By Dr Frank Shostak
Why do individuals pay 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.
Mainstream economics explains this law in terms of the satisfaction that one derives from consuming a particular good. For instance, an individual may derive vast satisfaction from consuming one cone of ice cream. The satisfaction he will derive from consuming a second cone might also be large but not as large 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.
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. It is also established that if the marginal utility of a product declines as the supply of this product increases, the price that we are willing to pay per unit also declines.
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. Since various goods generate a different amount 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.
The Menger explanation of how valuations formed
The question that arises is how can one talk about utility or benefit that a good offers without stipulating the purpose that a particular good serves?
According to Carl Menger – the founder of the Austrian School of Economics, individuals rank goods in accordance to the importance of those goods to individuals’ life and wellbeing. Various ends that individuals find important to their life and wellbeing are valued in a descending ranking.
Consider John the baker, who has produced four loaves of bread. The four loaves are his resources or means that he employs to attain various ends. Let us say that his highest end as far as life and wellbeing is concerned is to have the one loaf of bread for himself.
With regard to the second loaf of bread, John exchanges it for five tomatoes, which helps him to secure his second most important end. John then uses the third loaf of bread to exchange it for a shirt – his third most important end.
Finally, John decides that he will allocate his fourth loaf to feed wild birds. Feeding the wild birds is ranked as the fourth end on the John’s priority list as far as his life and wellbeing is concerned.
Observe that to attain the second and the third end John has to exchange his resources — the loaves of bread — for goods that will serve to achieve the ends.
Thus, to secure the end of having a shirt John has to exchange a loaf of bread for the shirt. Moreover, John must decide whether the purpose of having a shirt is for leisure or for work. Let us say that John has decided that the shirt must be for working purposes. This means that he will choose a shirt that will make him comfortable whilst making bread. Note, the suitability of the mean is what gives it value with respect to a particular end.
From this, we can infer that the end assigns the importance to the resource employed to secure this end. This implies that the first loaf of bread carries much higher importance than the second loaf because of the more important end that the first loaf secures.
Why the value is determined by the least important end?
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?
Consider that John has decided to use the highest end as the standard for assigning value to each loaf of bread. Note that to satisfy his second end to obtain five tomatoes John would have to exchange the one loaf of bread for five tomatoes. However, if a loaf of bread is valued by John higher than five tomatoes, obviously no exchange will take place.
Since the fourth loaf of bread is the last unit in John’s total supply, it is also called the marginal unit- the unit at the margin. This marginal unit secures the least important end. Alternatively, we can also say that the marginal unit provides the least benefit as far as the life and the life maintenance is concerned. If John had only three loaves of bread this would mean that, each loaf would be valued by the third end— having a shirt.
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 higher now than before the supply of bread has declined. Conversely, as the supply of bread rises, its marginal utility declines as each loaf of bread is now valued less than before the increase in the supply took place.
When confronted with various goods an individual makes his choice based on the suitability of goods to be employed as means to various ends. Note again that the ends are ranked with respect to his life and wellbeing. A limitation on reaching various ends is the availability of suitable means. To quell the thirst in the desert, an individual requires water. Gold in his possession will be of no help in this regard.
Now, following the Menger’s framework of thinking we can establish that the price of gold should be higher than the price of bread, all other things being equal.
The reason being, because gold is scarcer than bread. This means that the marginal unit of gold serves a much higher end than the marginal unit of bread as far as individuals’ life and wellbeing is concerned.
By the mainstream framework of thinking, individuals are presented as if a valuation scale is hard wired in their heads. Regardless of anything else this scale remains the same all the time.
We hold that, there can be no valuation without things to be valued. Value is established once an individual’s mind has interacted with a particular thing. The mind then establishes for what end, or purpose, a thing could be of use. Hence, the valuation scale emerges once the process of valuation took place. It also means that the valuation scale cannot remain unchanged.
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 wellbeing. Hence value does not exist outside the consciousness of men.
Also, the marginal utility is not, as the mainstream perspective presents, an addition to the total utility but rather the utility of the marginal end. According to Rothbard,
……. there is no such thing as “total utility,” only the marginal utility of a larger-sized unit. The size of the unit depends on its relevance to the particular action.
Conclusion
Following the framework of thought of Carl Menger, a particular end sets the value for the corresponding means. Ends are not set arbitrary but in accordance to it suitability to support individual’s life and wellbeing. In this sense, individuals’ valuations are always in reference to the facts of reality.
