The Speculator’s Edge, Two

The Speculator’s Edge, Two

Basic Economic Concepts essential to Speculation

2) Utility

  

Let’s see how these characteristics take effect in the real world.

Consider the case of Fred, a hunter. His basic economic needs include shelter, clothes, tools with which to hunt, and food. Since his society has achieved division of labour. Fred doesn’t expect to make his hut, clothes, or clubs; his job is to hunt. He is sufficiently proficient at it to kill more than he can eat. If he weren’t, he would have to find another job.

One afternoon, after a particularly tasty brontosaurus burger, Fred looks about and notices that his tiger-skin loincloth is going out of style, his club is splintering and needs to be replaced, and the roof on his hut is leaking. He goes over to the refrigerator and sees that he has stored up several boxes of brontosaurus burgers from his last hunting trip. He knows that Barney, the club maker, loves brontosaurus burgers, so Fred figures that Barney will be willing to trade a new club for a box of burgers. Since Fred needs a new club and since he can always get more burgers once he acquires one, he decides to make a trade on this basis. So he goes over to Barney’s and trades the burgers for the club.

This primitive trade is called a direct exchange. The important thing about it is that it takes place only because the utility of a new club is greater to Fred than a box of brontosaurus burgers, and the reverse is true for Barney. We can describe the trade as having taken place at a price: The Price of one club was one box of brontosaurus burgers. Note that while the price can be specifically described, the trade took place not because Fred and Barney agreed on the utility of the goods exchanged, but because they disagreed! If both Fred and Barney valued a club more than burgers, then no trade would have taken place.

Consider Fred’s position immediately before he goes over to Barney’s to buy a new club. Fred must engage in a little self-examination. Since his needs are many and his resources are scarce, he has to decide what his priorities are before he goes on a shopping spree. His decision is as follows:

1) a new club

2) a new roof

3) a new loincloth

4) a box of brontosaurus burgers

5) another box of brontosaurus burgers

6) another club

7) another loincloth

This list of priorities is based on the utility of the goods on the list. Since Fred just ate, the brontosaurus burgers are relatively far down the list. What Fred needs most right now is a new club so he can go hunting and obtain food to eat and to trade. The roof is next in importance, because Fred prefers to sleep in a dry hut. Next in importance is a new loincloth since the one he’s wearing is in tatters. Then comes a couple of boxes of brontosaurus burgers, which occupy their lower spot because Fred already has several  boxes in the refrigerator and he has just eaten.

Note that the additional club and loincloth are at the bottom of the list, since they are not needed as much as the identical items at the top of the list. This is an important point. While extra clubs and loincloths benefit Fred, the incremental benefit of each additional club or loincloth becomes smaller. Economists describe this phenomenon in an important law – the law of diminishing marginal utility. Simply stated, the law of diminishing marginal utility says that as the amount of a good consumed increases, the marginal utility of that good tends to decrease. So, economists like to say that the marginal utility of a second club is less for Fred than the other items above it on the list.

Of course, the list itself is a list of Fred’s subjective values. But Fred lives in an objective world. That is, the items on Fred’s list are also on other people’s lists, but not necessarily in the same order. For example, people who can’t hunt to save their lives have little desire for clubs at all, except to the extent that they can trade them for other goods that they do want. People who had their huts re-roofed just last week wouldn’t trade a berry for a new one this week. As all these people come to the market, they make trades that make sense to them subjectively, and just as important, they refuse to make trades that do not make sense. In other words, people allocate their own limited resources in such a way as to maximize their own subjective utility – they keep making trades until their schedule of assets conforms to their list of priorities. In the aggregate, the subjective needs of all of the participants in the market result in an objective hierarchy of goods. At any given moment, the prevailing hierarchy, regardless of what you or I think of it, is the hierarchy of objective values.

The Speculator's Edge,
Albert Peter Pacelli