By Dr Frank Shostak
Why do individuals assign a greater value to gold than to bread, when bread seems to be more “useful” than gold? To provide an answer to this question economists refer to the law of diminishing marginal utility. The concept of diminishing marginal utility is the essential building block of economics. There is however a difference the way this law is discussed by mainstream economics and the Austrian School of Economics.
The mainstream approach
The popular 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 economists have concluded that the more of any good we consume in a given period, the less satisfaction, or utility, we derive out of each additional unit. From this, it is established that if the satisfaction from the additional unit 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 is going to decline.
Now, according to this framework of thinking since gold is relatively less abundant than bread it follows that the price of gold should be ranked higher than the price of bread because the benefit derived from the additional unit of bread is going to be much lower than the benefit derived from the additional unit of gold. On the same basis, we can also derive that although air is essential to human life, because of it almost unlimited supply individuals are likely to assign to air a much lower price than to bread.
Utility in this way of thinking is presented as a certain quantity that increases at a diminishing pace as one consumes or uses more of a particular good. Given that utility is presented as some total quantity, also labelled as the total utility, it becomes possible to introduce mathematics here to ascertain the addition to this total, which is labelled as additional utility or marginal utility. On this way of thinking, human action is not navigated by reason but by biological needs.
According to Carl Menger, the founder of the Austrian School of Economics, individuals assign priorities to various goals that they want to achieve. The standard for setting priorities is individual’s life. Those ends that are of utmost importance for individual’s life maintenance are going to be assigned the highest ranking. Whilst ends that are of lesser importance to life maintenance are going to be assigned a lower ranking.
According to Menger,
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.
Consider John the baker, who has produced four loaves of bread. The four loaves are his means that John employs to attain various goals or ends. Let us say that his highest priority or his highest end as far as life maintenance is concerned is to have a loaf of bread for his personal consumption. The loaf of bread is of utmost importance to John in order to support his life.
The second loaf of bread enables John to secure five tomatoes for his personal consumption. By means of five tomatoes, John attains his second most important end, as far as his life maintenance is concerned. In order to secure, the five tomatoes John must exchange a loaf of bread for them. Let us say that John was successful and finds a tomato farmer that agrees to exchange his five tomatoes for the loaf of bread.
John uses the 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 of bread to feed wild birds.
Note that feeding wild birds is John’s fourth end – the least important end. The fourth loaf of bread is the last unit in John’s total supply of bread it is also called the marginal unit or the unit at the margin.
The marginal unit secures the least important end. Alternatively, we can also say that as far as life is concerned, the marginal unit provides the least benefit.
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. Similarly, to secure the end of having five tomatoes John had to exchange a loaf of bread for five tomatoes.
Note 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.
Ends determine the value of means
A given end determines the specific means that an individual is likely to select for the attainment of that end. For instance, to secure the end of having a shirt John would 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 a white colour and made out of a thin rather than thick material to keep him comfortable while working next to a hot oven.
Furthermore, we can also infer that the end assigns an importance to the resource employed. This implies that the first loaf of bread carries much higher importance than the second loaf of bread because of the more important end that the first loaf of bread secures.
Since individual’s ends determine the valuations of means and thus his choices, it follows that the same good is going to be valued differently by an individual as a result of changes in his ends.
Whilst as a rule individuals’ assign a greater value to gold versus water this need not be always the case. Thus to quell his thirst in the desert, the individual requires water. Any gold in his possession is going to be of no help in this regard. (The individual is going to assign the highest ranking of having water to maintain his life in the desert. Gold is going to have very low importance here).
Why the value of each unit of resources is determined by the least important end?
Now, John regards each of the four loaves of bread in his possession as interchangeable. How is then he going to value each of the four loaves? We suggest that he is going to value each loaf of bread in accordance with 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 is using the first end as the standard for assigning value to each loaf of bread. This would imply that he values the second, the third, and the fourth loaves much higher than he values the second, the third and the fourth end.
However, if this is the case, what is then the point of exchanging something that is valued more for something that is valued less? Observe that to satisfy his second end, which is to have five tomatoes; John would have to exchange one loaf of bread for five tomatoes. (Note that five tomatoes, which is the second end, is assigned a lower value than the first end). If John assigns a higher value to a loaf of bread than to five tomatoes most likely, no exchange is going to take place.
Observe, that 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 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 every loaf of bread is going to be valued much higher than before a decline in the supply of bread. Conversely, as the supply of bread rises each loaf of bread is now valued less than before the increase in the supply took place.
Also, observe that ends are not set arbitrarily but graded in accordance with their importance in maintaining life. If John had ranked his ends randomly and without any thought 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 then run the risk of weakening his body.
Utility is not some measurable quantity
In the Menger’s framework, utility is not about quantities but about priorities or the ranking of various ends with respect to an individual’s life. One cannot however, add priorities as such.
Consequently, marginal utility here is not as the mainstream perspective presents, an addition to the total utility but rather the utility of the marginal end.
Since total utility cannot be quantified various economic models that employ mathematical methods based on the view that such a 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.
Note that both the mainstream approach and the Menger’s way of thinking emphasize the importance of the relative quantity of a good in its price determination.
The difference however, is that the mainstream relies on psychology whilst Menger emphasizes the importance of a purpose that a good helps to achieve.
The mainstream approach highlights the satisfaction an individual derives from additional unit of a thing i.e. biological needs.
The Menger’s framework emphasizes the facts of reality that must be figured out and be considered to for the life maintenance.
Thus in order to maintain his life John requires a loaf of bread – this is of utmost importance to keep him healthy. To have a loaf of bread is the fact of reality that John must consider if he wants to stay healthy.
To have a working shirt is also important to John. He has to decide what kind of shirt he should have that is going to make him comfortable. John would have to figure out all this. His decision is going to be based on a thought process.
Note again, in the mainstream approach, utility is regarded as some kind of quantity, which, can be subjected to the rules of mathematics. This is however, not so with regard to Menger’s framework where utility refers to the ranking of goods with respect to life. Again, in the Menger’s framework goods are evaluated with respect to various ends with life assigned as the most important end.
In addition, in the mainstream approach there is a strong emphasis on indifference curves, which supposedly could be helpful in understanding individuals’ choices. Indifference, however, has nothing to do with individuals’ purposeful conduct. 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 an individual’s life.
In conclusion, we hold that it does not make sense discussing the marginal utility of a good without referring to the purpose that this good serves. The marginal utility theory as presented by popular economics describes an individual without any goals and which is driven by psychological factors. This individual is not aiming consciously to reach his goals.