Use and exchange value, consumer surplus and social welfare
"[N]o authority can make optimal choices for consumers. Adult and healthy consumers should be let free to choose their preferred bundle of goods that they can afford."
Editor's Note: This post can be found in Spanish translation here.
In The Wealth of Nations Adam Smith made an important distinction between the exchange- value (or price) of a commodity or service and its use-value (satisfaction derived from its consumption), which normally differ among themselves. Smith said:
In The Wealth of Nations Adam Smith made an important distinction between the exchange- value (or price) of a commodity or service and its use-value (satisfaction derived from its consumption), which normally differ among themselves. Smith said:
The word value, it is to be observed, has two different meanings, and sometimes expresses the utility of some particular object, and sometimes the power of purchasing other goods which the possession of that object conveys. The one may be called ‘value in use:’ the other, ‘value in exchange.’ The things which have the greatest value in use have frequently little or no value in exchange; and, on the contrary, those which have the greatest value in exchange have frequently little or no value in use. Nothing is more useful that water: but it will purchase scarce anything; scarce anything can be had in exchange for it. A diamond, on the contrary, has scarce any value in use; but a great quantity of other goods may frequently be had in exchange for it.
Although the above consideration could be used to question the efficiency and fairness of the market system, the truth is that competitive market prices conform a logic that is not always understood at first. The concepts of “marginal analysis” and “consumer surplus”, amply used by modern economists, will certainly help us establish the difference between exchange- and use-value.
Take the idea of utility (satisfaction) maximization first. Suppose John has a given, limited, income to buy two goods, say vegetable and meat. He is faced with the constraint that the quantity of vegetable purchased times its unit price plus the quantity of meat times its unit price has to be equal to his budget, Y, as shown in equation 1.
Y = PvQv + Pm Qm [1]
John, being a rational consumer, wants to maximize the utility (or satisfaction) of his purchase. Microeconomic analysis shows[i] that his total utility (or satisfaction) is maximum when the marginal utility of the last unit of vegetable (MUv) purchased, divided by its price, is equal to the marginal utility of meat (MUm) divided by its price. That is, when:
MUv / Pv = MUm /Pm [2]
In words, equation 2 tells us that total utility maximisation requires that the marginal satisfaction per dollar spent should be equal between vegetable and meat. In Economics it is generally accepted that, beyond a point, the “law of diminishing marginal utility” (LDMU) starts to operate. This law states that as more units of a product are consumed, the level of satisfaction derived from each additional unit will decline. Thus, if equation 2 were not satisfied, for instance, because MUv / Pv ˃ MUm /Pm, that is, on the margin vegetables bring John higher marginal satisfaction per dollar spent than meat, he would be better off purchasing less units of meat and more vegetables. And, in accordance with the LDMU, the marginal utility of vegetable would decrease and that of meat would increase, producing the equality of equation 2.
The above-exercise can be extended to n goods and services and the logic of the equation 2, known as budget constraint, would still apply: If that equality applies to goods 1 and 2, it should also apply to goods 2 and 3, and, therefore, to 1 and 3. An so on for all de goods (and services) considered by the consumer.(The mathematics behind it would be a little more cumbersome).
I enjoy watching people window-shopping in a mall, because many, most likely unconsciously, are doing the analysis contained in said equation 2: “That pair of Italian shoes is beautiful, but a bit too expensive”, said Pedro. “those jeans are nice and affordable –says Maria--; the same goes for that blue blouse”. I know most wine lovers, like myself, do not buy Chateau Petus or Romanee Conti, not only because their supply is relatively limited, but because they opt for the type of wine that maximizes their satisfaction per Dollar spent—for some, a Barolo is the choice; for others, a less-refined $10 a bottle will do.
Budget constraints can be expressed in terms of prices and income, in units of time and space, physical limitations, etc. Some may say that they first appeared with the fall of mankind (lapsus humani generis) mentioned in the book of Genesis. Without the scarcity that they imply there would be no need for economic analysis and economists.
Water, diamonds and consumer’s surplus.
It is a fact that, for the typical consumer, the satisfaction derived from the consumption of the first glass (or bottle) of water is very high indeed, because it is very likely used for drinking. A second bottle could be used for cooking meals, a third for washing the dishes, a fourth for taking a shower or watering plants, washing the car, etc. The most important uses have priority over the less important. This being so, the price that the consumer is willing to pay for an extra bottle of water is defined by the satisfaction that she derives from the consumption of the last bottle. Thus, if she buys and consumes (say) 50 bottles of water per week she derives a very high aggregate satisfaction (utility) and pays only 50 times the price of the last bottle.
It is a fact that, for the typical consumer, the satisfaction derived from the consumption of the first glass (or bottle) of water is very high indeed, because it is very likely used for drinking. A second bottle could be used for cooking meals, a third for washing the dishes, a fourth for taking a shower or watering plants, washing the car, etc. The most important uses have priority over the less important. This being so, the price that the consumer is willing to pay for an extra bottle of water is defined by the satisfaction that she derives from the consumption of the last bottle. Thus, if she buys and consumes (say) 50 bottles of water per week she derives a very high aggregate satisfaction (utility) and pays only 50 times the price of the last bottle.
The difference in total satisfaction the consumer obtains from the use of any good or service and the price she pays for it is enormous. That difference is called consumer surplus. And the higher the amount consumed, as in the example of water, the bigger the consumer surplus is. However, in the case of diamonds, which are consumed in relatively low quantities or, for most people, not consumed at all, their marginal utility is high and its exchange-value (market price) is also high. (Notice the operation of the law of diminishing marginal utility in both cases).
Consumers do not need to bother about the cost of production of the goods and services that that they get in the market. It is the producer, noticing the prices that consumers are willing to pay for a given product, who analyzes the maximum cost that he could incur in order to satisfy that demand.
Morals for public policy.
Utility functions –both total and marginal-- differ among different people. Some like cheese better than prosciutto; others prefer coffee over tea, bananas over apples, visiting a tropical forest over a crowded city. Some like red shirts but may not buy one at a given moment because they already have five. People’s preferences may vary with the age of the consumer. Young people look for discos and bars when traveling to, say, Europe, while their parents are more interested in visiting cathedrals and 4-star restaurants.
Utility functions –both total and marginal-- differ among different people. Some like cheese better than prosciutto; others prefer coffee over tea, bananas over apples, visiting a tropical forest over a crowded city. Some like red shirts but may not buy one at a given moment because they already have five. People’s preferences may vary with the age of the consumer. Young people look for discos and bars when traveling to, say, Europe, while their parents are more interested in visiting cathedrals and 4-star restaurants.
An immediate implication of the above circumstance is that, except for the case of small children, living with their parents, or a sick person in a hospital, no authority can make optimal choices for consumers. Adult and healthy consumers should be let free to choose their preferred bundle of goods that they can afford.
Adam Smith wrote, “consumption is the sole end and purpose of all production.” And, to let no doubt, he added that “the interest of the producer ought to be attended to, only so far as it may be necessary for promoting that of the consumer”. This being the case, the natural way to maximize society’s welfare is by promoting free markets, which make ample use of the advantages of the division of labor, specialization and trade. Prices and quantities traded are determined by the free interaction of supply and demand. This explains why Smith accepted that one of the functions of the Government was to promote the construction of “high roads, canals, &c” which support commerce.
Accordingly, “[i]n every country it always is and must be the interest of the great body of the people to buy whatever they want of those who sell it cheapest.” And he adds: “The proposition is so very manifest that it seems ridiculous to take any pains to prove it.”
More from Thelmo Vargas-Madrigal:
On the objective-functions of firms and consumers/ Sobre los objetivos de las empresas y de los consumidores
Adam Smith on Taxation/ Ideas de Adam Smith en Materia Impositiva
Adam Smith on Fiscal Policy/ Adam Smith y Política Fiscal
Reference:
Check, for instance, J.M. Henderson and R. E. Quandt, Microeconomic Theory—A Mathematical Approach, McGraw/Hill Book Company, Inc., New York, 1958. Pages 12 & 13.