It was not long before many economists objected that the value of a commodity had to be connected to its usefulness, or in their vocabulary, to its utility. Why would anyone pay more for something that did him less good? Adam Smith himself had attempted to refute this argument by the example of water and diamonds. Water, which is so useful, even crucial, to life, has a low total price, while the collection of diamonds in the world, which by comparison contributes almost nothing, has an astronomical value. The idea that the price is determined by supply and demand seems super&cially to reconcile these con£icting arguments. But on closer inspection it makes the puzzle more acute. The law of supply and demand does not say that price is the average of utility and cost, it says that price is equal simultaneously to the demand price and the supply price. When utility and cost are evidently so di/erent, as they are in the case of water and diamonds, it seems that we are caught in a contradiction. The ¡marginal revolution¢ in economic theory of the 1870s, led by Jevons in England, Menger in Austria, and Walras in France, solved the puzzle of value and price. Demand is determined not by utility, but by marginal utility, and supply is determined not by cost, but by marginal cost. When supply is equal to demand, marginal cost and marginal utility are equal, even though cost and utility may be very di/erent. Thus the price of a pound of diamonds is far higher than the price of a pound of water, because the social utility of the last (i.e., the marginal) pound of purchased diamonds is higher than the social utility of the last pound of purchased water. So too the cost of &nding the last marketed pound of diamonds is higher than the cost of &nding the last marketed pound of water....
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This note was uploaded on 12/08/2009 for the course ECON 251 at Yale.

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01b_Gains - GAINS FROM TRADE Consumer Surplus and Seller...

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