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.
However, what is behind this law? To provide an answer to this question economists refer to the law of diminishing marginal utility.
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 may derive vast satisfaction from consuming one cone of ice cream.
However, the satisfaction he will derive from consuming a second cone might also be big but not as big 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.
It is also established that because the marginal utility of a good declines as we consume more and more of it, the price that we are willing to pay per unit of the good also declines.
Utility in this way of thinking is presented as a certain quantity that increases at a diminishing rate as one consumes more of a particular good. Utility is regarded as a feeling of satisfaction or enjoyment derived from buying or using goods and services.
According to the mainstream way of thinking, an individual’s utility scale is wired in his head. This scale determines for the individual whether he will purchase a particular good. The valuation scale is given and there is no explanation on how it was established.
It follows then that the formation of valuations is arbitrary. Thus, I may choose a particular good due to the valuation scale wired in my head – we however do not know the causes that have established the valuation scale.
The decision to buy or not to buy a particular good is also labelled as subjective valuation. Note that the subjective valuation in this framework is associated with an arbitrary valuation of goods.
On this Rothbard wrote, “There can be no valuation without things to be valued.”[2]
In other words, valuation is the outcome of the mind valuing things. It is a relation between the mind and a good or service.
Now, if preferences are constant and given then it is possible to compress these preferences into a mathematical formulation, i.e., one can capture people’s wishes by means of a formula, so it is held. This is labelled by mainstream economics as a utility function.
Also, given that utility is presented as some total quantity, labelled as total utility, it becomes possible, so it is held, to ascertain the addition to this total, which is labelled as additional utility or marginal utility.
But does it make sense discussing a good’s valuation process without referring to the purpose that this good serves?
The Menger explanation of how valuations formed
According to Carl Menger, the founder of the Austrian School of Economics, the heart of an individual’s valuations is his life. An individual assigns values to goods in accordance to the importance of those goods to his life maintenance. Various ends that an individual finds important to his life maintenance are then valued accordingly in a descending ranking.
On this Menger wrote,
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.[3]
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 ends.
Let us say that his highest priority or his highest end is to have one loaf of bread for himself. This means that John will retain for his personal consumption one loaf of bread.
The consumption of a loaf of bread is of utmost importance as far as his life maintenance is concerned.
With regards to his second loaf of bread, John exchanges it for five tomatoes, which help John to secure his second most important goal. For John the five tomatoes are going to enhance his life and wellbeing.
John then uses a 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 birds is ranked as number four on John’s priority list as far as his life and wellbeing is concerned.
The end determines the importance of means
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 the 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 means is what gives it value with respect to a particular “end”.
For instance, in securing 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.
Note that his selection is not arbitrary but based on the facts of reality – he requires for working purposes a comfortable shirt. In this sense, the shirt chosen promotes John’s life and wellbeing.
As far as John 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 employed to secure John’s most important end, the second loaf of bread to secure the second most important end, etc.
From this, we can infer that the end also assigns an importance to the resource employed to secure this end. This implies that the first loaf carries much higher importance than the second loaf because of the more important end or goal that the first loaf secures.
Why the value of goods 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?
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. (Remember the second loaf of bread helps John to secure his second most important goal, the third loaf of bread the third most important goal and the fourth loaf of bread the fourth important goal).
However, if this is the case, what is the point of trying to exchange something that is valued more for something that is valued less?
We have seen that to satisfy his second end to obtain five tomatoes he would exchange one loaf of bread.
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 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 life maintenance is concerned.
If John had only three loaves of bread this would mean that, each loaf would be valued according to the 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 as 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 is derived here from the fact that individuals use means to secure ends.
Ends are not set arbitrary
Also, observe that ends are not set arbitrary but graded in accordance with their importance in maintaining life.
Whilst it is true that valuations are subjective – they are not formed – regardless of the facts of reality. They are not formed mechanically by some valuation scale but are formed consciously and purposely.
If John had ranked his ends arbitrarily 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 feeding himself he would run the risk of weakening his body and becoming seriously ill.
We have seen that by choosing a particular end an individual also sets a standard of evaluating various means. For instance, if my end is to provide a good education for my child, then I will explore various educational institutions and will grade them in accordance with my information regarding the quality of education that these institutions are providing.
Observe that my standard of grading these institutions is my end, which is to provide my child with a good education.
We have also seen that another limitation for attaining various goals is the availability of suitable means. Thus to quell my thirst in the desert, I require water. Diamonds in my possession will be of no help in this regard.
There is no such thing as total utility
Marginal utility is not, as the mainstream perspective presents, an addition to the total utility but rather the utility of the marginal end.
There is no such thing as adding to total utility because of an 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 arithmetically priorities as such. Since total utility does not exist as such, various models in economics that based on the view that such total exists are questionable. According to Rothbard,
Many errors in discussions of utility stem from an assumption that it is some sort of quantity, measurable at least in principle. When we refer to a consumer’s “maximization” of utility, for example, we are not referring to a definite stock or quantity of something to be maximized. We refer to the highest-ranking position on the individual’s value scale. Similarly, it is the assumption of the infinitely small, added to the belief in utility as a quantity, that leads to the error of treating marginal utility as the mathematical derivative of the integral “total utility” of several units of a good. Actually, there is no such relation, and 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.[5]
Conclusion
Following the framework of thought of Carl Menger we have established that subjective valuation is not about arbitrary consumer choices. A particular end sets the value for the corresponding means. Furthermore, ends are not established arbitrary but in accordance to their suitability to support people’s life and wellbeing. In this sense, valuations are always in reference to the facts of reality. If people had formed valuations arbitrary then they would have run the risk of endangering their life and wellbeing.
[1] Case, Karl E., and Ray C. Fair. Principles of Microeconomics (7th Edition) (Case/Fair Economics 7e Series). Amsterdam: Prentice Hall, 2003.
[2] Murray N. Rothbard, Towards a Reconstruction of Utility and Welfare Economics.
[3] Carl Menger, Principles of Economics, chapter 3.
[4] Murray N.Rothbard, Man,Economy,and State with Power and Market pp 302-310
[5] Ibid pp 305-306.
