How do we determine the value of things? Aristotle had asked a question that remained unanswered through centuries: Why water that is vital for all life is cheap, while diamonds are expensive, even though we can live without them? We had to wait for a long time for an answer provided by economic law of diminishing marginal utility.
Imagine that all you have is merely one apple. It is really precious for you, because it allows you to satisfy your hunger, and stay alive. For you this apple is absolutely essential, and you have to eat it right away. After that you decide to go for a walk and you come across two more apples. You are very happy with your find, so you eat the second apple to your heart’s content. You decide to keep the third apple for later because you are already full. As you stroll further, you stumble on a whole garden with hundreds of apples hanging from trees. It seems to you that your biggest dreams came true, so you decide to settle down near the garden. After a mere week you grow tired of the apples. In fact, at this time a mere thought of their taste seems nauseating to you, and you can’t even look at them any longer.
Your neighbour Gregory has a pear farm only a few hundred yards from your garden. He has the same problem you have, only with his pears. He has been eating them for few months now and he is fed up with them. So you meet with him and you both agree to exchange your produce. One pear from Gregory’s farm is worth much more to you than your apple, but the exchange is still fair, because Gregory values your apple much more than he values one of his pears.
This story provides several important points.
Each additional unit of a given good satisfies a less important need. The first apple appeases your hunger, letting you survive; the second apple fills you up; the third apple can be saved for later, thus satisfying your need to avoid future hunger.
This implies that each additional apple you have is worth less to you. The first one for you was a priceless necessity needed to avoid starvation; the second one was merely a pleasurable snack. With each consecutive apple its worth fades away in your eyes.
There are no goods of fixed value. They are valuable as long as people value them, and only to that extent. Imagine yourself one day finding a large and heavy statue bought many years ago by your grandfather, a sailor by trade, for your grandmother — a young woman then. You don’t really like the statue; it is only collecting dust. You decide to sell the statue to get rid of it. You think to yourself: “If someone would only pay for its delivery, then it would save me from the trouble of throwing it out.” It turns out that the price of the statue skyrocketed to 500,000 dollars because of bids made by two eccentric and rich art collectors. In fact they searched for the statue for the last ten years, because it was the last piece of a collection they were both trying to complete. This example shows that one and the same good can be valued very differently by different individuals.
Let us go back to the question posed by Aristotle. In case of a massive drought everyone would value water more than even the rarest of diamonds. We have no real use for diamonds while we are dying of thirst. But where there is plenty of water, our thirst may be quenched easily. Typically we value diamonds much more than water, because when we’ve got shelter, we don’t suffer from hunger nor from thirst, then we tend to satisfy our more sophisticated needs like aesthetics.
Diminishing marginal utility is true for money too. If you don’t have any money at all, then 1000 dollars will change your life substantially. You can use the money to rent a humble flat and buy some food. Although it won’t be a fancy existence, it will still be a huge positive change in your quality of life as compared with being homeless and constantly starved. But if your monthly income is 5000 dollars, then another 1000 dollars won’t improve your quality of life that much. Obviously you still want it, it will still be a substantial gain, but it won’t be a matter of life and death anymore. If your income is 1 million dollars, you might not notice another 1000 dollars. It may even not be desirable at all, because million dollars a month may pay for all of your material needs, and for you such things as love, time spent with your family, your own health, and leisure may hold even more worth. As those things cannot be bought, you may consider chasing additional money as futile, and choose to rather spend your time with your family.