The first chapter was the methodological introduction to the topic of economics, in which the human action approach to studying was explained and illustrated. In this chapter, we turn to the substance of the field of economics, and introduce the foundational concepts of economics, and the main questions economics seeks to address.
The foundations of modern economics were laid by the work of Austrian economist Carl Menger in the late nineteenth century. While economics as a field of inquiry had been around for millennia, Menger’s explanation of the subjective nature of value and economic decisions, and his introduction of marginal analysis, revolutionized the field and gave it a solid theoretical and methodological foundation, allowing for a systematic analysis of how humans economize and act, and a richer understanding of the nature of the consequences of their economic actions. Menger’s Principles of Economics textbook, written in 1871, is possibly the oldest economics textbook that is relevant and readable today. This chapter begins by summarizing some of the main concepts from Menger’s book and using his definitions to set the foundation for the analysis of the rest of the topics to be addressed later. It then discusses the foundational Mengerian concepts on which economic analysis is built: subjective value and marginal analysis.
- Utility & Value
Menger defines a good as a useful thing that we can direct to the satisfaction of human needs. For something to become a good, it first requires that a human need exists, second, that the properties of the good can cause the satisfaction of that need, third, that humans have knowledge of this causal connection, and, finally, that commanding the good would be sufficient to direct it to the satisfaction of the human need.
Utility is the capacity of a good to serve for the satisfaction of human needs. Utility depends on our ability to understand the connection between a good and the need it fulfills. Utility is a general prerequisite for an object having a goods-character. Only if something can offer utility can it be viewed as a good by humans.
Goods can be divided into two categories: economic and non-economic goods. The distinction between the two is scarcity: that is, the quantity demanded of economic goods is larger than the quantity supplied. For non-economic goods, supplies of the good exceed the quantities demanded by humans.
A non-economic good is a good available in quantities exceeding the demand required of it, preventing rivalry or competition for securing the good. The best example is air, which is essential for human survival, but is nonetheless plentiful everywhere. Therefore air is not an economic good. An economic good, being scarce, will have a larger demand than its supply, and this creates a rivalry around access to it and forces humans to make choices between it and other goods.
The scarcity of economic goods forces humans to economize: making choices between scarce alternatives. To ‘economize’, according to Menger, refers to humans’ tendency to want to maintain quantities as large as possible of the goods that can satisfy their needs, to conserve the useful functions of these goods, to prioritize their most pressing needs over the less pressing ones, and to obtain the greatest satisfaction from the good’s quantity.
Economics, as a field, is the study of human choices under scarcity. Economics focuses on analyzing how humans attempt to find solutions to the problem of disparity between what they have and what they want, and the consequences of their choices.
As scarcity is a permanent condition of existence, humans are constantly making choices between different courses of action, different goods, and different needs to satisfy. The need to make these choices forces us to juxtapose the utility we derive from different goods against each other so we are able to make informed choices.
Value is our subjective assessment of the satisfaction we derive from goods, and what allows us to make economic decisions. Menger defines value as “the importance that individual goods or quantities of goods attain for us because we are conscious of being dependent on command of them for the satisfaction of our needs.” Value is also “the importance that we first attribute to the satisfaction of our needs, that is, to our lives and well-being, and in consequence carry over to economic goods as the exclusive causes of the satisfaction of our needs.”
The foundation of economic analysis, and one of the groundbreaking insights from Menger’s work, is that value is subjective. It exists only in the mind of the person making the valuation. As Menger put it: “Value is thus nothing inherent in goods, no property of them, nor an independent thing existing by itself. It is a judgment economizing men make about the importance of the goods at their disposal for the maintenance of their lives and well-being.”
“Value does not exist outside the consciousness of men.”
It is not the inherent nature of goods that makes them valuable to us, but only our assessment of their suitability for meeting our needs. As their ability to satisfy our needs changes, so does their value to us. Value, then, is not a physical or chemical property of economic goods, but it is a psychic property they attain only when humans are able to assess them. In Menger’s famous words “Value does not exist outside the consciousness of men.”
My favorite example to illustrate the subjective nature of value is oil. Up until the 19th century, the presence of oil in a plot of land would decrease its value, as it required costly removal before the land could be utilized for agricultural, commercial, or residential use. For as long as human consciousness saw oil as a dirty nuisance, oil had negative economic value.
However, the invention of the internal combustion engine helped humans realize oil can be burned to power machines that satisfy their needs for transportation, electricity, and heat generation. And with that realization, oil went from being a costly nuisance to being an enormously valuable and essential commodity which nobody in the modern world can live without. Oil in the year 2020 is no different chemically and physically from oil in the year 1620, and yet its value has changed drastically. While our conscious assessment of our needs cannot change the physical and chemical properties of oil, it can change its economic value, as oil can go from having negative value to positive value once human consciousness realizes that it can satisfy our needs. As Menger put it: “The value of goods arises from their relationship to our needs, and is not inherent in the goods themselves. With changes in this relationship, value arises and disappears.”
To further illustrate this point, as this book was being written in 2020, as a sizable proportion of the world’s population was subject to governments imposing significant and throttling suspensions of movement and economic production worldwide. Oil is produced for immediate consumption, and there is very little spare capacity for the storage of oil worldwide, compared to the enormous quantities consumed. As industry and transportation ground to a virtual halt worldwide, the excess oil production had nowhere to go, and the price of oil actually became negative for a few days. Given the large surplus of supply over demand, and the lack of storage capacity, owning oil reverted to being a liability, as it was in the pre-industrial age, and its owners again had to pay to be relieved of it. After a few days, the oil price recovered to positive territory. Nothing changed in the inherent properties of oil as its price went from negative to positive to negative to positive again, but the subjective conditions of people making the valuation changed.
As the example of oil illustrates, value cannot exist outside human valuation and choices, reflecting humans’ own preferences. Value cannot be an objective property of objects, rather it is a conscious phenomenon in our minds. This does not mean value is not real. It is real and meaningful, and it shapes our actions and decisions which produce, consume, and utilize all the real material objects of our world. Menger’s recognition of the subjective nature of value was a very important turning point in economic thinking. Previous economists had struggled to explain how goods were valued, and why certain goods were more valuable than others. All of these valuation mysteries and paradoxes were only resolved with the Mengerian insight of subjective valuation and marginal analysis.
- Valuation: Ordinal and Cardinal
The first important implication of the subjective nature of value is that value cannot be measured and expressed objectively. Since valuation is subjective to the human making the valuation, and since this valuation is constantly shifting based on the changes in our needs and in our understanding of goods’ abilities to satisfy our needs, valuations differ from one person to another, and individual valuations are constantly shifting depending on individuals’ conditions. To express any measurement objectively, a scientific unit is needed as the standard measuring rod against which different objects are assessed. Weight, length, temperature, and other objective measures are expressed in objectively definable units that allow for precise comparison between different objects. But no such unit can exist for human valuation, since the value of a good is not an inherent objective property in the good, but a subjective psychic property dependent on the person making the valuation, dependent on the ever-changing conditions that determine the usefulness of that good to meeting needs. There is no objective standard by which satisfactions between different humans can be compared, as the individual humans themselves are the arbiters of value. In other words, there is no way of measuring objectively the satisfaction one person gets from a good in terms of the satisfaction any other person gets from the same good.
Without a standard objective unit, measurement is not possible, and valuation cannot be expressed in objective numerical cardinal terms, rendering impossible the measurement of economic value with mathematical precision. Without a constant unit serving as a reference for value and being ascertainable for anyone, it is not possible to express economic value of different goods in relation to one another. It is possible to measure the length of different objects because all of them can be measured against the constant reference of the inch, foot, mile, or meter. An individual looking to install a fridge in their kitchen can measure the fridge’s space in inches, and then look up the fridge’s dimensions online to say if it would fit. The measurement is meaningful and useful because the customer and the manufacturer of the fridge have a very accurate and precise definition of what the inch is. Without agreeing on a common constant unit, it would not be possible to know if the fridge would fit without trying it.
Without a common constant unit, the only way we can express valuation is in ordinal terms, in which goods are compared to one another, and ordered in terms of the valuing individual’s preference, but not valued in explicit quantitative terms. It is possible for an individuals to know their preference for one good over another since there is a constant term for this comparison, and that constant is the individual making the valuation. It is therefore possible to compare goods in terms of value, an individual can value good A more than good B, and good B more than good C. But this valuation is purely subjective, expressed in terms of the utility experienced by the person making the valuation. It is not possible for the person to express these preferences in quantitative and cardinal terms, such as valuing good A at a precise numerical value expressed in the same unit with which preference for good B is expressed. In proper economics, there can be no such thing as a statement accounting the value of goods, such as “the value of A = 14.372x, the value of B = 4.258x, and the value of C = 1.273x” where x is an objective unit of value that can be used for personal and inter-personal comparisons of utility.
As Mises put it: “There is a more and a less in the removal of uneasiness felt; but how much one satisfaction surpasses another one can only be felt; it cannot be established and determined in an objective way. A judgment of value does not measure, it arranges in a scale of degrees, it grades. It is expressive of an order of preference and sequence, but not expressive of measure and weight. Only the ordinal numbers can be applied to it, but not the cardinal numbers.”
Think of the way you personally value things in relation to one another. Are you able to express them in terms of one unit that measures them all? Can all the things you value, from material goods to friendships, family, and happiness be measured in terms of the same unit? Is there a set exchange rate between a family member and physical goods? Could you value your child in money terms? How many cars does a human need to exchange for their child? Human values cannot be measured using one standardized unit. Human valuations can only be compared, but they cannot be added, subtracted, multiplied. Without a common and constant unit, measurement and mathematical operations are not possible.
- Value and Price
The value of economic goods is distinct from, and not to be confused with, their price. The price of an economic good is not its objective valuation, nor the subjective valuation of both transacting parties. The price at which a sale is conducted illustrates only that the seller values the good less than the price, while the buyer values it more. Had this not been the case, the transaction would not have taken place.
A common mistake in economics is to conflate value and price, and with that, comes the idea that value can indeed be measured objectively, expressed in monetary units. But that cannot be accurate, since market prices only illustrate the upper and lower bounds on goods’ valuations. When someone agrees to sell a good for 1,000 sats, they are demonstrating that they value the good at less than 1,000 satos. Had they valued it at precisely 1,000 sats, they would not have been interested in exchanging it for 1,000 sats. Only if their valuation is less than 1,000 would an offer of 1,000 sats be tempting to sell. Equivalently, when the buyer parts with 1,000 satoshis to buy that good, all that we can say about their valuation of the good is that it is higher than 1,000 satoshis, else they would not have paid that sum for it. It is not possible to determine an individual’s precise valuation from their transaction, only its upper or lower bounds, at the time and place in which an exchange took place, in relation to the price that motivated the person to perform the transaction. The mere act of exchange tells us a lot about valuation.
- Free Exchange
Anytime that two people freely choose to engage in the exchange of economic goods, it must necessarily be true that they both believe they will benefit from the exchange, otherwise they would not exchange. That they both benefit from exchange indicates each one of them received something they value more than what they gave up. The only way this is possible is if we understand that they both have different subjective valuations of the exchanged good. If the value of these goods was objective, it would not differ from one person to another, and the exchange would not be possible, since neither would willingly choose to accept the good with the objective lower value in exchange for the good with the higher objective value. This will be discussed in more detail on the chapter on trade, illustrating the benefits from trade.
- Determinants of value
The fundamental difference between Austrian economists and other schools is that Austrians view value as subjective, while other schools conceive value as something objective, or objectively measurable. Some modern economics textbooks define value as a function of utility, which they measure in terms of an imaginary and undefined unit named util. There is no standard for what constitutes a util, and no way of measuring anything in terms of utils. Modern mathematical economists express value in explicit numerical terms, measured in monetary units, thus conflating it with price, and failing to explain why people would engage in transactions to exchange objects if they both gave them identical value. Marxists, on the other hand, think that value is determined by the labor that goes into the production of a good.
There is an intuitive appeal to the notion that labor determines value. We can see that economic goods always require some element of labor to make them satisfy human needs. Even fruits that grow in the wild require man to expend the labor needed to pick and eat them before they can satisfy his need. It is not possible to conceive of goods that satisfy human needs without any labor being expended on them, and this drives the proponents of the labor theory of value to conclude that it is the labor that gives value to goods, and that the value is measured by the amount of labor contributed. However, this is an untenable notion.
Goods are only valued because of their ability to satisfy our needs. A buyer is not interested in how much time and effort went into making a product when he purchases it, but only the services and utility the product provides him. Labor goes into the production of goods because of the expectation that it can produce a final outcome which is valuable to the consumer; labor does not magically make things valuable. It is possible to spend labor time in a failed production process that does not yield a usable product. The output would not become valuable to others just because of the effort spent on producing it; its uselessness renders it worthless to anybody who cares to value it. There is no guaranteed correspondence between the amount of labor expended in production and the value of that production. Workers may overestimate and underestimate the value of their labor, and it is only the choice of consumers on the market which passes that judgment.
While it is true that labor is needed to facilitate the production and consumption of anything that is valuable, it is a fallacy to extrapolate that the input of labor itself is what gives the value. Individuals’ subjective preferences determine value of goods, and producers and workers dedicate labor into production processes they believe would produce these valuable goods. Should the cost of the inputs into the production process turn out to be smaller than the market value of the output, the producer will make a profit, which indicates to them their investment in this process was productive to society, as it combined inputs to produce outputs at a higher price. Should the market price of the good be smaller than the inputs that went into producing it, this is a signal to the producer that they are engaging in a destructive production process, and the longer they engage in it, the more capital resources they squander.
Producers thus direct labor where they expect it to produce things of value to themselves and others. It is not the case that producers’ labor automatically converts invaluable objects into valuable ones, but producers look for valuable objects and attempt to produce them with inputs that are valued less than the final outcome.
In Austrian economics, value is subjective and depends on the time and place at which the valuation happens. Value is derived from human choice which is necessitated by scarcity. Value is assigned by individuals to each unit at the time and place in which they make decisions, but is not a universal property of the good. Without a subjective conception of value, it is not possible to find coherent explanations for why and how humans make the economic choices they make.
How consumers determine the subjective value of objects is up to them, and depends on their conditions and the time and place at which they make the valuation. The same good will have different valuation at different times and places to the same individual, depending on many factors, most notably, their existing stockpile of that good.
Perhaps Menger’s most important contribution to economics was marginalism. After establishing that the value of goods is not inherent to them, but is rather subjective and dependent on their ability to satisfy our needs, Menger applied this to the study of the value of different units of the same good, and in the process laid the foundation for modern economic analysis.
Since the value of goods is derived from their ability to provide us with satisfactions, and since different satisfactions have unequal value to us, the value of different units of the same good will also be unequal, as it depends on the satisfactions they meet. The same good will have a different value to the same person depending on what need of his it meets.
Individuals use the first unit of a good to meet the most important and pressing needs related to it. They will use the second unit to meet the second most pressing need. As the quantity of the good they own increases, the needs that are met are less valuable and less pressing. In other words, identical goods will not have identical value to individuals, because the utility derived from them is not identical. The first units will be the most valuable, and as the number of units consumed increases, each marginal unit would be less valuable than the previous one.
Menger thus illustrated that the valuation that we place on goods is not dependent on their total or overall utility, and that their utility is not something inherent in these goods in the abstract, regardless of their quantities. Rather, the importance which we attach to goods is inextricably dependent on the quantity of those goods, and their quantity in relation to the existing supply of the good we have at our disposal. Humans make decisions based not on the total or abstract utility of an object, but based on the utility offered by distinct quantities of the good and their ability to satisfy our distinct needs.
- Marginal Utility
Although Menger never used the term himself, his student Friedrich von Wieser would later introduce the term marginal utility to refer to the importance attached to the least important satisfaction which is secured by a single unit of the available quantity of the commodity. Mises would define it: “We call that employment of a unit of a homogeneous supply which a man makes if his supply is n units, but would not make if, other things being equal, his supply were only n-1 units, the least urgent employment or the marginal employment, and the utility derived from it marginal utility.”1
For example, the first unit of food a person eats is extremely valuable, as it is the difference between starvation and survival. The second unit of food will be the difference between mere survival and being well-nourished. While still very valuable to the individual, the second unit is not as valuable as the first unit. Further units of food will be acquired for enjoyment of taste, or for social gatherings, which, while valuable, are not as valuable as the previous units that were used to guarantee survival and health. As an individual’s consumption of food continues to increase, they eventually get to the point where they attach no value to an extra unit of food, and prefer to go without it even if offered it for free. Increasing the number of units consumed leads to the units being deployed to meet less pressing needs, which means each successive unit has a utility lower than the previous unit, and hence, a lower valuation to individuals.
With this important insight, Menger exploded the idea that goods’s value is inherent in them as goods, and illustrated that the value is dependent on the needs the goods satisfy, which is in turn dependent on the abundance and scarcity of the good specifically and only to the person making the valuation. Nobody is ever asked to make a valuation of all the total supply of a good, or to value a good in the abstract. Economic decisions pertain only to individual units of goods, and individuals are at any point in time making decisions about the next unit of a good they want to consume, not a lifetime supply of it, nor the good in the abstract.
- Law of Diminishing Marginal Utility
An important implication from Menger’s approach to valuation is the law of diminishing marginal utility, which states that an individual’s valuation and utility derived from a good will decline as the quantity of the good they hold increases. Since individuals use the first units of a good that they acquire for the fulfillment of the most pressing needs it can address, it must therefore follow that the first unit of any goods will be valued highest by that individual. As their holdings of that good increase, and each marginal unit goes toward meeting a less pressing need, each marginal unit will have a lower value to the individual. As the value of a good to a person at any point in time depends on which need it satisfies, the more a person has of something, the less the valuation they attach to it.
The marginal utility of a good declining as its quantity increases is an important insight into individual decision making. Anyone who has made an expensive purchase may relate. In the first day in which you have your new car or toy, the novelty factor is overwhelming, and you are captivated by it. This declines with time as you become more accustomed to its many features and traits. What was novel becomes common, and loses the allure it had when you had not experienced it. You still get joy from driving the car or playing with the toy, but the joy from each extra use is smaller with each use.
The law of diminishing marginal utility is another reminder that there is no such thing as the objective value of good X, as that value changes depending on the abundance of good X, and what needs it satisfies. There are only ever subjective values of the next (marginal) unit of good X to the person making the valuation. This is dependent on the subjective preferences of the valuing individual, and the abundance of the good.
- Valuation by the least valuable use
Another implications from Menger’s approach to understanding valuation: as individuals deploy their inventory of a good toward meeting their most pressing needs, their valuation of the marginal unit will reflect their valuation of the least important satisfaction this good assures, and so when making purchase decisions, an individual’s valuation of a good will reflect their valuation of the least important satisfaction it provides. A man deciding to pay for a meal will not pay based on how much they value food in the abstract, or how much they value all the food they have eaten throughout their life. He will pay up to the value he attaches to the next meal itself. Considerations of the real value of all food to the man are irrelevant. As a man who has had enough food throughout his life to keep him nourished and healthy up to this point, he does not value the next unit of food the same as he values all the food he has eaten in his life. He is not valuing it as if it was the difference between life and death, because it is not. The decision about the next meal is valued according to the need that the next meal satisfies for the man, which, being one meal, will be significantly lower than the value of the meal keeping them alive. We can then see how when people have to make a choice about any particular good, they are valuing it in light of the least valuable use possible, because that is the only choice that exists at the margin. All the more valuable uses were already met with previous food units.
The person considering purchasing a bottle of water from a restaurant, for example, is not going to pay based on the value they get from water for survival, or for meeting their basic daily needs. They are simply deciding about the marginal next unit of water they consume, having already allocated other units of water to their more pressing needs. The price paid for water will be nowhere near the value the individual places on survival, because the decision to buy the bottle of water in a modern city pertains only to the consumption of an extra bottle of water, and not for survival. As water is essential for human survival, all human societies only arise in places with enough water to meet people’s essential needs. With these needs secured, the price of marginal units will not reflect the value of the basic needs, but rather, the value of the less pressing needs. This helps us understand why water is relatively cheap even while it is essential. Its essential nature ensures humans are usually in possession of large quantities of it and make their marginal purchase decisions based on marginal units going to less pressing needs.
We can see why goods that are vital and important for survival are usually not expensive. In the modern world, people are not paying for water based on the value they attach to survival that is dependent on water. They are already living in a time and place that secures their most important requirements of water at very low prices. Their individual purchase decisions pertain to acquiring marginal quantities of water that might alleviate mild thirst but are not necessary for survival or health. But if you were to place an individual in a situation where they are unable to secure water for any of their vital needs for a few days, the least valuable use water would offer them would still be the difference between life and death, and that would make them value it very highly. As Mises explained:
“Acting man is not in a position in which he must choose between all the gold and all the iron. He chooses at a definite time and place under definite conditions between a strictly limited quantity of gold and a strictly limited quantity of iron. His decision in choosing between 100 ounces of gold and 100 tons of iron does not depend at all on the decision he would make if he were in the highly improbable situation of choosing between all the gold and all the iron.”
“What counts alone for his actual choice is whether under existing conditions he considers the direct or indirect satisfaction which 100 ounces of gold could give him as greater or smaller than the direct or indirect satisfaction he could derive from 100 tons of iron. He does not express an academic or philosophical judgment concerning the “absolute” value of gold and of iron; he does not determine whether gold or iron is more important for mankind; he does not perorate as an author of books on the philosophy of history or on ethical principles. He simply chooses between two satisfactions both of which he cannot have together.”
“When faced with the problem of the value to be attached to one unit of a homogeneous supply, man decides on the basis of the value of the least important use he makes of the units of the whole supply; he decides on the basis of marginal utility.”
Water – Diamond Paradox
The immediate significance of Menger’s marginal analysis was that it was the first economic resolution to the water-diamond paradox, an explanation of which had evaded economists for centuries. How could economists explain that water, which was essential for human life, was usually very cheap, if not free, whereas diamonds, which are luxury goods that serve no essential purpose for humans, are very expensive? If value really is subjective, then why do people attach so much value to trivial things they don’t need like diamonds, while attaching only little value to essential goods like water? Wouldn’t this fit more nicely with a labor theory of value, which would postulate that diamonds are more valuable because more labor is involved in their production?
However, viewed through the lens of marginal analysis, we can discern that the value of goods themselves is not inherent in them as goods, but is rather a function of the subjective human needs they meet. Market value does not pertain to some inherent property of the good, or to the value that all of its stockpiles afford us, it is based on the least important of the satisfactions the good meets. Since drinking water is usually available in large quantities wherever humans are settled, it therefore follows that the most pressing needs of water are already met, and that market choices are being made over units meeting far less pressing needs. Should a person in a modern city forgo buying a bottle of water, they will be forgoing only one small need for water at a certain time. They would still have access to the water they need for their most pressing and important needs of survival and hygiene. Diamonds, on the other hand, being very rare and available in very small quantities, are purchased by people deploying them to some of their highest valued uses.
It is quite possible to imagine a scenario in which both water and diamond are very scarce, and the marginal units available of both would go toward meeting the most pressing needs for these two goods. A man stranded in a desert who has not had a sip of water for days would be willing to pay a far larger price for the first unit of water than the first unit of diamond, as that water would be the difference between life and death for him.
It is therefore inaccurate to say that diamonds are more valuable than water. In situations where water is plentiful and diamonds are scarce, the water going to the least valuable uses is less valuable than diamonds whose scarcity ensures that their allocation to the least valuable uses still remains highly valuable. In situations in which water is scarce enough that the marginal unit will be deployed to satisfy the need for survival, water would undoubtedly be more valuable than diamonds.
1Mises, Human Action, p.124