Jacob: Welcome to Crash Course Economics. I'm Jacob Clifford.
Adriene: And I'm Adriene Hill. We've been discussing macroeconomics: GDP, unemployment, fiscal and monetary policy. Now, we’re going to start talking about microeconomics. Microeconomics looks at individual markets and the decision-making of consumers, businesses, and governments. It answers questions like, "How many workers should we hire?" "Is increasing the minimum wage a good idea?" and "Why is health care so expensive?"
Jacob: You might be wondering which is more important: micro or macro? The answer is micro/macro. Actually, macro/micro. They're both essential.
Let’s start with one of the most important concepts in microeconomics: marginal analysis. For economists, the word "marginal" is pretty much the same as "additional." Marginal analysis examines how individuals, businesses, and governments make decisions, focusing on additional benefits and additional costs.
Businesses do the same when deciding how many workers to hire. They compare the additional revenue that another worker will likely generate for the company to the additional cost of hiring that worker, including wages and benefits. If hiring that worker brings in more marginal revenue than marginal cost, then congratulations! Someone's got a job!
This idea can also apply to people's feelings about things. Take the development of city parks: citizens obviously get more total satisfaction from four city parks than from only three. But that doesn’t necessarily mean the government should build four parks. Instead, the government looks at the additional benefit or satisfaction generated by the fourth park and compares it to the additional costs, which include the use of city land and tax money spent on construction. If the additional benefit is higher, then they build the park. The government continues doing this for each additional park. The benefit of the first park is greater than the additional benefit of the second park, and so on. Eventually, the marginal benefit of another park will be less than the marginal cost, and they will stop building.
Sure, it’s nice to have lots of parks, but the difference between having 200 parks and 201 parks is pretty small. This is the Law of Diminishing Marginal Utility. By the way, when economists talk about consumers, the word "utility" refers to the satisfaction or happiness people derive from consuming a good, a service, or 201 parks. You could reword this as the Law of Decreasing Additional Satisfaction. As you consume additional amounts of something, you'll eventually get less and less additional satisfaction.
It's like how the first slice of pizza or cookie you eat is fantastic, and the second might be even better. Still, eventually, each additional slice gives you less enjoyment. Economists have even created a term to help quantify satisfaction called "utils."
Utils are like happiness points and are completely subjective. One person might get 100 utils of satisfaction from the first slice of pizza, while another might only get 10. So, these concepts make sense, right? But the whole numbers thing, this "utils" idea, does seem a bit contrived. People don't actually make these calculations, do they?
Yeah, they do. You might not write them down or think about your happiness in terms of utils, but you unconsciously use marginal analysis every day.
Let’s go to the Thought Bubble.
Marginal analysis can explain all sorts of human behavior. Let’s say Stan goes to an amusement park. He’s unlikely to ride the best ride in the park—the tallest rollercoaster—over and over all day. Why? Even if there’s a one-time park admission fee and the rollercoaster is free, there’s still a cost: how long he has to wait in line. So Stan estimates his marginal utility of riding the ride and compares that to the wait.
Riding the best rollercoaster might give him the highest utility of all the rides in the park, but it might not be worth waiting in a four-hour line. A smaller ride gives him less utility, but if the line is super short, he’ll choose that one instead. Even if there’s no line for the large, super-awesome rollercoaster, he probably won’t ride it all day because eventually it gets old.
Marginal analysis explains the behavior of consumers like Stan, but it also explains the pricing strategies of businesses. Assume instead that the rollercoaster charges $5 for each ride. Because Stan gets less utility each time, he might not be willing to pay full price for the third ride. The seller gets this and figures it might be better to charge Stan less for that third ride. That’s why we have deals like "Buy two, get the third half off."
The point is, we all use marginal analysis when making decisions.
Thanks, Thought Bubble. So that's marginal analysis. Armed with our new knowledge, let’s go back and look at the most important model in microeconomics: supply and demand.
Let’s use the market for strawberries. Remember, the price of strawberries is on the vertical axis, and quantity is on the horizontal axis. The demand curve for strawberries is downward-sloping, showing the Law of Demand. When prices are high, people don’t want to buy very many, and when prices are low, people want to buy a lot.
The shape of the demand curve reflects the Law of Diminishing Marginal Utility. The first pint of strawberries you buy gives you a lot of additional utility. The second one gives you a bit less, and the third pint even less. If you eat ten pints, you’re going to get sick. So, as you consume more, you’re willing to pay less and less. This explains why the demand curve is downward-sloping and why it’s essentially just a marginal benefit curve.
The supply curve is upward-sloping, representing the Law of Supply: an increase in price gives producers an incentive to produce more. It turns out that supply curves are really just marginal cost curves, representing the additional resources and energy that each additional pint of strawberries costs.
This graph explains why markets tend to be so efficient with scarce resources. If strawberry producers produce too few strawberries, the marginal benefit of the last unit will be greater than the marginal cost. That’s the market calling out for more strawberries: "Give us strawberries, please!" If they produce too much, the marginal cost would exceed the marginal benefit, wasting resources on things that consumers don’t value.
Equilibrium is efficient because the marginal benefit of the last unit consumed equals the marginal cost of that unit. The market is making the exact amount that consumers want. This relates to an example Adam Smith used: Why are diamonds more expensive than water? Water is crucial for survival, while diamonds do nothing but sparkle. Yet, the price of a bottle of life-giving water is around $1.20—if you're overpaying for water—and the average one-carat diamond is well over $3,000.
This is called the Diamond-Water Paradox, explainable by marginal analysis and the Law of Diminishing Utility. The total utility we get from water is very high, but since it’s so plentiful for most, the marginal utility is really low. If you can stay hydrated, cook, shower, wash your clothes, and occasionally use your slip 'n' slide, the additional satisfaction of another gallon of water is small, resulting in a lower price.
On the other hand, diamonds are extremely scarce due to the expensive and dangerous extraction process. With few diamonds available, the additional satisfaction of obtaining another one is relatively high, so people are willing to pay a higher price. If diamonds fell from the sky like water, we wouldn't derive much additional satisfaction from them, and their price would be low. It might seem irrational that society values diamonds more than water, but using marginal analysis, it sort of makes sense.
Relative scarcity contributes to a product's value—partially explaining why Action Comics No. 1, the first comic book featuring Superman, recently sold for over £3 million on eBay. However, just because something is limited doesn’t automatically make it valuable. There are plenty of other scarce items that we don’t value as highly as diamonds, like panda boogers. They’re super rare, but we don’t use them in engagement rings or pay outrageous prices for them.
The point is, utility is subjective, and demand depends on the tastes and preferences of consumers. That’s why there’s no market for panda boogers.
Wait, Stan tells me that because of the internet, there does seem to be a market for panda boogers! But it’s probably a small one. I think the example still holds.
Anyway, demand also depends on the number of substitutes. For instance, strawberries have plenty of substitute goods: cherries, raspberries, blueberries. When the price of strawberries goes up, consumers buy less because they’ll choose something else instead. This is known as the substitution effect, which, along with the Law of Diminishing Marginal Utility, shapes the demand curve.
Let’s see what this looks like in the real world. Have you ever wondered why gas stations don’t have sales? It has to do with substitutes and what economists call elasticity of demand. Elasticity shows how sensitive quantity is to changes in price. When the price of gas rises, people don’t buy that much less because they need it, and there are few close substitutes.
Now, while you can walk, ride your bike, or get an electric car, there's nothing else you can put in your current gas guzzler. This relationship works in the opposite direction as well: if gas stations had sales, consumers wouldn’t buy much more gas. Economists would say that the demand for gasoline is relatively inelastic—a large percent change in price leads to a small percent change in quantity demanded. This is represented on the graph by a steeper demand curve.
Other products with relatively inelastic demand include electricity, healthcare, and coffee—there’s no substitute for my five cups of coffee in the morning. Some products have perfectly inelastic demand; if the price goes up, people who can afford it will always buy the same amount. An example is insulin for diabetics because they need it to survive.
What about the demand for pizza? There are many close substitutes. I could eat a burrito or a burger; I don't really need pizza. So a small increase in price could cause demand to decrease significantly. For pizza, the demand curve would be flatter, indicating that the demand for pizza is relatively elastic. If a pizza place has a sale, many customers would choose pizza over other substitutes like burgers and burritos.
Now there’s also elasticity of supply. A steep curve shows the supply is relatively inelastic, meaning a large change in price leads to a small change in quantity supplied. For example, building an airplane is difficult and time-consuming, so even if a buyer is willing to pay more, they’ll still have to wait.
Relatively elastic supply occurs when quantity is sensitive to price changes because producers can respond quickly—items like t-shirts and strawberries. On the other hand, the supply of Vincent Van Gogh paintings is perfectly inelastic. When the price goes up, the quantity doesn’t change. It doesn’t matter if people want more; Van Gogh isn’t going to paint anymore.
So, that’s microeconomics in a nutshell. It doesn’t focus on GDP or unemployment; it analyzes the details. Understanding concepts like marginal analysis and elasticity is helpful. You’re going to use them to make decisions anyway, so you might as well understand what’s happening. Ideally, that will help you make better choices.
We hope the additional benefits of watching this video outweighed the additional costs. I’d say it was at least 50 utils for me.
Adriene: And not that it’s a util contest, but I’d say it’s 55 utils.
Jacob: See you next week!