No Free Lunch: Economics for a Fallen World: Third Edition, Revised

Chapter Two: Fundamentals of Economic Behavior 43 most urgent wants first . This is known as the Law of Diminishing Marginal Utility . The more we consume of a good, the less utility a good provides. Let’s say you have five pairs of cheap sunglasses. The first pair might be with you all the time, so you’re always on the ready. Perhaps the second is used as a backup in the car. The next pair you might leave in your dorm room so if you misplace your primary pair, you have one readily available. Perhaps the fourth pair is in a different color, for just that right mood. Each one is valued progressively less, because we assume that individuals make valuations constantly and act to satisfy his or her most urgent need first. We will see in subsequent chapters that individuals make optimal decisions when the ex-ante (expected) marginal utility of a given activity just exceeds the ex-ante marginal utility of the next most preferred alternative that is not chosen. INSTITUTIONS ARE THE DIFFERENCE! Economists have studied various possible explanations for successful economies: natural resources, cultural differences, colonialism, etc. But the biggest driver of successful economies is the quality of their institutions. (See Mancer Olson’s fairly readable classic article on the importance of institutions.) In other words, rich countries get rich not by exploiting others, but by choosing institutions that enable economic growth. So what do we mean by institutions? And what are the key institutions which support economic growth? First, watch this short video on institutions by economist’s Tyler Cowen and Alex Tabarrok. The Importance of Institutions Now that you have some feel for why institutions matter, let’s explore the concept further. First, what are institutions? And what are examples of good and bad institutions? Nobel laureate Douglas North defined institutions as “the humanly devised constraints that structure human interaction.” As an example of these constraints, consider the rule of law. The rule of law (as opposed to the caprice of rulers) is critical to economic growth. Let’s think about why. Say you work really hard, and build up a $10 million business, and all of a sudden the legislature seizes all businesses worth more than $100 for “the good of the common man.” What are you likely to do? It’s not clear what you’ll do, but one thing that is not likely is for you to go out the next day and say, “Well that was bad luck. I think I’ll just go out and work 70 hour weeks for the next five years to get another $10 million business.” If there were no rule of law to give you consistent protection from arbitrary political corruption, why would you bother working hard? Somebody could always just come and take it. Law of Diminishing Marginal Utility: as more of a good is consumed, the additional (incremental, or marginal) utility is positive, but lower than the utility provided by the previous unit consumed