Marginalism describes both an economic method of analysis and a theory of value. According to this theory, individuals make economic decisions "on the margin"; that is, value is determined by how much additional utility an extra unit of a good or service provides. It would be difficult to overstate how important this concept is to contemporary economic understanding. The development of marginal theory is commonly referred to as the Marginalist Revolution and is seen as the dividing line between classical and modern economics.

The Marginalist Revolution

Adam Smith was the founding father of economic science, but even he was perplexed by real economic value: Why do people sometimes value non-essential goods more than essential goods? A paradox in value appeared to exist that couldn't be rationally explained.

The best-known example of this is the diamond-water paradox. Even though diamonds serve no vital purpose and water is essential to human life, individual diamonds are far more valuable than individual units of water. On the surface, it seems like water should be worth more.

Independently and almost simultaneously, three economists solved this puzzle in the 1870s: Stanley Jevons, Carl Menger and Leon Walras. They suggested that individual consumers don't choose between all of the world's water versus all of the world's diamonds; obviously, they would pick water if given that choice.

Rather, individuals pick between increments of a good. They separately determine the worth of having one additional unit of water or one additional unit of diamonds. These individual choices are made on the margin. Ostensibly, water is far easier to come by, and most people already have access to enough water to fulfill their wants. In these conditions, the value of that extra unit of water is relatively low. This is not usually the case with diamonds, because diamonds are rare and expensive to buy. Of course, an incredibly thirsty man in the desert might value that extra unit of water more than an extra diamond.

The development of marginalism theory helped to better explain human rationality, human action, subjective valuation and efficient market prices. In so doing, marginal analysis opened the door for a new era in microeconomics.