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Does wealth experience diminishing marginal utility?

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Confucius Posted: Fri, Oct 26 2012 1:31 PM

Thoughts?

If the answer is yes, what are the implications? Suppose that two people have equally honed skills and experience at innovation and entrepreneurship. But one of them, Jean Luc, is already raking in $10 million a year while the other guy, William is bringing in $200k per year. If the aquisition of wealth experiences diminishing marginal utility, will Jean Luc have less incentive to use his skills toward new innovation and new entrepreneurship with the same furvor as William would?

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Neodoxy replied on Fri, Oct 26 2012 1:39 PM

There has been a fair amount of writing on this subject, but the biggest problem with our analysis here is that preferences are not constant. While necessarily money must experience decreasing marginal utility, the thing is that people's preferences change, and a large part of this is dependent upon previous experiences. For instance if you take money away from someone who's used to having 4 course lobster dinners every night, a big pool, and a mansion filled with playboy bunnies, then if you decrease his wealth to that of a merely moderately wealthy man, then he may experience much less utility than if you had brought him down to this state when he was newly rich and was just getting used to luxury. However his luxury has may well now have become a very part of his preference set.

We are many times wealthier than the average man living a century ago, but we really don't act like it in how we seem to judge our utility for goods.

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Anenome replied on Fri, Oct 26 2012 1:51 PM

The implications are that for all intents and purposes, having $10b is functionally equivalent to having $100b. Both fortunes are essentially unspendable :P Which is why you have Gates and the like simply giving away entire fortunes to charity.

Too bad Gates wasn't a libertarian, we could've had him funding seasteads and junk :P

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Unspendable? 10b would buy just a couple of aircraft carriers, or just one, if you want to support it.

With 100b, intelligently spent, you could actually have a fighting chance against most militaries :)

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Anenome replied on Fri, Oct 26 2012 2:36 PM

Andris Birkmanis:

Unspendable? 10b would buy just a couple of aircraft carriers, or just one, if you want to support it.

With 100b, intelligently spent, you could actually have a fighting chance against most militaries :)

I know, haha, I had a similar thought. It's not really unspendable if your eyes are big enough :P but if you just want to consume personal luxuries it's pretty much unspendable :P That'd buy a whole lot of caviar. Even Gates's house was only $500 million.

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Confucius:
If the aquisition of wealth experiences diminishing marginal utility, will Jean Luc have less incentive to use his skills toward new innovation and new entrepreneurship with the same furvor as William would?


Wealth =/= Money.  See this article by Bob Murphy, "Money vs. Wealth", and/or the Mises Wiki:

https://mises.org/daily/4507

http://wiki.mises.org/wiki/Wealth

The more/less money you have does not in any way diminish a person's entrepeneurship abilities.  A poor person can still be a successful entrepeneur by providing customers what they want (making profits), and a relatively rich person can be a horrible entrepeneur (making losses).  All that matters is being able to forecast the future wants of consumers better than the other guy, and being able to then provide that good/service for the customers.

Also, try not to confuse revenue with profits.  Just because you are making $10 million a year in revenue compared to the other guy's $200k revenue, DOES NOT mean you are a better entrepeneur.  Although quite advanced (not too sure how deep you are in the economics literature), I would recommend reading Man, Economy, and State for many more details.

Yes, money has a diminishing marginal utility, but this is just the nature of satisfying wants.  The first unit of a good will satisfy the most urgent want, while second/third/fourth units will begin satisfying lower wants.  Wants are infinite, so there are ALWAYS more wants to be satisfied, whether you have $10, $100,000, or $10,000,000,000.

Also, as a side note, be sure to NOT fall into the trap of interpersonal comparisons of utility.  Remember that utility is ORDINAL (think ranking system, 1st, 2nd, 3rd, 4th,.... nth), and not cardinal (1,000,000 utils, 500,000 utils, 100,000 utils, .... .0000001 utils).

There is a common argument for welfare in which they try to use Diminishing Marginal Utility to try to justify very high tax rates on the rich, because "a dollar gives a lot more utility to a poor person than a rich person."

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Confucius replied on Fri, Oct 26 2012 4:23 PM

This seems like it would be relevant to tax policy. The claim from the right typically is that lowering taxes increases a government's revenue and that taxing wealthier people will harm investment and entrepreneurship. 

If wealth experiences diminishing marginal utility, then as one gains more wealth wouldn't they have less incentive to take risks or push themselves in other ways to aquire more? I'm not sure how this could be tested but if it's true then it might be possible to show that people with increased levels of wealth beyond a certain point put increasingly less of it at risk and have fewer entreprenureal and innovative contributions. Ultimately such people would still invest vast sums of money but perhaps not as much as they would if they thought some greater satisfaction could actually be gained from it.

 

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Confucius replied on Fri, Oct 26 2012 4:27 PM

There is a common argument for welfare in which they try to use Diminishing Marginal Utility to try to justify very high tax rates on the rich, because "a dollar gives a lot more utility to a poor person than a rich person."

Yes this is what I'm curious about. Not necessarily for welfare but in terms of state revenue and the argument people have about the impact of taxes on revenue. I agree with everything else you said although I mostly don't find it relevant to my initial "implications" question.

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Confucius:
as one gains more wealth wouldn't they have less incentive to take risks or push themselves in other ways to aquire more?


Every person has a certain subjective level of "riskiness" (I would be careful with the terms "risk" and "uncertainty", they get very easily confused) they are willing to take, but that is not dependant on wealth, it is just based on their personal preferences.

For more specifics on the Risk/Uncertainty seperation, I would recommend a little of "Man, Economy, and State" Chapter 8.9, and its relevant footnotes (Footnotes 39, 40, 42):

https://www.mises.org/document/1082/Man-Economy-and-State-with-Power-and-Market

The example that always pops into my head is getting a loan.

Someone may be willing to get a loan from the bank only by putting up some of their savings as collateral, another person might be willing to put up their house/car/left kidney/life savings, thus getting a much lower interest rate than the other guy.  Person A or B can either be rich or poor, it does not really matter... all that matters is that Person B has a higher willingness to take on risk than Person A.

Confucius:
I'm not sure how this could be tested but if it's true then it might be possible to show that people with increased levels of wealth beyond a certain point put increasingly less of it at risk and have fewer entreprenureal and innovative contributions.


Again, this is just dependant on the individual's subjective "risk preference" (I don't know the official term for it off the top of my head).  If anything, I would argue that "safe" preferences would be satisfied first, while more and more risky things get taken on the further down the scale you go... Sort of like a person's Preference Scales except focusing solely on risk.

1st: I would prefer to invest $1,000 and have a 90% chance of getting $10,000.
2nd: I would prefer to invest $1,000 and have a 80% chance of getting $10,000.
3rd: I would prefer to invest $1,000 and have a 75% chance of getting $10,000.
...
nth: I would prefer to invest $1,000 and have a 1% chance of getting $10,000.

But in real life things are not that easy, usually the more "risky" something is, the higher the payoff, and it is up to each person's subjective preferences as to how much risk they are willing to take compared to the potential reward.  Person A might only be willing to go to the 75% success rate, while Person B might stop at a 10% success rate.  Also, the scales are constantly changing.

1st: I would prefer to invest $1,000 and have a 50% chance of getting $100,000.
2nd: I would prefer to invest $1,000 and have a 90% chance of getting $10,000.
3rd: I would prefer to invest $1,000 and have a 1% chance of getting $1,000,000.
4th: I would prefer to invest $1,000 and have a 80% chance of getting $10,000.
...
nth: I would prefer to invest $1,000 and have a 1% chance of getting $10,000.

I would recommend Man, Economy, and State.  I believe Rotbhard tackles this sort of thing using the ERE (Evenly Rotating Economy) and profits.  Over time, the amount you would need to invest would get higher and higher as well, and real profits would tend towards zero.

Confucius:
Ultimately such people would still invest vast sums of money but perhaps not as much as they would if they thought some greater satisfaction could actually be gained from it.


All depends on their subjective preferences and levels of risk they are willing to take.  As mentioned above, this is all subjective and constantly changing.

Confucius:
Yes this is what I'm curious about. Not necessarily for welfare but in terms of state revenue and the argument people have about the impact of taxes on revenue.


You mean the Laffer Curve?  There is definitely a lot of articles on Mises about the subject, and definitely a few speeches on the topic.  I definitely know they discuss it in the Mises Universities, I am just trying to find out in which speech covers it specifically.

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Confucius replied on Thu, Nov 1 2012 12:01 PM

All depends on their subjective preferences and levels of risk they are willing to take.

Thanks for the reply. However I think this is a given and only begs the question. Of course everyone has different perferences in their willingness to take risks.What I am curious about is the impact that increased wealth has on one's subjective willingness to take investment risks.

 

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Groucho replied on Thu, Nov 1 2012 1:31 PM

If people are born into wealth or obtain it by total luck (lottery, inheritance) I believe it greatly increases their willingness to take risks. "A fool and his money. . ."

On the other hand, the wealthy who became that way by surviving in the markets usually develop a keen understanding of accounting and are driven to do better every year in comparison to how they did in the previous year. If anything I think they become more conservative in their decisions. They might be willing to risk more of their wealth in an investment as they get "richer", but not more likely to make decisions that are inherently riskier or apt to fail (barring senility. . .).

But at the logical extreme there is diminishing utility in the sense that one person cannot continue accumulating wealth forever until he owns all the wealth, even if he were immortal (imagine sitting on a pile of gold and diamonds high as Mount Everest and the world around you is barren as Mars and inhabited only by starving feral waifs). But that's a long, long way up from what anyone can obtain through legitimate market processes. Like all the worst horrors in history, it would take a government to make it happen.

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The Law of DMU definitely applies to wealth for a single individual. Each addition unit of wealth that I acquire is used to satisfy a want which is lower on my value scale than the want which was satisfied by the last unit of wealth I acquired.

But can we use the Law of DMU to make comparisons between several individuals? That is, to say something like "the rich value each additional dollar less than the poor."

Suppose a poor person is capable of satisfying wants #1-5 on his value scale out of his normal income, while a rich person is capable of satisfying wants #1-20 on his value scale out of his normal income. One additional unit of money for the poor person might allow him to satisfy want #6, whereas one more unit of money for the rich person might allow him to satisfy want #21. From this it might appear that we can conclude that the rich person benefits less from the gain (or suffers less from the loss) of an additional unit of money than the poor person, since for the rich person it's only his 21st most important want that's in question, whereas for the poor person his 6th most important want is in question - but that would be a mistake. The value scales do not line up; for example, we cannot say that the poor person's #6 is just as important as the rich person's #6. That X is #6 in the poor person's value scale refers to his valuation of X relative the other things in his value scale, not so some objective "quantity" of value, in the sense of #6 having "more" than #7. Hence, there's no basis for comparing the poor person's #6 and the rich person's #6. There's no common ground between them, no common feature/property in terms of which they could be compared.

All that said, even though we don't know whether the poor person's #6 is more important to him than the rich person's #21 is to him, and we can't know because there's no way to measure "how much" each person values each item except in relation to their other subjective valuations, I don't see anything wrong with saying "a dollar means less to a rich man than to a poor man," provided we take that as a loose way of speaking, and don't try to draw it out into an entire science of welfare economics.

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