Tuesday, 25 March 2008

How martinis refute basic economics

Dorothy Parker was no economist. She was a writer of quips, and an enthusiast for martinis -- admirable qualities in any human being, but insufficient to qualify her as any kind of economist -- but economists might note that in one of most loved quips she unwittingly refutes the marginal value revolution on which most of modern economics is based.

For years, you see, economists had been trying to solve what they called 'the problem of value,' or by some 'the water-diamond paradox.' Why, they wondered, was water so much more valuable to human life, but it is diamonds that are worth much more in money terms? (These are the sort of questions that still keep economists awake at night.) This was said by many economists to create an "irreconcilable contradiction" between use value and exchange value.

The problem wasn't left unreconciled for long, however. The idea of 'marginal value' was hit upon simultaneously by three different chaps, and in a flash it explained the conundrum. Put simply (well, as simply as an economist can) it states:
The ... importance or personal value that an individual attaches to a unit of any good diminishes as the quantity of the good in his possession increases.
 Put even more simply, however valuable something might be to our survival, then the more we have of it the value we place on each successive unit diminishes with each unit. Simple, yet profound. Since we generally have loads of glasses of water and very few diamonds to lay with -- however it might have been at Dorothy Parker's, that at least is the state of play around our house -- we find that your relatively rare professionally-cut precious stone is worth much more than our glass of water, even though it's the water and not the diamonds that it necessary to sustain life.

If we've just come out of the desert after losing our way, then our first glass of water will be worth our life itself -- and we'd be willing to pay whatever diamonds we've got to buy it. But by the time we're sipping our second or third glass we're starting to look around and wonder if we've paid too much, and by the third or fourth glass we're starting to wonder what we're going to tell the wife about where her diamonds went.

Here's another example. If we're stuck in a bush cabin with just five sacks of grain to last until the next harvest, then the most important sack is the one we've labelled "grain for survival," while the least important is the one further down the line that we've labelled "grain to feed the parrot." While grain itself is crucial for survival, you see, the value we place on our grain is contextual: the value is that of 'the last unit,' which in this case is equivalent to the value we place on feeding the parrot who keeps us entertained, rather than the value we place on eating to keep ourselves alive. (George Reisman draws more insights from this example here.)

All value comes from the margins, you see, with value diminishing with each successive unit. While this is a rule widely accepted by every school of economics since at least the fall of the Berlin Wall, Dorothy Parker's martinis pose a challenge to this. The value of martinis, she insists, increases with each subsequent unit. Here's her mantra:
I like a martini
Two at the most, after three
I'm under the table, after four
I'm under the host.
See, martinis actually get better with each drink! If our first martini is labelled "the martini I like" and the second "the martini I really like," then by the third we're up to "the martini that really likes me," and then -- depending on the value we put on our host -- by the last we might attach the label "a night of unrelieved pleasure." Let's just hope we can remember it afterwards, and to whom we need to send the diamonds to keep them quiet.

Economists are recommended to undertake the necessary empirical research forthwith to explain this particular paradox.

Tomorrow, the martini diet ...


  1. A little edit...

    Don't you mean "increases" for the last word in this quote?

    "The ... importance or personal value that an individual attaches to a unit of any good diminishes as the quantity of the good in his possession decreases. "

  2. Oops. Yes, you're right.

    That's embarrassing--that quote has been up there incorrectly for over two years!


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