People See Taxes and Positive Marginal Utility

I once had a professor named Babu Nahata.  If you were one of those students who wanted to go to class and just sit there, then you would probably drop his class.  Being older and foreign, some of the awkward moments that would emerge from being less than “nice” in a classroom were lost on him.  One thing in particular made students very uncomfortable.

He would ask a question of the class and then stare at us until someone answered.  He wouldn’t just stare at the back wall or scan across the room.  If you looked up at him and made eye contact, then you had been caught.  There was no escape.  He would look at you looking at him.  You wanted to look down or away, but that wouldn’t stop his gaze.  His mouth agape, he’d stare at you particularly and give intermittent nods as if to say “That was in fact the question and now it’s time for you to answer”.

We being undergrads and he being foreign, most students didn’t know the answer and couldn’t decipher from his tone which bias would best serve them to provide the least wrong answer.  He would keep staring until enough people answered incorrectly or until no fewer than 2 minutes passed (think about that. 120 excruciating seconds of an old Indian dude staring, slack-jawed, and you mentally pleading for it all to just go away).

One such question that Nahata asked in an intermediate micro class has stuck with me ever since.  He drew a supply and demand graph on the board and asked “What is this?”.   Maybe some people weren’t econ majors.  Maybe they knew the ways of the Nahata due to prior experience.  Being a confident econ major, I raised my hand and Nahata looked at me (that’s another thing.  He wouldn’t call on anyone – just look at them).

“Supply and Demand” I said.


This was obviously a trick question.  I knew for a fact that it was supply and demand.  What was his angle?  I was not amused.  The stare didn’t go to another student – it remained on me.  And after an answer like mine, what the hell could anyone try?

Finally, after much discomfort by everyone but himself, Nahata said “This is MARGINAL demand and MARGINAL supply”.

I felt cheated. “What silliness.  OF COURSE it is. A petty distinction.”

Years later, in grad school, the significance of his answer and its relevance to my other micro foundations finally dawned on me.

Supply and demand is about transactions.  It’s about marginal or additional transactions.  Once costs have been born, transactions made, and welfare enjoyed, then it’s all over.  What’s next? Another time period and more marginal welfare. There is no stock of welfare.  Another professor of mine had controversially asserted that consumption was the destruction of welfare.

Now my claim is that taxes don’t reduce welfare.  If in the previous period I transact ten times, a tax is introduced, and then in the next period I transact seven times, then how can it be said that my welfare is reduced?  I enjoyed positive additional welfare from the past ten transactions, and I’ll enjoy even more welfare from the next seven.  Where is the loss in utility?  Supply and demand doesn’t have anything to say about the total stock of utility – that’s not a real thing.  What we have is continuous time, that we can segment for ease of analysis, during which we have a volume or stream of additional utility that varies in magnitude.

Taxes don’t make you worse off if you were doing nothing in the first place.  They don’t change your stock level of utility (there isn’t meaning in such a thing). Taxes do have the effect of reducing the total additional transactions in a market. It is therefore wrong to say that taxes reduce your utility.  It is more accurate to say that the marginal utility is less than it would have been without the tax.  Introducing taxes into a market where welfare flows were previously [and continue to be] positive simply reduces the amount of additional utility which you enjoy.  You are not worse off.  If the default action is that you make transactions, then the amount by which your utility flow would decrease is typically what we label the cost of a tax  (There are additional problems with this illustration of loss in a general equilibrium model, but that’s another post).

Because the welfare stream is usually positive, it’s hard to show someone who hasn’t been trained in economics where the harm from bad tax policies lie.  They look at a market and say “Behold, the positive utility stream.  We are not worse off.”  If they think that positive marginal utility implies that people still prefer life to death, then they are strictly correct.  People only remain alive when doing so is better than the alternative.  The default of not transacting doesn’t happen, people trade and enjoy positive marginal utility, and therefore must be better off than they’d be by not transacting at all.

This is part of the difficulty in convincing people that poor tax policy is in fact poor.  It’s a point that Bastiat famously argued.  The relevant point of comparison is not whether you are better off now with a tax VS not having transacted.  Of course you are better off.  The point of comparison is what you would have done if that tax were not present.  And we do not see the non-transactions taking place. We are comparing two potential [positive?] utility streams, only one of which may happen.  We are comparing relative marginal utilities between reality and a circumstance which never occurred.


PS – If we really do care about the marginal utility within time, then how is this related to RGDP?  Might this lend validity to RGDP as an indicator of well-being since RGDP is a flow – just like marginal utility?

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