1 - Value, cost and price: a historical introduction to marginalism

Summary

Marginalism is a branch of economic theory that investigates what goes on at the margin of economic activity. Economic activity can be divided into producing and selling (the supply side), and consuming and enjoying (the demand side).

Let us imagine a farm that grows potatoes that are sold to and bought by the inhabitants of a small village. The amount of available fertile land is limited, which implies that the farm can only produce a certain amount of potatoes. Let us further assume that the population of the village grows, and consequently more potatoes are needed to feed the villagers. As the farm can only produce a limited number of potatoes, the inhabitants of the village will bid against each other to buy them and the farmer will be able to raise the price of the potatoes. Given that the price of potatoes has increased, the farmer may find it profitable to increase production. She may try to find additional land for cultivation, but this would require serious investment. The farmer may also try to produce more potatoes on the land she already has, by employing more labourers and/or by utilizing more equipment and manure. In either case, producing more potatoes will drive up the cost of growing each potato for the farmer. The farmer will increase her production if the additional income that she generates by selling more potatoes exceeds the additional expense required to produce them.

Economists would consider this to be the “margin” of the economic activity: the conditions under which the last potato is produced. An additional potato will generate additional income or marginal revenue, but it will also have to be produced using additional expenses or marginal costs. Therefore, when more potatoes are produced, which means that the margin is extended, the marginal cost of a potato will increase. The farmer will produce more potatoes as long as the marginal revenue from a potato exceeds the marginal cost of that potato. The marginal revenue is determined by the price that the inhabitants are willing to pay for a potato. Since potatoes are required for the survival of the inhabitants, they are in high demand.