Subjectivism and Marginal Utility Shouldn’t Be Marginalized in Economics

This entry will illustrate the subjective value theory and the theory of marginal utility, which are very important in economics. 

„Oh, you’re subjective! Be objective.“

„This is just your subjective opinion.“

These or similar statements are commonly used expressions. In this connection, the word ’subjective‘ has a negative connotation.

When we, for example, accuse a person of having a subjective opinion, we think that this person’s judgement is affected by personal views, feelings, prejudices and/or non-factual interpretations. The opposite is, of course, an objective opinion that is perceived to be based on facts or factual observations.

The term ’subjectivism‘ can be found in relation to philosophy and ethics. Among other issues, we come across the following definitions in The Cambridge Dictionary of Philosophy (1995/1999):

„‘Ethical subjectivism’ usually means the doctrine that ethical statements are simply reports on the speaker’s feelings (though, confusingly enough, such statements may be objectively true or false).“ (p. 284)

In terms of „relativism, the denial that there are certain kinds of universal truths…subjectivism…maintains that individual choices are what determine the validity of a moral principle. Its motto is, Morality lies in the eyes of the beholder.“ (p. 790).

„(S)ubjectivism, any philosophical view that attempts to understand in a subjective manner what at first glance would seem to be a class of judgments that are objectively either true or false – i.e., true or false independently of what we believe, want, or hope.“ (p. 885)

Judging from these quotations, subjectivism in philosophy and ethics emphasizes the individual’s feelings as well as his/her (subjective) perspective concerning moral principles, ethical statements and judgements. Unlike these ethical judgements, subjective, aesthetic judgements are triggered by individuals‘ responses of pleasure or displeasure.

In economics the term refers to the ’subjective theory of value‘ / ’subjective value theory‘. This theory was first developed by the Austrian economist Carl Menger, the English economist William Stanley Jevons and the French mathematical economist Léon Walras in the late 19th century.

‚It’s Up to the Consumers‘ – The Subjective Theory of Value

According to the subjective theory of value (-> here is another article about this theory), acting subjects or individuals carry out assessments, which are, in turn, expressed by their economic (trans-)actions. As consumers we are, of course, acting subjects.

We as consumers or acting subjects, thus, assess the value of a good. Correspondingly, we conceive of its utility as subjective, deciding for ourselves what is useful.

That means, determining factors for the value and the utility of goods are primarily neither any amount of labour that is required for the production of the good nor any third party observers who declare one good to be more important or useful than another. Likewise, a good’s inherent quality only plays – if at all – a subordinate role. What is crucial for the subjective value theory are the consumers‘ subjective views and demands.

Besides a variety of demands, we as consumers generally have numerous and subjective goals. In order to achieve our desired ends, we choose means and evaluate the suitability of the chosen means. Such an evaluation depends on how much we value particular aims.

‚Why Do People Dive for a Gold Treasure ?‘ – The Importance of a Market System

However, the means do not determine our goals as the following example demonstrates: a hidden gold treasure in the sea is not valuable because humans or a particular person  dive for it but because gold is valuable for many people. At this point, we need to be aware of the basic principles of a market (economy).

We can basically define a (free) market economy as the ‘collection of (voluntary) exchanges between buyers and sellers’. The famous Austrian economist Friedrich August von Hayek suggested the neologism ‘catallaxy’ as a name for ‘the order of the market which spontaneously forms itself’. It comes from the Greek verb ‘kattallattein’ and means in English ‘to exchange’, ‘to admit into community’ and ‘to change from enemy into friend’.

Accordingly, economic phenomena, in the narrower sense, emerge, when people on a market interact with each other or with strangers and, in this way, prefer exchange to violence since they recognize exchange as an activity for their mutual benefit. People, strictly speaking, expect to gain (subjective) benefits from exchanging their property and other goods with one another.

Let’s return to our example of the gold treasure. Although this person might have various different reasons to dive for the treasure, within the framework of a market or an exchange system he/she is certainly driven by an additional motivation. Because of the fact that many other people subjectively value gold, the possession of the gold treasure enables him/her to offer it in the expectation to receive an appropriate compensation or a valuable consideration.

‚It All Boils Down to the Resulting Product‘ – The Priority of Production Results and the Prior Relevance of Judgements by Acting Subjects

Moreover, within the framework of a market the utility we expect of a good or service is normally independent of production costs or efforts. On a market – where we usually encounter strangers – we rather prioritize production results. For instance, when you do not like a particular dish, your are hardly interested in how long the cook took to prepare it and how many ingredients he/she used.

Taste is subjective but not arbitrary. Despite various moods and other unpredictable/unknown factors we can frequently predict what human beings like or need since our predictions are based on experiential expectations. Nonetheless, the only primarily relevant judgement of taste is the one the acting subject makes.

This subjectivity/subjectivism makes economics difficult. We cannot look into people’s mind. Yet, we have one advantage: We can look into our own mind to see that we are not objects that are controlled from outside but subjects that are in control of our actions.

As mentioned above, the basis for each consumer’s demand is what he/she subjectively needs and subjectively considers useful. Apart from this, consumers not only make subjective judgements about goods and services as such but also about goods and services in particular situations. For the consumer a specific good or service is in some situations more useful than another good (or service), though he/she regards the latter in general as valuable.

Consequently, the subjective judgement about utility varies, even for the same consumer, whose judgement is affected, amongst other aspects, by what and how much he/she already possesses. In this context, we will now address related issues – marginalism and marginal utility. Like subjectivism, marginal utility should not be marginalized in economics.

‚Everything But Marginal‘ – The Meaning of Marginal Utility

Marginalism is an economic theory or perspective that centers around the ‚margin‘ of economic activities, changes and dynamics. The theory, roughly speaking, tries to explain the difference in the value of goods and services by pointing to their incremental or marginal utility.

With regard to this theory, the total utility does not take centre stage. Instead of comparing, for instance, entire classes of goods against one another, people rather value goods unit by unit. Hence, marginal utility represents the subjective amount of satisfaction or the subjective enjoyments you get when you possess, consume or use an additional unit of a good or a service.

Marginal utility, to put it more precisely, is actually the utility of the relevant unit of goods that is decisive for an economic action. Mostly, this relevant unit is the last one that is added to a particular volume of goods or the first one of a specific volume of goods that is given up.

Regardless of whether we place a high value on water as such or have never thought about this, the marginal utility of your first or sometimes another glass of water is higher, if you are thirsty. By contrast, after the first glass of water diminishes your thirst, the marginal utility of additional glasses of water is, needless to say, lower.

Broadly speaking, marginal utility decreases dependent on how much we have of a specific good. To clarify this with another example, imagine a farmer who harvests wheat. If he/she is not in possession of any wheat, the first sack of wheat has a high significance for the farmer because it might save him/her from starvation. Then, if the farmer’s survival is guaranteed, he/she can use the rest of the wheat for other purposes.

Whereas the first sack of wheat helps the farmer survive (or, in other words, achieve the most important aim), additional sacks of wheat give him/her the possibility to reach less important goals. For instance, by storing the other units of wheat, the farmer can make provisions for the future. Or, he/she might decide to exchange the last unit/s of wheat – which is/are added to the total amount of wheat – for a unit of a new and different good that has a higher value for him/her.

These examples of the bottles of water and the farmer’s sacks of wheat illustrate the law of diminishing marginal utility: if the total quantity of a good increases, the marginal utility of a successive unit or the last added unit of this good diminishes. As early as the 19th century the German economist Hermann Heinrich Gossen (1810-1858) summed this up in the first of his laws of economics:

Gossen’s First Law: “The amount of one and the same enjoyment diminishes continuously as we proceed with that enjoyment without interruption, until satisfaction is reached.”

After the presentation of the law of diminishing marginal utility or Gossen’s First Law, we will turn to the ‚water-diamond paradox‘ which is repeatedly brought up in relation to marginal utility.

‚Where Are Our Priorities ?‘ – The Water-Diamond Paradox

The water-diamond paradox deals with the different values of water and diamonds or a diamond. At first glance, questions regarding their value in use and questions of where our priorities are seem easy to answer. In contrast to mere luxury items like diamonds, water is vital for life.

Paradoxically, as far as their value in exchange is concerned, a bottle of water has a low price tag and water is served for free in restaurants, while diamonds are very high-priced. Simply put, the water-diamond paradox results from the difference between two ways to ‚measure‘ the value of goods and items – the distinction between value in use and value in exchange.

Economists explain this paradox by means of water’s and diamonds‘ marginal utility. That is, in normal life we do not face the tradeoff of the total utility of water versus the total utility of diamonds, or we never have to choose between all the existing water and all the existing diamonds. If this was the case, our priorities would be clear: we would undoubtedly pick the water.

The point that matters is the incremental or marginal utility of, for instance, having either another bottle of water or another carat of a diamond, irrespective of their value in use. When we look at the real world, there is a plentiful supply of water so that a bottle of water can be replaced easily.

A different situation appears in terms of diamonds since, as opposed to water, these objects are far, far more scarce. It is altogether tremendously difficult (and costly) to replace a diamond ring. Therefore, compared to another bottle of water the marginal utility of another carat of a diamond is greater. Simultaneously, the scarcity of diamonds accounts for diamonds‘ high value in exchange or their high market price.

We can also apply these principles to the ‚value‘ of products and the ‚value‘ of labour. Some people might complain about the fact that the latest gaming console is far more expensive than, say, a copy of the Holy Bible or the fact that a professional athlete often earns millions, whereas, for example, a math teacher receives a much smaller salary.

Such people might additionally ask the question of where our priorities lie. This question refers to moral values and/or the ’social value‘. Nevertheless, it leaves out the value in exchange as well as the concept of marginal utility.

All in all, it is easier to replace copies of Holy Bibles and math teachers than gaming consoles and professional athletes, who may be responsible for boosting ticket sales or increasing advertising revenue. Our choice in the real world is not between the total utility of gaming consoles and the total utility of Holy Bibles or between all the professional athletes and all the math teachers. We all should take this into account.

Sources:

I used introductory books by the American economists Robert P. Murphy and Thomas Sowell as well as books by the Austrian economist and philosopher Rahim Taghizadegan. The examples are taken from their works. Apart from these books, the above mentioned The Cambridge Dictionary of Philosophy and a book by Stephen Gaukroger about objectivity were helpful. 

 

 

The (Im-)Possibility of Economic Calculations: Why Socialism Must Fail in Contrast to a Free Market Economy, or Why Prices Are Important

The free market economy has undeniably succeeded in raising the standards of living in the West. But capitalism has always generated numerous debates. Especially during economic crises, the capitalist or free market economy is frequently the target of attacks.

Members of extreme left-wing parties or organisations in Western countries, for instance, not only criticise bankers, managers and speculators but also reject our capitalist system altogether, which they suggest to replace with a socialist system. Such a suggestion is well-nigh absurd because, in economic terms, socialism is doomed to failure.

As early as 1920 the economist Ludwig von Mises gave a good explanation for the deficiencies of a socialist system in his article “Economic Calculation in the Socialist Commonwealth”. For him a socialist economy, in contrast to a capitalist system, does not provide an appropriate basis for ‘economic calculations’.

A Socialist Economy and Its Serious Problems

With regard to socialism, we have to take certain features as well as conditions for granted. In a (pure) socialist system the “commonwealth” (e.g. in the form of the state) would own all of the resources and/or means of production. It would be, so to speak, in control of all the factors (i.e. labour, natural resources, real capital etc.) for the production of goods and services. Under these conditions, socialist enterprises would face serious problems.

Generally speaking, a socialist system would not have a market for resources, which, in turn, would not become objects of exchange. Enterprises or people, in other word, could not trade money for capital goods, vehicles, plots of land and/or other items. Correspondingly, in a (pure) socialist economy there would be no price formation in connection with capital goods or resources, even though prices are vitally important in an economy.

The Vital Role of Prices

To illustrate the importance of prices, it is useful to depict their characteristics in a free market economy because of the fact that in this economic system they can float freely. A free market system represents, so to speak, ‘the collection of voluntary exchanges of buyers and sellers’. What prevails are the laws of supply and demand. As a medium of exchange for their economic transactions people, of course, use money in different forms (cash, credit cards etc.).

Within a free market system prices basically constitute signals or messages. They convey the relative scarcity of goods and services. Simply put, if a product has a high price tag, it is scarce, whereas a product with a low price tag is plentiful. Prices are, therefore, not arbitrary, random or chaotic. Nevertheless, they, needless to say, fluctuate in a market economy by responding to supply and demand in addition to adapting to changing needs and conditions of scarcity.

Another crucial function, in this context, refers to the allocation of resources. That is, through their responses to supply and demand or conditions of scarcity prices play a vital role in allocating resources to the most productive uses. They determine, for example, where a particular resource is needed, how much of each resource is used and how resulting products are supplied to millions of consumers.

The Impact of Prices on Consumers and Producers

Apart from this, it is worth looking at consumers as well as producers. In general, price-coordinated markets give consumers the opportunity to ‘communicate’ to other people what and how much they desire and, additionally, how much they are willing to pay or offer for a particular product or commodities.

Producers, at the same time, signal to consumers what they want to supply or sell in exchange for money or another form of compensation. Consequently, price-coordinated markets guide both consumers and producers, whose behaviour is also affected.

A price-coordinated system enables consumers and producers to make responsible economic decisions. Imagine you, as a consumer, intend to purchase an expensive luxury article. Before spending a lot of money on this high-priced item, you would certainly ensure that your other needs are satisfied or taken care of.

Now try to empathize with a producer. (Or, perhaps, you are one.) Again prices serve as points of orientation. Although producers cannot realistically know what numerous different consumers desire, prices indicate what needs to be produced or where resources should be employed. This brings us to other but related issues – profits and losses.

The Significance of Profits and Losses

Consider the following scenario: You are a car manufacturer, producing cars with a particular combination of features (model a). More precisely, during the production process your enterprise purchases specific parts or resources from other companies, utilizes self-made components and has the cars of model a assembled by your employed workers. Hence, production costs incur.

You, eventually, sell the cars for a price that not only covers the production costs but also allows you to turn a profit. Let’s assume they sell well. Also imagine you produce other types of cars with a different combination of features (model b) in a production process that is more complicated and expensive. You, then, offer the cars of model b for a higher price, but they sell badly.

As a result, you would have to reduce the prices for model b to whatever level was necessary to stimulate sales, even if you took a loss because by not selling the unsold cars and, thus, not covering the high production costs, you would be in danger of incurring a bigger loss. In the future, you would surely continue to manufacture the profit-yielding model a, while you would stop putting your resources into the production of the unprofitable model b.

These scenarios, in sum, show the significance of the prospect of profits and threat of losses since they create incentives. Furthermore, we learned about the vital importance of prices in the production process as well as in the use of resources. Prices together with profits and losses form the foundations for what Ludwig von Mises calls an “economic calculation”. However, such a calculation would be impossible in a (pure) socialist economic system.

Groping in the Dark vs. Reasonable Economic Management, or the Fate of Socialist “Commonwealths” vs. the Opportunities of a Free Market Economy

A “commonwealth”-controlled socialist economy, as von Mises points out, would completely lack free price formation. The absence of free market prices for capital goods or resources entails the absence of points of orientation (regarding the use of these resources) and incentives, which are provided by the hope for profits and the threat of losses. Accordingly, a socialist system would have no basis for an economic calculation. This would result in –  to quote von Mises’s words – ‘groping in the dark’.

Socialist systems like the one in the former Soviet Union were, in fact, state-controlled. In these economies prices were also set by central planners. Due to the absence of price formation in response to supply and demand, neither socialist planners nor Soviet enterprises could estimate the production costs. Moreover, they could not calculate on the basis of a profit-and-loss account whether resources or a certain combination of them had been used efficiently.

By contrast, the free market economy opens up various possibilities. Here the means of productions are not owned by “a commonwealth” (e.g. in the form of the state) but are in the hands of private entrepreneurs. These people and their enterprises do not befall the fate of socialist planners because there are free market prices for resources and a market for capital goods or means of production, which become objects of exchange.

Through the existence of a market and prices for resources, an economic calculation is feasible. According to von Mises, the possibility of these calculations allows for reasonable economic management.

Alongside these economic calculations, another important feature concerning free market economies is the existence of competition. The fact that they compete against other entrepreneurs or enterprises requires private entrepreneurs to choose among different combinations of resources to use them productively and to save costs. Profits and losses signal them whether they employed the resources in an efficient way.

 

Parts of this text are only loosely based on von Mises’s article. In addition to this, I used introductory books by the American economists Thomas Sowell and Robert P. Murphy.