Table of Contents
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. Hence value does not exist outside the consciousness of men.
– Carl Menger
The first chapter was the methodological introduction to the topic of economics, illustrating the Austrian approach centered around human action. In this chapter, we turn to the substance of the field of economics, its foundational concepts, and the main questions the field seeks to address.
The foundations of modern economics were laid by Austrian economist Carl Menger in the late nineteenth century. While economics as a field of inquiry had been around since the time of Aristotle, 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. Menger’s groundbreaking work provided a richer understanding of the nature of the consequences for humans of their economic actions. Menger’s Principles of Economics textbook, written in 1871, is possibly the oldest economics textbook still relevant and readable. This chapter begins by summarizing some of the main concepts from Menger’s book, using his definitions to set the foundation for the analysis of the topics addressed in later chapters. 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 something useful 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 satisfy 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 being a good. 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. The distinction between the two is scarcity: Demand for economic goods is always greater than the quantity supplied, whereas for non-economic goods, their supply exceeds the quantities demanded by humans.
A non-economic good is a good available in quantities exceeding the demand for it, which precludes rivalry or competition for securing the good. The best example is air, which is essential for human survival, but is nonetheless plentiful everywhere humans live. Air is, therefore, not an economic good.
An economic good, being scarce, will have a greater demand than its supply, and this creates rivalry around access to it, forcing 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 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. It 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, or expect to 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, according to Menger, 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.”
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; it is a psychic property they attain only when humans 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 nineteenth 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. Once humans realized that refined oil could be burned in an internal combustion engine to power machines that satisfy their needs for transportation, electricity, and heat generation, oil went from being a costly nuisance to an enormously valuable and essential commodity, which nobody in the modern world can now 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 from negative to positive. While our conscious assessment of our needs cannot change the physical and chemical properties of oil, it can change its economic value. Oil went from having a negative to a positive value once human consciousness recognized it as useful. As Menger puts 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 is being written in 2020, a sizable proportion of the world’s population is subjected to governments worldwide imposing significant and throttling suspensions of movement and economic production. Oil is produced for immediate consumption, and there is very little spare capacity for its storage, relative to the enormous quantities consumed. As industry and transportation ground to a virtual halt, excess oil production had nowhere to go, and the price of oil plummeted and even 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 preindustrial age, and its owners again had to pay to be relieved of it. The oil price soon recovered to positive territory and continued its rise upward. Nothing changed in the inherent properties of oil as its price went from negative to positive to negative to positive again; the conditions of people making the valuation changed, and so did their subjective valuations.
As the example of oil illustrates, value cannot exist outside human valuation and choice, reflecting their preferences. Value cannot be a constant property of objects; it is a conscious phenomenon in our minds. This does not mean value is not real. Value is real and meaningful, and it shapes our actions and decisions, which direct the production, consumption, and utilization of the real material objects in 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 mysteries and paradoxes surrounding valuation 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 it cannot be measured and expressed objectively. Since valuation is subjective to the human making it, 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, as discussed in Appendix 1. Weight, length, temperature, and other scientific measures are expressed in objectively definable units that allow for a 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 of 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 for meeting needs. There is no objective standard by which satisfactions of humans can be compared, as the individuals themselves are the arbiters of value. In other words, there is no way of objectively measuring 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, making it impossible to measure economic value with mathematical precision. Without a constant unit as a reference for value ascertainable for anyone, it is not possible to express the economic value of different goods in relation to one another. It is possible to measure the length of different objects because they can all be measured against the constant reference of an inch, foot, mile, or meter. An individual looking to install a fridge in a kitchen can measure the fridge’s allotted space in inches and then look up the fridge’s dimensions to see whether it would fit. Such measurement is meaningful and useful because the customer and the manufacturer of the fridge have a very accurate and precise shared definition of what the inch is. Without agreeing on a common constant unit, it would be impossible to know whether the fridge would fit without installing 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 explicitly quantitative terms. It is possible for an individual to know their preference for one good over another since there is a constant for this comparison—the individual making the valuation. It is, therefore, possible to compare goods in terms of value, as an individual can easily determine if they 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 impossible 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 for 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 interpersonal comparisons of utility.
As Mises puts 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 terms of money? How many cars does a human need to exchange for their child? Human values cannot be measured using one standardized unit. Human valuations an only be compared, but they cannot be added, subtracted, or 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 either of the 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. With that mistake comes the idea that value can indeed be measured objectively, expressed in monetary units. But that cannot be accurate, since market prices only illustrate a bound on goods’ valuations, strictly subject to a given time and place. When someone agrees to sell a good for $1,000, she is demonstrating that she values the good at less than $1,000. Had she valued it at more than $1,000, she would not have been interested in exchanging it for $1,000. Only if her valuation is less than $1,000 would an offer of $1,000 tempt her to sell. Equivalently, when the buyer parts with $1,000 to buy that good, all that we can say about his valuation of the good is that it is higher than $1,000, or else he 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. The mere act of exchange tells us a lot about valuation.
Any time 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 perform it. Mutually beneficial exchange indicates each party 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 in Chapter 9 on trade, illustrating the benefits from trade.
Determinants of Value
The fundamental difference between Austrian school economists and other schools is that Austrians view value as subjective, while other schools conceive of value as something objective, or objectively measurable. In order to maintain that pretense, 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. Some modern mathematical economists express value in explicit numerical terms, measured in monetary units, thus conflating value with price and failing to explain why people would engage in transactions to exchange objects if both objects have identical values. Marxists, on the other hand, think that value is determined by the labor that goes into the production of a good, an absurd contention according to which things become valuable if work is expended on producing them, regardless of anyone wanting to own them. If you were to spend equal time baking a normal cake and a cake out of mud, the Marxist would argue that both cakes would be valued the same.
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 labor that gives value to goods, and that value can be 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 in the services and utility the product provides him. Labor is expended on producing 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 expend labor on 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 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, but it is only the choice of consumers in the market that can pass that judgment and determine the value of goods. Producers and workers dedicate labor to production processes they believe will produce these valuable goods. Should the cost of the inputs into the production process turn out to be smaller than the market price of the output, the producer will make a profit. This indicates that her investment in this process was productive to society, as the combined inputs cost less than the price of the outputs produced. Should the market price of the good be less than the inputs that went into producing it, this signals to the producer that she is engaging in a destructive production process, and the longer she engages in it, the more capital resources she squanders.
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 it 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 do.
How consumers determine the subjective value of objects is up to them. The same individual will value the same good at different valuations at different times and places, depending on many factors; most notably their existing stockpile of that good.
Menger’s other momentous contribution to economics is the concept of 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 satisfaction, 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 at a given point in time.
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 have different values for individuals, because the utility derived from them is not identical. The first units are the most valuable, and as the number of units consumed increases, each marginal unit is less valuable than the previous one.
Menger thus illustrated that the valuation we place on goods is not dependent on their total or overall utility and that their utility is not something inherent to these goods in the abstract, regardless of their quantities. Rather, the importance that 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 on the utility offered by distinct quantities of the good and their ability to satisfy our distinct needs.
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 secured by a single unit of the available quantity of a commodity. Mises defines it by saying: “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.”
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. Further units of food will be acquired for the 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 lower utility than the previous unit and hence, a lower valuation to individuals.
With this important insight, Menger disproved the idea that the value of goods is inherent to them as goods. He illustrated that value is dependent on the needs the goods satisfy, which are, in turn, dependent on the abundance and scarcity of the goods, and only to the person making the valuation. Nobody is ever asked to make a valuation of 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 primarily making decisions about the next unit of a good they want to consume, not their lifetime supply of it, nor the good in the abstract.
Law of Diminishing Marginal Utility
An important implication of Menger’s approach to valuation is the law of diminishing marginal utility. This law 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 good 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 the need it satisfies, the more a person has of something, the less the value 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. On the first day that you have a 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 before you experienced it. You still get joy from driving the car or playing with the toy, but the specific joy declines with each extra use.
The law of diminishing marginal utility is another reminder that there is no such thing as an objective value of good X, as that value changes depending on the abundance of good X and the 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 implication from Menger’s approach to understanding valuation: As individuals deploy their inventory of a good to meet their most pressing needs, their valuation of the marginal unit will reflect their valuation of the least important satisfaction this good assures. Thus when making purchasing decisions, an individual’s valuation of a good will reflect his valuation of the least important satisfaction it provides. A man deciding to pay for a meal will not pay based on how much he values food in the abstract or how much he values all the food he has eaten throughout his 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 alive and healthy enough to demand a new meal at 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 food keeping him alive in general or the value of all the previous meals that ensured his survival up to today. 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 to 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 though it is essential. Its essential nature ensures humans are usually in possession of large quantities of it and make their marginal purchasing decisions based on the marginal units going to less pressing needs.
We can see why goods that are vital and important for survival are usually inexpensive. In the modern world, people do not pay for water based on the value they attach to survival, which is dependent on water. They already live in a time and place that secures their most important requirements of water at very low prices. Their individual purchasing 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 she is unable to secure water for any of her vital needs for a few days, the least valuable use it would offer her would still be the difference between life and death, and that would make her value it very highly. As Mises explains:
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 is 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 do not need, like diamonds, while attaching only little value to essential goods like water? Would this not fit more with a labor theory of value, which would postulate that diamonds are more valuable because they involve more labor in their production?
However, as discussed above, 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 forego buying a bottle of water, he will be forgoing only one small need for water at a certain time. He would still have access to the water he needs for his 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 for some of their highest-valued uses.
It is possible to imagine a scenario in which both water and diamonds 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 higher price for the first unit of water than the first unit of diamond, as water would be the difference between life and death for him.
It is, therefore, inaccurate to say that diamonds are more valuable than water. The water-diamond paradox illustrates the importance of individual circumstances to the assessment of subjective value. In situations where water is plentiful and diamonds are scarce, water going to its least valuable uses is less valuable than diamonds, whose scarcity ensures that their least valuable uses still remain 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.