This year marks the 150th anniversary of a radical change in the way economists came to understand the logic of human decision-making and the formation of prices in society. There occurred what is often referred to as the “marginalist revolution” in place of the classical economists’ notion of a “labor theory of value,” which was generally accepted from the time of Adam Smith.
In 1871, there appeared two books, Carl Menger’s (1840-1921) Grundsätze der Volkswirtschaftsliche, (or, Principles of Economics as it was translated into English), and William Stanley Jevons’ (1835-1882), Theory of Political Economy. This was followed shortly after by Leon Walras’ (1834-1910) Elements of Pure Economics in 1874. Menger, Jevons, and Walras each made their contribution independent of even knowing about the others’ existence. Yet, the focus, very often, has been on the common elements to be found in their respective expositions.
The Classical Economists on the Market Process
All three of them, each in his own way, challenged the idea that the exchange value of goods in the marketplace was based on some version of the quantity of labor that had gone into their respective manufactures. Consumer demand was generally taken merely as “given,” as something that any tradable good had to possess if any good were to be bought, but it was viewed as a more “passive” than “active” element in influencing the working or structures of market activities.
The classical economists had developed a fairly clear and cogent analysis of how private enterprise, guided by the profit motive, organizes and directs production to where the “given” consumer demand suggests the most profitable gains may be made; that competition among private enterprises will compete profits away where they are found to exist, and to shift production out of those areas in which losses are being experienced. The end result of which is that supplies are tending to match demands, and no more than “normal” profit is earned by business firms in those areas of the market where entry is unrestricted and resources may be freely reallocated from one part of the market to another.
While virtually every classical economist emphasized that if any good were to be demanded and purchased in the market, it must possess “utility;” that is, qualities and characteristics desired for some consumption use by consumers, they said very little beyond that, other than the common sense understanding that consumers tend to buy more of the good as its price decreases and less when its price goes up.
It is easy enough to find a handful of economists in the 19th century who can be shown to have more subtle understandings and analysis of utility and demand than has just been suggested, but I do not think it is an unfair statement that, generally, the logic of consumer choice was not fully and successfully analyzed.
The Marginalist’s Challenge the Labor Theory of Value
Enter our three “marginalists,” Menger, Jevons, and Walras, in the early 1870s. At one level, the difference between the classical economists and the marginalists was the issue of categorical versus incremental. The “classical’ paradox of value arose precisely because from Adam Smith on there was the “why is it” that things of great “objective” value often have significantly lower “exchange” value than objects of nonessential importance – water versus diamonds. Their answer was that while water was essential to human life it generally was widely and abundantly available with little or no human effort to bring it to man’s use. While a diamond, though a mere ornamental bobble, usually required a far greater human effort to bring any amount to market. Hence, an essential item was had at a very low market price, while a nonessential one traded for a much higher price.
As historians of economic thought have almost unanimously pointed out, it all came down to the faulty insistence of thinking in “either/or” terms; that is, all water versus all diamonds. Think, instead, in incremental terms of having singular units of each good in succession, and the paradox melts away. Precisely because water is relatively plentiful in comparison to all uses people may have for it, and with each additional available unit of water assigned in descending order of importance to uses for which a person may have for it, the “marginal” or “final” unit is assigned to the rather low, least most important use for which water is capable of serving.
With the supply of water hypothetically approaching the satiation point for which the “marginal unit” can be applied, the price that the consumer likely would be willing to pay for that last unit is far, far less than if it the available supply was only able to satisfy the first, second, or third most important uses for which units of water might be used. The available supply of diamonds “cuts” people’s respective marginally ranked value scale for them much, much higher up and away from any comparable satiation point. Thus, the price a person might be willing to pay to acquire his desired marginal unit of a diamond is significantly above the price he is willing to pay for the marginal unit of water.
Demand Guides Markets, and Costs as Opportunities Foregone
Rather than it being the relative labor costs of bringing alternative goods to market that determines their relative prices, it is the demand curves, and the respective (marginal) utility ranking scales underlying them, that guides and determines which goods are more profitable for which to undertake production, and therefore the “costs” worth incurring in terms of scarce resources and labor to bring them to market.
It would be a few years later with, especially, the “second generation” of “marginalist” economists – Friedrich von Wieser and David Green and Herbert Davenport for instance – that cost was more clearly reinterpreted not as a physical quantity of labor devoted to the manufacture of a good, but the (marginal) utility or worth of the alternative “opportunity” foregone in devoting scarce means to the use of one desired consumer good rather than some other. Thus, cost, too, was a matter of an evaluating mind deciding the more or less importance of a desired alternative end and not a measured amount of some “objective” quantity of labor. It was the “marginal” value of competing ends that determined the worth of useful means employed in different ways, and not the other way around with the relative labor inputs determining the relative value of the ends in the form of the prices of finished goods.
This was considered part of the common intellectual heritage of Mengers, Jevons and Walras’ contributions that were most frequently emphasized by historians of economic thought over a good part of the 20th century. If a distinction was made between them, it usually was that Menger had not reached the analytical heights of his two marginalist colleagues due to his (and his followers’) reluctance or inability to appreciate and apply mathematics for a more precise and deterministic analysis of the logic of the margin.
Menger’s Distinct Approach to Economic Thinking
Only later in the 20th century did a number of economists, and others including Carl’s son, the noted mathematician, Karl Menger, Jr. (1902-1985), begin to make the case that in Menger’s nonmathematical approach could be found a subtle analysis of things much closer to the reality of human decision-making and choice than that offered by an approach that narrowly focused on the first derivative of a function and a series of simultaneous equations. Menger not only explained marginal decision-making in terms of the discrete units of goods (rather than the hypothetical infinitesimal of a continuous mathematical function) as real choices are made by real people in the real world, but a choice making that is enveloped by and inescapable from the presence and relevancy of market and social processes in time, with uncertainty and people’s imperfect expectations concerning the future.
Another distinction between Menger’s analysis and those of Jevons and Walras was that Menger was far more conscious and incorporating of the historicity of economic processes and the evolutionary character of the institutions through which men make their choices and interact with each other in the market process. For Menger, the “complex phenomena” of the market and the larger society cannot be simply taken as “given.” In his view, a successful analysis of human affairs must be able to explain how the institutions of the market have emerged and taken form through the often-unintended self-interested interactions of multitudes of individuals, whose activities generate social arrangements and outcomes that none of the participants had planned as part of their own, respective, actions in attempting to achieve their personal purposes and ends.
Money and the Unintended Consequences of Human Action
His theory of the origin of money became his stereotypical instance of such processes. People desiring to better their circumstances through gains from trade sometimes find that a barter transaction cannot be consummated due to a failure of, say, a double coincidence of wants between the potential traders. Rather than leave the arena of exchange disappointed, individuals may imagine or see the existing success of others in first trading away their own less marketable good for one that is more highly demanded by many in the marketplace. Even if this individual has no particular use for this good, himself, he sees that once a quantity of it is in his possession, he will find it much easier to acquire from others what he wants because he now has something more readily accepted in exchange by potential trading partners.
Slowly this discovery and practice will spread from one individual to another, and another, and another, until finally someone or some small handful of commodities, having especially useful qualities and characteristics for trading purposes, will be “institutionalized” through routine, habit, custom and tradition as the “money-good(s)” of the market. Who can deny that a little reflection makes it clear that without the emergence of such a medium of exchange, the complex systems of division of labor and the various forms of direct and indirect trade that we take for granted would have been nearly impossible to have developed in the way they have?
Many Useful Institutions are Unintended Social Outcomes
Menger, by the way, never denied that while many institutions of society have their origins in just such “spontaneous,” unplanned and unintended processes of human interaction, once they are established, they can be open to more intentional and planned reform, improvement, and change, as well as continue to evolve and transform through time through the same “spontaneous” processes that had brought them into existence. Commonly they end up being the product of both, being changed “unintendedly” in various and sundry ways that people in their everyday interactions are not aware of and being modified by social and political “designs” of various sorts. A mixture of the “intended” and the “unintended.”
For Menger, a whole array of social institutions have demonstrated their origin in this “spontaneous” process, including language, religion, law, political organizations and arrangements, money, markets, “all these social structures in their various empirical forms and in their constant change are to no small extent the unintended result of social development,” Menger said. “The prices of goods, interest rates, ground rents, wages, and a thousand other phenomena of social life in general and of economy in particular exhibit the same peculiarity.”
One finds little or none of this type of analysis in either Jevons or Walras. In Jevons’ case, markets and their institutional forms are not only simply taken as existing, but to reach the equilibrium market conditions he desires to demonstrate on the basis of the “pleasure-pain” of marginal benefit and marginal cost, he presumes without explaining or even suggesting how, that markets are “perfect,” with agents possessing near full knowledge about themselves, others and all circumstances that might otherwise result in any of them making a wrong decision and a false exchange that would prevent precisely the balanced maximizing of utility at the refined mathematical margins of choice.
Walras’ Artificial Auctioneer to Make Markets Work
Walras is famous for presuming that the existence of an auctioneer, a “crier,” who shouts out alternative bid and ask prices on the basis of which the auctioneer proceeds to tabulate the quantities of demand and the quantities of supply at these alternative possible prices, until he lands upon that set of relative prices at which the supplies and demands for each and every good will be correctly matched, at which point, and only at such a point, are transactors allowed to consummate their trades with each other. How such auctions would have emerged, and why in the forms and rules that participants let the “crier” know their truthful answers about how much they would be willing to buy or sell at the different prices he cries out, and have come to agree among themselves not to trade at any prices other than the ones the auctioneer says are those that will simultaneously “clear” all markets, is never explained. The most Walras ever said was that the actual processes of the real ongoing markets “empirically” do and achieve what he posits his imaginary “crier” to be doing in his make-believe market.
It might be said that Menger does not get much further than his comarginalist founders in terms of explaining the logic of markets and the coordination of supply and demand on the basis of marginal decision-making. He, too, attempts to show how marginal evaluations of a group of buyers and sellers result in a relatively narrow range within which a market-clearing price would have to fall, rather than a pinpoint equilibrium determined price such as Jevons and Walras attempted to postulate, based on how they, respectively, specified market conditions and what is either known or given as information for the actors to make no mistakes.
For Menger the Market Process of Price Formation is Important
But there is this important difference in emphasis and concern in Menger: a precise determination of any and all equilibrium prices do not matter to him, other than as illustrations of the nature and logic of market processes. Jevons and Walras, on the other hand, consider it imperative to be able to demonstrate what the set of equilibrium prices would have to be, given the underlying market circumstances. This is essential to their analysis, but for Menger it is peripheral. Said Menger:
“However much prices, or in other words, the quantities of goods actually exchanged, may impress themselves on our sense, and on this account form the usual object of scientific investigation, they are by no means the most fundamental feature of the economic phenomena of exchange. This central feature lies rather in the better provision two persons can make for the satisfaction of their needs by means of trade . . .
“Prices are only incidental manifestations of these activities, symptoms of an economic equilibrium between the economies of individuals, and consequently are of secondary interest for the economic actors . . . The force that drives them to the surface is the ultimate and general cause of all economic activity, the endeavor of men to satisfy their needs as completely as possible, to better their economic positions.”
Hence, it is the logic and process of price formation in general, and in differing situations, that is crucial for Menger. With ever-changing circumstances through time, the underlying supply and demand conditions embedded in the valuational judgments of market participants will not remain the same. As a result, the market generated prices of yesterday are likely to be different than those of today, just as tomorrow’s prices will vary from those in the present. What was important, therefore, in Menger’s view, was the general “laws” of prices and price formation that could make any emerging and observed prices intelligible in terms of an analytical understanding of their causal origin in the individuals’ subjective (personal) valuations and the interactive competitive process that results in the transitory price relationships of the changing moments.
Böhm-Bawerk’s Market Process of Price Formation
It is from this beginning in Carl Menger that it may be said that the “Austrian” focus on market processes instead of equilibrium states has its origin. It is of note, for instance, that when Menger’s follower, Eugen von Böhm-Bawerk (1851-1914), offered his own exposition of value and price in a long “digression” in his Positive Theory of Capital (1889), which builds on that of his mentor, he assumed neither that market transactors possessed perfect knowledge of all relevant exchange circumstances nor interjected a magical “crier” telling people when it was appropriate to trade at equilibrium prices.
Instead, market participants enter Böhm-Bawerk’s market knowing their own supply of the good they wish to sell, a general idea of the minimum price at which they may be willing to sell it and a general idea of some price they might be willing to bid for some other good they are interested in buying. But it is only in the actual competition of other sellers offering a good similar to his own and rival buyers also making bids to buy the same good he is interested in purchasing, that each particular individual must make up his mind whether to offer to sell his own good for less to win customers and how high he might be willing to go to outbid those closest to his initial bid to buy.
Thus, it is only in the process of competing as seller or buyer that the individual market participant “discovers,” if you will, his own value scales as a seller and buyer, and has it open to revision, as some of his supply rivals and demand competitors offer to sell for less than him or bid more to buy than him. In other words, in Böhm-Bawerk’s market, the participants themselves initiate and make bids and offers, actively compete against one another in the “endogenous” process of creating and forming prices until enough demand-side bidders and supply-side sellers have, respectively, dropped out and left the market, that a price is found at which supplies are brought into balance with demand.
Even in the case of Böhm-Bawerk’s simple market setting, bids and offers and market prices emerge and then form out of the subjective valuations and purposeful actions of the participants themselves. Here is a conception of actual price formation from within the market, rather than through the magic of set up assumptions or imaginary marketwide auctioneers giving prices to people to which they passively respond until they are told to trade.
Menger on the “Spontaneous” Development of Communities
Now, the same applies to Menger’s analysis of the origin of monopoly and the emergence of market competition. It is true that in his Principles, Menger attempts to logically demonstrate the range in which a market price has to fall when there is, say, one seller and several buyers bidding for what he has for sale. But Menger is also interested in placing his conception of a monopoly price in the larger context of the historical origins and reasons for there to be a monopoly situation of a single seller in the market.
Menger pointed out that it has not been uncommon for monopoly to have arisen and been maintained due to the interventions of the political authority; that is, government. But his wider focus is how competition “naturally” emerges from situations of a single seller in the market. The setting for understanding this, once again, is Menger’s attention to the spontaneous and unintended development of social and economic institutions. In his Investigations into the Methods of the Social Sciences, with Special Reference to Economics (1883), he explained that new towns and cities historically may sometimes have been the intentional creation of a political authority or some designing, collaborative group. But, in general, he suggested,
“As a rule, however, new localities arise ‘unintentionally,’ i.e., by the mere activation of individual interests which of themselves lead to the above result furthering the common interest, i.e., without any intention really directed toward this. The first farmers who take possession of a territory, the first craftsman who settles in their midst, have as a rule only their individual interest in view. Likewise, the first innkeeper, the first shopkeeper, the first teacher, etc.
“With the increasing needs of the members of the society still other economic subjects find it advantageous to enter new professions in the gradually growing community to practice the old ones in a more comprehensive way. Thus, there gradually comes into being an economic organization which is to a high degree of benefit to the interests of the members of a community . . . Yet this organization is by no means the result of the activation of the common will directed toward its establishment.”
The American West as An Example of Menger’s Thinking
The imagery that most easily comes to mind, especially for an American, is the settling of the American West across the continent. Settlers arriving as immigrants landed at established port cities, but soon, wave after wave, moved west into unsettled places and on to unclaimed land. A farm is laid out, a house and a barn are built and the planting field is prepared. Not far is another farming family doing the same. With enough such family farming enterprises, another immigrant moving west sees an opportunity to open a general store as a means of earning a livelihood rather than taking up farming himself, maybe because he worked in a store in the “old country,” making him feel more comfortable doing a type of work to earn a living with which he is already familiar.
Soon a livery stable is established, a barber shop, and a hotel and saloon. A medical doctor, moving west, is passing through this town and realizes that here is a chance to open a practice, since there seems to be no other doctor anywhere near this area. With farms and shops and enterprises growing the community, some lawyer looking for a place to hang out his shingle to handle deeds, disputes, and related documents builds or rents an office. A traveling minister preaching the word of God, decides that this town might be somewhere to settle down himself with enough potential parishioners to support a church and its pastor. The young ones in the town and surrounding farms may need some “book learning,” and a committee of the town’s folk advertise for a ‘schoolmarm” to join their community. The townspeople may find it worthwhile, at some point, to hire a sheriff, as well, to keep the peace.
Menger on Why Monopoly Comes Before Competition
In this social process of emerging towns, Menger suggests that monopoly, meaning an initial single seller of a good or service, is the “natural” starting point of such an emerging community system of division of labor. In other words, monopoly comes first and competition arises out of it, over time, when there are no legal or similar impediments to supply-side rivalry. He makes this very clear in his Principles:
“We would interpret the concept of the monopolist too narrowly if we limited it to persons who are protected from the competition of other economizing individuals by the state or some other organ of society . . . Every artisan who establishes himself in a locality in which there is no other person of his particular occupation, and every merchant, physician, or attorney, who settles in a locality where no one previously exercised his trade or calling, is a monopolist in a certain sense, since the goods he offers to society in trade can, at least in numerous instances, be had only from him. The chronicles of many a flourishing town tell of the first weaver to settle there when the place was still small and poorly populated . . . Monopoly, interpreted as an actual condition and not as a social restriction on free competition, is therefore, as a rule, the earlier and more primitive phenomenon, and competition the phenomenon coming later in time . . . [being] closely connected with the economic progress of civilization.”
It is only with the development of more intense and extensive economic development, Menger argued, that competition emerges out of monopoly. The growing number of people needing the product or services of the, up until now, single supplier in this community becomes more than he is able to fully provide or satisfy. The market outgrows what he is able to do for his fellows in this town and developing city. At first, the increasing demand for such a single-seller’s services enables him to raise his price and “ration” the availability of what he can supply as either a good or service by this means, and reap the financial benefit.
But allow time to pass, along with the frustrations of the buyers in this growing community due to the greater cost of getting what the monopolist supplies, and the limited amount of what he can actually provide to his increasing number of customers, given his own limitations, and the door is “naturally” opened to the arrival of rivals and the emergence of competition in place of there being only “one” on the supply side. Again, as Menger explained it:
“A first artisan of any particular kind, a first physician, or a first lawyer, is a welcome man in every locality. But if he encounters no competition and the locality flourishes, he will, almost without exception, after some time acquire the reputation of a hard and self-seeking man among the less wealthy classes of the population, and even among the wealthier inhabitants of the place he will be regarded as selfish.
“The monopolist cannot always comply with the growing requirements of society for his commodities (or labor services) . . .The economic situation just described is usually such that the need for competition itself calls forth competition, provided there are no social and other barriers in the way.”
Adam Smith on the Limit of the Market
It is interesting to note that at no point in this discussion does Menger even footnote Adam Smith’s discussion, “That the Division of Labor is Limited by the Extent of the Market,” in The Wealth of Nations (1776). Smith’s point was that there would be no purpose to any individual totally specializing in a production of any one good, if the market is not large enough to absorb all increased output that specialization would enable him to offer in trade. Only as the general society in which he lives slowly grows sufficiently large that the greater wares of each specialist in the division of labor can be profitably, and mutually, absorbed can the full benefit of specializations and the rising productivity that it permits, be fully taken advantage of.
Even if a farmer would do far better for himself being a blacksmith, instead, he would be better off not fully giving up growing much of the food he and his family need to live, and doing only a bit of blacksmithing on the side if he has only a few neighbors who need their horses fitted with horseshoes. But as the community grows and a greater number of residents also have an increasing number of horses that need to be shod, a point may be reached when he can fully specialize in blacksmithing and earn significantly more by filling this niche in the intensifying division of labor and buy all the food he needs from others who, in turn, can afford to expand their efforts completely into food production and purchase everything else they need by feeding their neighbors.
Monopoly and Competition Reflect the Size of Markets
A similar logic applies to Menger’s analysis of the emergence of competition out of monopoly. Invariably, in early societal development, the need for any occupation, profession, and many production activities will be relatively limited due to the few customers for such services or products to make it impossible or unprofitable for more than one supplier and seller to occupy some specialized corner in this still small market arena.
The arrival of the single supplier, where none had been present before, as Menger says, may be cheerfully appreciated by the townsfolk he has joined. But over time, as the town expands, he may find himself only able to handle so much of the growing business for his services. People needing the lawyer’s skills for deeds, wills, contract preparations, etc., find that he does not have, or is unwilling, to provide all the hours in the day needed to fulfill their demands. The same with the medical doctor, or the town blacksmith, or the hotel owner in terms of rooms he has available for those looking for a place to temporarily stay.
Separate from the grumbling others may make about the monopolist, as Menger mentions, due to his not being about to satisfy their need for his services, or that to ration his available output or services, he raises the price he charges his neighbors to bring his supply into balance with their demand, the division of labor can now successfully incorporate more than a monopoly supplier due to a wider extent of the market.
As markets grow, monopoly begets competition, Menger is saying. And notice, he did add the caveat, assuming no legal or related barriers to entry that shelters the single seller from the emerging winds of competitive profitability that attracts others into his corner of the division of labor. Extending Menger’s logic to innovation as well as market size, we can see how his chain of reasoning can easily lead to Joseph Schumpeter’s (1883-1950) idea that real entrepreneurship is partly reflected in the marketing of new or radically different versions of some existing products. But invariably at the start, this innovator is the only producer, supplier and marketer of this new and/or improved product. He may be for a time “the” seller of the good, a “monopolist.”
But if time is allowed to pass, and if the product does demonstrate a demand for it that offers significant profitability, the monopolist’s very success will attract and bring about the competition that undermines and eliminates his monopoly status in the future. Successful monopoly in open markets begets the competition that replaces it.
The Unintended Process from Monopoly to Competition
Though Menger does not express this from monopoly to competition process in the explicit words of “unintended” development with which he discusses a number of other market and social phenomena, the logic is the same. The artisan, or lawyer, or medical doctor, or even blacksmith may have not intended to create a “monopoly” position for himself. He merely discovers a niche in a small but growing market within which he can successfully earn a living. But his usefulness to those in the community attracts more business for him over time, partly from more existing residents seeing the value of his services and partly from new customers due to an increasing number of people living in this community.
It is not that he means to appear “selfish” or “greedy,” in the eyes of some of his neighbors whose wants he is not able to fully satisfy, it’s just that he can only produce so much of his product or supply only so many hours in the day to those wanting his services. Rather than arbitrarily picking and choosing whose demands we will fulfill, he raises his price. Some in the community purchase less of what he offers or cannot afford it at all. Either way, the demand is limited to what he is able to or is willing to supply. His market is outgrowing his monopoly status.
Over time, rivals will appear. The market is now large enough to profitably sustain two sellers, three sellers, a dozen sellers of the same good or service. Newcomers on the supply side offer their services or products for less or with better features, qualities or characteristics to that of the former single seller. Price decreases, output increases, diversity of types and availability of services widen. The “primitive” conditions, as Menger expressed it, of monopoly, grow into competition with the market’s progressive “civilization” of rivalrous and vibrant competition.
Rethinking Economics in Light of Carl Menger
How very different many aspects of economic theory and policy judgments might have been if the analytical paths proposed by Carl Menger concerning the logic of individual choice, rivalrous price formation, the meaning and nature of monopoly, and the “naturalness” of emergent competition as part of the unintended consequences of human action had been followed instead of the directions that were taken in the economics profession.
While time only moves in one direction, an understanding of Menger’s unique contributions can still influence readers when they think about social and market processes; ideas and approaches can be rethought and redirected. Let us hope that the 150th anniversary of both the “marginalist” revolution, and Menger’s distinct development of it along with his ideas about the surrounding social and market processes, can serve as the inspiration for such a rethink when thinking about man, markets and the institutions in which we live.
This article was first published by the AIER, and can be found here.
Chart of the Day
Warren Buffett and Charlie Munger answer questions on Zen Buddhism, cost of capital and big ideas at the 2001 Berkshire Hathaway annual meeting.