Essential Austrian Economics: Marginal Thinking
One of the most important contributions of Carl Menger, the founder of the Austrian School,
was the development of what's known as marginal thinking.
Menger, along with other economists working independently around Europe, solved a longstanding
puzzle in economics: The Water-Diamond paradox. Why is water so inexpensive when it's necessary
for life, while diamonds, which have limited practical usefulness, are incredibly expensive?
Prior to marginal thinking, economists couldn't answer this question.
Economists treated all decisions as if they are all-or-nothing,
meaning that we either have water or diamonds. But such an approach can't explain the low price
of water and high price of diamonds. What Menger and others realized is
that people don't make decisions based on an all-or-nothing basis.
Instead, we decide to have a little bit more or a little bit less of something,
based on what we value more at the time. In other words, we make judgements about
what we value in terms of purchasing one more unit of a good or service—and
so, we value things at the margin. But marginal thinking also explains
how the value people place on a good or service is influenced by scarcity.
The more abundant something is, like water which is very abundant, the less its perceived value
compared to goods like diamonds, which are quite scarce, and therefore fetch much higher prices.
But now imagine you're hiking in the desert and you run out of water.
Suddenly the normally abundant water is now incredibly scarce and its value to you—
as you become more thirsty in the hot desert-- probably now exceeds what you'd pay for a diamond.
This marginal way of thinking not only solved the water-diamond paradox but explained how people
actually make decisions in their lives. The development of marginal analysis
revolutionized economics and continues to influence the way we think about the world today.
