The law of diminishing marginal utility is at the heart of the
explanation of numerous economic phenomena, including time preference and the
value of goods; and it also plays a crucial role in showing that socialism is
economically and ethically inferior to capitalism.
The law of diminishing marginal utility, as developed by Carl Menger
(1840–1921), is axiomatic in nature; that is, it is irrefutably
true. In mainstream economics, however, this fundamental economic law is
typically interpreted as resting on psychology, namely the law of satiation
of wants.
Such an interpretation, however, does not actually conceive the law of
diminishing marginal utility as a fundamental economic law — which
has truth value irrespective of time and place — but as a fleeting
explanation of certain economic phenomena, which may or may not hold in a
given situation.
Given the importance of the law of diminishing marginal utility for
economic theory and policy, it is important to keep advertising that the law
of diminishing marginal utility is irrefutably true — because it
follows from the axiom of human action. For ignoring this truth leads to
fallacious and erroneous conclusions, and eventually to false economic theory
and economic policies.
The Axiom of Human Action
Ludwig von Mises (1881–1973) reconstructed economics as an axiomatic
science, which he called praxeology: the science of the logic of human
action. The central element of praxeology is the axiom of human action.[1]
The axiom of human action basically says that human beings act. This may
sound trivial at first glance. However, at second glance it becomes obvious
that Mises's axiom of human action and its implications are far from being
trivial:
To start with, an axiom is a (set of) proposition(s) presumed to
be true on the basis of logical necessity; it serves as presenting
different subject matters as formal and coherent theories, all of which are
propositions which can be deduced from the axiom. For instance, Pythagoras's
theorem is deducible from the axioms of Euclidian geometry.
The axiom of human action is of a special nature: It represents a synthetic a priori
proposition, to use the terminology of Immanuel Kant (1724–1804). A
synthetic a priori proposition is knowledge that (1) cannot be denied without
running into an intellectual contradiction, and (2) is derived from reflection
rather than observation.
The axiom of human action cannot be denied without running into an
insoluble contradiction. This is because denying the axiom of human action
implies human action — that is the human act of denying. Arguing that humans
cannot act is thus a contradiction in itself, an absurdity.
Further, the axiom of action is derived from human reflection: it is
independent of experience. This is because one cannot observe humans making
an action per se. In order to know what "action" means, one has to
know what action is — which implies that knowledge about action exists prior
to action.
That said, the axiom of human action fulfills both of Immanuel Kant's
requirements for qualifying as an a priori synthetic proposition: it is
self-evidently true, and it is derived from reflection. That said, logical
deductions from the axiom of human action must be also absolutely, or apodictically, true as well.
By developing praxeology, Mises showed that economic theory is the formal
logic of the irrefutably true axiom of human action. According to Mises,
economic theory is not concerned with psychology, but with the implications
of the axiom of human action.
The Law of Diminishing Marginal Utility
The law of diminishing marginal utility can be logically deduced
from the axiom of human action. To show this, let us start with some remarks
on utility.
Utility is a subjective concept. It denotes "satisfaction" (or
"happiness" or "contentment"). It rises if and when an
individual increases his or her state of satisfaction. Conversely, if and
when someone considers himself in a worse state of affairs, his utility
decreases.
What is more, utility is an ordinal concept, meaning that utility
cannot be measured in terms of higher or lower utility from the
viewpoint of an individual; and changes in utility among different people
cannot be measured. All one can say is that utility is higher or
lower from the viewpoint of an individual.
Rothbard explained why this is:
In order for any measurement to be possible, there must be an eternally
fixed and objectively given unit with which other units may be compared.
There is no such objective unit in the field of human valuation. The
individual must determine subjectively for himself whether he is better or
worse off as a result of any change.[2]
Marginal utility means the utility of increments of goods; it
means the utility of enjoying an additional good. Marginal utility does not
mean increments of utility — which would imply measurability of utility.[3] So what does the law of
diminishing marginal utility say?
The law says, first, that the marginal utility of each (homogenous)
unit decreases as the supply of units increases (and vice versa);
second, that the marginal utility of a larger-sized unit is greater than
the marginal utility of a smaller-sized unit (and vice versa). The first
law denotes the law of diminishing marginal utility, the second law the law
of increasing total utility.
These two dimensions of the law of diminishing marginal utility follow
directly from the axiom of human action; they can be logically deduced from
it, and they do not in any way depend on psychology or any behavioral assumption.
This will be shown in what follows.
The A Priori Nature of the Law of Diminishing Marginal Utility
A priorism denotes a theory that yields true propositions without
the need to take recourse to empirically derived knowledge: its truth value
can be established a priori, independent of (sensual) experience.
Praxeology, resting on the axiom of human action, asserts something about
reality and can be validated without taking recourse to experience; it is an
a priori science. Furthermore, the law of diminishing marginal utility
follows logically from the irrefutably true axiom of human action, and as
such it is also a priori true; this conclusion doesn't have anything to do
with psychology.
To show this, we must remind ourselves of the obvious and less-obvious
implications of the axiom of human action.
The axiom of human action implies that humans act, and that human action
is purposeful, aiming at certain ends. Human action is
distinguishable from those types of human behavior that are purposeless or
purely reflexive. To assume the contrary would result in an insoluble
intellectual contradiction.[4]
The axiom of human action implies substituting a more satisfactory state
of affairs for a less satisfactory one. For if there were perfect contentment
(and thus full satisfaction), no human action would result — which is, as
noted earlier, unthinkable.
Human action implies employing means to the fulfillment of ends,
and the axiom of human action implies that means are scarce. For if
they were not scarce, means would not serve as objects of human action; and
if means were not scarce, there would be no action — and that is unthinkable.
Because means are scarce — with respect to the ends that they could
possibly serve — they must therefore be economized. As a result of
scarcity, the actor has to allocate scarce means to serve the most desired
ends, and so certain ends will have to remain unsatisfied. From this it
follows that the larger the supply of means is, the more ends can be
satisfied.
As means are scarce, human action implies that individual actors must rank
their alternative ends. Human action is therefore indicative of judgment and
valuation — or, as Rothbard said, demonstrated preferences: the
highest-ranking ends are those which the actor values most highly.
Against this backdrop it becomes obvious that the law of diminishing
marginal utility follows from the axiom of human action.
First, given the supply of a good, a rise in the supply of the good
leads to a decline in the marginal utility of the unit: the more goods
are available, the more of the less-urgent ends can be satisfied. People thus
value goods at the margin: If, for instance, someone has to give up one of
his goods serving the fulfillment of his ends, he will give up the lowest
ranking end, that is, the marginal unit. It is the latter that
determines the good's valuation from the viewpoint of the actor.
Second, the total utility of a greater supply of goods is always
greater than the utility of a smaller supply of goods — as the former
allows the satisfaction of more ends than the latter.
Mises summarizes the law of diminishing marginal utility succinctly:
In treating marginal utility we deal neither with sensuous enjoyment nor
with saturation and satiety. We do not transcend the sphere of praxeological
reasoning in establishing the following definition: We call that employment
of a unit of a homogeneous supply which a man makes if his supply is n
units, but would not make if, other things being equal, his supply were only n-1
units, the least urgent employment or the marginal employment, and the
utility derived from it marginal utility. In order to attain this knowledge
we do not need any physiological or psychological experience, knowledge, or
reasoning. It follows necessarily from our assumptions that people act
(choose) and that in the first case acting man has n units of a
homogeneous supply and in the second case n-1 units. Under these
conditions no other result is thinkable. Our statement is formal and
aprioristic and does not depend on any experience.[5]
Three Applications of the Law of Diminishing Marginal Utility
Finally, let us consider three economic aspects in which the irrefutably
true law of diminishing marginal utility plays an important role — something,
however, that is all too often ignored by mainstream economics. Such faulty
economics thereby support — intentionally or unintentionally — destructive
policies.
(1) A rise in the money stock. A rise in the money stock must,
for logical reasons, reduce the exchange value of a money unit. This is
because the additional money unit can be used to satisfy an additional end
that is necessarily less urgent than the satisfaction of the preceding end. A
rise in the money stock will thus necessarily lead to a decrease in
the marginal utility of the money unit (compared to the situation in which
the money stock had remained unchanged).
As a result, a rise in the money stock can never be "neutral" in
economic terms. It necessarily leads to a decline in its exchange value —
when compared with a situation in which the money stock had remained
unchanged; and it should also be noted here that a rise in the money stock
affects different market agents differently (the "Cantillon Effect").
A monetary policy of increasing the money supply is therefore never
"neutral": It necessarily lowers the exchange value of the money
unit, and it necessarily benefits some people (namely the first receivers of
the new money) at the expense of others (namely the late receivers of the new
money).
(2) A lowering of the market interest rate. The pure market
interest rate reflects societal time preference — which, in turn, is also
implied in the axiom of human action. Time preference means that market
agents value goods available today (present goods) more highly than goods
available in the future (future goods).
And the more that present goods (out of current income) are exchanged
against future goods (as is typically illustrated by the positive slope
of the savings schedule in the savings/investment and interest-rate space),
the higher will be the valuation assigned to present goods relative to future
goods — and this is a result of the irrefutably true law of diminishing
marginal utility. The pure rate of interest is thus expressive of the
relation between the valuations of present goods and the valuations of future
goods.
If government intervenes in the time market — by, for instance, increasing
the supply of bank circulation credit and fiat money — it necessarily
causes a deviation of the market interest rate from the pure interest rate
(namely pushing the market interest rate below the pure market interest
rate), which subsequently must lead to malinvestment and
boom-and-bust.
(3) Violating individuals' property rights.[6] Violations of individual property rights (for instance
through government taxation, regulations, etc.) will make property owners
value present goods increasingly more highly than future goods
— a conclusion which follows from the law of diminishing marginal utility.
Violations of individual property rights thus raise peoples' time
preference, increasing consumption at the expense of savings and investment,
thereby reducing (or even reverting) the pace of capital accumulation. An
interventionist-socialist societal order will therefore necessarily
lead to impoverishment relative to a free market societal order, in which
there are no systematic violations of individuals' property rights.
