Many real-world phenomena can be explained by applying theory of consumer choice. Let’s just explain two of them.
The Water-Diamond Paradox
Adam Smith was puzzled by the fact that some essentials goods have lower price value than do some unimportant goods. For example, why water, which is essential to our life, has lower price than gold, which is not as useful as water is? This paradox can be solved by knowing that water is in a greater supply relative to diamond, so the price of it should be lower. In contrast, diamonds are very rare and costly so mine.
The marginal unit of water is lower than that of gold. The reason is utility-maximizing rule. That’s why consumers and producers use it in abundance at producing electricity, heating building, irrigating soil and so on. Consumption is expanded until its marginal utility, which permanently declines, equals to its low price. Conversely, less diamonds are purchase because their price is very high, so their marginal utility remains high.
Although marginal utility (MU) of water is low and that of gold is high, the total utility (TU) that water produces is very high but total utility (TU) of gold is quite low. Total utility derived from water is very high because we use it at different activities and in very big amounts it is the sum of marginal utilities of all liters used (that can be millions or even more). However, total utility got from diamonds is very low, because of their high price, which means that only a small quantity of diamonds is bought. So water-diamond paradox is solved: water has much more total utility than diamonds, even if the price of latter one is very high. But relative price relate to Marginal Utility not Total Utility.
Cash and Noncash gifts
Marginal-Utility rule also may help us to understand why people generally prefer cash to non-cash gifts, which cost the same amount of money. Explanation is easy, non-cash gifts may not match receiver’s wants or preferences, and don’t value as much total utility as cash does, because receiver know their own preferences better than the gift-giver does. Also cash offers more choices how to spend that amount of money.
Since giving of non-cash gifts is common, considerable value of the gift may be lost if they don’t match receiver’s wants. For example your mum paid 20 $ for the Madonna’s audio CD she gave you for birthday, but you would pay for it maximum 15$. So, there is an amount of money lost. If we multiply this amount by million or billions of dollars spent each year, we’ll get an enormous number.
However there may be some creative ways of handling this problem. People may obtain cash refunds or exchanges for these gifts. So they may maximize their total utility.
This is economic way of thinking. So we have to respect it. That’s why I underlined “generally” word there. People are different, so their tastes and wants are, as normally, different and the ways of handling these situations may be diverse.
Finance & Economics!!! 