TGIF: The Objectively Invaluable Menger

Many people are uneasy with the free market. I think that's because they subscribe, implicitly if not explicitly, to the labor theory of value. Workers, people lament, seem not to reap the full and just reward for their labors. Belief in the labor theory puts adherents in good company. Adam Smith and his successor, David Ricardo, were labor theorists. Fédéric Bastiat held a variant of the labor theory.

Of course, labor theorists are also in some bad company, like Karl Marx, a true enemy of the people in whose name hundreds of millions have been murdered. In fairness, it should be acknowledged that Marx did not subscribe to a naïve labor theory, as it is sometimes assumed. He would not have thought a mud pie that took an hour to make would or should fetch the same price as a cherry pie that took as long. Marx wrote in Capital, "A thing cannot have value, if it is not a useful article. If it is not useful, then the labor it contains is also useless, does not count as labor and hence does not create value.” (Austrian economist Eugen von Böhm-Bawerk reproduced this quote in Karl Marx and the Close of His System.)

Nevertheless, the labor theory was the basis of Marx's influential exploitation theory. In the market, so it is said, bosses get away with paying workers less than the value of their product, leaving them to toil for subsistence wages. Never mind the mind-blowing rise in workers' living standards since the Industrial Revolution. Who are you going to believe, Marx or your own eyes? Hey, didn't another guy named Marx say that? (Hint: It wasn't Groucho.)

The evidence of our senses aside, if you refute the labor theory, you also refute the exploitation theory. If the market price of a good is higher than what the workers were paid per unit, the reason is not that their boss screwed them. The chief reason is that time is valuable. Workers want to be paid now, not later, when and if the goods are sold. The employer is willing to wait and take the risk. His return includes, among other things, the implicit interest rate that permeates intertemporal human action.

Opposing the labor theory of value is the subjective theory of value, which has been most consistently developed by the Austrian school. As I noted in a previous article, subjectivism in economics is not the same as subjectivism in philosophy. It means that when economists analyze markets, they must take as given the personal preferences that human beings demonstrate by their actions, which by nature entail choice. This view need not conflict with philosophical objectivism (or Objectivism, for that matter).

Carl Menger radically shifted economics from the labor theory to the subjective marginal utility theory. (People choose among units of goods "on the margin.") We are forever in his debt. Here's some of what he had to say in Part III of his landmark work, Principles of Economics:

When I discussed the nature of value, I observed that value is nothing inherent in goods and that it is not a property of goods. But neither is value an independent thing. There is no reason why a good may not have value to one economizing individual but no value to another individual under different circumstances. 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 amounts. What one person disdains or values lightly is appreciated by another, and what one person abandons is often picked up by another. While one economizing individual esteems equally a given amount of one good and a greater amount of another good, we frequently observe just the opposite evaluations with another economizing individual. Hence not only the nature but also the measure of value is subjective. Goods always have value to certain economizing individuals and this value is also determined only by these individuals.

I hardly think that anyone could disagree. Note that these differences present people with potential mutual gains from trade. Two people exchange things only because they value the things exchanged differently; each prefers what the other has to what he himself has. Neither sees the items as equivalent in value, and what would be the point in trading equivalents? Prices emerge in a money economy when people with diverse preferences seek their well-being by selling in the dearest market and buying in the cheapest. Competition limits the price range of goods.

I would, however, take issue with Menger's use of the word measure. As one of Menger's intellectual heirs, Ludwig von Mises, would later write, we rank our values; we cannot measure them. No unit analogous to ounces or inches exists. Ordinal, not cardinal, numbers are the order of the day. Note that you can't do math with ordinal numbers. What's first plus second? Third?

Menger now gets to the labor theory:

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. A non-economic good (a [superabundant] quantity of timber in a virgin forest, for example) does not attain [exchange] value for men if large quantities of labor or other economic goods were applied to its production. Whether a diamond was found accidentally or was obtained from a diamond pit with the employment of a thousand days of labor is completely irrelevant for its value. In general, no one in practical life asks for the history of the origin of a good in estimating its value, but considers solely the services that the good will render him and which he would have to forgo if he did not have it at his command.

Again, who would disagree? When you shop, does the usefulness of a good depend on how long or how intensely someone worked on it? Do you even inquire?

Goods on which much labor has been expended often have no value, while others, on which little or no labor was expended, have a very high value. Goods on which much labor was expended and others on which little or no labor was expended are often of equal value to economizing men. The quantities of labor or of other means of production applied to its production cannot, therefore, be the determining factor in the value of a good. Comparison of the value of a good with the value of the means of production employed in its production does, of course, show whether and to what extent its production, an act of past human activity, was appropriate or economic. But the quantities of goods employed in the production of a good have neither a necessary nor a directly determining influence on its value....

The determining factor in the value of a good, then, is neither the quantity of labor or other goods necessary for its production nor the quantity necessary for its reproduction, but rather the magnitude of importance of those satisfactions with respect to which we are conscious of being dependent on command of the good. This principle of value determination is universally valid, and no exception to it can be found in human economy. The importance of a satisfaction to us is not the result of an arbitrary decision, but rather is measured by the importance, which is not arbitrary, that the satisfaction has for our lives or for our wellbeing. The relative degrees of importance of different satisfactions and of successive acts of satisfaction are nevertheless matters of judgment on the part of economizing men, and for this reason, their knowledge of these degrees of importance is, in some instances, subject to error.... Error is inseparable from all human knowledge...

Economics, then, is about how mortal, fallible individuals peacefully cooperate in a world of time and scarcity to obtain the things they believe will improve their lives. The arrangement is imperfect, but the coercively utopian conjurings of Marx, Lenin, Trotsky, Mussolini, Stalin, Hitler, Mao, Castro, and even Richard Wolff don't even qualify as alternatives. Read some economic history and trust your own eyes.

TGIF: The Great Carl Menger

There can be no doubt among competent historians that if ... the Austrian School has occupied an almost unique position in the development of economic science, this is entirely due to the foundations laid by this one man.... [I]ts fundamental ideas belong fully and wholly to [?].... [W]hat is common to the members of the Austrian School, what constitutes their peculiarity and provided the foundations for their later contributions is their acceptance of the teaching of [?]. —F. A. Hayek

Who was Hayek writing about?

Carl Menger, of course. Menger (1840-1921), a professor at the University of Vienna, launched the Austrian school of economics with his trailblazing Principles of Economics, published in 1871. (It was not translated into English until 1950.) He is famous for being one of three economists who independently and nearly simultaneously shifted economics onto a radically different track: marginal utility. Hence, the term marginal revolution in economics.

This was a radical recasting of value and price theory. "The value of goods arises from their relationship to our needs, and is not inherent in the goods themselves. With changes in this relationship, value arises and disappears...," Menger wrote. "It is a judgment economizing men make about the importance of the goods at their disposal for the maintenance of their lives and well-being." Menger was not a moral philosopher but an economist, explaining how human action generates market phenomena such as prices.

While the classical economists thought in terms of entire classes of goods and subscribed to the labor, or cost-of-production, theory of value and price, the marginal-utility theorists focused on how individuals act to satisfy their wants. A person chooses and necessarily makes tradeoffs among discrete units of goods—a quart of milk, a dozen eggs, a pound of ground beef—according to his unique personal circumstances: his preferences, purposes, aspirations, likes, and dislikes. He doesn't care how much labor or material went toward making a product. He cares about how useful a product is to his prioritized purposes. The more units he has of a given good, the less valuable any one unit is because he would abandon his lowest ranked purpose if a unit were lost. That's the law of diminishing marginal utility. Overall, that consumers value particular goods imparts value to the factors of production—not vice versa. Means are valued for their contribution to ends. Menger emphasized this change in direction in the flow of value.

In this sense, value is subjective; it's a relationship between a valuer (the subject, or actor) and something he believes will increase his well-being. A person can err about whether a good will affect his well-being, but so long as he expects to benefit, he will value and pursue it. That will influence the market somewhat. (Hence, the commitment to subjectivism in economic analysis does not commit one to subjectivism in philosophy.)

Since personal circumstances vary widely, so do individuals' relative valuation of goods, creating potential mutual gains from trade. In other words, people exchange unequal values from their points of view, contrary to what the classical economists thought. 

Menger took economic subjectivism and marginalism further than his co-revolutionists, William Stanley Jevons and Leon Walras. For instance, he realized that value scales rank rather than measure preferences. There are no utils.

Despite his plan, Menger did not develop his new approach all the way, but he got the ball rolling. That ball was moved further along by his intellectual heirs, including Eugen von Böhm-Bawerk; Ludwig von Mises: F. A. Hayek, who won a Nobel Prize in 1974; Murray Rothbard; Israel Kirzner; and far too many next-generation economists to name. (For more on Menger's achievements, see David Henderson's article "Carl Menger" and Steven Rhoads's "Marginalism." Also see Peter Klein's foreword to the Menger book linked above.)

What I find interesting about Menger lately is his commentary on Adam Smith and the issue Smith is so famous for, the division of labor. I quote from Menger's Principles:

“The greatest improvement in the productive powers of labour,” says Adam Smith, “and the greater part of the skill, dexterity, and judgment with which it is anywhere directed, or applied, seem to have been the effects of the division of labour.” And: “It is the great multiplication of the productions of all the different arts, in consequence of the division of labour, which occasions, in a well-governed society, that universal opulence which extends itself to the lowest ranks of the people.”

In such a manner Adam Smith has made the progressive division of labor the central factor in the economic progress of mankind—in harmony with the overwhelming importance he attributes to labor as an element in human economy. I believe, however, that the distinguished author I have just quoted has cast light, in his chapter on the division of labor, on but a single cause of progress in human welfare while other, no less efficient, causes have escaped his attention.

What escaped Smith's attention? you ask. In reply, Menger described a primitive economy that enjoyed the advantages of dividing up and specializing in the various laborious tasks. To be sure, the people in that economy would be better off than otherwise. But:

Let us now ask whether a division of labor carried so far, would have such an effect on the increase of the quantity of consumable goods available to the members of the tribe as that regarded by Adam Smith as being the consequence of the progressive division of labor. Evidently, as the result of such a change, this tribe (or any other people) will achieve either the same result from their labor with less effort or, with the same effort, a greater result than before. It will thus improve its condition, insofar as this is at all possible, by means of a more appropriate and efficient allocation of occupational tasks. But this improvement is very different from that which we can observe in actual cases of economically progressive
peoples. [Emphasis added.]

Menger here says that the mere division of labor will take a group only so far, but its progress must fall short of what we see in the world. What does he mean?

Let us compare this last case with another. Assume a people which extends its attention to goods of third, fourth, and higher orders, instead of confining its activity merely to the tasks of a primitive collecting economy—that is, to the acquisition of naturally available goods of lowest order (ordinarily goods of first, and possibly second, order). If such a people progressively directs goods of ever higher orders to the satisfaction of its needs, and especially if each step in this direction is accompanied by an appropriate division of labor, we shall doubtless observe that progress in welfare which Adam Smith was disposed to attribute exclusively to the latter factor. We shall see the hunter, who initially pursues game with a club, turning to hunting with bow and hunting net, to stock farming of the simplest kind, and in sequence, to ever more intensive forms of stock farming. We shall see men, living initially on wild plants, turning to ever more intensive forms of agriculture. We shall see the rise of manufactures, and their improvement by means of tools and machines. And in the closest connection with these developments, we shall see the welfare of this people increase.

By "goods of third, fourth, and higher orders," Menger of course meant producer, or capital, goods, that is, intermediate manmade products intended to produce goods for or closer to the consumer level.  Tools, equipment, and machines magnify the productivity of labor many times. Without them, human output is meager, even with a division of labor. This is Menger's complex structure of production, the stages of which are classified according to how close or far in time they are from the retail level.

Time (which implies risk) is revealed as critical. The higher the order, the longer the period until the final good is ready for sale to consumers. "Thus," Menger wrote, "in the process of change by which goods of higher order are gradually transformed into goods of first order, until the latter finally bring about the state called the satisfaction of human needs, time is an essential feature of our observations." Radical.

The further mankind progresses in this direction, the more varied become the kinds of goods, the more varied consequently the occupations, and the more necessary and economic also the progressive division of labor. But it is evident that the increase in the consumption goods at human disposal is not the exclusive effect of the division of labor. Indeed, the division of labor cannot even be designated as the most important cause of the economic progress of mankind. Correctly, it should be regarded only as one factor among the great influences that lead mankind from barbarism and misery to civilization and wealth....

The Austrian school thus started with Menger's observation that Adam Smith, widely held to be the father of economics, overlooked "the most important cause of the economic progress of mankind." That took some confidence.

In its most primitive form, a collecting economy is confined to gathering those goods of lowest order that happen to be offered by nature. Since economizing individuals exert no influence on the production of these goods, their origin is independent of the wishes and needs of men, and hence, so far as they are concerned, accidental.

People in such a condition are fundamentally passive concerning their environment. A low standard of living should surprise no one.

But if men abandon this most primitive form of economy, investigate the ways in which things may be combined in a causal process for the production of consumption goods, take possession of things capable of being so combined, and treat them as goods of higher order, they will obtain consumption goods that are as truly the results of natural processes as the consumption goods of a primitive collecting economy, but the available quantities of these goods will no longer be independent of the wishes and needs of men. Instead, the quantities of consumption goods will be determined by a process that is in the power of men and is regulated by human purposes within the limits set by natural laws. Consumption goods, which before were the product of an accidental concurrence of the circumstances of their origin, become products of human will, within the limits set by natural laws, as soon as men have recognized these circumstances and have achieved control of them.

Human beings moved from passive to active in satisfying their wants. That was a turning point in history.

The quantities of consumption goods at human disposal are limited only by the extent of human knowledge of the causal connections between things, and by the extent of human control over these things. Increasing understanding of the causal connections between things and human welfare, and increasing control of the less proximate conditions responsible for human welfare, have led mankind, therefore, from a state of barbarism and the deepest misery to its present stage of civilization and well-being, and have changed vast regions inhabited by a few miserable, excessively poor, men into densely populated civilized countries. Nothing is more certain than that the degree of economic progress of mankind will still, in future epochs, be commensurate with the degree of progress of human knowledge. [Emphasis added.]

If only he could see what reason, capital accumulation, division of labor, and trade have wrought! The lesson we should take from Menger is that all government actions that obstruct the formation of capital and free exchange—such as tariffs, to pick a random example—torpedo human welfare.