By Dr Frank Shostak
Why do individuals value bread less than gold, when bread seems to be more important in supporting an individuals’ life than gold? 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 great but not as great 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. From this, it is also held 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.
Now, according to the mainstream framework since gold is relatively scarcer than bread it follows that the price of gold should be higher than the price of bread because the marginal utility derived from bread is going to be much lower than the marginal utility derived from gold.
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 total utility, it becomes possible to introduce mathematics here to ascertain the addition to this total. Does it however make sense discussing the marginal utility of a good without referring to the purpose that this good serves?
Menger’s explanation
According to Carl Menger, the founder of the Austrian School of Economics, individuals assign priorities to the various goals that they wish to achieve. As a rule, according to Menger, the highest priority is going to be assigned to life maintenance. Various ends that an individual will find useful for his life maintenance will be assigned a descending rank in accordance with his own preferences.
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 is to have one loaf of bread for himself. The loaf of bread is of utmost importance for John in order to sustain his life. 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 is going to allocate his fourth loaf to feed wild birds.
Observe that to attain the second and the third end John has to exchange his resources — the loaves of bread — for goods that would serve to achieve his ends. Thus, to secure the end of having a shirt John has 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.
Ends determine the value of means
A given end dictates or establishes, the specific means or resources that will be chosen by the individual for the attainment of that 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.
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 — the four loaves of bread.
Observe that the first loaf of bread is employed to secure the most important end as far as John’s life is concerned, the second loaf of bread the second most important end as far as John’s life is concerned, etc. From this, we can infer that the end also assigns an importance to the resource employed to secure the 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 of bread secures.
The value of each unit of resources is determined by the least important end
Now, because John regards each of the four loaves of bread in his possession as identical 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, the third, and the fourth loaves much higher than the ends he secures.
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?
Thus, to satisfy his second end to obtain five tomatoes he would exchange one loaf of bread for five tomatoes. If, however, 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, i.e., the unit at the margin. This marginal unit secures the least important end. Alternatively, we can also say that as far as John’s 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 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 decline in the supply of bread.
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 ascertained from the fact that individuals use means to secure various ends.
Furthermore, marginal utility here is not as the mainstream perspective presents, an addition to the total utility but rather the utility of the marginal end. Utility is not about quantities but about priorities or the ranking that each individual sets with respect to his life.
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.
Now, 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. Individuals by pursuing purposeful actions cannot be indifferent between various goods. 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 individuals’ life.
Conclusion
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. In this sense, popular economics describes a mindless individual.
