Why do individuals pay much higher prices for some goods versus
other goods? The common reply to this is the law of supply and
demand. But what is behind this law? To provide an answer to
this question economists refer to the law of diminishing
marginal utility.
At that point, most people stop listening. Too technical for
me! But in fact, it is not. The concept of marginal utility is
the essential building block of a sound theory of human action
as it applies in the science of economics. But too often, the
mainstream theory is misleading. So I offer this Austrian
attempt to demystify the idea. Mainstream economics explains the law of diminishing marginal
utility in terms of the satisfaction that one derives from
consuming a particular good. For instance, an individual derives
vast satisfaction from consuming one cone of ice cream. The
satisfaction he will derive from consuming a second cone might
also be vast but not as vast as the satisfaction derived from
the first cone. The satisfaction from the consumption of a third
cone is likely to diminish further, and so on.[1]
From this mainstream economics concludes that the more of any
good we consume in a given period, the less satisfaction, or
utility, we derive out of each additional, or marginal, unit.
From this it is also believed that if the marginal utility of
a product declines as we consume more and more of it, the price
that we are willing to pay per unit also declines.
Since various goods generate different magnitudes of utility,
mainstream thinkers have concluded that consumers should
allocate their money income in such way that the marginal
utility per dollar spent is the same for all goods purchased.
Utility in this way of thinking is presented as a certain
quantity that increases at a diminishing pace as one consumes
more of a particular good. The question that arises in response to this way of thinking
is how can one talk about a utility or a benefit that a good
offers without stipulating the purpose that a particular good
serves?
The Menger-Mises
explanation
In the Austrian view, every individual is seen as employing
the resources or means at his disposal in order to secure
various ends. The use of resources is not done haphazardly but
in accordance with an individual's priorities. The individual
ranks various ends or goals that he wants to attain. According
to Menger human life sets the order of priorities for various
ends.
As concerns the differences in the importance that
different satisfactions have for us, it is above all a fact
of the most common experience that the satisfactions of
greatest importance to men are usually those on which the
maintenance of life depends, and that other satisfactions
are graduated in magnitude of importance according to the
degree (duration and intensity) of pleasure dependent upon
them. Thus if economizing men must choose between the
satisfaction of a need on which the maintenance of their
lives depends and another on which merely a greater or less
degree of well-being is dependent, they will usually prefer
the former.[2]
Consider John the baker, who has produced four loaves of
bread. The four loaves of bread are his resources or means that
he employs to attain various goals. Let us say that his highest
priority or his highest end, as far as his life is concerned, is
to have one loaf of bread for himself. This means that John will
retain for his personal consumption one loaf of bread.
The second loaf of bread helps John to secure his second most
important goal, as far as life is concerned, and that is to
consume five tomatoes. Let us say that John was successful and
finds a tomato farmer that agrees to exchange his five tomatoes
for a loaf of bread.John uses a third loaf of bread to exchange it for the third
most important end, which is to have a shirt. Finally, John
decides that he will allocate his fourth loaf to feed wild
birds.Observe that to attain the second and the third end John had
to exchange his resources — loaves of bread — for goods that
would serve to achieve his ends. To secure an end of having a
shirt John had to exchange his loaf of bread for the shirt. The
loaf of bread is not suitable by itself to fulfil the services
that the shirt provides.
The suitability of the mean is what gives it value so far as
a particular end is concerned. From this we can infer that a
given end dictates or establishes, so to speak, the specific
means or resources that will be chosen by the individual for the
attainment of the end. For instance, to secure the end of having a shirt John must
decide whether it is going to be a leisure shirt or a work
shirt. John will have to select among various shirts the most
suitable for his specific end — let us say to have a work shirt.
Being a baker John may conclude that the shirt must be of
white color and made out of thin rather than thick material to
keep him comfortable while working next to a hot oven. According to Rothbard, "an individual evaluates ends
(consumption) on his value scale and that his valuation of means
(for production) is dependent upon the former."[3]
As far as John's life is concerned, feeding wild birds is
ranked the lowest among the ends that John is aiming at given
his pool of resources — four loaves of bread. Observe that the
first loaf of bread is employed to secure the most important end
the second loaf of bread the second most important end, etc. From this we can infer that the end also assigns importance
to the resource employed to secure the end. This means that the
first loaf carries much higher importance than the second loaf
because of the more important end that the first loaf secures.
(While it is intuitively correct to say that the importance
of an end assigns importance to the resource employed to attain
the end, we need to qualify this process further. If there had
been a large gap between the value of the end and the value of
the resource then it would imply that the resource is
undervalued. Once something is undervalued this attracts
competition, which in turn will bid the value of the resource up
to a point where further bidding will eliminate the gap). Now, because John regards each of the four loaves of bread in
his possession as interchangeable he assigns to each loaf of
bread the importance as imputed from the least important end,
which is feeding wild birds. Why does the least important end
serve as the standard for valuing the loaves of bread?
Imagine John uses the highest end as the standard
for assigning value to each loaf of bread. This would imply that
he values the second, third, and fourth loaves much higher than
the ends he secures. But if this is the case, what is the point
of trying to exchange something that is valued more for
something that is valued less? Since the fourth loaf of bread is the last unit in John's
total supply it is also called the marginal unit, i.e., the unit
at the margin. This marginal unit secures the least important
end. Or we can also say that as far as life is concerned, the
marginal unit provides the least benefit.
If John had only three loaves of bread this would mean that
each loaf would be valued according to end number three — having
a shirt. This end is ranked higher than the end of feeding wild
birds. From this we can infer that as the supply of bread
declines the marginal utility of bread rises. This means that
every loaf of bread will be valued much higher now than before
the supply of bread has fallen. Conversely, as the supply of
bread rises, its marginal utility falls and each loaf of bread
is now valued less than before the increase in the supply took
place.
Note that the law of declining marginal utility was derived
here from the fact that individuals use means to secure various
goals or various ends. Also observe that ends are not set
arbitrarily but graded in accordance with their importance to
maintain life. If John had ranked his ends randomly then he would have run
the risk of endangering his life. For instance, if he had
allocated most of his resources to clothing and feeding wild
birds and very little to feed himself he would run the risk of
weakening his body and becoming seriously ill. Furthermore, marginal utility here is not, as the mainstream
presents, an addition to the total utility but rather the
utility of the marginal end. There is no such thing as addition
to total utility as a result of the additional unit of a good.
As we have seen utility is not about quantities but about
priorities or the ranking that each individual sets with respect
to his life.[4] Obviously
one cannot add up priorities to a total.
How are prices set?
A major problem with the mainstream framework of thinking is
that people are presented as if a scale of preferences is hard
wired in their heads. Regardless of anything else this scale
remains the same all the time. What the mainstream way of
thinking presents is not human beings but robots. The human
robot chooses goods because the valuation scale has told him so.
The valuation scale somehow knows which good offers the best
utility without letting us know how the scale knows all that.
If the valuation scale is part of the human brain then it
makes a lot of sense to attempt to extract this scale either by
means of questionnaires or various psychological tests and
laboratory experiments. Once the valuation scale is extracted
social scientists can establish how to allocate scarce resources
in the most efficient way.
It makes little sense that a valuation scale should reside in
the head of an individual irrespective of the facts of reality.
After all the difference between a robot and a human being is
that a human being can change his mind regarding the importance
of a particular good for him.
For instance, the priority of ends is likely to change with a
change in an individual's pool of resources. With an increase in
his pool of resources an individual who previously assigned a
high ranking to have a second hand car might now decide that a
new Mercedes is much more important, while the second hand car
will not feature at all on his priority list. Despite the change
in the valuation scale the law of declining marginal utility
always remains in force for the reasons we have already
outlined. Also, there can be no valuation without things to be valued.[5]
Value is established once an individual's mind has interacted
with a particular thing. The evaluation process is then
establishes for what end, or purpose, a particular thing could
be of use.
On this Carl Menger wrote,
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. It is therefore, also quite erroneous
to call a good that has value to economizing individuals a
"value", or for economists to speak of "values" as of
independent real things, and to objectify value in this way.[6]
The view that the valuation scale can be regarded as
hard-wired in peoples' minds provides the foundation for the
supply-demand curve framework. According to popular thinking, at
a given price there is going to be a particular quantity of
goods supplied and demanded.
Following the mainstream view of the law of declining
marginal utility and a fixed valuation scale, mainstream
thinkers have concluded that as a given price of a good falls,
its quantity demanded increases while the quantity supplied
declines. The culmination of the entire exercise is the
intersection of the supply-demand curves, which establishes the
equilibrium price. At this price the quantity supplied is equal
to the quantity demanded.
The law of supply and demand framework as presented by
mainstream economics doesn't originate from the facts of reality
but rather comes from the imaginary construction of economists.
In the supply-demand curve framework there are no entrepreneurs.
Instead, the shift of curves comes in response to various
factors that set prices. For instance, it is held that a shift
in the demand curve to the right for a given supply will lift
the price of a good. The price will also increase if, for a
given demand curve, the supply curve shifts to the left. In
other words, the supply-demand curve framework doesn't deal with
human beings but with automatons that react to various factors.
Since mainstream thinking ignores the fact that human action
is about purposeful conduct, one is not surprised to find that
their framework of price determination has nothing to do with
human beings.
According to Mises, the prices of goods are not given as
such; they are established in a particular transaction at a
particular place and at a given time by human beings.
A market price is a real historical phenomenon, the
quantitative ratio at which at a definite place and at a
definite date two individuals exchanged definite quantities
of two definite goods. It refers to the special conditions
of the concrete act of exchange. It is ultimately determined
by the value judgments of the individuals involved. It is
not derived from the general price structure or from the
structure of the prices of a special class of commodities or
services. What is called the price structure is an abstract
notion derived from a multiplicity of individual concrete
prices. The market does not generate prices of land or
motorcars in general nor wage rates in general, but prices
for a certain piece of land and for a certain car and wage
rates for a performance of a certain kind.[7]
From the means-end framework we can deduce that an individual
enters an exchange if he believes that this exchange will
improve his life and well-being. Thus given his pool of
resources, which is four loaves of bread, if John has agreed to
exchange a loaf of bread for five tomatoes, this implies that he
assigns to five tomatoes a much higher importance than to a loaf
of bread. Remember that he ranks the importance of each loaf of
bread according to the least important end (feeding wild birds).
Likewise the tomato farmer ranks the loaf of bread much
higher than the five tomatoes in his possession. It follows then
that the heart of the act of exchange is the fact that
participants in an exchange are of the view that they will make
personal gain. Thus, John will not exchange his fourth loaf of
bread for a piece of chocolate, if he considers having the
chocolate a less important end than feeding birds. In short, it
doesn't make much sense to exchange something that is valued
more for something that is valued less.
As a rule it is a supplier who sets the price. After all it
is the supplier who offers the goods to the buyers. So it is the
supplier who must set the price of a good before he presents the
good to the buyers.
In order to secure the price that will improve his lot, the
price that the supplier sets must cover his direct and indirect
costs and provide a margin for profit. By setting the price the
supplier must make as good an estimate as possible regarding
whether he will be able to sell his entire supply at the price
set.
The process of making the estimate involves figuring out the
possible responses of the buyers and the possible responses of
his competitors — other suppliers. If his estimates where
accurate then he makes a profit. By making a profit the supplier
expands his pool of resources, which in turn enables him to
attain more ends. His standard of living improves.
Observe that while the cost of production in some cases would
appear to be the main factor in price determination, this is not
so. Ultimately it is the evaluation of the buyer that dictates
whether the price set by the supplier is going to be realized.
Every buyer decides in his own context whether the price paid
for a good betters his life and well-being.
If the cost of production were the driving factor behind
setting market prices then how would we explain the prices of
goods that have no cost because they are not produced — goods
that are simply there, like undeveloped land? Likewise the
cost-of-production theory cannot explain the reason for the high
prices of famous paintings. According to Rothbard,
Similarly, immaterial consumer services such as the
prices of entertainment, concerts, physicians, domestic
servants, etc., can scarcely be accounted for by costs
embodied in a product.[8]
Now, let us say that for whatever reasons the supply of a
good has risen. If the supplier wants to sell his entire
expanded supply he will have to lower the price.
The lower price will enable the entrance of various
individuals that prior to the increase in the supply of a good
couldn't afford the good. Prior to the increase in the supply of
the good the incomes of those individuals was completely
absorbed in accommodating much higher priority goods and
services.
So by lowering the price, the supplier effectively expands
the means in these individuals' possession, which enables them
to attain another end — their living standards have now gone up.
Furthermore, the lower price has also expanded the means of
various previous buyers. As a result they can now afford a
greater amount of a good and perhaps secure new goals.
Now the calculation of the supplier indicates to him that his
profit per unit of a good has fallen on account of a decline in
the price, however the total profit on account of the increase
in the stock sold has increased. Hence the supplier's pool of
means has now expanded and he can now aim at and secure new
goals. So what we have seen here is a process where an expansion
of means or an increase in the supply of a good has lifted the
living standards of the seller and the buyers.
What then is the meaning of the equilibrium price that
mainstream economists hold is determined by the supply and
demand curves? The equilibrium price is established once a
supplier sets a price at a level that will attract enough buyers
for his supply of a good. Consequently, once the seller sells
his goods in return for money or other goods he has reached his
goal as far as bettering his life and well-being is concerned.
He therefore has reached so-called equilibrium. Likewise the
buyer who uses his resources to secure the good offered by the
seller has bettered his life and he therefore has reached his
equilibrium, so to speak.[9]
Conclusion
In the mainstream way of thinking it is not individuals but a
given hard-wired valuation scale in their minds that decides
what is good for them. The prices of goods in the mainstream way
of thinking are established by mechanical shifts in supply and
demand curves. This framework depicts human robots rather than
human beings.
If the selection of goods is set mechanically, how in the
world can one talk about utilities and choices? Without
conscious, purposeful conduct, the use of the word "utility" is
a contradiction in terms. After all, the benefit that a good
provides must be in relation to individuals' particular ends and
their particular set-up.
Contrary to mainstream thinking, the Austrian framework shows
that it is the importance of various ends that determine the
selection of goods by individuals. The means-end framework also
shows that the prices of goods are not set mechanically by some
kind of supply-demand curves but by the goal-seeking choices of
individuals.
Frank Shostak is an adjunct scholar of the Mises Institute
and a frequent contributor to Mises.org. He is chief economist
of Man
Financial, Australia. Send him
mail and see
his outstanding Mises.org
Daily Articles Archive. Comment on the
blog.
Notes
[1] Case, Karl E., and
Ray C. Fair. Principles of Microeconomics (7th Edition)
(Case/Fair Economics 7e Series). Amsterdam: Prentice Hall,
2003.
[2] Carl Menger,
Principles of Economics,
chapter 3.
[3] Murray N. Rothbard,
Man, Economy, and State,
chapter
10.
[4] Murray N. Rothbard,
Man, Economy, and State,
chapter 3.
[5] Murray N. Rothbard,
"Toward a
Reconstruction of Utility and Welfare Economics."
[6] Carl Menger,
Principles of Economics,
chapter 3.
[7] Ludwig von Mises,
Human Action,
chapter
16, section 13.
[8] Murray N. Rothbard,
"The Celebrated Adam
Smith," originally in Economic Thought Before Adam
Smith:
An Austrian Perspective on the History of Economic Thought,
Vol. I, Edward Elgar Press, 1995; Mises Institute, 2006.
[9] Murray N. Rothbard
The Logic of Action One, p. 132.