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Marginal Utility Is Not Rocket Science

Mises Daily: Tuesday, June 05, 2007 by

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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.

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"Value does not exist outside the consciousness of men." – Carl Menger

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.