Principles of Economics — The Theory of Value

This is the second part of the series in which I summarize Carl Menger’s ‘Principles of Economics’. It captures the important third chapter of the book, and builds the theoretic framework around the value of different goods. For a summary of chapter one and two, see this article.

Chapter III — The Theory of Value

1. The Nature and Origin of Value

If the requirements for a good over a specific time period are greater than the quantity available for that same time period, and if men seek to satisfy their needs for it as completely as possible, they will feel compelled to engage in the activity earlier described as economizing. Their subjective perceptions of what relation exists between requirements and availability give rise to what Menger terms the value of goods. Value is thus the importance that individual goods or quantities of goods attain for us because we are conscious of being dependent on command of them for the satisfaction of our needs. The value of goods is in other words a phenomenon that springs from the same source as the economic character of goods. But while it springs from that same phenomenon, it also has the extra component of the significance that command of each concrete unit of the available quantities of these goods has for our lives and well-being.

A caravan merchant for example, upon finally reaching a small, inhabited oasis, might be willing to part with much gold for a given quantity of water, which at that place possibly would be an economic good. After the immediate thirst of him and his camels are satisfied, it is easy to see why for a second quantity of water, he would likely be less willing to part with the same amount of gold. If, on the other hand, instead of arriving to a small oasis, the caravan merchant arrives to the Nile, the plentiful state of the total quantity of water are likely enough to satisfy all possible needs for water for the humans in proximity of it, and so the non-economic good can be fetched without any parting of gold, and it would be economically inconsequential that the merchant and his camels are almost dying of thirst.

Value, like the economic character of goods, is nothing inherent in them. It is merely the importance that we first attribute to the satisfaction of our needs, and in consequence carry over to economic goods as the exclusive causes of the satisfaction of our needs. Non-economic goods can not attain value at all, since the requirements for such goods are smaller than available quantity. Menger takes as an example an inhabitant of a forest that has several hundred thousand trees at his disposal, while needing only twenty a year for the full provision of his requirements for timber. He will not consider him injured in any way, in the satisfaction of his needs, should a forest fire destroy a thousand trees. Since his requirements are met anyway, a tree can be said to have no value to him; it is a non-economic good. If on the other hand the forest also contains ten fruit trees whose fruit is consumed by the same individual, then not a single one of those trees can be burned in the fire without causing him to be unable to satisfy as much requirements as before the fire. For this reason each of those fruit trees has value to him, and is an economic good.

Menger brings up other contemporary economists’ confusion with regards to the concepts of utility and use value. While they, according to Menger, would have liked for the concept of use value to disappear altogether, and to be replaced with utility, Menger wants no such thing. Utility is the capacity of a thing to serve for the satisfaction of human needs. He points out that both an economic and a non-economic good may have utility, but a non-economic good may have no use value, or in fact any value at all, as we have seen in above example. One absurd example of something with utility but no use value would be a cubic foot of air.

Menger concludes: The value of goods is in other words nothing arbitrary, but always the necessary consequence of human knowledge that the maintenance of life, of well-being, or of some ever so insignificant part of them, depends upon control of a good or a quantity of goods. Men can be in error with regards to this knowledge, giving rise to imaginary value. A counterfeit gold coin could easily attain an imaginary value if the person commanding it lacks the knowledge that what he holds in his hand is not, in fact, gold. Value is thus nothing inherent in goods, no property of them, nor an independent thing existing by itself. It is a subjective judgement economizing men make about the importance of the goods at their disposal for the maintenance of their lives and well-being. Hence, value does not exist outside the consciousness of men.

2. The Original Measure of Value

The differences we observe in the magnitude of value of different goods in actual life can only be founded on differences in the magnitude of importance of the satisfactions that depend on our command of these goods. To explain these differences in value to us, we must (1) subjectively rank the importance of different satisfaction of needs to us, and (2) objectively know which satisfaction of needs depend on the command of which particular good.

A. Differences in the magnitude of importance of different satisfactions (subjective factor).

It is quite logical that economizing men find it more important to satisfy needs with regards to human life and well-fare, than they find to satisfy needs with regards to pleasure. Requirements of food as a general need will always rank higher in importance than for example requirements of watching the newest movies in a local cinema as a general need. It is important to understand, however, that this difference in importance can disappear fully on the margin. As an example, Menger mentions that the initial intake of food satisfies a basic need that humans must seek to satisfy in order not to die, but for each additional unit of food, the additional satisfaction of a need diminishes, and becomes negative even as no one can eat unlimited amounts without danger to the health. Another example is the command over houses. While the first house may be deemed extremely important to fend off cold and hazardous weather, commanding a second house would likely be better described as something for enjoyment or pleasure. After enough houses in possession, any added unit may satisfy so little need as to be considered a matter of indifference.

To further explain these relationships, Menger introduced the below table, where column I expresses the importance to some one individual of satisfaction of his need for food, where column II expresses the importance to the same individual of satisfaction of his need for shelter, and so on, until column IX that expresses the importance to the same individual of satisfaction of his need for having modern art paintings on the wall. The vertical columns then contain numbers from 10 to 1, where 10 represents the satisfaction of which life depends, 9 the satisfaction of which general health and well-being depends, 8 the satisfaction of which general comfort depends etc.

From the above description, we can now imagine a person waking up in the middle of a dark forest, lost and alone. His most important need to satisfy, represented by the number 10 in column I, is food. After acquiring a specific quantity of food, like berries, we can now see how he is indifferent between acquiring a second unit of food and a good that satisfies his immediate need for shelter, represented by the number 9 in column II. If column III expresses his need for light, we can see how he will likely not actively pursue the satisfaction of this need until he commands more food as well as a shelter. Only then would he be indifferent between a third unit of food, a second unit of shelter (which could be represented by a better or larger shelter), and a way to see better in the dark. Only after satisfying a great many needs will column IX be of any relevance at all. These columns can of course be extended indefinitely, and may express the far-away need for goods that a person will never care for in his or her life time. The activity of always seeking to satisfy the need represented by the highest possible number in any of the columns, is the activity of economizing.

B. The dependence of separate satisfactions on particular goods (objective factors).

Usually, not a single good but a quantity of goods stands opposite not a single concrete need but a complex of such needs. As an example, Menger takes an isolated farmer, after a rich harvest. A portion of this harvest secures him the maintenance of his own and his family’s lives until the next harvest, and another portion the preservation of health; a third portion assures him seed-grain for the next seeding; a fourth portion may be employed for the production of beer or whiskey; and a fifth portion may be used for the fattening of his cattle. The farmer is thus dependent upon the grain in his possession for satisfactions of very different degrees of importance, and will naturally use the grain to satisfy needs in order of importance. If available quantity satisfies his needs fully but not more, one unit of the good has a value to him equal to the satisfaction of the need of least importance. If available quantity satisfies his needs fully and there are quantities left, one unit of the good can have no value to him as in the case of the loss of it, he can just replace that unit with another unit.

Menger summarizes it in the following way:

1. The importance that goods have for us and which we call value is merely imputed. Basically, only satisfactions have importance for us, because the maintenance of our lives and well-being depend on them. But we logically impute this importance to the goods on whose availability we are conscious of being dependent for these satisfactions.
2. The magnitudes of importance that different satisfactions of concrete needs (the separate acts of satisfaction that can be realized by means of individual goods) have for us are unequal, and their measure lies in the degree of their importance for the maintenance of our lives and welfare.
3. The magnitudes of the importance of our satisfactions that are imputed to goods — that is, the magnitudes of their values — are therefore also unequal, and their measure lies in the degree of importance that the satisfactions dependent on the goods in question have for us.
4. In each particular case, of all the satisfactions assured by the whole available quantity of a good, only those that have the least importance to an economizing individual are dependent on command of a given portion of the whole quantity.
5. The value of a particular good or of a given portion of the whole quantity of a good at the disposal of an economizing individual is thus for him equal to the importance of the least important of the satisfactions assured by the whole available quantity and achieved with any equal portion. For it is with respect to these least important satisfactions that the economizing individual concerned is dependent on the availability of the particular good, or given quantity of a good.

The above points can sound a bit dry or technical, but are all highly logical. To show this, we will briefly discuss an example that Menger brings up. Suppose that a sailing ship still has 20 days of sailing to reach land, and only 10 pounds of biscuits per voyager are left as edible food in the storage room. It is assumed that half a biscuit is just enough to maintaining ones life every day, and so the available quantity is just enough to keep everyone alive until the ship reaches land. It is easy then to see that there is no such thing as an intrinsic or inherent value in a pound of biscuits. Consider an exceedingly rich man on the boat, offering vast gold riches in exchange for biscuits. None of the voyagers in command of the exact amount of required biscuits would exchange any of it. Not for any amount of gold. If on the other hand each voyager commands 15 pounds of biscuits, their lives would no longer be in danger should they trade away less than, or equal to, 5 pounds of biscuits. Evidently, the rich man would be able to acquire biscuits at some given exchange rate to gold. This exchange rate could still be very high, since although 15 pounds of biscuits may be enough to maintain life and more, it may very well be far from the amount required to satisfy total hunger and nourishment during the 20 day journey. Now, read the fifth point above again, and it is a bit easier to understand what it refers to.

C. The influences of differences in the quantity of goods on their value.

Human needs can often be satisfied by goods of different types and still more frequently by goods that differ, not as to type, but as to kind. If the differences, as to type or kind, between two goods are to be responsible for differences in their value, it is necessary that they also have different capacities to satisfy human needs. In other words, it is necessary that they have what we call, from an economic point of view, differences in quality. From an economic standpoint, the qualitative differences between goods may be of two kinds. Human needs may be satisfied either in a quantitatively or in a qualitatively different manner by means of equal quantities of qualitatively different goods.

Menger has two examples. With a given quantity of beech wood, for instance, the human need for warmth may be satisfied in a quantitatively more intensive manner than with the same quantity of fir. In other words, beech wood is an excellent fire wood, and with the same quantities, more warmth can be reached. To satisfy a need to reduce hunger, a given quantity of beef might work just as well as an equal quantity of chicken meat, but the beef might satisfy this need in a qualitatively more intense manner due to containing more nutrients. With goods of the first category, the inferior quality can be fully compensated for by a larger quantity, but with goods of the second category this is not possible. No amount of mediocre doctors can satisfy a need for excellent healthcare.

D. The subjective character of the measure of value. Labor and value. Error.

The measure of value is entirely subjective in nature, and for this reason a good can have great value to one economizing individual, little value to another, and no value at all to a third, depending upon the differences in their requirements and available quantities. Hence not only the nature but also the measure of value is subjective.

The value an economizing individual attributes to a good is equal to the importance of the particular satisfaction that depends on his command of the good. There is no necessary and direct connection between the value of a good and whether, or in what quantities, labor and other goods of higher order were applied to its production. Menger takes as an example a diamond accidentally found in nature, and a diamond dug up from a pit-mine. The second discovery obviously demands magnitudes of more effort in terms of machinery and labor services, but the diamond itself is for that matter not worth more than the one found accidentally in nature. This is Menger’s dismissal of the ludicrous Labor Theory of Value. When buying a specific good in a store, few, if any, buyers asks the seller whether it was hard or easy to produce that good, and derive a value from the answer.

3. The Laws Governing the Value of Goods of Higher Order

A. The principle determining the value of goods of higher order.

Menger is here quick to iterate his annoyance with non-subjective theories of value: Among the most egregious of the fundamental errors that have had the most far-reaching consequences in the previous development of our science is the argument that goods attain value for us because goods were employed in their production that had value to us. The value of goods of lower order, rather, cannot be determined by the value of the goods of higher order that were employed in their production. On the contrary, it is evident that the value of goods of higher order is always and without exception determined by the prospective value of the goods of lower order in whose production they serve. We have seen from earlier chapters that requirements for goods of higher order is always dependent on requirements for goods of lower order. We therefore have the principle that the value of goods of higher order is dependent upon the expected value of the goods of lower order they serve to produce.

It is important to understand that the value of goods of higher order is not dependent on the current value of the good of lower order. The time component in the production process results in the necessity of trying to estimate the value of the good of lower order for a future point in time when it can finally be commanded. Menger takes ice as a very good example. Ice in winter may be valueless to everyone since it is available in abundance, but simultaneously corresponding goods of higher order necessary for the production of ice may have a high value since the corresponding good of lower order likely will have a high value in the coming summer. We see then that the principle that the value of goods of higher order is governed, not by the value of corresponding goods of lower order of the present, but rather by the prospective value of the product, ought to be the universally valid principle of the determination of the value of goods of higher order.

B. The productivity of capital.

The transformation of goods of higher order into goods of lower order takes place, as does every other process of change, in time. The times at which men will obtain command of goods of first order from the goods of higher order in their present possession will be more distant the higher the order of these goods. To participate in this process, as opposed to pure collecting activities, an individual must command quantities of economic goods of higher order (or quantities of economic goods of any kind, when a brisk commerce has already developed and goods of all kinds may be exchanged for one another) in the present for future periods of time — in other words, he must possess capital.

This means that command of quantities of economic goods for a certain period of time is for economizing individuals a means to the better and more complete satisfaction of their needs, and therefore a good — or rather, an economic good, whenever the available quantities of capital services are smaller than the requirements for them.

C. The value of complementary quantities of goods of higher order.

In order to transform goods of higher order into goods of lower order, the passage of a certain period of time is necessary. Hence, whenever economic goods are to be produced, command of the services of capital is necessary for a certain period of time. During these time periods, the quantity of economic goods (capital) is fixed, and not available for other productive purposes.

Menger discusses the value of the goods of higher order that assure us command of for example a given quantity of grain a year in the future. The value of the seed grain, the services of land, the specialized agricultural labor services, and all the other goods of higher order necessary for the production of the given quantity of grain will according to Menger be equal to the prospective value of the grain at the end of the year, but only on condition that the value of a year’s command of these economic goods to the economizing individuals concerned is included in the sum. The present value of these goods of higher order by themselves is therefore equal to the value of the prospective product minus the value of the services of the capital employed. The reason is simple. Buying 100 bushels of wheat today, given that they are not changing in any physical property over time, will always be preferable than buying the necessary goods of higher order today needed for the production of 100 bushels of wheat in the future. Economizing men will value the goods of higher order at a discount to make up for the drawbacks of the entrepreneurial activity, like the wait for production to finish, or the amount of uncertainty with regards to quantities or qualities.

This entrepreneurial activity includes: (1) obtaining information about the economic situation; (2) economic calculation — all the various computations that must be made if a production process is to be efficient (provided that it is economic in other respects); (3) the act of will by which goods of higher order (or goods in general — under conditions of developed commerce, where any economic good can be exchanged for any other) are assigned to a particular production process; and finally (4) supervision of the execution of the production plan so that it may be carried through as economically as possible. In advanced production processes, there will be individuals directing entrepreneurial activity full-time, and it is thus easy to see why also such a service is a good of higher order, just as the service of herding a flock of sheep is a good of higher order.

So to summarize: the aggregate present value of all the complementary quantities of goods of higher order (that is, all the raw materials, labor services, services of land, machines, tools, etc.) necessary for the production of a good of lower or first order is equal to the prospective value of the product. But it is necessary to include in the sum not only the goods of higher order technically required for its production but also the services of capital and the activity of the entrepreneur.

D. The value of individual goods of higher order.

Menger states a general law of the determination of the value of a concrete quantity of a good of higher order. Assuming in each instance that all available goods of higher order are employed in the most economic fashion, the value of a specific quantity of a good of higher order is equal to the difference in importance between the satisfactions that can be attained when we have command of the given quantity of the good of higher order whose value we wish to determine and the satisfactions that would be attained if we did not have this quantity at our command. To phrase it simpler, the value of fertilizers as a means to help in the production of wheat will be equal to the difference of the value of the future higher wheat production with the help of fertilizers, and the future lower wheat production without it.

This law corresponds exactly to the general law of value determination, since the output difference referred to above represents the importance of the satisfactions that depend on our command of a given good of higher order. If we examine this law with respect to the value of the complementary quantities of goods of higher order required for the production of a consumption good, we obtain a corollary principle: the value of a good of higher order will be greater (1) the greater the prospective value of the product if the value of the other complementary goods necessary for its production remains equal, and (2) the lower, other things being equal, the value of the complementary goods.

E. The value of the services of land, capital, and labor, in particular.

Menger is quick to point out that land occupies no exceptional place among goods. That mistaken belief has been commonly held historically, and has arguably even contributed to misguided and ultimately catastrophic efforts of the creation of money ‘backed by land’. If land is used for consumption purposes (like ornamental gardens or hunting grounds), it is a good of first order. If land is used for the production of other goods, it is a good of higher order. Land must therefor be treated as any other good when having its value assessed.

With labor as an often proposed special class of goods, the story is more or less the same. There are labor services that are useless, and even injurious, to economizing men. Those are therefore not goods. There are other labor services that have goods-character but not economic character, and hence no value. (In this second category belong all labor services that are available to society, for some reason or other, in such large quantities that they attain non-economic character — the labor services connected with some unpaid office, for example.) Labor services are therefore not always goods or economic goods simply because they are labor services; they do not have value as a matter of necessity. It is thus not always true that every labor service fetches a price, and still less always a particular price. More on prices in future chapters.

In reality, the prices of actual labor services are governed, like the prices of all other goods, by their values. But their values are governed, as has been shown, by the magnitude of importance of the satisfactions that would have to remain unsatisfied if we were unable to command the labor services. Where labor services are goods of higher order, their values are governed in accordance with the principle that the value of a good of higher order to economizing men is greater (1) the greater the prospective value of the product, provided the value of the complementary goods of higher order is constant, and (2) the lower, other things being equal, the value of the complementary goods.

Entrepreneurial activity must according to Menger be counted as a category of labor services as it is an economic good as a rule, and as such has value to economizing men. Labor services in this category have two peculiarities: (a) they are by nature not commodities (not intended for exchange) and for this reason have no prices; (b) they have command of the services of capital as a necessary prerequisite since they cannot otherwise be performed.

So with respect to goods of all kinds, all phenomena of value are the same in nature and origin, and the magnitude of value is always governed according to the same principles. Moreover, as we shall see in the next chapters, the price of a good is a consequence of its value to economizing men, and the magnitude of its price is always determined by the magnitude of its value. It is also evident, therefore, that rent, interest, and wages are all regulated according to the same general principles.