Why do individuals value bread less than gold, when bread is obviously more “useful” 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 much 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.
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.
Now, according to mainstream thought, since gold is relatively scarcer than bread it follows then 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. On the same basis we can also derive that notwithstanding that air is essential for human life, due to its 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 called total utility, it becomes possible to introduce mathematics here to ascertain the addition to this total, which is referred to as additional utility or marginal utility. However, does it make sense to discuss the marginal utility of a good without referring to the purpose that it 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 will be assigned to life maintenance. The various ends that an individual will find useful for his life maintenance will be assigned a descending rank in accordance with his own preferences:
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 of bread are his resources, or the means that he employs to attain various goals.
Let us say that his highest priority or 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 secure his second most important goal, as far as life is concerned, which is to consume five tomatoes.
Let us say that John was successful and finds a tomato farmer who agrees to exchange his five tomatoes for a loaf of bread.
John exchanges his third loaf of bread to achieve his third most important end, which is to have a shirt. Finally, John decides that he will allocate his fourth loaf toward feeding wild birds.
To attain the second and the third ends John had to exchange his resources—loaves of bread—for the 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 in itself to provide the services that the shirt does.
Ends Determine the Value of Means
A given end dictates or establishes, so to speak, the specific means or resources that the individual will choose for its attainment. 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 from among various shirts the most suitable for his specific end—let us say that it is to have a work shirt.
Being a baker, John may conclude that the shirt must be of a white color and made of a thin rather than thick material to keep him comfortable while working next to a hot oven.
Feeding wild birds is ranked 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 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 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 interchangeable, he assigns to each loaf 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 that 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 more highly 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? We have seen that to satisfy his second end, to obtain five tomatoes, he would exchange one loaf of bread. If, however, John values a loaf of bread more 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 life is concerned, the marginal unit provides the least benefit.
If John had only three loaves of bread, it 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 more highly 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. The law of declining marginal utility is derived here from the fact that individuals use means to secure various goals or various ends.
However, ends are not set arbitrarily but graded in accordance with their importance in maintaining 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 feeding himself, he would have run the risk of weakening his body and becoming seriously ill.
Utility Is Not Some Sort of Quantity That Can Be measured
Marginal utility is not, as the mainstream perspective presents it, an addition to a total utility but rather the utility of the marginal end. There is no such thing as the addition to total utility as a result of an additional unit of a good. As we have seen, utility is not about quantities, but about priorities—the rankings that each individual sets with respect to his life.
Obviously one cannot sum priorities up as such. Since total utility does not exist, the various mathematical methods that were introduced in economics based on it 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.
Menger’s Marginal Utility Theory Is Drastically Different from the Mainstream
Both the mainstream approach and Menger’s emphasize the importance of the relative quantity of a good in its price determination. The difference, however, is that the mainstream relies on psychology while Menger emphasizes the importance of the purpose that a good helps to achieve.
The mainstream approach regards utility as some kind of quantity which can be subjected to the rules of mathematics. This is not so in Menger’s framework, where utility refers to the ranking of goods with respect to life and well-being.
Given that goods are evaluated with respect to various ends (with life assigned as the highest priority), the marginal utility theory as developed by Menger is drastically different from the mainstream approach.
In addition, in the mainstream approach there is a strong emphasis on indifference curves, which supposedly can be helpful in understanding individuals’ choices. Indifference, however, has nothing to do with individuals’ purposeful conduct. In pursuing purposeful actions, individuals cannot be indifferent to various goods. When confronted with various goods an individual makes his choice based on their suitability to be employed as means to various ends. (Note again that the ends are ranked with respect to his life.)
It does not make sense to discuss the marginal utility of a good without referring to the purpose that it serves. The marginal utility theory as presented by popular economics describes an individual without any goals, and who is driven by psychological factors. This individual is not aiming consciously to reach his goals. In this sense, popular economics describes not a human being but a human robot.
