WorldSys: Austrian Economics Home Study Course, Week 2

The World Systems Project is going to begin with a thorough examination of Austrian economics, starting with Robert P. Murphy’s outstanding “Austrian Economics Home Study Course“. The plan is to blog my answers to the weekly questions, with posts and book reviews tossed in as I go along. 

It should go without saying that the following contains ‘spoilers’, and if you intend on doing the home study course on your own you might not want to read further.

1 What is marginal utility

Utility can be thought of as ‘usefulness’ or ‘satisfaction’, and margin means ‘this unit in this context’. One never chooses ‘chocolate cake’ as an abstract class, but a slice of chocolate cake at a specific time in their lives.

For most people most of the time the first slice has high utility because chocolate cake is sugary and delicious. The next slice has less utility because appetite for sugary deliciousness isn’t unlimited. By the third slice they’re probably tiring of cake, and by the fourth they might be positively sick of it. At a certain point they crossover into negative utility — the chocolate cake is actually making them nauseous.

When you’ve had no chocolate cake the first slice has a high marginal utility because it is the very first slice. After you’ve finished the first slice the second slice is evaluated on the margin; that is, in light of the fact that you’ve already had a slice, and compared to other foods you could be eating. As noted above the second slice will have less utility on the margin, the third less still, and the fourth even less.

2 What is the law of diminishing marginal utility

Extending the analysis from the previous question we can see that each successive unit of a good, evaluated on the margin, diminishes in utility. Displaying the wondrous depths of the imagination for which economists are famous, this phenomenon is called ‘the law of diminishing marginal utility’.

3 Can utility be compared between different people?

Not directly, but obviously we can use people’s testimony and their actions to decide on who ranks a given good more. In fact, this is the basis of exchange. The only reason two people will trade goods is because they each value what the other person has more than they value what they currently have.

4 If we take money from a rich man and give it to a poor man, have we raised total social utility?

No, Austrians don’t talk about ‘total social utility’ or try to compare utilities between people. It’s possible that a given poor person would value $100 more than a given rich person, but this needn’t be the case. Plenty of impecunious ’SurferDudez’ genuinely don’t, like, care about money, man.

5 does marginal utility involve a cardinal conception of utility? I.e., are there units of utility?

No. People value units of goods, but in Austrianism it makes no sense to speak of units of utility (such as ‘utilons’).

6 What is the purpose of Böhm-Bawerk’s example involving sacks of grain?

To demonstrate a somewhat tricky principle at the foundations of subjective/marginal value theory: that the value of a good is determined by the least-pressing use to which it could be put. Or stated another way, if you have several units of a good, the value of any of them is equivalent to the satisfaction lost by the loss of one unit.

Böhm-Bawerk asks us to imagine a farmer with five sacks of grain, to each of which he allots a purpose. The first sack is used to keep him alive until the next harvest; the second, to fill out his diet and bring him to full health; the third, to add culinary variety by allowing him to feed chickens with the grain; the fourth, to distill brandy; the fifth, to raise parrots which he finds entertaining.

Having five sacks of grain, the value of the fifth sack is whatever pleasure would be lost by not being able to keep parrots. If he did lose one sack, then he’d have four, and the value of the fourth sack would be the brandy he wouldn’t be able to enjoy.

This is a neat illustration of the law of diminishing marginal utility.

7 What is the water-diamond paradox?

The water-diamond paradox was a sticking point in classical economics deriving from their lack of a sound theory of subjective value. The question is: why is water so much less valuable than diamonds even though the former is required for life and the latter is not? This issue led classical economists into all number of specious distinctions (e.g. between ‘use value’ and ‘exchange value’) and blind alleys because they had no way of tying prices to the values of acting individuals.

Crucially, what they missed is that nobody chooses between the abstract category ‘diamonds’ and the abstract category ‘water’. Instead, everybody chooses between a specific unit of diamonds or water. Given how abundant water is in much of the world each successive unit of it is less valuable than a diamond because diamonds are very rare. But these valuations are entirely subjective and can change from person to person, or even change at different times for the same person.

8 Does the term subjective theory of value imply that Austrians consider their theory to be true only for some people?

No. ‘Subjective’ here simply means ‘in the mind of an acting human being’. The value of a good derives from some person’s valuation of it, not from objective, inherent properties, but this does not mean value is arbitrary. Rather, Menger held that value arises from men’s knowledge of the requirements of their life — i.e. they value bread because it feeds them, flour because it makes bread, wheat because it makes flour, and so on.

9 Can marginal utility analysis be applied to money.

Of course. Money is valuable because it allows for the possession of other goods, and therefore all the principles of marginal utility apply to it.

10 Why were the ideas of Menger so revolutionary? What did the classical economists believe?

The classical economists tried to develop a theory of market prices using supply and demand, but faced grave difficulties because they had no theory of value by which to understand consumer choice. Stated more plainly, the classical economists wanted to explain the price of oranges by looking at how orange growers and merchants made economic calculations, while having no way at all of referencing individual preferences for oranges. Upon this shaky foundation they erected a relatively sophisticated theory of prices and production but a profoundly crude theory of distribution, with a focus on big, homogeneous categories like ‘land’, ‘labor’, and ‘capital’. Their subsequent investigations were aimed at discovering the laws by which the aggregate income of these categories could be understood.

But Menger’s insights were profound even by the standards of previous subjective value theorists. He was not the first person to discuss concepts like ‘utility’ and ‘scarcity’, but he was the first to develop them into a consistent, integrated framework which explained prices and economic activity more generally.

He did not set about to destroy classical economics; his aim, rather, was to take their immutable economic laws, their emphasis on supply-and-demand, and their laissez-faire policy prescriptions and to put them on a sounder basis rooted in individual consumer choice — while simultaneously healing the divide between the sophisticated pseudo-praxeological theory of prices and production on the one hand and the crude, cartoonish theory of production on the other.

11 Isn’t the value of a good equivalent to the amount of resources used to produce it?

No. This ‘labor theory of value’ was one of the products of the deficient value theory of classical economics.

12 Other pioneers of marginal utility analysis used mathematical expositions. Why didn’t Menger?

Because Menger pioneered the concept of ordinal value rankings, as opposed to cardinal value rankings. Cardinal rankings have numbers attached to them, such as “I value pancakes ten times more than I value waffles”, a fact which might make them amenable to certain kinds of mathematical analysis. But ordinal rankings do not have any numbers attached. Menger, and his Austrian heirs, reject the idea of cardinal value rankings and the mathematical implications thereof in favor of a purely ordinal conception of value.

13 Why did Schumpeter say that “Menger is nobody’s pupil”?

Because Menger more or less invented the core ideas of Austrianism out of whole cloth. To be sure these ideas had intellectual predecessors, but Menger alone produced a framework in which they were set upon a foundation, integrated, and applied consistently.

14 What is Menger’s theory of goods?

Menger’s great study of economics began with the recognition that man is embedded in a tapestry of cause and effect, and though value is subjective, satisfaction even of subjective values must be related causally to the external world.

Goods, on this view, are those parts of the world that are a crucial aspect of the causal process by which human beings satisfy their wants. Humans value chairs because chairs are causally related to the satisfaction of the human desire to sit. Humans value ice cream because ice cream is causally related to the human desire to eat sugary dairy products. Humans value condoms because — well, I surely needn’t spell that out.

Not all goods are created equal; there is a hierarchy. Lower-order goods are those, like bread, which directly satisfy a desire like hunger. Second-order goods are those, like flour, which are used to make or procure lower-order goods. We can go on: third-order goods might include wheat, grain, mills, and labor used in manufacturing bread.

Humans value third-order goods (grain) because they value second-order goods (flour) because they value lower-order goods (bread) because they sometimes get hungry.

This distinction implies an important corollary: man must rank his preferences and act to satisfy the highest preference first.

Note that this is a powerful alternative to the labor theory of value which held sway among classical and marxists economists. This theory held that the value of bread derived from the costs of producing it. But this cannot account for the fact that, in economic ignorance, people routinely use scarce higher-order resources to make goods that nobody wants. Quite apart from this, it faces further ignominy because it cannot derive the actual prices of the means of production. It has to take them as a give and then work down from there to get the value of bread. Pretty crummy as explanations go.

Menger inverted this reasoning and solved both problems.

15 Would Menger classify oxygen as a good?

No. In addition to the hierarchy of lower- and higher-order goods, Menger made a further distinction between economizing and non-economizing goods. An economic good is a good like bread which is scarce and therefore subject to economizing. That is, I have to think about how much I want bread, how important it is relative to other uses of my money, and so on.

A non-economic good is something that exists in superabundance, like oxygen, and so is not ‘valued’ in the way that scarce goods like diamonds and tomatoes are valued. No one thinks to themselves ‘I have to make sure to allocate an appropriate amount of time and money to breathing today’, because oxygen is everywhere. It therefore doesn’t count as a ‘good’.

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