Lecture Three: Subjective Value and Marginalism
Sources used: Carl Menger, Principles of Economics; Jack High, “Marginal Utility” and Mario Rizzo, “Cost,” and Steven Horwitz, “Subjectivism,” in The Elgar Companion to Austrian Economics; Karen Vaughn, Austrian Economics in America; James Buchanan, Cost and Choice; Frank Shostak, "Marginal Utility Theory is Not Rocket Science."
The subjectivist/marginal revolution solved the diamond/water paradox that haunted Smith, Ricardo and others up to that time. It did not haunt Marx, as it was not his purpose or goal to worry about market prices per se.
As we will see, Menger was different from Jevons and Walras in how he explained both the subjectivism and the marginalism. Therefore, different paths in economic theorizing were blazed.
Menger’s Subjective Value:
The quotations below are from Principles of Economics by Menger.
Menger, like Adam Smith, wanted to explain human progress.
He wanted to understand historical change and grounds his theory of historical processes in a causal theory that includes human action as well as physical causes.
Humans interacting with each other and with the physical world.
What are these causal relationships that lead to progress of human wealth?
Menger saw the primary economic problem as: people need to learn the “causal connection between things and the satisfaction of their needs.”
Once someone understands how something in the physical world can help satisfy a need – that person understand the causal connection. Then it is a matter of obtaining this thing.
But nothing will have value unless this causal connection exists.
“Value is therefore nothing inherent in goods, no property of them, but merely 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.” (p. 115)
This leads to his value theory (of say “X”):
1. A human need
2. Causal connection of X to the human need
3. Knowledge of the connection
4. Command over X
If we add:
5. Insufficient quantity of X to satisfy requirements
Then we have scarcity and an economic good.
Only when the first “four requirements are present simultaneously can a thing become a good. When even one of them is absent, a thing cannot acquire goods-character, . . . “ (p. 52)
Menger’s utility is different from his value. Something might give us utility but it is not a good with value if it is what we would call today a non-scarce good or a free good. Menger calls these “non-economic” goods for that reason.
These goods do not have exchange value – and no use value either.
Utility:
Value:
In this sense, they will not command a market price. When Menger is discussing value, he is eluding to a market price.
So if something satisfies the first four properties above – but not the fifth – it is a non-economic good.
What he calls “imaginary goods” are goods that are only, in the opinion of people, able to meet a need but do not do so in some objective or physical sense.
So – someone might believe that drinking beer will decrease their chances of getting cancer. So to that person – beer does fulfill a need and therefore has value. But in reality (let’s say) there is no real causal connection between drinking beer and not getting cancer.
Imaginary goods:
This is where most Austrians that came after Menger disagreed with him. In understanding markets, we don’t have to make judgments about how right or wrong actors are with respect to what they think the causal connection of a good is to meeting an end. “All that matters is the subjective perception of the actor.” (Horwitz) That is what leads them to act the way they do.
“The actors’ mental state at the moment of choice is where explanation of price formation and market processes begin.” (Horwitz)
Back to Menger - When we add #5, we bring in scarcity and can ask how sufficient is the quantity of the item to satisfy the need? And now we have an economic good.
And of course, “with changes in this relationship, value arises and disappears.” The relationship between a good and it meeting a need (according to the knowledge and thoughts of the actor).
Differences in the Magnitude of the Value of Goods:
Here is where Menger is talking about understanding where a market price comes from. Why one good is more valuable than another.
We must look at:
1. To what extent different satisfactions have different degrees of importance to us (subjective factor) and
2. which satisfactions of concrete needs depend, in each individual case, on our command of a particular good (objective factor).
“If this investigation shows that separate satisfactions of concrete needs have different degrees of importance to us, and that these satisfactions, of such different degrees of importance, depend on our command of particular economic goods, we shall have solved our problem. For we shall have reduced the economic phenomenon whose explanation we stated to be the central problem of this investigation to its ultimate causes. I mean differences in the magnitude of value of goods. ” (p. 122)
Note that #1 is getting us to DEMAND.
And #2 is getting us to SUPPLY.
But be careful, even though he calls this the “objective factor” – he is not saying that the costs to supply a good are objective in some sense. He is saying that the amount of a good under our command is “objective.” There are 100 or there are 500 in some objective sense.
Let’s look at #1 – the subjective factor.
There are needs of different kinds, according to Menger. For example, he says most likely we will first want to consider the maintenance of our lives. These needs are probably the most important. Then needs that increase our well-being. Then needs that just bring us additional pleasure, etc.
So he assumes numbers that represent “importance of satisfactions” – 10 being the highest (these are on what life depends, for example), then down from there and ends with 1. If something is less important to us – then the scale begins with 9, and so on.
Menger's Ranking:
So basically, each of us – within our own minds – rank order needs. Then we also determine the causal connection of goods to these needs. So if maintaining life is our highest valued need – and we conclude that food will help us do that – then we will value food very highly
(Menger’s 10). Once we have satisfied that need with a particular amount (let’s call it a unit) of food, then another unit of food might satisfy a lower valued need – we would stay alive without it but would not be as healthy. The next unit of food, say, does not help us with either of these needs, but instead increases our enjoyment of life (it is chocolate cake, for example). So this unit of food satisfies a lower valued need, and so on.
So as we obtain a good, we first satisfy the highest valued need. Then the next and so on and so on. With each marginal need satisfied (and the marginal value of each need is falling), the value of the good doing the satisfying is also falling.
Here we have Menger’s diminishing marginal utility. Although remember – he would not and did not call it that. He would call it diminishing marginal value (had he used the word marginal).
Diminishing marginal utility (or value):
Note the difference between this explanation and the explanation we find in most textbooks. The idea that as we consume more of something, the marginal value falls because of psychological (the second piece of chocolate cake isn’t as good as the first because you have already had one and therefore don’t like it as much – it doesn’t give us as much “utility”) or physiological reasons (we get full, for example).
This is not saying that. He is saying that we are valuing each marginal unit of the good less because it satisfies a lower valued need on our individual need scale. It isn’t that we don’t like the second piece of chocolate cake as much – it is that it is satisfying a need that is lower valued than the need the first piece satisfied. (More on this difference later).
Let's Review The Diamond/Water Paradox - As Menger Discussed it in Particular
The diamond/water paradox asked why diamonds were of such high value (say, in terms of price), while water did not have much value (relatively low price) – yet water is necessary for life but diamonds are not.
As Adam Smith said, “Nothing is more useful than water, but it will purchase scare any thing. A diamond, on the contrary, has scarce any value in use; but a very great quantity of other goods may frequently be had in exchange for it.” (Adam Smith, The Wealth of Nations)
The Classical economists tried to answer it with the labor theory of value But were never satisfied with their answers – and rightly so. There were obvious exceptions to this principle. Land, for example, commanded a price even if no labor went into its production. Non-reproducable goods, such as Rembrandt paintings, exchanged at prices that had little to do with labor.
Menger’s marginal utility reversed cause and effect with respect to this labor theory of value.
An expensive car does not command a high price because of how much labor went into its production. On the contrary – it is because it commands a high price that so many engineers and craftsman can be paid to produce it.
Imputation Theory:
The value of labor is imputed from the value of the final good it produces. Not the other way around!
Prices of consumer goods determine the prices of labor, land and capital.
But – we still have not answered: What determines the price (value) of consumer goods? Why are diamonds more expensive than water?
The answer was twofold:
1. we don’t compare the whole stock of a good with the whole stock of another good – focus on the relative units of the good. Or the marginal unit.
2. And the value placed on the goods is subjective in nature.
It is the least important or marginal use that determines the value of water to us.
If diamonds were so abundant that we could use them for shoe ornaments – they would not command such a high price. If the supply of water decreased substantially – to the point where we only had enough to drink – its price would skyrocket.
The Austrian Differences
So while MU theory was (and is) held in common with pretty much all economists, Menger’s theory generally was different enough to form a distinct line of thought.
Jevons and Walras: Assumed a continuous utility function: U=f(x)
X being some good . So utility depends upon the consumption of x.
Marginal utility = the first derivative of total utility. Or the change in total.
Menger: focused on discrete (disconnected), discontinuous value scales.
Consumer ends – e1, e2, e3 . . . en.
X being a good that helps attain an end.
The MU of x is the importance that the consumer places on a unit of x. And this is imputed to the good from the least valuable end obtained by using it.
The MU of satisfying e1 is disconnected to the MU of satisfying e2 in some mathematical sense. There is no need or way of summing up total utility or having a total utility function.
If a consumer has 3 x’s – then the MU of x is the importance she attaches to e3, since she can attain that end. If she loses one x, then the MU of x relates to e2 and so on.
Attaining e2 does not relate to the marginal utility in obtaining e3 for example in the same way that the theory was explained for Jevons and Walras. To them – the MU from the first bite of chocolate cake will relate to the MU of taking the second bite.
Austrian Opportunity Cost
Opportunity cost then is the end foregone when x is used for another end.
Consumer has one x. Uses it to obtain e1. She then forgoes e2 – her next highest valued end.
This is her opportunity cost.
So, for example, opportunity cost is usually defined as the highest valued alternative foregone. Austrians might add a word: The highest valued alternative END foregone.
If Bob buys X instead of Y (which he would have bought if he had not bought X) – his opportunity cost is not Y – it is the end that he forgoes because he didn’t buy Y. Bob is giving up a subjectively valued end – not Y per se.
Austrian Diminishing Marginal Utility
We saw this difference earlier.
Jevons suggested that the total utility function increases at a decreasing rate. In this way, MU goes down as the supply of the good increases. Again, explained on psychological or physiological grounds. The first bite of chocolate cake is better than the second (because the first bite was taken).
For Austrians the law follows from the value scale.
As consumers get additional units of x, he applies them to less important ends – so the MU of x diminishes as the supply increases (utility of ends decreases). MU of x3 is less than that of x2 because the consumer places less importance on e3 than on e2.
We can relate this theory to a typical demand curve we see today:
Austrian (Menger):
The first unit bought is applied to e1 – and therefore the consumer is willing (and we have to add able in here as well) to pay a higher price than for the second unit – which is applied to e2 (a lower valued end) and so on.
Mainstream (Jevons and Walras):
The first unit bought is consumed and the consumer derives a relatively high marginal utility from it. The second unit consumed - the MU is derived from the fact that the first unit is consumed. It falls due to psychological or physiological reasons.
But what about supply? That is – how many ends are we able to satisfy depends on the amount of the good we have command over – how many are supplied?
But what does that depend upon?
Guess what – subjective value!! This is where Austrian economists are considerably different from much of mainstream. This is where, according to Austrians, Alfred Marshall went very wrong by explaining the supply side of a market as being based upon objective costs of production.
Austrian explanation of the Law of Increasing Marginal Opportunity Cost:
The law of increasing marginal opportunity cost corresponds directly to the law of diminishing marginal utility. In fact, it is just diminishing marginal utility considered from another angle.
Remember, if a consumer has 10 units of x and gives up one of the units, the opportunity cost will be e10 – the end she forgoes. If she gives up a second unit of x, cost will be higher. She forgoes a more important end, e9, and so on.
This is ultimately the reason that as more of a good is supplied to the market, its cost will increase.
For example: Each time an additional unit of x is produced – resources are used that could have produced Y. Therefore, the ends that Y could have helped attain will not be attained.
Think of it this way: it costs Bob $1.00 to produce the whistles he sells. Usually, the economist stops there. OK, $1.00 is our objective cost of production.
But wait – where did the $1.00 come from? Why not $2.00?
Bob must buy his resources to produce his whistles. So when Bob buys say, a piece of wood to make his whistle – he is bidding that wood away from another use (the whistle’s opportunity cost). But of course, things do not have opportunity costs – only people do!
So the opportunity cost of the wood is actually the end that is foregone by people who are not able to buy, say, a wooden spoon because the scarce wood is used for the whistle instead. If this end is of high value to people (the end that a wooden spoon would help achieve) – then spoon producers will be bidding a pretty high price for the wood themselves (they would be able to because the consumers are willing to pay a relatively high price for something that would help them achieve a relatively high valued end).
In order for Bob to obtain the wood, then, he must bid at least as much as the spoon makers are bidding. This is what determines the $1.00 cost that Bob faces.
And remember – as more and more spoons are not produced – we move up the value scale of ends not met by those who would have bought the spoons. Therefore, as Bob produces more whistles – higher and higher ends are forgone by consumers and they will pay higher and higher prices for spoons. Spoon makers will then bid higher and higher prices of wood – increasing the cost to Bob.
This is the law of increasing marginal opportunity cost. And it all goes back to the same analysis that is used to explain diminishing marginal utility!! The subjective value of people’s ends!
The standard supply curve then is upward sloping because of this law. It basically reflects the opportunity cost of higher and higher valued ends not met when resources are pulled away from other production processes:
Why is this important to Austrian analysis? Knowledge!
Let’s return to Menger’s theory regarding an economic good:
His value theory (of say “X”):
1. A human need
2. Causal connection of X to the human need
3. Knowledge of the connection
4. Command over X
If we add:
5. Insufficient quantity of X to satisfy requirements – then we have an economic good.
1 and 4 above are statement of preferences and constraints. Very mainstream (maximize utility subject to a budget constraint – for example). But where do we put 2 and 3?
2 is an objective condition of reality – that something can serve human purposes (except with the “imaginary goods” for Menger – which to other Austrians do not exist in the sense that it doesn’t matter if the consumer is right or wrong about this connection for the consumer to act).
3 though is the central ingredient of economic growth according to Menger – knowledge!
It is so often assumed that this knowledge exists in mainstream economics without understanding why or how – how the knowledge is acquired is not central. But to Menger and Austrians, knowledge takes a leading role.
How knowledge is generated?
How knowledge is acquired?
How changes in knowledge changes actions?
How changes in knowledge leads to different outcomes in society?
Etc.
Knowledge about how our individual ends can be attained. If we don’t have that knowledge – we don’t progress – we don’t even survive.
And also important to Menger and Austrians: TIME.
“The idea of causality, however, is inseparable from the idea of time. A process of change involves a beginning and a becoming, and these are only conceivable as processes in time.” (p. 67)
As we will see this is a precursor to Austrian capital theory but also of understanding markets in general. Markets are processes – ever changing, knowledge generating processes. We HAVE to understand these processes as best we can to understand human well-being.
Therefore, going back to the very “essence” of both demand and supply is important to Austrian economists on several levels (although these are not mutually exclusive):
1. Understanding markets as social phenomena that come out of individual valuations of ends - understanding the process of price formation is key to understanding what markets really are – how and why they come about.
2. Knowledge – prices are full of knowledge about the ends that people value (but also knowledge about consumer understanding of the causal effect of a particular good or service). They also then give knowledge to people – leading to changes in their behavior. So how this knowledge comes about and how changes in knowledge change outcomes for us is important.
3. Resource Allocation and Other Outcomes – With the understanding of markets and market prices – we can understand how and why resources are allocated in the way they are. This is directly related to knowledge as well.
4. Changes in Knowledge when Prices are “Distorted”- If either side of our market is changed by an “outside force” – meaning that a price does not simply reflect the subjective value of consumers (and their knowledge of causal connection) – but it reflects something else as well – we can have a better understanding of how that will change the outcomes in markets if we have an understanding of non-distorted prices. Examples:
a. Demand side: If an excise tax is placed on one good. This changes the relative prices of goods, changes the way people will attempt to meet their ends. This changes resource allocation – and has outcomes we want to try to understand.
b. Supply side: If the amount that a producer pays for a resource is in some way controlled (minimum wage law for example) – this will again, change the way by which resources are allocated and thereby change outcomes in markets. It is not simply that they will “create a surplus of workers” for example – but this distorts the information or knowledge that is embedded in a market wage. We no longer have a “market” wage determined by subjective opportunity costs but something else. Therefore – all decisions made based upon this wage will also be “distorted.” What are the implications of these distortions?
DO ICE THREE
More on Subjective Cost Theory
Remember that the Austrian emphasis on causes leads to emphasizing the subjectivity of costs.
When something is assumed to be “given” – the cause is not explained. This is not acceptable to an Austrian economist.
Costs are subjective, forward-looking and short-lived!
They are tied to the moment of choice.
Thus we should define costs in the following way: “the cost of adopting a course of action is the expected want [or end] satisfaction that is perceived to be sacrificed by forgoing the next most highly-valued course of action.” (Rizzo)
Process: The process of determining cost is another aspect of the process of determining value (as we saw with diminishing marginal utility or value and the law of increasing marginal opportunity costs).
Discovery: Cost, like value, must be discovered – that is, in both cases, the individual must discover which causes of action lead to which results in terms of want satisfaction. And in the case of costs – which are forward looking with respect to choice – he must discover and evaluate the choices in front of him. Therefore, costs are always “perceived” in that sense. But these perceived costs associated with alternatives must all be discovered – they are never “given.”
The Entrepreneur: The discovering of costs is a part of the general entrepreneurial view of economics. This is why the concept of equilibrium leaves out some important points of understanding according to the Austrian analysis. Everything has already been discovered!
For example, the idea that a firm is in “maximizing profit” or “minimizing loss” when
MR = MC.
Again – all discovery has been undertaken. It is assumed away. More on this later.
James Buchanan’s implications of subjective cost are well stated (Cost and Choice):
1. Cost exists only in the mind of the decision maker.
2. Cost is forward-looking, based on anticipations.
3. Cost can never be realized (or, in some sense, achieved). [we never really know what we gave up]
4. Cost can never be measured by an outside observer (not even really by the individual himself – how can want satisfaction be measured?).
5. Cost can be dated only at the moment of choice.
6. Cost must be borne exclusively by the decision maker.
This is why equilibrium models often obscure the concept of subjective cost:
· Presence of perfect knowledge means that there is never uncertainty about costs
· Past/present/future are the same
· Agents have perfect hypothetical knowledge – they know what would have been the case in an alternative choice
· The impossibility of measuring costs loses some of its force when a money “equivalent” is measureable. Once we have this money “equivalent” – people lose sight of costs in terms of subjective ends forgone – and just think about the dollar amount. Bob’s choice meant that he made $100 instead of $75 vs. Bob’s choice meant that he gave up the satisfaction of making $75 instead of making $100. But that satisfaction is not measurable! So two people, both having a cost of $75 does not mean that their costs are equal in any meaningful sense.
Example: Let’s look at the theory of the firm –
Review the mainstream (textbook) explanation:
All actors are trying to maximize profit or minimize loss (monetary).
A firm will operate at an output level where Marginal Revenue = Marginal Cost (that is the best it can do).
Therefore, long-run equilibrium in the competitive model is where P=MR=AR=MC=ATC
This meets both productive efficiency (producing at lowest cost - ATC is minimized) and allocative efficiency (can't move the resources to a higher valued use since this is where the firm is making a zero economic profit -- just earning its opportunity cost).
So:
The model assumes the owners of the firm want to maximize monetary profit. The idea of value being the goal of the individual owners is lost. It is dollars – not the satisfaction that the dollars would bring - or even a non-monetary satisfaction.
If we imagine the firm outside of long-run equilibrium, then cost is the entrepreneur’s own valuation of a course of action he rejects –
And because money revenue is regarded as the entrepreneur’s single aim, this outcome would be an alternative money revenue. It can never be anything else in the model.
Let’s examine Buchanan’s implications of the subjectivity of costs in the context of the theory of the firm:
· Costs exist only in the mind of the decision-maker.
Response: The cost is not forgone revenue or profit, it is the subjective cost of the entrepreneur.
Cost is not an outlay by the firm – but the alternative perceived opportunity.
· Cost is based on anticipation
Response: – where is the anticipation in the theory of the firm? The decision has been made. There is no entrepreneur!
· Cost is never realized.
Response: The decision maker never knows for sure the she has “covered costs.” Can we ever be sure we have “maximized profit?” "Minimized loss?" No.
Remember to maximize profit in a long run equilibrium means that any alternative would bring in less profit. But we really don’t know that that is the case. And this is why entrepreneurs are always searching for more information, discovering new opportunities – they don’t simply stop when profit is supposedly “maximized.” There is no information-generating process in the mainstream theory of the firm.
· Costs exist only at the moment of choice.
Response: This means costs exist (for the overall firm) at the firm’s planning and implementation stages – when decisions are made and action is taken. Where is this in the theory of the firm?
The only “process” the model talks about is – if price is either below or above ATC where MR = MC – then firms will exit or enter, changing price, and therefore changing profit until it is maximized.
So this model does tell us something about how markets work – why firms (in a sense) will exit or enter an industry, for example.
But much of what is interesting and useful about the subjectivity of costs is missing. Most important to an Austrian economist is that the entrepreneur is missing!
To the degree we are interested in processes, we cannot ignore the entrepreneur and the subjective costs upon which the entrepreneur makes decisions.
Why would the process be interesting? Who cares!! Why does it matter?
Well we will discuss the idea of the entrepreneur in more detail later – but basically, the entrepreneur discovers opportunities and acts upon them. And the way by which they discover them is through knowledge discovery and generation. Knowledge that includes, for example, relative prices of resources and consumer goods. If this is true – then how those prices themselves come about is very important. If the prices are changed (for whatever reason) – the entrepreneur will change her decisions. The entrepreneur’s decisions also will change the opportunities available to others. So the circumstances under which all of these decisions are made is important.
The process of discovery - the incentives, the decisions, the actions, the outcomes all change when there is a rule change.
For example, why does unemployment change? Much of it has to do with the decisions that entrepreneurs make since they are the job creators.
Do No Harm!!
So what rules or institutions, for example, can hinder or help this process of discovery that entrepreneurs undertake?
The bottom line is that the outcomes of this process effect people’s lives.
Example:
Rule #1: Progressive income tax system
Rule #2: Consumption tax
Would entrepreneurs make different choices under these two different regimes? How would the choices be different? How would those choices effect job creation? Consumer choice? Etc.
The equilibrium model of a firm maximizing profit doesn’t talk about any of this. It can talk about increasing or decreasing costs (generally) in the model and how that might change the "equilibrium" output level – but that’s about all it can do. If ATCs increase, profits go down, firms exit, resources move elsewhere where there is more profit to be made. And there is always that alternative in the model.
What about entrepreneurs deciding to just leave those resources idle because of too much uncertainty in the decision-making process? That seems to be what is happening now. We need to attempt an explanation of that. But we cannot using this model.
Summary:
Process of Discovery of alternative potential ends by the entrepreneur/decision- maker (the ends are not given, they must be discovered) -
Choice (subjective costs) - Incentives.
Outcomes of these choices.
But what hinders or helps the process of discovery (the beginning step)? That is the interesting question according to Austrian economists.
DO ICE THREE (A)