The captain, taking the order at Table No 3, asked "regular water or mineral water?" An irritated Wafers waved him off suggesting that "ordinary" would do. Pay Rs 15 for mineral water, huh thought Wafers. "So you think the water is too pricey?" remarked China, the IITian. A shocked Wafers asked, "How did you know?" Muscles, studying to become a heart surgeon, said "Elementary, my dear Wafers. The scorn in your face told it all." Wafers decided that she must attend some seminar on body language. The CA course gave her no insights on this.
Muscles was prescribing. "You see, the water in Chennai is bad. With the Tsunami having struck, epidemics will be on the rise. It pays to drink mineral water." China, ever eager to compare the dragon (China) with the elephant (India), wondered how the Chinese would have dealt with the problem.
Wafers' mind lay elsewhere. She was thinking of the beautiful gift her dad had bought on New Year eve. "You see, my dad bought diamond earrings for my mom last week," she told the gang. "What?" screamed Muscles. "The country is agonizing over Tsunami and your dad blows money over diamonds." Wafers didn't say, "Look it's my dad's money". Instead she said, "Hey, forget Tsunami. I am fatigued by it".
China couldn't help smile. The irony was palpable. Here was the daughter waving off a captain who had suggested a Rs 15 mineral water. And there was her father buying diamond earrings worth Rs 25,000/-. He asked: "Do you think that what is more valuable should always cost more?" Wafers roared 'Of course'. China continued: "Wrong. We need water to live. We don't need diamonds to live. If the benefit of water outweighs the benefit of diamonds, why does water cost practically nothing while diamonds are terribly expensive?"
Wafers choked. "Come on", she thought, "this is crazy". And then she remembered Lionel Robbins from her Economics class. "What had he said? Ha, Economics is a science of scarcity". She told China: "Because, water is available in plenty. (Water, water everywhere.) And diamonds are not." She felt she had served an ace. "Not really", said China. Muscles joined in, "I think I have the answer". Is he going off on a medico talk thought Wafers. "A household's consumption choices are determined by two things, Income and Preferences," remarked Muscles. Wafers realized Muscles was speaking economics. "How much we consume is limited by our income. So, given an income to spend, how we divide between two goods depends on our likes and dislikes - our preferences."
"Super doctor" thought Wafers, now back on her time machine. She remembered her professor explaining preferences. "Economists use the concept of utility to describe preferences. The benefit (or satisfaction) that a person gets from the consumption of a good or service is called utility", he had said. And for elaboration had added, "Total utility is the total benefit that a person gets from the consumption of goods and services. The more you consume, the more is the total utility as each unit provides some utility," he had said.
The professor had then explained the phrase marginal utility. Wafers had thought that "marginal" meant "negligible." But the professor said: "Marginal utility is the additional utility arising out of consuming an additional unit of the commodity." Her friend had supplied an example. If the total utility of 100 units is 1000 utils and that of 101 units is 1020 utils, the marginal utility is 20 utils.
"So you are thinking about utility, marginal utility and the law of diminishing marginal utility?" asked a grinning China. Wafers was shocked. Was her face so transparent? For the second time that evening she decided that she must attend some program on body language.
"Yup", said Wafers. "I think this water-diamond paradox has to do with marginal utility. See, as we consume more and more of something, the desire for that item reduces. Marginal utility reduces with increasing consumption". Noticing Wafers sip her third cup of Coke, Muscles remarked, "I guess having gulped two cups of coke, you are not that desperate for the third. The marginal utility of the third cup is much less than that of the first." Touché.
China now got into the act. "How should a person divide his income over the two goods"? And himself supplied the answer: "The spending should maximize total utility." For Wafers it was all dejavu.
Her professor had said: "A household's "income" and the "price it faces" limit the utility that it can obtain. Based on income and price, a household consumes goods in such a way that they maximize total utility". She again remembered Lionel Robbins. "Wants are unlimited. But resources are limited. To meet those wants, people must make choices." The professor had rounded up saying "In making these choices, they try to maximize total utility." It had looked heavy stuff then. She had simply jotted it down and gulped it into her memory!
Wafers was brought back to the present by China, who asked: "How does a person divide his income between two goods?" As both Muscles and Wafers watched, China continued, "Suppose a person keeps flipping between two goods. At what point will he stop?" Muscles said, "When he feels that there will not be any change in utility when he switches from one item to another". Wafers pitched in: "And that would happen when the marginal utility for every extra rupee we spend is same for both the items". Bravo.
"I think we are about to crack this riddle," remarked China. For centuries, philosophers had been puzzled over why water, so essential to life itself, costs little, but diamonds, (useless compared to water) were expensive. "Yes," said Wafers. "We can explain this by distinguishing between total utility and marginal utility. The total utility that we get from water is enormous. But, because we consume a lot of it, the marginal utility -- the benefit we get from one more glass of water -- diminishes to a tiny value. Diamonds, on the other hand, have a small total utility relative to water, but because we buy few diamonds, they have a high marginal utility. As a result, they are priced high." She was impressed by her own analysis.
China agreed and disagreed! "The first part is OK. But why should this make the price of diamonds so high?" And with characteristic IIT flamboyance he said, "When a household maximizes its total utility, it allocates its budget in such a way that the marginal utility per rupee spent is equal for all goods". Muscles asked, "You mean the marginal utility for a good divided by the price of the good is equal for all goods?" China nodded. And added: "This is true for diamonds and water as well. Diamonds have a high price and a high marginal utility. Water has a low price and a low marginal utility. When the high marginal utility of diamonds is divided by the high price of diamonds, the result is a number that equals the low marginal utility of water divided by the low price of water. The marginal utility per rupee spent is the same for diamonds as for water."
Wafers wondered whether China had a reservoir of brains.
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