University of Cambridge Economics Essay

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Chapter 23
ECONOMI(:S RESTRUCTURED:
Marginalism
and Optimization
2.
THE AUSTRIAN SCHOOL: ACCENT ON UTILITY
530
MENGER
In 1871, the year in which Jevons published The Theory of Political
Economy in England, there appeared in Vienna Menger’s Grundsatze der
Volkswirtschaftslehre, translated into English in 1950 under the title Principles of Economics. Unlike Jevons, Carl Menger (1840-1921), the Austrian
co-discoverer of the marginal principle and of the subjective theory of value,
was a graduate of the faculty of law, which in the academic tradition of
the German-speaking countries was also in charge of instruction in economics. After a short interlude in financial journalism and government
service, the publication of the Grundsatze brought Menger an appointment
as instructor at the University of Vienna, where he held the chair of political economy from 1879 until his retirement in 1903. At that time Vienna
was still the political and cultural center of a four-hundred-year-old and
far-flung empire, which held together a great diversity of nationalities,
including Germans, Hungarians, Czechs, Slovaks, Poles, and residents of
the Balkans.
Menger, who also served as tutor and confidant of the heir to the
Hapsburg throne, eventually occupied a commanding position in the academic economics of his native country. As his literary output was smaller
than Jevons’s, did not branch otlt into other disciplines, and did not require
time-consuming quantitative studies of the type cultivated by Jevons, he·
could and did give close attention to his teaching duties, which he discharged
” ‘ with great distinction. He gained a substantial following among the young
economists of his time, and his fame was spread abroad by enthusiastic
students. As his influence grew, he came to be recognized as the unchallenged
leader of the Austrian school.
F•
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THE INTELLECTUAL ENVIRONMENT
In the intellectual environment of his homeland Menger did not have
the Benthamite tradition to draw on for nourishment and inspiration, as
did Jevons, and in his theorizing he faced the opposition of the historical
economists of Germany, one far more deeply entrenched and enduring than
that which Jevons encountered in England. If in spite of these obstacles
Menger made important contributions to the pure theory of economics by
developing a utility analysis culminating in the subjective theory of value,
this accomplishment may be ascribed to the convergence of a number of
disparate sets of circumstances. There was, to begin with, in the Germanspeaking countries the strong tradition of the philosophy of Kant’s idealism,
paralleling and rivaling that of Hegel, au. idealism that interpreted the
phenomena of the external world as creations of the human mind. There
was an affinity between this philosophy and the subjective theory of value,
which derived economic value from man’s state of mind. The intellectual
atmosphere generated by Kant’s philosophy would foster the development
of a subjective theory of value, regardless of whether or not the economist
· enunciating such a theory was a full-fledged Kantian. Earlier nineteenthcentury economic thought in Germany contained a number of hints pointing
toward a subjective theory of value, and Menger, unaware as he was of
Gossen’s complete analysis, which stemmed from Bentham, was influenced
by these.
For the further development of these ideas German academic economics offered no fertile ground since it was dominated by historicallyminded economists who had no use for abstract economic analysis and
proposed to replace it by descriptive studies of concrete historical detail.
It was no accident that an Austrian rather than a German economist transformed these incipient ideas into a full-fledged and influential structure of
thought because historical economics did not gain a foothold in Austria.
The reasons for this must be sought in the Austrian intellectual tradition
and in the political circumstances that surrounded academic life in Vienna
at Menger’s time. As for the former, both the natural law heritage and the
influence of the Enlightenment, the wellsprings of economic theorizing, had
greater powers of survival in Austria than in Germany, where they succumbed to the idolatry of power . ..However inefficient, paternalistic, and
at times ruthless the Austrian rule turned out to be during the nineteenth
century, it never relinquished its claim to enlightened despotism. Joseph
von Sonnenfels (1732-1817), the great cameralist, who in 1763 became
the first occupant of a chair of economics at the University of Vienna, was
a humanist imbued with the spirit of the Enlightenment. His views tempered
the absolutis,m of his age and prepared the ground for the great reforms of
Joseph II. Sonnenfels’s textbook on economics was used in Austrian universities until 1848, and he left behind a legacy of liberal thought in economics
and politics, much of which was dissipated during the period of romantic
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reaction in the early nineteenth century but which was never entirely lost.
From Sonnenfels’s legacy there stemmed a faith in reason and a
willingness to postulate general principles valid for all mankind. These
dispositions, hostile as they were to historicism, derived further strength
from the natural law idea, which, although it lost its hold in Germany
proper, survived in Catholic Austria, there to fulfill a function not unlike
that rendered by utilitarianism in England-to serve as a paradigm for
the construction of general principles of economics. John Stuart Mill’s
theorizing and his liberal bent would preclude a_!ly profound influence of
his work in Germany, even though German historical economists might pay
lip service to his authority. It was in Austria that his work struck a chord
of response. There he found a translator and there was published what
for a century remained the only complete edition of his writings.
If the Austrian intellectual tradition was not receptive t~ a German
historicism that denied the validity of an abstract-generalizing social science, this tradition gained powerful support from the political circumstances
that attended Menger’s work in Vienna, then the capital of a multinational
empire which was rent by centrifugal pressures and on which the impending
dissolution had already cast its shadow. The meticulous attention to and
glorification of the national past, as cultivated by the historical economists,
might have been conducive to national unity in Germany, where a single
nationality aspired to nationhood. In Austria, where a multiplicity of nationalities pressed for emancipation, the pursuit of historical economics,
which underlined national diversity, would have been divisive. Much more
in line with the logic of the situation was the development of an economics
that purported to stress the element common to all humanity and proceeded
on a level of abstraction high enough to make national diversities appear
immaterial. It was to the development of such an economics that Menger
devoted his great gifts when he prepared his Grundsiitze to launch his university career. The Austrian school did not start out to rebut Marx, as some
students of doctrinal history have surmised, but to fortify the multinational
empire of the Hapsburgs.
Menger thus developed his ideas on a level of abstraction which
removed them from considerations of time and space; however, abstract
and general as his approach was, what led him on in his study of economics
during the late 1860s was, if a report to this effect can be believed, a
practical problem of the day. One of his duties in government service was
the preparation of market surveys, and in the discharge of this duty he
found it difficult to reconcile the conventional price theory with the facts
of life. Hence his attempt to reconstruct the theory of value and price on
a new foundation. As in other instances of “high theory,” such as Ricardo’s
theory of profit and the whole structure of his thought derived therefrom,
concrete reality provided the stimulus to abstract theorizing. In other circumstances, the reverse would come true: Propositions that at first glance
appeared most abstract, remote from reality, and entirely impractical would
be pregnant with profound implications for policy and the world of reality.
ECONOMIC GOODS AND THEIR VALUE
Menger gave a great deal of attention to definitions, an approach
inspired both by his legal training and by the scholarly tradition in Germanspeaking countries. A cogently argued chain of reasoning carries the reader
from “useful things” to “goods” and eventually to “economic goods.” Much
of this definitional matter, with its emphasis on the subjective and relative
character of the relevant attributes of economic goods, did in time become
part of the standard doctrine and was incorporated into elementary textbooks throughout the world. Menger had a predilection for interpreting
economic relations as causal ones, and in line with this view he defined
goods as useful things that can be brought into a cause-and-effect relationship with the satisfaction of human needs. Unlike Jevons, he developed
his argument in terms of subjectively felt needs rather than in terms of
pleasure. The need-satisfying quality of a good and the needs themselves
are not necessarily real but may be imaginary, with the latter contingency,
in Menger’s opinion, becoming less frequent as civilization progresses.
“Goods of first order,” such as bread, serve human needs directly, whereas
“goods of higher orders,” such as flour and baking utensils, grain mills,
labor services of the farmer, and so forth, serve them indirectly. As Menger
underlined, goods of higher order require complementary goods; without
these, they lose their character as goods.
Goods are economic goods when “requirernents”-the amount that
a person must have to satisfy his needs-exceed the available quantity.
Although Menger did not use this term, the implication is that economic
goods are scarce. In connection with economic goods there arises the problem of economizing, that is, of choosing between needs, satisfying some and
leaving others unsatisfied, and of doing so in a manner that will achieve
an optimum result. Menger approached his task outside the utilitarian tradition, and his economizing man does not seek to maximize pleasure but to
satisfy his needs in the most efficient manner.
NEEDS AND THEIR SATISFACTIONS
Needs and their satisfactions are of unequal importance as regards
both the satisfaction of needs of different kinds and the more or less complete satisfaction of one and the same need. Needs and satisfactions can be
graduated, beginning with vital needs and descending to needs of lesser
importance, until eventually saturation is reached. Menger employed neither diagrams nor mathematical formulas to support his argument, and
instead he’ presented a table consisting of hypothetical scales indicating
the importance of the satisfaction derived from the consumption of successive units of ten different goods. The goods were labeled I to X, and the
scales extended from 10, which denotes vital importance, to zero. The ten
scales are reproduced here:
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8
7
4
3
2
1
6
5
6
5
5
7
4
3
3
2
1
0
0
4
2
1
3
2
1
1
0
10
9
9
8
8
7
7
6
5
6
5
4
3
2
1
3
2
1
X
VI
III
4
IX
V
II
6
5
4
3
VII VIII
IV
I
2
1
4
3
2
2
1
1
0
0
0
0
0
0
0
Menger used columns I and V to illustrate the diminishing importance
of an individual’s need for food and tobacco respectively. If the vital need
for food has been satisfied to an extent numerically indicated by the figure
6, the consumption of tobacco, although on the whole less vital, assumes
an importance equal to the further satisfaction of the now less pressing need
for food. In discussing this matter, · Menger did not refer to diminishing
utility but to the declining importance of needs and their satisfaction. He
established the principle that people will first provide for those needs whose
satisfaction has the greatest importance for them and will then make
provisions for needs of lesser importance until all needs are satisfied up to
an equal degree of importance. The next step in the argument, a crucial
one, was the derivation of a subjective theory of value from the principle
just enunciated. Menger raised the question of what the result would be
if an individual were to lose one unit of a stock of homogeneous goods, and
he declared it to be the loss of satisfaction of the least important need
that could be provided for if the total stock were left unimpared. Hence,
he concluded, the value to an individual of any one unit of the total quantity of a good is equal to the importance of the least significant satisfaction
attained with the help of a unit of the total quantity of the good.
THE THEORY OF IMPUTATION
Value is not an inherent quality of goods but is imputed to them.
Although, strictly speaking, only satisfactions have value because man’s
life and well-being depend on them, man nevertheless imputes value to
the goods whose availability makes satisfactions possible. Menger then went.
on to expand this theory of imputation-Zurechnung-to goods of higher
, order, which satisfy needs only indirectly and whose value is determined
by the anticipated value of the goods of lower order to be produced with
their help. Menger’s approach to the valuation of producer goods, that is,
to the theory of distribution, yielded a marginal productivity theory of
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—–=. . .
sorts, in which, however, the value of the productive service was interpreted
not in terms of the change of the physical product or of the value of the
physical product but in terms of the changing satisfaction of needs. In
accordance with the loss principle employed earlier by Menger in the valuation of goods of first order, he identified the value of a good of higher
order with the satisfaction potentially yielded by goods of lower order but
lost because of the withdrawal of a unit of the good of higher order. The
theory of imputation opened up a unified view of distribution. It related
the value of the product to that of the productive services and integrated
the theories of value and distribution. In all these respects it went beyond the treatment that the classics had accorded to factor earnings. In the
later development, however, the theory of distribution would unfold itself
along the lines sketched by Thiinen rather than along Menger’s ideas.
Like Jevons’s, Menger’s theory of value assigned no place to cost of
production as a determinant of value. Both developed their arguments
on the basis of a given stock of goods that has been produced at costs
incurred in the past, which are now irrelevant. Referring to these, Jevons
made the famous observation that “bygones are forever bygones; and we
are always starting clear at each moment, judging the value of things with
a view to future utility.” In a similar vein, Menger pointed out that
“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.” This extreme reaction to the value theory of the classics with
its emphasis on labor or cost of production as determinant of value would
later be corrected by Alfred Marshall, who coordinated cost of production
with utility as determinants of value.
Menger’s discussion of value and of the nature of goods filled about
one-half of the content of the Gru.ndsatze. The rest he devoted to an exposition of the theories of price and money. In his price theory he distinguished
between different types of market situations and arrived, for example, at
the conclusion that price is indeterminate under conditions of bilateral
monopoly. His price theory remained fragmentary, however, since, like
Jevons, he did not incorporate costs and supply in his analysis and, moreover, developed it in terms of barter rather than with the help of demand
functions or curves.
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4
MONETARY THEORY
In his analysis of money, included in the Grundsatze and in an
encyclopedia article published in 1892, Menger applied the subjective theory
of value tp money. The origin of money, he held, is not to be sought in an
explicit convention or in the action of public authorities. Instead, it was
the interest of economizing individuals which led them to exchange their
goods for other, more saleable, goods. Money is the most marketable, or
sal1e:able, good, and its value is determined in the same manner as that of
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other goods that are objects of exchange transactions. In this interpretation,
money was not introduced by design and in consequence of a plan but as
an unintended result of the unconcerted actions of a multitude of individuals
pursuing their own interests. At first glance, Menger’s concept of “organic,”
or “natural,” that is, nonpurposive, social formations recalls Adam Smith’s
“invisible hand,” which leads men to promote ends that are no part of
their intention. There is, no doubt, an affinity between the two ideas, but
they do not refer to exactly the same phenomenon. Smith had in mind
the incidental effects resulting from the concurrence of simultaneous activities rather than the growth of institutions over time and in response to
custom and tradition, an essentially Burkean idea, which was adopted by
the exponents of historical jurisprudence and which Menger took over
from them.
MENGER ON THE METHODS OF SOCIAL SCIENCE
Menger returned to nonpurposive social formations m his second
principal work, a polemical study of the proper methods of economic science, which was originally published in 1883 and pf which an English
translation appeared in 1963 under the title Problems of Economics and
Sociology. This work was both a denunciation of German historical economics and a spirited defense of Menger’s own abstract-generalizing approach to economics. Beyond this, Menger’s study of economic methods
marked the beginning of a period in which economic theory was largely
identified with microeconomics, just as Lionel Robbins’s Essay on the Nature
and Significance of Economic Science ( 1932), written fifty years later but
stemming from a similar tradition, marked the end of this period. Having
sponsored a subjective theory of value which interpreted value in terms of
the state of mind of an individual, Menger declared it to be the principal
task of economic theory to investigate the behavior of economizing individuals. The economic life of the nation, he held, is the result of innumerable economic efforts undertaken by individual agents. These are the true
elements that constitute the national economy, and they form the proper
subject matter of economic theory. Menger considered his methodological
individualism confirmed by such nonpurposive social formations as the rise
of money, of towns, of fairs and markets, and of the division of labor,
interpreted by him as social structures that are the unintended outcome of
the pursuit of individual interests.
Menger’s methodological individualism, in which microeconomic
phenomena are singled out for analysis, forestalled systematic attention to
the behavior of economic aggregates, the determiiaia.tion of the national
income, and the overall performance of the economy, which before the
advent of Keynesian economics received only casual treatment by business
cycle specialists. Moreover, methodological individualism assigns no sig-
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537
nificant functions to public policy in the economic sphere and by implication, if not explicitly, has its corollary in laissez faire and political individualism.
Modern economics has not adhered to the precepts of Menger’s
methodology and has instead branched out into macroeconomics. It has
also failed to follow Menger’s ideas in a number of other respects. Menger
called for the interpretation of economic relationships in terms of causes
and effects and rejected their interpretation in terms of mutual interdependence, which has become the standard approach in modern economics.
Perhaps related therewith, because mathematicians study functional rather
than causal relationships, Menger did not employ and had no use for
mathematical economics. He considered symbols and figures inadequate
tools for the exploration of the “essence” of things, that is, if his brief
remarks may be so interpreted, inadequate for what to him appeared too
profound, lasting, and rife with ramifications and qualitative attributes to
allow for expression in the form of symbols with no empirical content or in
that of figures of fleeting relevance.
WIESER AND BOHM-BAWERK
Menger’s most important followers were Friedrich von Wieser ( 18511926) and Eugen von Bohm-Bawerk (1851-1914). Classmates and friends,
and eventually brothers-in-law, the two were not, strictly speaking, students
of Menger’s but came under his intellectual influence when in their early
twenties they read Menger’s Grundsatze. Because of Menger’s early retirement, .Austria_n s who later became prominent, including Hayek, Mises, and
Schumpeter, were not students of Menger but rather of Wieser and BohmBawerk, who held . a variety of teaching posts in the far-flung Hapsburg
empire of their time. Wieser taught briefly at Vienna, then at Prague, and
eventually again at Vienna as Menger’s successor, his academic work being
interrupted by wartime service as minister of commerce. Bohm-Bawerk
alternated between teaching, first at Innsbruck and later at Vienna, and
work in the ministry of finance, which he headed during three periods.
The two junior members of the original Austrian group had quite
different personalities. Bohm-Bawerk was an indefatigable controversialist
and close student of the economic literature; Wieser was noted for olympic
detachment from the controversies of his time and restricted his reading to
a regimen of intellectual hygiene recalling that of Comte-his brother-in-law
would in vain attempt to draw him into discussions about matters of professional concern. Nevertheless, Wieser’s intellectual interests were broader
than Bohm-Bawerk’s or even Menger’s and included work in sociology.
Distinguished as the accomplishments of Wieser and Bohm-Bawerk
were, neither had a mind equipped with the creative originality of Menger.
In their work they pursued a number of ideas that had been suggested by
the founder of the school. Both kept burning the light of economic theory
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in the German-speaking countries, a light that the historical economists
had all but extinguished in Germany proper. Both turned out brilliant
restatements of the subjective theory of value which gained the new doctrine
adherents at home and abroad. Both tried, albeit with the same inadequate
means, to develop further Menger’s price theory. Wieser in particular gave
much attention to the elaboration of the theory of imputation, with which
Menger had attempted to explain the valuation of producer goods. Wieser
also expanded Menger’s theoretical structure by incorporating ii: it a theory
of cost, interpreted by him as indirect, or sacrificed utility, foregone because
of the use of a resource for a given rather than for other purposes. The
germ of Wieser’s concept of opportunity cost was -already contained in a
seminar report he delivered in 1876, and although it was more fully developed in his own later publications as well as by Bohm-Bawerk and other
writers, it was Wieser who pioneered in this important matter.
· In the writings of Wieser and Bohm-Bawerk there emerged what from
then on was to become a feature characteristic of the Austrian tradition in
economics-a critical reaction to the work of Karl Marx. This reaction,
which was- relatively mild in the case of Wieser, became stronger in the
writings of Bohm-Bawerk and the later Austrians, who expanded their
attack to include not only Marxian socialism but also reform socialism
and economic interventionism in general. In a world that had largely
abandoned laissez faire, the later Austrians became its last defenders.
WIESER AND SOCIALIST ECONOMICS
In his Natural Value ( 1889, Eng. trans. 1893), Wieser attempted to
demonstrate that economic value is a “natural” category in the sense that
any rationally ordered society, regardless of its institutions, would have to
make valuations. He drew the important conclusion, which set a precedent
for the later study of the economics of socialism, that a socialist economy
could not dispense with valuations:
Wants there would still be, there as elsewhere; the available means would still be insufficient for their full satisfaction;
and the human heart would still cling to its possessions. All goods
which were not free would be recognized as not only useful but
valuable; they would rank in value according to the relation in
which the available stocks stood to the demand; and that relation
would express itself finally in the marginal utility. Social supply
and demand or amount of goods and utility socially compared
with one another, would decide value. The elementary laws of
valuation, as we have explained them, would be entirely and
unlimitedly effective for the whole community.
Although Wieser stressed the relevance of the subjective theory of
value for a socialist state, he as well as Bohm-Bawerk rejected the labor
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theory of value and subjected it to searching criticism, the latter in a volume
entitled Karl Marx and the Close of His System ( 1896, Eng. trans. 1898),
for a generation the leading criticism of the work of Karl Marx.
539
BOHM-BAWERK AND INTEREST THEORY
Bohm-Bawerk made his principal contributions to the theories of
interest and capital, and it was with these that he developed his most effective criticism of socialism. He went considerably further than Wieser, who
left the question of the viability or desirability of socialism unanswered
and merely underlined the validity of fundamental economic principles
under both capitalism and socialism. Bohm-Bawerk’s main argument was
that the socialist criticism of capitalism was in fact a criticism of the human
condition, that is, of the central problem of scarcity, with which socialism
would have to cope just as did capitalism.
Bohm-Bawerk’s views were set forth in Capital and Interest ( 1884,
Eng. trans. 1890) and The Positive Theory 0f Capital (1889, Eng. trans.
1891). The former was a somewhat tendentious doctrinal history of interest theories, whereas the latter contained his own theoretical contributions, which attracted a great deal of attention and stimulated controversies
that are far from being settled at the present time. People tend, BohmBawerk argued, to overestimate future resources and to underestimate future
wants; besides, goods available now will yield goods of higher value in
the future. In the light of these “three reasons” -the first two psychological
and the third technological-people will be inclined to place a higher value
on present than on future goods of the same kind and quantity, and to
induce them to exchange present for future goods they are to be paid an
agio, or premium, which equates the value of present and future goods.
This agio, or premium, is known as interest.
A few examples, which B6hm-Bawerk himself provided, will illustrate
the meaning of the three reasons. People tend to overestimate future resources: If they suffer in the present from the lack of certain goods, they
may have reason to hope to be more amply provided for in the future. Cases
in point are temporary distress or calamity, as well as the situation of all
those who look forward to a career that ,”‘ill better their economic status.
People tend to underestimate future wants: They do so because of deficient
powers of the imagination and of the will and because life is uncertain and
short. Present goods will yield goods of higher value in the future: A person
who needs drinking water may go to the spring and drink from his cupped
hands. Or he may hew a log into a bucket and store a supply of water in
his house, but this more advantageous sit~ation requires time to procure
an ax and ‘ fell a tree. For even greater convenience, he may construct a
pipeline ‘that ,conducts the water to his house. Here the road that leads
from the expenditure of labor to the availability of water becomes longer
and more roundabout, but the result is still more rewarding. It is on these
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grounds that people appraise presently available goods more highly than
goods that will become available in the future.
Bohm-Bawerk’s first two reasons for interest, the psychological ones,
lend support to what came to be designated as the time-preference theory
of interest, whereas the third appears to be a newly garbed productivity
theory of capital. This latter interpretation, however, was not endorsed by
Bohm-Bawerk, who recognized only land and labor as original factors of
production and refused to consider capital a factor of production coordinate
with these. In his analysis, capital enhanced the productivity of land and
labor; its employment was “time absorbing” and required more “roundabout” processes of productipn which lengthened the “period of production.” By producing a net, a fisherman would greatly enlarge his catch, but
the process of producing the final output now required a detour which made
it more time-consuming and lengthy, beginning with the incorporation of
land and labor inputs into the net and into the tools or machinery with
which it was manufactured.
All parts of this analysis, which Bohm-Bawerk presented with great
assurance, were challenged in time. It was pointed out that people might
overestimate future resources but would do so only if they expected their
incomes to rise, an assumption not necessarily implied within the framework
of Bohm-Bawerk’s stationary economy. His second reason pointed to a
defective telescopic vision, which caused people to place a premium on
present goods. But the family motive for accumulation and the demonstrable
willingness of people to make provisions for an uncertain future, tendencies
that might assert themselves even at zero interest rates, made it appear
likely that some people were inclined to place a premium on future rather
than on present goods. As for his third reason, which he considered sufficient in itself to explain interest, it was pointed out that in the absence of
time preference, that is, of the psychological reasons, the third reason would
not give rise to interest but would induce people to devote all present goods
to the production of future ones. The fact that people did not behave in
this manner was due to their time preference, to the psychological reasons.
Bohm-Bawerk’s formulation of the third reason did not satisfy those
critics who insisted that it demonstrated the productivity of capital. Some
of them attempted to restore the conventional triad of productive factors,
and others denied the validity of drawing dividing lines between classes of
productive agents all of which contributed the same type of productive
service or input. Considerable efforts were made to clarify Bohm-Bawerk’s
concept of a period of production, visualized as starting with the initial
dedication of original factors of production-land and labor-to a process
of production and ending with the emergence of the final product ready
for consumption. The period of production, whose affinity with the capitaloutput ratio has been recognized in recent years, was apparently considered
by Bohm-Bawerk as an operational concept that would lend itself to empirical verification. Critics denied this, and some went as far as to question
the logic of its construction and to express doubt whether the period of
production, as Bohm-Bawerk understood it, would be finite. To F. H.
Knight, a well-known American critic of Bohm-Bawerk’s, the reference to
the original factors of production meant the conundrum of an infinite
regress since he found it impossible to visualize the production of a consum