So here’s a brief recap of where I stood last week with this set of posts:

  1. Marginal Utility Theory explains how we ascribe value to things.
  2. As a rational individual, my goal is to maximise my utility in life (because we’re all hedonists in a rationally economic world).
  3. My total utility is limited by my means – which is a rough way of saying that the total possible utility I can achieve in life is linked to the total utility I can offer to my employer/the world.
  4. By establishing a personalised “exchange rate” between satisfaction and money, I can rather usefully turn my marginal utility curve into a demand curve.
  5. If we take everyone’s individual demand curves for a product and add them together, we get the market demand curve.
  6. If we aggregate all the market demand curves, we get Aggregate Demand*.
    *Confession: that didn’t feature in a post yet. But it’s really just an extension of point 5.

I’m going to be talking about “value” and “price” in this post. For many, those concepts seem interchangeable. But they are two fundamentally different things. I’ve written about this before: Observation Number 4: More on the Value VS Price Misconception (which I recommend, because my friend Remy was so glowing about it in a post comment, and I have an ego, and there it is).

Now for the fun part…

Does Marginal Utility Theory sound reasonable to you?

Admittedly, we’re not looking for perfection in a theory – it just needs to be mostly correct. It’s like talking about mothers loving their children: it’s a reasonably accurate assessment of the maternal instinct. Sure, you get exceptions. But mostly, you can rely on a mother to love her children.

First Off – Marginal Utility Is Not As Unlikely As It Sounds

The main complaint that people usually have when they look at something as complex as marginal utility goes something like this:

“There is just no way that I spend time calculating marginal utilities in the background as some kind of rationalisation for what I want. Madness.”

Well, it’s not that impossible. Here’s an anecdotal reason why (and for the record, I’m paraphrasing a scene from Patrick Rothfuss’s “A Wise Man’s Fear”):

  1. A professor walks into a room of final year engineering students. He’s holding a ball, and he tells them that he’s going to throw it in 15 minutes time.
  2. He then asks them to try and work out where the ball will land.
  3. The students work for 7 minutes individually, before they give up in frustration.
  4. The professor then tells them that they can work together until the time is up.
  5. They pool their efforts. One student had drawn pages of parabolas to work out trajectories. Another had differentiated and integrated Newtonian formulae using a variety of assumptions. A third had attempted to analyse the fluid dynamic impact of the air on the ball, taking into account the draughts from the open windows and doors. And so on.
  6. After 15 minutes, they are no closer to an answer. There are just too many variables to consider.
  7. The professor stops them, and then calls in his 8 year old son.
  8. The professor throws the ball.
  9. His son runs and catches it.

The point: it’s entirely possible that our minds have performed with subconscious and instant ease something that seems mathematically impossible and/or tedious to do consciously.

Sidebar: if I’m entirely honest, I’ve been looking for a way to work that story into a post, because it was fun to read. But I fully expect someone to come back at me with something about the difference between linear and iterative thought processes, and when the latter is better than the former. Anyway.

But even if we accept that our minds are totally capable of scaling and ranking everything instantaneously, it makes sense that we would need a starting point. An anchor of some kind, against which everything else can be measured.

And that concept is not so foreign. If you look at ancient forms of money, the barter transaction was generally replaced by something that was commonly valued or commonly used. For example, valuing everything in terms of bushels of wheat, or dried fish.

But given that, it does sound like we’ll have a slight proclivity toward anchoring…

The Curse of the Black Pearl AKA The Anchoring Bias*
*I owe Dan Ariely a debt of gratitude – this section is almost a direct quote from Chapter 2 in his book “Predictably Irrational”.

Salvador Assael was a Sephardic Jew born in Milan in 1923 (here’s a link to his New York Times orbituary). His family fled Italy just before World War II, and eventually settled in America. Just after the war was over, Assael started trying to sell Swiss watches to the Japanese – which seems a strange thing to do, given that Japan was suffering from the after effects of two nuclear bombings and, like, being the loser in a World War.

Anyway, unsurprisingly, the Japanese couldn’t really pay him in money; instead, they paid him in white pearls sourced from the South China Sea. And Salvador Assael became famous for trading in white pearls.

In the 1970s, he heard (from a frenchman) about the black-hued pearls found in the waters around French Polynesia. He brought a few strands of these black pearls back to New York and tried to sell them, with very little success. Eventually, he persuaded his friend Harry Winston (of Harry Winston fame) to set the pearls and put them on display in his jewellery store on 5th Avenue, with an outrageous price tag. They sold almost immediately – and the multimillion dollar Tahitian pearl industry was born.

The important points to take from this:

  1. Black pearls were an entirely new product on the market. No one had seen them before, it wasn’t clear if they carried social prestige or not, and no one really knew what they were worth.
  2. The problem wasn’t so much a lack of demand as it was a complete lack of demand curve.
  3. Harry Winston, being a famous jeweller with a respected opinion and the right clientele, created context with his outrageous price tag.
  4. And voilà, the price of the black pearl anchored its value relative to the other jewellery in the store, and now there could be a demand curve, and there was instant demand.

What this suggests is that the development of a demand curve is not nearly as rational and independent as traditional economic theory would suggest. Here’s the hope of traditional economics:

  1. We work out the value that a good holds for us individually
  2. We assess the value of the good relative to the other factors that determine price (market demand, market supply, our means/income to spend, etc).
  3. We then decide whether a price is reasonable.
  4. Then, much like an auction, the price gets bid up or down.

What was happening in the Black Pearl: price was dictating value.

And not to sound like a conspiracy theorist, but here’s the question: do we demand what we want, or do we demand what other people want us to want? That is: how independent are our wants?

The Impact of Social Security Numbers

In the aforementioned Chapter 2 of “Predictably Irrational”, Dan Ariely goes on to test the anchoring bias. One experiment ran as follows:

  1. Students were asked to write down the last two digits of their social security numbers at the top of a page.
  2. After that, they were asked to bid on a variety of items (chocolate, a computer mouse, a bottle of wine, etc).
  3. The prices bid were then grouped by the magnitude of the last two digits of social security number.

Assuming that we’re all rational and unaffected in our value proposition, you’d expect there to be no link between the size of social security number and the prices bid. Every grouping of social security numbers should have ended up in largely the same ballpark distribution of price.

The overwhelming and highly-statistically significant result? The higher the social security number, the higher the bid. Which is a bit impressive.

But to me, it makes so much sense. Mainly because I spend most of my day not really knowing what I want. Instead, I operate on habit (like eating and sleeping patterns) and going along with the crowd (are you getting Maccy D’s? Cool, I’ll get too). Most of my behavioural preferences are based on what my parents like and how I grew up. Some of my “likes” have a lot to do with the image I want to project and/or the image that I feel I ought to project. It’s actually quite a pain to be an original individual.

Of course, being a herd animal does make one rather boring. But that’s a small price to pay for not having to think too deeply.

Nevertheless, having behaviourally-conditioned wants and preferences does leave you spending money on things that you don’t necessarily like. It also makes economies and markets more volatile – because now it’s all about waves of taste and Malcom Gladwell’s tipping points and it’s not under anyone’s control.

I sometimes think that the bigger economic solution to all the chaos would be a general social movement toward self-reflection and self-empowerment. If we were all a little less influenced, and a little more self-determined: at a microeconomic level, we’d make better individual decisions; and at a macroeconomic level, there’d be more stability, because we wouldn’t all rush to a correlation of 1 in a crisis.

And bonus: you wouldn’t need everyone else to co-operate in order to start that process, because the direct and immediate benefit is a personal one.

Either way, I think that Marginal Utility Theory should be treated with a little less deference…