Why do individuals pay much higher prices for some goods versus other goods? 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 large but not as large 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. It is also establishes that because the utility of a good declines as we consume more and more of it, the price that we are willing to pay per unit of the good also declines.
Utility in this way of thinking is presented as a certain quantity that increases at a diminishing rate as one consumes more of a particular good. Utility is regarded as a feeling of satisfaction or enjoyment derived from buying or using goods and services.
According to this way of thinking, an individual’s utility scale is wired in his head. This scale determines for the individual whether he will purchase a particular good. If preferences are constant, it is possible to capture these preferences by means of a mathematical formula, so it is held. This formulation is labeled as a utility function.
In addition, given that utility is presented as a total quantity, it becomes possible to ascertain the addition to this total, which is labeled as additional utility or marginal utility.
Does it, however, make sense to discuss the process of a good’s valuation without referring to the purpose that this good serves?
Menger’s Explanation of How Valuations Are Formed
According to Carl Menger, the founder of the Austrian school of economics, an individual assigns values to goods in accordance to the importance of these goods to his life maintenance. Various ends that an individual finds important to his life maintenance are then valued in a descending ranking.
On this Menger wrote,
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 means, which he employs to attain various ends. Let us say that his highest priority or his highest end is to have one loaf of bread for himself. This means that John will retain for his personal consumption one loaf of bread. The consumption of a loaf of bread is of utmost importance as far as his life maintenance is concerned.
John exchanges his second loaf of bread for five tomatoes, which help John to secure his second most important end. For John the five tomatoes are going to enhance his life and well-being. John then exchanges his third loaf of bread for a shirt—his third most important end. Finally, John decides that he will allocate his fourth loaf to feeding wild birds. Feeding the birds is ranked as number four on John’s priority list as far as his life and well-being are concerned.
Ends Determine the Importance of Means
Observe that to achieve 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 achieve the 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 fulfill the services that the shirt provides.
The suitability of the means is what gives them value with respect to a particular “end.” For instance, in securing 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. Note that his selection is based on the facts of reality—he requires for working purposes a comfortable shirt. In this sense, the shirt chosen promotes John’s life and well-being. As far as John is concerned, feeding wild birds is among the least important given his pool of resources—four loaves of bread.
As can be seen, John employed the first loaf of bread to secure his most important end, the second loaf of bread to secure his second most important end, etc. From this, we can infer that the end assigns the importance to the resource employed to secure this end. This implies that the first loaf of bread carries much higher importance than the second loaf of bread because of the more important end or goal that the first loaf secures.
Why the Value of Goods Is Determined by the Least Important End
Because John regards each of the four loaves of bread in his possession as same, this means that each loaf could be employed by him to secure any of his ends. How, then, does he value each loaf of bread in his possession? He assigns to each loaf of bread the importance as imputed from his least important end, which is feeding wild birds. Why does the least important end serve as the standard for valuing the loaves of bread?
If John used 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 than the ends he secures. (Remember the second loaf of bread helps John to secure his second most important end; the third loaf of bread, the third most important end; and the fourth loaf of bread, the fourth most important end).
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? Note that to secure his second end of obtaining five tomatoes John would exchange one loaf of bread. If John values a loaf of bread more than five tomatoes obviously no exchange will take place. However, if each loaf is valued in accordance with the least important end, (end number four) which is feeding wild birds, then five tomatoes, are going to be valued by John higher than a loaf of bread. Consequently, an exchange is going to take place.
Since the fourth loaf of bread is the last unit in John's total supply, it also called the marginal unit—the unit at the margin. This marginal unit secures the least important end. Alternatively, we can also say that the marginal unit provides the least benefit as far as life maintenance is concerned.
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 fell. Conversely, as the supply of bread rises, its marginal utility falls, as 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 is derived here from the fact that individuals use means to secure ends.
Ends Are Not Set Arbitrarily
Ends are not set arbitrarily but are graded in accordance with their importance in maintaining life. If John had ranked his ends arbitrarily, 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 becoming seriously ill.
Note that by choosing a particular end an individual also sets a standard for evaluating various means. For instance, if my end is to provide a good education for my child, then I will explore various educational institutions and will grade them in accordance with my information regarding the quality of education that these institutions are providing. This means my standard of grading these institutions is my end, which is to provide my child with a good education. Another limitation for attaining various goals is the availability of suitable means. Thus, to quell my thirst in the desert, I require water. Diamonds in my possession will be of no help in this regard.
There Is No Such Thing as Total Utility
Marginal utility is not, as the mainstream perspective posits, an addition to the total utility, but rather the utility of the marginal end. There is no such thing as adding to total utility as a result of an additional unit of a good. Utility is not about quantities but about priorities or the ranking that each individual sets with respect to his life.
A particular end sets the value of the corresponding means. Ends are not established arbitrarily but in accordance to their suitability to support people’s lives and well-being. In this sense, valuations are always in reference to the facts of reality. If people formed valuations arbitrarily, they would run the risk of endangering their lives and well-being.
