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Can You Say Marginal Rate of Substitution?

October 24, 2007

Tags Calculation and KnowledgePraxeology

Once, when my newborn son was barely back from the hospital, I was holding him in my arms with my wife looking on. I asked him, "Can you say marginal rate of substitution?"

My wife recognized that as a bit of economics jargon and accused me of trying to turn our son into an economist like me.

While it was said as a little joke between the two of us, the longer I teach and write, the more I seriously wish people actually thought in such marginal terms, because many of the times that we confuse ourselves and others are due to our failure to do so.

The marginal rate of substitution (MRS) is the term describing the rate at which a person would willingly give up one good or service in exchange for another, from his current situation (i.e., at the current margin of choice). Its focus is on the trade-offs, made necessary by scarcity, that individuals are willing to make between alternatives, a focus often absent in how we reason, which leads to serious misunderstandings and impaired choices.

The word "need" is a prime example of the failure to think in terms of marginal trade-offs.

Since many choices forced on us by scarcity are between different "needs," calling something a need diverts attention from the actual choices faced. For instance, a person's need for water to drink is irrelevant to virtually every choice they make about water. If the price of water rose from its current level, they would not cut back appreciably on water to drink. Instead, they would cut back on some of the many low-valued uses they put it to (and all of us frequently treat water as nearly valueless, because it is cheaply available, and we use it whenever the benefits of doing so exceed its very low price). That is, people's water needs will not be given up, so discussing water in terms of need adds confusion rather than insight. The same is true for innumerable other supposed needs.

The word "need" is also typically used to imply that someone ought to have something they don't. Therefore, "need" is used to imply that they should therefore be given the good (which is why "need" in political discourse really means "I want it but I do not want to pay for it"). But if you had sufficient resources at your disposal, you would buy something if you really needed it. Further, since to give you a good requires that someone else must have the resources taken from them, to talk in terms of need blinds people to the real choice: how much should A's supposed need force B to pay for A's benefit — when A will not.

The confusion generated by talking in terms of need is often compounded by using the word "we," as well, when things are to be provided to some from tax revenue raised from others. For example, people often argue for goods and services that "we" should provide. But the largest source of tax revenue is the income tax, which comes disproportionately from higher-income earners, while a large number pay zero income taxes (e.g., many students and retired people) or even negative income taxes (particularly those who receive EITC refunds).

As a result, when most people say "we" should pay for something, it really means "you, not I," making such arguments highly misleading, if not duplicitous. And when such spending will be financed not by current taxes but by deficits — which are just delayed taxes whose incidence is kept unknown until after the fact — the same argument applies. One cannot correctly analyze such programs or proposals without knowing who will actually be forced to pay how much, so we can recognize the real marginal tradeoffs.

Misusing the word "need" is just one example of the problems caused by thinking in categorical language. For instance, someone might say that good A is more valuable than good B (e.g., food as a category is more important than sleep as a category). However, that is not true: the relative value of various goods in reality depends greatly on circumstances and preferences (e.g., as anyone who does not want to get up when their alarm goes off in the morning is aware, sleeping a few more minutes may often be more valuable to them than eating in the next few minutes). Basing decisions on such erroneous premises makes mistakes inevitable.

Failing to think at the appropriate margins of choice is a staple of politics, with adverse effects. For instance, politicians are always telling people what they are for. But that is typically not what citizens really want to know, since politicians are all "for" pretty much the same things (e.g., peace on earth, our "general welfare," Mom and apple pie, etc.).

Since politics consists of trade-offs, what we really want to know is the rate at which they would trade one thing they are for against other things they are also for, or the rate at which they would accept what they are against in order to get more of what they are for (i.e., at what price in other things that they are for will they "sell us out" on a particular issue). But what they are officially for or against gives us little insight into any of that.

Polls, after money the lifeblood of politics, also typically fail to ask the right marginal questions. One may ask, "Should we add another lane to the 101 freeway in the San Fernando Valley?" But the answer depends on what it is going to cost the person asked. Without knowing what costs respondents think they will pay when they answer, we have almost no idea what a yes or no response means. For that matter, even if the question specifies a cost of, say, $200 per year, we still can't be sure of what their answer means, because they may be answering based on the often very different costs they actually expect to bear, rather than the cost specified in the poll question.

The deceptive mirage of central planning is also a result of failing to think in marginal terms. Those who find the cure for everything in planning ignore the fact that market prices reveal people's MRS between goods, and without market processes to reveal that information, it is unknowable to planners. Central planning, which throws away the process by which relevant tradeoffs are revealed, must throw away the wealth and mutual gain that acting on otherwise unknowable information makes possible, as both Mises and Hayek demonstrated.

Assertions of objective efficiency, and the regulatory impositions based on them, represent another failure to think at the margin. Preferences and circumstances differ, and anything that could alter the value of the expected marginal benefits or the marginal opportunity costs of a choice to a decisionmaker could change what people deem efficient. As a result, to regulate away allegedly inefficient options is either redundant (if an option is considered inefficient by everyone, no one will use the option anyway) or itself inherently inefficient (forcing people away from what they consider more beneficial choices).

For instance, where I live, air conditioners cannot be sold if they have less than a minimum level of thermal efficiency. But for someone cooling an infrequently used cabin, the added cost of the more energy-efficient air conditioner may easily be more than the value of the energy saved during use. And there are many other cases where supposedly technically inefficient choices are economically efficient (e.g., the fact that most of us choose to live in our current homes and drive our current cars, instead of "state of the art" new models).

Not only do objective efficiency claims mislead, but they also serve as cover for assertions that someone other than the owner of a good should be given the power to decide for them. Their reasoning is that since the owner isn't making the efficient choice (an oxymoron, from the owner's perspective) their judgment should "obviously" be substituted for that of owners — for their own good. But what they really mean is that effective ownership should be taken away from current owners and given for free to those who "know better," which is just a thinly disguised form of theft.

Failing to think at the margin makes some people blind to why trade is mutually beneficial. They think of market exchanges as involving equal values, so that no wealth is created by supposedly quid pro quo exchanges, rather than recognizing that exchanges take place only when all parties expect their marginal benefit to exceed their marginal cost (i.e., when they have different marginal rates of substitution between the goods or services involved). Failing to see the gains from trade, they also fail to see the harm imposed on society from restricting or penalizing it, a fallacy behind a host of very damaging restrictions on voluntary arrangements.

Marginal misunderstandings appear in all sorts of decisions, especially about public policy (especially because people have far worse incentives to think carefully when they are spending other people's money rather than their own).

For example, the current push to ensure that everyone has health insurance is supposedly motivated by the desire for everyone to have access to health care, but access to health care is a vastly different issue than health insurance (just as the absence of food insurance does not mean people will not eat). Food stamps are supported by people who don't trust recipients to spend assistance on food, yet by substituting for money that would have been spent on food, food stamps act just like money for most recipients, doing nothing toward the underlying rationale for their use.

And the list goes on.

One need not talk in terms of marginal rates of substitution to avoid confusion about issues such as these. However, thinking at the margin about the innumerable choices scarcity has faced us with is a valuable antidote against mistaken reasoning.

It is particularly important insurance against those who would "sell" some political panacea with misleading language and arguments. Given the vast sea of political rhetoric that uses just such misrepresentation and misdirection to win political power at the expense of individual rights (at an MRS that is appalling to lovers of liberty), it is an important part of the arsenal against the continuing expansion of the state. After all, only such careful thinking can force its proponents to defend their real positions to citizens, rather than baffling and befuddling, as they do now.


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