What Would You Do With an Extra $100

For some Mainers, the answer might be to stock up on Allen’s Coffee Brandy and buy a few lottery tickets.  Others would pay off some credit card debt or put the money in the bank.  Some might buy blankets and towels to give to the local humane society to better care for furry friends.  A donation to the local food bank might be in order; or you might take your best friend out for an extra good meal.

Whatever your answer, economists would say that it has to do with the concept of marginal utility of income.  Economists assume that you would choose the option for newfound income that gives you the greatest extra (marginal) satisfaction (utility).

The idea of marginal utility is central to modern economic thinking.  Economists believe that for most goods or services humans experience diminishing marginal utility.  The first slice of cheesecake with chocolate sauce is superb, provides high utility.  A second slice may be good, but not as good as the first.  The extra (marginal) satisfaction (utility) from the second slice is less (diminishing).  The third slice of cheesecake is a struggle to get down and the fourth is sickening, perhaps creating negative utility.

If you took an economics course sometime in your life, you may remember demand curves.  They have a negative slope because of this idea that marginal utility is diminishing.  In most cases this explains why people are often willing to pay a higher per unit price for the purchase of one item than they would if they were buying two of that same item — diminishing marginal utility.  Hence the popularity of BOGO sales by retailers – buy one, get one half price.  You’ll buy the second item only if you can get it for less than you paid for the first.

It turns out that for most people, income is like cheesecake.  It has diminishing marginal utility.  After your basic needs of food, clothing, and shelter are met, extra income generates less utility than the income received just before it.

But every individual is different (coffee brandy vs. donations to the food pantry).  While economists are confident from lots of empirical research that diminishing marginal utility of income applies to individuals, they have long been reluctant to compare the utility of income between people.  The admonition to young economists is, “thou shalt not make interpersonal utility comparisons.”  Economists are supposed to be objective and leave ethics to philosophers or editorial writers.  Who is to say that choosing cheesecake over lottery tickets makes society better or worse?

So deciding who gets income is not a problem that economists like to address.

There are two problems with this insistence on nominal objectivity.  First, at least at the extremes, it is patently obvious that the marginal utility of income is different between people.  There is no denying that $100 would be much more valuable to a homeless person on a cold March night in Maine than it would be to Bill Gates or Mark Zuckerberg. So you can, in some case, make utility comparisons between people. Second, since much economic policy affects the distribution of income (see my early blog post Class Warfare?), economists cannot hide behind the veil of objectivity when it comes to income.

Here is the policy implication.  Even if public policy is neutral in terms of its effects on different income groups, that could disadvantage lower income recipients.  If the marginal utility of income is greater among lower income people, $100 to them will generate more total well-being than it would to those with higher incomes.  Just saying that a rising tide lifts all boats ignores this reality.

Saez -- Income Inequality Time Series

Share of U.S. Income Going to Top 10% — Source: E. Saez

 

As is now well documented, economic policy in the U.S. has led to a steady increase in income inequality since the 1970s. The highest income earners have gained the most.  In effect we have shifted the share of national prosperity steadily from those who may benefit more from extra income to those who likely benefit less from extra income.  Yes, I am violating the admonition to young economists.  I am willing to admit that making “interpersonal utility comparisons” is legitimate.

So as we confront proposals for replacing the Affordable Care Act or making changes in the Federal Tax Code let us stay keenly focused on distributional effects.  Who will get to decide what to do with an extra $100, or $1,000,000, as the case may be?

 

Mark W. Anderson

About Mark W. Anderson

I am proud to be a Mainer, born in Caribou and schooled at Brewer High School, Bowdoin College, and the University of Maine. I am grateful for a 35 year career at UMaine, the last decade in the School of Economics.