Study Guide to the Theory of Money and Credit
2. On the Measurement of Value
Summary
The classical economists relied on an objective theory of value, and naturally thought that money was a measuring rod of this objective value. Modern economics is based on a subjective theory of value, which traces the source of value to the mind of the individual actor. Value is the significance given to a particular good by a person.
Subjective value is bound up with the idea of exchange. Each party to a voluntary trade gives up an item that is lower on his value ranking (or scale of values), in exchange for an item that is higher on his ranking. Exchanges will occur until there are no more mutually beneficial trades. Individuals’ subjective valuations give rise to objective exchange ratios or prices.
The law of diminishing marginal utility states that the value of the last unit of a commodity decreases as the person acquires a greater quantity of the commodity. The various schemes to define an objective measurement of satisfaction—a “util”—cannot get around the fact that value scales involve a ranking (1st, 2nd, 3rd, etc.) and not a measurement of the intensity of value. It is impossible to perform arithmetical operations on the marginal utilities of various units in order to compute the “total utility” or total value of the entire stock of the good. If someone says, “Diamonds are more valuable than water,” what he means is that if forced to give up one diamond or one gallon of water, he would choose to give up the latter.
Knowledge of objective money prices causes people to revise their subjective value scales. Objective money prices provide a “common denominator” for the market exchange values of all the various goods and services available.
However, money prices themselves are constantly changing. That is why Mises and Menger prefer to say that money is an index (not a measurement) of prices, since it is less liable to confusion.
Chapter Outline
1. The Immeasurability of Subjective Use-Values
The classical economists (such as Adam Smith) relied on an objective theory of value, which held that the value of a commodity was based on an objective criterion (such as the amount of labor required for its production). In this mindset, it was natural to view money as a measuring rod of this objective value. Just as a thermometer shows a higher reading on a hot day than on a cold day—reflecting the objectively warmer temperature—so too did the classical economists think that a higher price tag indicated that a more expensive good had a higher objective value than a cheaper good.
However, modern economics is based on a subjective theory of value, which traces the source of value to the mind of the individual actor. In modern economics, value doesn’t reside in physical things per se, but instead is an attribute ascribed to physical things by subjective preferences. Value is the significance given to a particular good by a person, who can imagine ways to use the good to become more satisfied.
Subjective value is bound up with the idea of exchange. If a man values a piece of iron more than a piece of bread, it means that he would choose the former if faced with a choice between the two. Even Robinson Crusoe, alone on his desert island, reveals his valuations by his “exchanges” with nature. For example, he may value satisfying his hunger more than he values satisfying his desire to lounge on the beach, and that is why he “exchanges” his leisure time for coconuts (by climbing trees).
With more than one person, valuation guides exchanges made in the marketplace. Each party to a voluntary trade gives up an item that is lower on his value ranking (or scale of values), in exchange for an item that is higher on his ranking. This apparent contradiction—where each person gives up something “less valuable” in exchange for something “more valuable”—is perfectly sensible because value is in the eye of the beholder, i.e., value is subjective.
In the market, exchanges will occur until there are no more mutually beneficial trades. The underlying subjective valuations driving acts of exchange do not involve a “measurement” of value. (For an analogy, someone can rank his friends in order of importance, without implying that there is an objective unit of friendship that the person measures in each person before constructing the ranking. Someone can report, “Jim is my best friend and Sally is my second-best friend” without being able to say, “Jim is a 24 percent better friend than Sally.”) All that is necessary is that a person be able to look at any two possibilities, and decide which he prefers.
Even though market exchanges are driven by subjective valuations that are themselves nonquantifiable, nonetheless these exchanges in turn give rise to objective exchange ratios or prices. For example, suppose Alice has three pears while Bob has two apples, and that on her value scale Alice ranks “two apples” more highly than “three pears,” whereas Bob has the opposite ranking. These subjective valuations—which do not involve any measurement of the amount of value or utility residing in each combination of fruit—mean that the two people can gain from trading the three pears for the two apples. This mutually beneficial trade then establishes that the objective price of an apple is 1.5 pears, and that the price of a pear is two-thirds of an apple. Thus Alice and Bob’s subjective rankings of apples and pears, allowed for the formation of an objective market price reflected in their exchange. But it would be nonsensical to describe this scenario as one in which “an apple gives 50 percent more value to people than a pear.”
The law of diminishing marginal utility states that the value of the last unit of a commodity (in someone’s possession) decreases as the person acquires a greater quantity of the commodity. This follows from the observation that a person will necessarily assign subsequent units of a commodity to those purposes that he deems less and less significant. For example, if a person has only one gallon of water, he will attach a great significance to it, because it is necessary to stave off thirst.
As a person’s access to water becomes greater, however, the last (or marginal) gallon of water becomes less significant. The 25th gallon, perhaps, will be devoted to cooking, and is not nearly as important as the 1st through 24th gallons, which were devoted to drinking. And the 1,000th gallon might be used to wash the car, a relatively unimportant goal.
The various schemes to define an objective measurement of satisfaction—a “util”—cannot get around the fact that value scales involve a ranking (1st, 2nd, 3rd, etc.) and not a measurement of the intensity of value. The renowned Chicago School economist Irving Fisher, for example, devised a clever argument by which he equated the utility of the 100th loaf of bread with the utility derived from the last and second-last units of fuel oil. At the same time, the utility of the 150th loaf of bread was equal to the utility of only the last unit of fuel oil. Fisher concludes that the 150th loaf of bread must have only one-half the utility of the 100th loaf. But this assumes away diminishing marginal utility in the fuel oil.
2. Total Value
If it is impossible to measure the value in a single unit of a good, it is obviously impossible to perform arithmetical operations on the marginal utilities of various units in order to compute the “total utility” or total value of the entire stock of the good. One problem with this approach is that a free good (such as air) would end up with a total value of zero, since the marginal utility of one cubic meter of air is zero in most circumstances.
It must be repeated that utility or value is a concept related to the acts of choice that a particular individual contemplates. If someone says, “Diamonds are more valuable than water,” what he means is that if forced to give up one diamond or one gallon of water, he would choose to give up the latter. But if an individual had to choose between all the water in the world, or all the diamonds, then he would choose to retain the water (at least if he wanted to live longer than a few days). Only in this contrived case can we meaningfully speak of the “total value” of the entire stock of water, because in this situation the “total value” and the “marginal value” are the same; the unit under consideration is all the water in the world.
3. Money as a Price Index
At this point, it should be clear that money cannot serve as a measuring rod of subjective value. There is a sense in which money is a measure of objective market exchange value, however. For example, if a car trades for $20,000 while a motorcycle trades for $10,000, then the car has twice as much exchange value. Someone bringing a car to market can obtain “twice as many goods and services” for it, where the amount is measured in money prices.
Knowledge of objective money prices causes people to revise their subjective value scales. Someone who despises smoking and loves vegetables may nonetheless place a higher value on an unopened carton of cigarettes than on a tomato, because she can sell the carton for money, and then use the money to buy a tomato as well as many other items. In this way, objective money prices provide a “common denominator” for the market exchange values of all the various goods and services available.
However, because money prices themselves are determined by the underlying subjective valuations of the traders, they are constantly changing. The various combinations of goods that one motorcycle can “buy” today, may be different tomorrow, not only because the price (quoted in money) of the motorcycle can change, but also because the prices (quoted in money) of all others goods can change. That is why Mises and Menger prefer to say that money is an index (not a measurement) of prices, since it is less liable to confusion.
Important Contributions
• The replacement of the classical economists’ labor (or cost) theory of value, with subjective value theory, was a true revolution in economic theory. The classical theory explained the price of a good by the amount of labor or (more generally) the cost of producing the good. Although such an approach explained the fact that prices and production costs tended to be similar, there were many problems. For example, it was clear that the actual day-to-day prices of goods were not determined by production costs, so at best the cost theory explained long-run tendencies, not the determinants of actual market prices. Worse still, “costs” are themselves prices, and so to explain the price of a good by the costs of producing it, only pushes the problem back one step. By explaining the prices of consumer goods through the interaction of subjective valuations in the market—and then using these consumer prices to explain the prices of the producer goods needed to make them—the subjective value theorists resolved these problems. Although other economists participated in the Subjectivist/Marginal Revolution, it was the Austrian economists who worked out the logical foundations of the new approach, as Mises’s frequent references to Menger, Böhm-Bawerk, and Wieser testify.
• Irving Fisher was an incredibly influential economist from the Chicago School, and arguably one of the founders of modern, mainstream economics. Although economists paid lip service to the subjectivist revolution in value theory, nonetheless they often fell back into the old habit of viewing utility as a cardinal, measurable substance. Mises’s critique of Fisher is a good illustration of this tendency. Modern Austrian economists also chide their mainstream peers for relying on mathematical models of “utility functions” that can easily lead the economist into forgetting that modern price theory only assumes that individuals can rank various combinations of goods from best to worst. There is no need to assume that a consumer has an intensity of preference for various goods that could be measured by units of utility.
New Terminology
Free good: A good that has a price of zero, because it is not scarce. There is enough of the good to satisfy all human wants that it can technically fulfill.
Law of diminishing marginal utility: The rule, deducible from the nature of economizing action, that each additional unit of a good or service will have a lower value, because a person will allocate successive units to satisfying ends that are less and less important.
Objective theory of value: An explanation of value that relies on the objective properties of a good, such as its cost of production or the amount of labor that went into its construction. (The classical economists, such as Adam Smith and David Ricardo, held an objective theory of value.)
Prices: The market exchange ratios between various goods and services. In a monetary economy, prices are typically quoted in terms of the money good.
Scale of values: An analytical tool by which the economist interprets the actions of an individual, who subjectively ranks particular units of goods and services in order from most to least important.
Subjective theory of value: An explanation of value that relies on individuals’ subjective rankings of particular units of goods and services. (The so-called Marginal Revolution of the early 1870s—spearheaded by Carl Menger, William Stanley Jevons, and Léon Walras—overturned the objective theory of value and ushered in the subjective theory.)
Value: The importance that an individual places on a particular unit of a good or service.
Study Questions
1. Explain: “In the older political economy, the search for a principle governing the measurement of value was to a certain extent justifiable.” (p. 38)
2. Why would an isolated individual still need to engage in a “comparison of values” before taking action with respect to scarce goods? (p. 38)
3. Why does an exchange of two items require that the people making the exchange place the items in reverse order on their value scales? (p. 39)
4. Explain: “The untenability of [Wieser’s] argument is shown by the fact that it would prove that the total stock of a free good must always be worth nothing.” (p. 45)
5. How does money aid the entrepreneur? (pp. 48–49)
