Why do individuals pay higher prices for some goods than others? The common reply references laws of supply and demand, but what are these laws? The answer is found in the law of diminishing marginal utility.
Most economists explain this law by describing the satisfaction one derives from consuming a good such as an ice cream cone. The satisfaction derived from consuming a second cone might be less than the satisfaction derived from the first cone, and so on. Mainstream economics concludes that the more of any good we consume in each period, the less satisfaction, or utility, we derive out of each additional unit, so the price that one is willing to pay per unit also declines.
By quantifying utility, economists can introduce mathematics here to determine the additional satisfaction to determine total utility. Thus, the law of declining marginal utility is derived from diminished satisfaction of consuming a particular good. After consuming several ice cream cones, an individual feels satiated, making human action dependent upon biological needs, not reason. According to Ludwig von Mises, “It is impossible to describe any human action if one does not refer to the meaning the actor sees in the stimulus as well as in the end his response is aiming at.”
The Menger Explanation
According to Carl Menger, the founder of the Austrian school of economics, individuals rank various goals they deem important to meeting their needs. The ends people consider as the most important for maintaining life are assigned the highest ranking, while less important ends are given lower ranking.
Consider John the baker who produces four loaves of bread, which are the means to help meet his needs. Assume that his highest priority is to have one loaf of bread for personal consumption, leaving three other loaves for other uses.
The second loaf allows John to secure his second most important goal, which is to consume five tomatoes, and he finds a tomato farmer who agrees to exchange five tomatoes for a loaf of bread. John uses the third loaf to exchange for the third most important end, which is a shirt. Finally, John allocates his fourth loaf to feed wild birds.
To attain the second and the third ends, John exchanged his resources—loaves of bread—for goods to serve his ends. John exchanged his loaf of bread because it was not as useful to John as a shirt. Thus, the first loaf of bread secures the most important end, the second loaf of bread the second most important end, and so on.
Least Important End Sets the Standard of Valuation
John gives each loaf the value imputed from the least important end, which is feeding wild birds. Why does he do this? (John’s four loaves are interchangeable. This implies that each loaf will have the same value as far as John is concerned.) Now assume, instead, that John uses the highest end as the standard for assigning value to each loaf of bread, which means he values the second, the third, and the fourth loaves higher than the ends he secures.
If this were the case, why would he exchange something valued more for something that is valued less? Under such circumstances, no exchange after the first one would occur. Yet, because John continues to engage in exchange, the remaining three loaves must have declining value.
Remember that the fourth loaf of bread is the last unit in John’s total supply. It is also called the marginal unit. This loaf secures the least important end, which means that as far as John is concerned, the marginal unit provides the least benefit.
If John had only three loaves of bread this would mean that each loaf would be valued according to the end achieved by the third loaf—having a shirt because it is ranked higher than feeding wild birds. From this, we infer that as the supply of bread declines, the marginal utility of bread rises. Every loaf of bread is valued higher than before as the supply of bread decreases. Conversely, as the supply of bread rises, its marginal utility falls and each additional loaf of bread is now valued less than before the increase in the supply took place.
In John’s case, the least important loaf of bread determines the value of bread out of a given supply. As the supply of bread increases, its unit value will decline because the marginal loaf of bread serves the least important goal.
People Do Not Set Arbitrary Goals
Individuals do not pursue arbitrary ends but rather seek to maintain life and well-being, using available means at their disposal. Instead, they look to meet their most pressing needs before looking to less important goals. For instance, had John arbitrarily allocated most of his resources to feeding wild birds, he would not have enough to feed himself.
Furthermore, marginal utility is not, as the mainstream perspective presents, an addition to the total utility but rather the utility of the marginal end. Utility is not about quantities but about priorities or the ranking set by each person. Obviously one can assign cardinal values to priorities. Since total utility does not exist as such, mathematical methods that were introduced in economics and in the modern portfolio theory to measure total utility and marginal utility are questionable.
The heart of price determination is the law of decreasing marginal utility. According to mainstream economics, this law is linked to the intensity of individual’s satisfaction with respect to a particular good which declines with increasing supply of that good. Therefore, the intensity of satisfaction is the key in determining the price of a good.
Instead, a good’s usefulness to secure one’s ends gives it value. We rank goods ordinally according to their ability to satisfy our needs. There is no need to bring mathematics into the picture.