Chapter I: The Problem

“Grasp the exhaustless life that all men live! Each shares therein, though few may comprehend: Where’er you touch, there’s interest without end.”

GOETHE (Faust, Prelude on the Stage)

1. Ordered Anarchy

On the threshold of every scientific speculation about the universe (as the Greek philosophers taught us long ago) is inscribed the word “wonder.” Before explaining anything, we must first feel that it needs explanation; before answering questions, we must first learn how to ask them. Science cannot progress where men take the world, their own existence, for granted. If our knowledge of these phenomena is to increase, we must see them naively, with the eyes of children. Unfortunately, if understandably, the more the familiar and commonplace is a given fact, the less does it excite the sensation of “wonder.” Is there anything, for instance, more familiar or more humdrum than economic life? What is so usual, even banal, as the housewife’s daily marketing, the farmer’s sale of a calf, the working-man’s weekly pay check, the sale of a share on the stock exchange? Still, it needs but a moment’s reflection to discover behind these banal occurrences something unexplained, even mysterious. Once we have made this discovery, we have already taken the first steps onto the terrain of economics.

Despite the power of the human imagination, it can only feebly picture the economic life of our age in all its variety and complexity. If only we might at this moment have the gift of omnipresence, what an unimaginable number of activities, mutually interacting with and determining each other, we would behold. We would see millions of factories in which thousands of different products are being manufactured; people sowing somewhere, somewhere reaping; a thousand boats and trains hauling to the four corners of the earth cargoes of fantastic variety; shepherds tending flocks in Australia and New Zealand; miners digging copper ore in the Congo or in the American far West and starting it on its way throughout the whole world; the Japanese spinning silk, the Javanese gathering tea—all swelling an unbroken stream of goods flooding across the land into warehouses and factories and from thence into millions of shops. We would see a still finer network of little streams going from the shops into countless households, rivulets of food and clothing and all the other things required by an army of billions: laborers, office workers, clerks, businessmen, farmers—the very ones whose work has created the mighty river of goods. Simultaneously, we would see another current of goods (machines, tools, cement, and similar products not intended for direct consumption) supplying the factories in city and country—the auxiliary goods needed to keep the first stream of consumption goods flowing. And still the panorama would not be complete, for in every direction we would see a host of services being performed: a surgeon beginning an operation, a lawyer making a plea, an economist endeavoring to explain the economic system to a circle of unknown readers. And more than this: we would behold the bewildering moment-to-moment fluctuations of the money market and the securities market—phenomena which we sense are contributing in a mysterious fashion to the movement and progress of our economic system. Finally, our attention would be drawn to small and large ducts labeled “taxes” and “exercises” debouching at all stages of the economic process and serving to divert part of the flow of goods to the state for the maintenance of the army, the administrative agencies of the government, the schools and the courts.

Today, we are witnessing a rapid decline in the number of individuals who satisfy their wants independently of the outside world. The modern farmer manages to retain in a greater degree than any other class the independence of the self-sufficient man, although even he satisfies a growing share of his needs by selling his surplus produce in exchange for the things he does not raise. The rest of mankind, however, is almost completely dependent upon this indirect method of want-satisfaction. Indirect production, in turn, is based upon the principle, familiar to everyone, of the division of labor, but it presupposes, nonetheless, a harmonious coordination of the divided elements of the economic process.¹ Who in the countries of the free world is charged with this coordination? What would happen if no one were in charge?

Consider, for a moment, the problem of the daily provisioning of a great city. Its millions of inhabitants must be provided with the basic necessities, to say nothing of the “luxuries” which cheer and brighten existence: so many tons of flour, butter, meat, so many miles of cloth, so many millions of cigars and cigarettes, so many reams of paper, so many books, cups, plates, nails, and a thousand other things must be daily produced in such wise that a surplus or deficiency of any particular good is avoided. The goods must be available hourly, monthly, or annually (according to the kind of good in question) in exactly the quantities and qualities demanded by a population of several millions. But the people’s demand for goods is necessarily dependent upon their purchasing power (money). The existence of purchasing power presupposes, in turn, that the millions who appear in the market as consumers have previously as “producers” (whether employees or independent proprietors) so adjusted their output, both in quantity and quality, to the general demand for goods that they were able to dispose of their stock without loss. Now the highly differentiated modern economic system encompasses not alone a single city, however great, not alone a country however vast, but, in a way to which we shall give our particular attention later, the whole terrestial globe. The craftsman in an optical instrument factory makes lenses for export to the most distant countries, which in turn supply him with cocoa, coffee, tobacco and wool. While he is polishing lenses he is also producing, indirectly, all these things more abundantly and more cheaply than if he produced them directly. This immensely extended and intricate mechanism can function only if all its parts are in such constant and perfect synchronization that noticeable disorder is avoided. Were this not the case, the provisioning of millions would be immediately imperiled.

Who is charged with seeing to it that the economic gears of society mesh properly? Nobody. No dictator rules the economy, deciding who shall perform the needed work and prescribing what goods and how much of each shall be produced and brought to market. Admittedly, people today must perforce accept a great deal more dictation from authorities of all kinds than a few decades ago. Yet by and large the world outside of the Communist bloc—the “capitalist” world, to use a popular if vague expression—still adheres to the principle that decisions about production, consumption, saving, buying and selling, are best left to the people themselves. Thus, the modern economic system, an extraordinarily complex mechanism, functions without conscious central control by any agency whatever. It is a mechanism which owes its continued functioning really to a kind of anarchy. And yet capitalism’s severest critics must admit that all of its parts synchronize with amazing precision. Political anarchy leads invariably to chaos. But anarchy in economics, strangely, produces an opposite result: an orderly cosmos. Our economic system may be anarchic, but it is not chaotic. He who does not find this a wondrous phenomenon and thereby deserving of the most patient study cannot be expected to take much of an interest in economics.

The order which is immanent in our economic system compels recognition even by those who are far from finding it perfect. Indeed, even those who radically disapprove of this kind and degree of order and who wish to replace it with a system of conscious and centralized control (socialism) cannot deny that it exists. Order there is in our economic system; we have a centuries-long proof of it; it is a fact which is beyond debate but which is at the same time compatible with every political faith. Honesty compels the admission that the existence of ordered anarchy is cause for astonishment, that it is something which urgently requires explanation. Further reflection, moreover, must occasion serious doubt as to whether an enormously complicated and differentiated process such as is represented in the economic systems of the advanced industrial nations could be “commanded” in all its details from on high, after the fashion of an army or a factory, without the direst consequences. The existence of order in spite of anarchy—”spontaneous order” if we wish—is not alone an astounding phenomenon in itself. The processes peculiar to economic life in a free society make evident the fundamental superiority of the spontaneous order over the commanded order. Spontaneous order is not just another variety of order, albeit one with the surprising ability to function, if need be, even without command from on high. For if the organization of the economic system of a free society can be shown to differ fundamentally from the organization of an army, there is reason for believing that a spontaneous economic order is the only possible one. Notwithstanding, our enthusiasm for spontaneous order will be tempered by the realization that as measured against any given ideal, it may leave much to be desired.

2. Other Enigmas of Economics

Once we have become aware of the element of the mysterious and the problematical in the economic process in which we ourselves are engaged, we are alerted as well to the enigmatic aspects of all the individual parts of the process. Once we have begun to ask questions and have sloughed off the naive unconcern of the unphilosophical man who regards all these things as “given,” our intellectual curiosity pushes us ever deeper into the thickets of economics. What about “interest,” for example? Here is one of the biggest conundrums of economics and one which will no doubt appear as disconcerting at first sight to the modern tenderfoot as it did to the writer in his own youth. Or again: how many are there who regard money as something self-evident, something on which it is unnecessary to waste much discussion? They know what money is in its concrete form of coin and bank note and that one must have it to survive, but that is the end of the matter for them. It requires a serious monetary disturbance, such as the inflationary crises which developed in some countries after both World Wars, to bring home to people what irreplaceable services are rendered by a healthy monetary system, what fecund and also destructive forces lie hidden in those pieces of paper and those small discs of metal which are passed so nonchalantly from hand to hand. Then, even the uninitiate can see some point in reflecting on the meaning of money. And when once this act of reflection has commenced, how quickly comes insight into and appreciation of the mysteries and the problems which lie hidden here. It is then that the realization comes that money is not something natural and self-evident, but a human invention, and as such an historical phenomenon which acquires significance only at a certain stage of economic development, namely, that of an advanced society founded on the market and the division of labor.

Let us take a step further, leaving aside for the moment the broader interrelationships of economic life (whose problematical aspects are really not so difficult to discern) and confine our attention to a single banal fact, selected at random. Assume that we have a pencil costing $.05 and a watch costing $50. Whence comes this difference in price? There are three possible explanations. First: the two prices are simply the result of chance. Chance, clearly, plays a role in the formation of prices as anyone will attest who has ever attended an auction or paid some exorbitant price in an Eastern bazaar. And there is little doubt but that on most of our imperfectly organized markets the formation of prices takes place within a more or less wide range of indeterminacy. Yet no one would seriously maintain that price formation is governed only by the capricious play of chance. It would, at any rate, be difficult to make such an assertion about the pencil and the watch. There is too great a difference between the two prices and too little likelihood of supposing an inversion of the prices. Experience proves that, in reality, prices of all commodities are coordinated in a single system in which each individual price tends to remain stable for a considerable period of time, varying only within relatively narrow limits; a marked change will occur only for good and sufficient reasons.

A second explanation is that prices are arbitrarily set by the public authorities. It will be at once evident that this explanation does not apply in our case nor to our experiences, though we are all familiar with a few instances in which the authorities have fixed prices. In wartime, of course, the exception becomes the rule and an elaborate apparatus of price control is set up by the government to prevent a rise in the prices of vitally needed commodities (ceiling price policy). Even in normal times, there are many prices which are fixed (institutional prices). Examples are theatre tickets, taxi fares, etc. But it is precisely our wartime experiences with price control which have made at least one thing clear: a government which fixes prices too far below the level they would have reached in the absence of the official regulations will encounter increasing resistance, ending in complete defiance. It is well to remember that even in these instances of compulsory price fixing, the fixing is linked to factors which have nothing to do with compulsion or chance. It is these factors which provide the last and most satisfactory explanation: prices are formed in accordance with inherent social necessities. The elucidation of such price formation is one of the chief tasks of economics.

3. Marginal Utility

The preceding examples, which were intended to give us some idea of the tasks of economics, have turned our attention from the narrow confines of our personal experiences to a consideration of the larger fabric of society with which they are mysteriously interwoven. It is as if, all this time, we had been unconcernedly and thoughtlessly drawing water from a brook for our own private needs when, of a sudden, we look up and perceive that our brook is, in reality, a broad and majestic river stretching away upstream into illimitable distances. A recognition of the existence of the great social problems is a long step forward on the road to an understanding of economics.

But we would be traveling, ultimately, in a wrong direction were we not to consider another circumstance which leads us back to ourselves and to our own individual experiences. For it is imperative that we keep clearly in mind that the economic system is not an objective mechanical thing which functions whether we will or no, but a process to which we all contribute in the totality of our reflections and our decisions. At bottom, it is the millions upon millions of subjective events taking place in the mind of each individual which form the substrata of economic phenomena. It is the feelings, judgments, hopes and fears of men which are manifested objectively in such things as prices, money, interest, prosperity and depression. But around what axis do these movements of the human psyche revolve? An answer to this question will provide us with the key to an understanding of all the objective events of economic life—to an understanding, in brief, of the “phenomena of the market.”

The meaning of all economic decisions and actions can be summed up in the word economize. When we have only a limited quantity of an important or useful commodity, we invariably tend to husband the inadequate supply. When we cannot have as much as we would like of a thing, there must be a certain order in our use of it if “waste” is to be avoided—if we wish, that is, to forestall our acting in an uneconomic manner. Unhappily, we do not live in Cockaigne; there are only a few goods of which there is an inexhaustible supply (free goods). Under normal circumstances, the air of our atmosphere is a free good, though it is at the same time the most essential commodity we know. A calisthenics addict may fill his lungs to bursting with air and no one will label him a glutton. But if he continues his exercise too long, a glance at the gymnasium clock and his own increasing fatigue will soon alert him to the fact that at least two things do not exist in unlimited quantities: time and physical strength. These things must be husbanded. However important and useful breathing exercises are, they cannot be kept up indefinitely without neglecting even more important things. Because time and physical strength are limited in quantity, they are not free goods, but economic goods. We are forced to economize them no matter how little importance we attach to life’s other activities.

Economic goods and not free goods determine our behavior. Our whole life is made up of decisions which seek to establish a satisfactory balance between our unlimited wants and the limited means at hand to satisfy them. To say that economic goods are limited in quantity is simply to say that the existing stocks of such goods are unable to satisfy the total subjective demand for them. It is important to note that this is not the same thing as objective scarcity. Rotten eggs are, happily, scarce, but even so, there are too many of them, economically speaking (Robbins). Not only do we not want them, but energetic efforts are made to see that as few as possible come into existence. They have no value for us, indeed, they are an inconvenience, which is to say that they have a negative value. On the other hand, an economic good which is not objectively scarce can increase infinitely in value, if life itself depends upon its possession. So the sorely-beset hero of Shakespeare’s Richard III feels compelled to offer his kingdom for a horse. The scale of values of things encompasses, then, all values from minus (negative value) through zero (free goods), through a range of finite values (economic goods) to infinite values (meta-economic goods). The place of any good in this scale of values is determined ultimately by the strength of the subjective demand for it.

Air and water are ordinarily ranked very low on our scale of values, though they are essential to life. On the other hand, a diamond is valued very highly, though it is not in the least an object of vital importance. This circumstance leads us to a further important concept which is indispensable for an understanding of the subjective foundations of economic life. Our preceding discussion has made tacit use of this concept; it behooves us now to give it the most careful scrutiny.

When it comes to assigning a good its place on the scale of values, the determining factor is utility—not a general utility based on the degree of the good’s vital importance, but the specific, concrete utility of a definite quantity of the good. The larger the supply of a good at our disposal, the smaller is the amount of satisfaction procured by its individual units, and hence the lower is such a good ranked on our scale of values. The reason for this is that with increasing satisfaction of a want, the utility (satisfaction or enjoyment) furnished by each successive dose diminishes. Moreover, take away any one of a number of identical units and the loss of utility or satisfaction will be the same as if any other had been taken away. It follows that the minimum utility of the last dose or increment determines the utility of every other unit of the supply and therefore the utility of the whole supply. The value we attach to water is not determined by the infinite utility of the single glass of water needed to save us from perishing of thirst; it is determined by the utility of the last dose used to bathe ourselves or to sprinkle the flowers. We call the utility of this last dose final or marginal utility.

We may now affirm the following theses: (1) marginal utility diminishes with increasing supply, that is, with the increasing possibility of satisfying a want; (2) marginal utility determines the utility of all other units of the supply; (3) as the quantity of a good is increased, there is a corresponding fall in its place on our scale of values, providing our taste (scale of preferences) has not changed in the meantime; (4) the utility of the whole supply (total utility) increases as quantity increases, but at a decreasing rate due to the absolute decline of marginal utility. In fact, if marginal utility diminishes faster than quantity increases, total utility may decline absolutely.

Now it is readily apparent that marginal utility will fall at a different rate for different commodities. Oddly enough, the rate of fall is greater the more vital the commodity. Let us reconsider the example of water. Each of us can remember a long walk on a hot summer’s day when we had only one thought in mind: water. We at least reach a spring and, consumed by thirst, fling ourselves down to drink. The first mouthful of water is swallowed greedily, but with the second there is an abrupt lessening of satisfaction. Finally, we bathe our faces, we refill our canteens, and then forget both thirst and water to stretch out on the grass in leisurely contemplation of the countryside of which “we can’t get enough.” We will observe that as the result of the extremely rapid fall in the marginal utility of water, its total utility can easily become negative. Those unfortunates who, during the Middle Ages, were tortured by forceful infusions of water, could have furnished convincing proof on this point. Or consider the proverbial discontent of the farmer with the weather. He complains as often that it rains too much as that it rains too little—a further proof that water is characterized as much by the urgent need we have for it, as by the extremely rapid fall in its marginal utility.

From the concept of diminishing marginal utility may be deduced still another: elasticity of demand. In general, the elasticity of demand for a good varies inversely with the urgency (intensity) of the demand for it. Later, we shall see how this principle underlies important phenomena of the price structure, especially on the markets for agricultural goods. With low elasticity of demand (rapid rate of fall in marginal utility), the total utility of a supply may decrease absolutely, as illustrated in the well-known fact that the income derived from grain production in a given year may be smaller for an abundant harvest than for a lean one.

The meaning of “rapidity of fall in marginal utility” and of “elasticity of demand” will become clearer if we apply these concepts to certain considerations of a practical nature.

Remembering that elasticity of demand varies for different commodities, it is obvious that individuals will tend to consume more nearly the same amounts of a given commodity the less elastic is the demand for it—and this despite differences in income. And inelasticity of demand, we will recall, is the greater, the more essential to life is the commodity in question. Another outcome of these relationships is this: the smaller is one’s income, the larger is the share of it which is expended on foodstuffs. This fact was first demonstrated by the Prussian statistician Engel in 1857 (Engel’s law). Somewhat later, another statistician, Schwabe, arrived at identical conclusions for housing expenditures (Schwabe’s law). We may conclude, therefore, that taxes on basic consumption goods hit the poor more severely than the rich.

A closer scrutiny of the expenditures of the rich will show that the notion of the rich gluttonously stuffing themselves is inexact, the stomach capacity of most individuals being approximately the same. Of course, the larger is a man’s income, the greater will be his consumption of luxury goods, such goods having a high elasticity of demand (slow fall in marginal utility). But even such luxury wants are not sufficiently elastic to absorb the whole of a very large income. The result is that the unspent portion of the very large income is saved. This gives us an inkling as to how important is the function of the rich in the formation of capital. It follows that very little can be expected from a redistribution of the large incomes among the poorer classes. For if the rich spend for their vital needs but little more than the poor, the poor will hardly be benefited by such redistribution. Moreover, the amount of money which the rich spend on luxuries is relatively insignificant, in spite of what the lay mind imagines. The rich are so few in number that the amount they expend on luxuries is trifling in comparison with the total expenditures of the rest of the citizens. (For example, of the 58,701,000 individual income tax returns filed in 1958 in the United States, only 236 showed incomes of $1,000,000 or more; only 115,000 income units earned $50,000 or more [Statistical Abstract of the United States for 1961]). As for that part of the large income which is saved, it cannot figure in any scheme for the redistribution of the wealth since the cessation of saving will invite general economic decline. It should be remembered that the wealth of a Henry Ford consisted not of money but of factories which were built with his savings, factories which even a Communist state would have built had it the necessary means. Looked at in this light, people like Henry Ford are really public servants who administer our productive resources after the manner of trustees and who, if their trusteeship is bad, undergo the immediate and heavy punishment of financial loss. The problem, then, is not whether the fate of the poor will be appreciably better in a society where there are no rich. The problem is, rather, whether it is preferable to put state functionaries in the place of private entrepreneurs and to convert private enterprises into state enterprises; and further, whether the economic, social, and political power wielded by the rich is such as to result in economic evil or social injustice.

Let us clarify this point by still another illustration. Let us suppose that a poor street cleaner wins first prize in a lottery. How will he dispose of his sudden wealth? We see at once that it is the elasticity of his wants which will play the decisive role. Obviously, he will first satisfy his pressing needs for food, clothing, and shelter. But it is soon apparent that for these inelastic needs the point of satiety is quickly reached. The larger the winnings from the lottery and the richer the individual before his winnings, the smaller will be the percentage of his total income expended on inelastic or vital needs. However, while it is certain that all men will spend a part of their incomes for the basic subsistence goods, we cannot predict how they will distribute the remainder of their incomes among other wants. People will consume more nearly the same amounts of a given commodity the more inelastic is the demand for it. The more elastic is the demand for a commodity, the more probably will its consumption vary with the fluctuations of individual taste. It has been shown, for instance, that during the years 1926-27 the percentage of national income spent for food in Canada, Switzerland, and England was, surprisingly, the same (30-31 per cent), while expenditures on other items varied considerably among the three countries.

If it is now the whole population instead of the street cleaner which is enriched, the same sequence of cause and effect will be operative. The percentage of income expended on food (inlastic demand) diminishes, while other needs assume increasing importance. This means that the relative importance of agriculture will ultimately diminish, and that within the agricultural domain itself grain production will become relatively less important than the production of more highly valued foods (milk products, meat, eggs, fowl, vegetables and fruit). Similarly, non-agricultural branches of production satisfying ‘luxury” wants of a still higher type (“tertiary production”) will increase in importance as the general standard of living rises. Trade, transportation, tourism, motion pictures, radio, television, the legitimate theatre, books, art works, concerts, etc. absorb an ever-larger share of the national income as the standard of living rises. Otherwise expressed, rises in living standards go hand in hand with increased production, in the agricultural domain, of butter, meat, fruit, etc. As incomes rise still further, the ultimate stages in the developmental process—urbanization and industrialization—are attained. Our own age clearly reflects this evolution.

Thus far we have sketched the broad outlines of the principle of marginal utility, a clear apprehension of which will show it to be almost a commonplace. But as the above examples indicate, it is a commonplace which is indispensable to an understanding of economics. Indeed, it is upon this principle that the whole edifice of modern economic theory has been built. It is to a group of economists who initiated their researches within the last fifty years that we must assign the credit for this accomplishment.²

4. Choice and Limitation: the Essence of Economics

We have now reached a point in our inquiry where we can begin to grasp the fundamental nature of economics. On every hand we are hemmed in by scarcity: by scarcity of goods, scarcity of time, scarcity of physical strength. We cannot fill one hole without opening another somewhere else. In this world of scarcity we are faced with a twofold task. In the first place, we must choose from among our several wants those which are in most urgent need of satisfaction. In the second place, since marginal utility decreases with the increasing satisfaction of a want, we are compelled to interrupt this satisfaction sooner or later. We are under the continual necessity of achieving some kind of balance between our unlimited wants and our limited means. This we do by making a choice from among our wants and by limiting the extent to which any one of these wants is satisfied.

On what basis shall we make these decisions? It is certain that we shall arrange our purchases in such fashion that the satisfaction procured by the last increment of one commodity will be approximately equal to that afforded by the last increment of any other commodity. This is the abstract explanation of what is, in reality, a very simple process, something we do at every hour of the day without waiting on the proper formula. A very clear illustration of what is involved here is to be found in the otherwise trivial act of packing one’s bag for a journey. Since we cannot take all of our possessions with us, we first decide upon the things which we most urgently require (choice). At the same time, we proceed to balance a plus in shirts by a minus in shoes, a plus in books by a minus in suits, in such a way as to arrive at a reasonable proportion among the several items (limitation). Silly as it may sound, it is really true that the traveling bag is ideally packed when the marginal utilities of suits, shirts, socks, handkerchiefs, shoes and books are at the same level and higher than the utilities of the things left behind.

Our example may be objected to on the grounds that it omits the possibility of taking along more and bigger bags. This complicates our problem somewhat, but changes nothing with respect to the principle involved. For how would the size and number of bags be decided on unless by all sorts of utility comparisons between more and bigger bags? Those to whom such an objection occurs have only to consider the plight of the soldier in the field who is restricted to one haversack and consequently must take very seriously indeed the operations of “choosing” and “limiting.” Who would have thought that the whole of economic activity is only an endless series of very complicated variations on the simple and fundamental theme of packing a bag? Our whole life is made up of an immense number of similar decisions serving to balance continuously means with wants. Choice, limitation, equalization of marginal utilities—these are the concepts to which we must repeatedly return. They determine how we use our incomes, how we direct our businesses, how we organize production, how we divide up our time between work and leisure, and even between sleep and wakefulness. The utility we renounce constitutes the “costs” of the utility we realize in our private economy as well as in the national economy. To economize is simply to be constantly making a choice from among different possibilities. Economics is at bottom nothing other than the science of alternatives. Choosing and limiting are the eternal functions of every human economy, whatever its organization, be it the isolated economy without exchange or our highly developed market economy founded on the division of labor and the circulation of money.

NOTES

1. (p. 3) A Glance at Economic History

It is universally agreed that the division of labor in modern times has been extended and refined to a degree unknown in previous history. Completely self-sufficient economies of the Robinson Crusoe type are practically unknown today. Indeed, it is doubtful whether a wholly exchangeless economy of this kind, ambiguously termed natural economy (ambiguous because the term is also applicable to a moneyless exchange economy), could have existed at any period in history in pure form and on a large scale. The contention that, for instance, the early Middle Ages were characterized by such natural economies has been refuted by contemporary historical investigation. See A. Dopsch, Naturalwirtschaft und Geldwirtschaft in der Weltgeschichte (1930).

Economic historians have attempted to trace through the course of economic history the red thread of a principle labeled “development.” This has produced the so-called theories of economic stages, the earliest of which we owe to Friedrich List in his National System of Political Economy (1841; Eng. trans. by Lloyd, 1885). More scientifically accoutered statements of the same theory appear in Bruno Hildebrand’s Die Nationalökonomie der Gegenwart und Zukunft (1848). Hildebrand distinguished three stages of development: the natural economy, the money economy, and the credit economy. K. Bücher’s Die Entstehung der Volkswirtschaft (tr. under the title of Industrial Evolution by S. Morley Wickett from the 3rd German ed., New York, 1901) distinguishes the stages of (1) the search for food by individuals, (2) the closed household economy (isolated economy without exchange,) (3) the urban economy of the Middle Ages (with its emphasis on production for individual consumers of “custom-made” goods), and (4) the modern market economy (production of goods which are supplied by middlemen to an anonymous circle of buyers). G. Schmoller and many others have enriched the literature devoted to this theme and it remains the object of intensive study by economic historians. As it turns out, the idea that economic history can be reduced to a series of developmental stages was much too arbitrary and required doing more or less violence to the facts. The basic error was to conceive of this “evolution” as progressing in a straight line—an echo of the eighteenth century’s faith in linear progress. Recent researches have shown that the ancient world, and in particular the Roman Empire, reached an astonishing degree of economic development. The ancient world too, it appears, had its capitalism and its world economy. For information on this point, the reader is referred to M. I. Rostovtzeff’s magnificent work Social and Economic History of the Roman Empire (New York, 1926).

A theory which has enjoyed a considerably longer life is the one made popular by Bücher, viz., that from the Middle Ages onward, economic life evolved directly from more primitive to more complex forms, up to the present worldwide division of labor. To this theory are joined more or less romantic and idealized notions of the idyllic characteristics of medieval economic life and medieval economic thought. The writings of Sombart, especially his voluminous work Der Moderne Kapitalismus (three volumes: I, II-1902; III-1928, Berlin), have given currency to these ideas among a wide circle of readers. Here too, recent investigation demonstrates the need for thorough revision of received opinion. We know now that even in the Middle Ages there was an intense degree of economic activity and that it is legitimate to speak of a “world economy of the Middle Ages,” an economy which was not by any means confined to the exchange of luxury-type goods. We have evidence also that the individuals engaged in this economic activity—and this should not surprise—exhibited a pronounced propensity for business enterprise. What is particularly significant is that this highly developed economic system of the Middle Ages crumbled at the beginning of the modern era, to be succeeded by a less differentiated type of economy in the period which saw the rise of mercantilism and of national territorial states. Like the world economy of antiquity, the world economy of the Middle Ages fell in ruins, together with the political system which supported it. It is a story with special relevance to our own age. See F. Rörig, Mittelalterliche Weltwirtschaft, Blüte und Ende einer Weltwirtschaftsperiode (Jena, 1933). In his Die Grundlagen der Nationalökonomie (6th ed., 1950, tr. into English as Foundations of Economics, London, 1950), Walter Eucken offers a fundamental criticism of the evolutionary interpretation of economic history and a convincing analysis of the relations between economic history and economic theory. See also: Ludwig von Mises, Theory and History, An Interpretation of Social and Economic Evolution (New Haven, 1957).

2. (p. 12) Marginal Utility: Foundation of Modern Economic Theory

The significance of the marginal utility principle was recognized quite early, for example, by Gossen in 1854. Later, it was further developed and established as the foundation of modern theory by three scholars working simultaneously but independently: the Austrian Carl Menger (1871), the Englishman W. Stanley Jevons (1871), and Leon Walras, a Frenchman who was then teaching in Switzerland (1874). The most important stages in later development of the principle are indicated by the following works: Friedrich von Wieser, Theorie der gesellschaftlichen Wirtschaft (1914; English tr. Theory of Social Economics by A. F. Hinrichs, New York, 1927); E. von Böhm-Bawerk, Positive Theorie des Kapitals (1889; there are several versions in English, the earliest being that of William A. Smart in 1891 and the most recent being that of George D. Huncke and Hans F. Sennholz, Capital and Interest, South Holland, Illinois, 1959); Alfred Marshall, The Principles of Economics (London, 1890); V. Pareto, Cours d’économie politique (Lausanne, 1896/97); M. Pantaleoni, Principii di economia pura (Florence, 1889; English tr. Pure Economics, London, 1898); J. B. Clark, The Distribution of Wealth, (New York, 1899); Philip H. Wicksteed, The Common Sense of Political Economy (London, 1910; newly edited by L. Robbins, 1933); K. Wicksell, Lectures on Political Economy (2 vols.; London, 1934; published originally in Swedish in 1901); G. Cassel, Theoretische Sozialökonomie (1918; English ed. The Theory of Social Economy, 1923); Ludwig von Mises, Nationalökonomie, Theorie des Handelns und Wirtschaftens (Geneva, 1940; an amplified version of this work in English is Mises’ Human Action, New Haven, 1949). These works are truly the pillars upon which reposes all of modern theory. In spite of their differences of perspective and of opinion on many individual matters, they form a unified body of thought which the serious student of economics cannot afford to neglect.

In some quarters, the marginal principle is contemptuously dismissed as a plaisanterie viennoise and nothing more. But it cannot be too strongly emphasized that the whole of present-day economic thought is inconceivable outside the framework of this fundamental concept. Even those economists who expressly deny the usefulness of the marginal utility theory are heavily dependent upon it, nevertheless. An especially typical example of this is supplied in the book cited above by the Swede Gustav Cassel. Cassel, if the truth be known, is largely in debt to Walras and his school, though he never once refers to this source. By putting Walras’ involved theories into intelligible form and by enriching them with his own valuable ideas, Cassel performed a most useful service and contributed greatly to the advancement of economic science, especially in Germany after World War I. But there is no doubt that he is a product of the general tradition of modern economics.

Pantaleoni’s observation (1897) that there are really only two schools of economists, those who understand economics and those who don’t, is worth recalling. If limited to pure theory, the statement is by no means the joking exaggeration it might appear to be. This is evident in the theoretical developments of recent decades. Thus, the three schools which simultaneously discovered the principle of marginal utility (the Austrian school of Menger and Wieser, the Lausanne school of Walras and Pareto, and the Anglo-American school of Jevons, Marshall and Clark) have shown a convergent evolution. The Austrian and Anglo-American movements agree much more than they disagree (especially as a result of the strong emphasis on and persistent investigation of objective cost factors by the Anglo-American school). The Lausanne school, however, is distinguished from the others, firstly, by it emphasis on synthesis rather than analysis. With but brief attention to the motives underlying individual economic behavior, it attempts by means of mathematical formulae to arrive at a method for determining when a state of total economic equilibrium exists. Secondly, the Lausanne theory is more a functional theory (one, that is, which describes mutual dependencies in a state of equilibrium) than a genetic-causal one (which explains how and why the factors work toward a given equilibrium).

The Lausanne school teaches a general and doubtless more comprehensive truth, but this is of little help in solving individual problems. Granted the necessity of dwelling, even at some length, on the more general and more comprehensive truth, the Lausanne theories are too abstract for significant practical application, entirely apart from the forbidding and not altogether necessary mathematical formulae in which the theories are expressed. In spite of the respect which it rightly inspires, the work of the Lausanne school seems somewhat like a mathematical castle in Spain. Its divorcement from reality gives it a patently static character and this is precisely what renders it of little use in solving the most important concrete problems of the economic system, viz., those arising from disturbances of economic equilibrium. On this subject, the reader should consult: Hans Mayer, “Der Erkenntniswert der funktionellen Preistheorien,” in Wirtschaftstheorie de Gegenwart (vol. 2, 1932; in this memorial to Friedrich von Wieser is to be found perhaps the most comprehensive survey of modern economic theory; an excellent supplement is the anthology published under the auspices of the American Economic Association entitled A Survey of Contemporary Economics, ed. H. S. Ellis, Philadelphia, 1948; a critical review of the most recent trends in economic thought is furnished in the essay by Murray N. Rothbard, “Toward a Reconstruction of Utility and Welfare Economics” in the “Festschrift” for Ludwig von Mises On Freedom and Free Enterprise, New York, 1956). It is clear from the foregoing that the differences among the schools are not differences between true and false but differences of presentation and emphasis, and even these have lessened with the passage of time.

Modern marginalist theory must be understood against the background of the so-called classical theory which it overthrew. The fathers of classical theory were Adam Smith (An Inquiry into the Nature and Causes of the Wealth of Nations, 1776), David Ricardo (The Principles of Political Economy and Taxation, 1817), and Thomas Malthus (Essay on the Principle of Population, 1798). Classical theory was further refined by J. B. Say, J. H. von Thünen, Senior, Hermann, J. S. Mill, and others. One of its last representatives was J. E. Cairnes, whose book, Some Leading Principles of Political Economy (London, 1874) still makes enjoyable reading and was published, piquantly enough, in the same year which saw the birth of modern theory.

A fact which, of course, did not escape the classical theorists was that utility is somehow connected with value. Obviously, a thing which is good for nothing can have no value, but does utility determine value? For the classicists, the case of water and diamonds seemed to prove that utility might well be one of the conditions, but not the cause of the value of a good. Because they had not grasped the specific character of utility (marginal utility), they reasoned that so soon as a thing possessed any utility whatsoever, its value (price) was determined by quite other factors. Unfortunately, the classical economists, in spite of their acumen, did not succeed in reducing these value factors to a homogeneous formula. In fact, from their early gropings, three distinctly different theories emerged. They began by distinguishing two kinds of goods: scarce goods, whose quantity could not be increased by production and goods which could be “produced at will.” The value of the first would be determined solely by the degree of their scarcity; the value of the second by their costs of production, thus by something objective. Onto this classification, the classicists grafted a distinction between a normal price (natural price) and a market price which oscillates around the normal. The normal price was supposed to be determined by the costs of production whereas the market price was determined by supply and demand.

The existence of three different explanations of the same phenomenon was unsatisfactory enough. But the classicists, in addition, became ever more entangled in the internal inconsistencies of their concepts the more they sought to get to the bottom of things. Of what do the “costs of production” consist? How can cost factors be reduced to a common denominator? Up to the very end, the classical school struggled vainly to find an answer to these questions. (See A. Amonn, Ricardo als Begründer der theoretischen Nationalökonomie, 1924). It became increasingly clear, too, that a cost-of-production theory was of no help at all in explaining a variety of important phenomena (monopoly price, prices of jointly produced goods, international price formation).

The labored disputes of the classical economists were brought to an end with the simple discovery that their too hasty examination of the utility concept had led them to confuse general with specific utility. From this time on, the objective-technical explanation of value was supplanted by the subjective-economic emphases of modern theory. It is to be noted also that the marginal utility concept makes the labor theory of value, which constitutes the theoretical base of Marxism, wholly untenable. In fact, the purely economic basis of Marxism must be regarded today as merely an intellectual anachronism. Specifically, a suit is not eight times as valuable as a hat because it requires eight times as much labor as a hat to produce. It is because the finished suit will be eight times as valuable as the finished hat that society is willing to employ eight times as much labor for the suit as for the hat (Wicksteed). It is upon this discovery that the remaining parts of Marxist theory (surplus value, capitalist disintegration) have foundered. This certainly does not mean that socialism can be dismissed as mere foolishness, but simply that it cannot be scientifically established upon a Marxist base.

Notwithstanding, it would be an error to believe that classical theory is a collection of sterile fallacies. On the contrary, modern theory itself remains heavily in debt to the spadework of the classical school. There is no difference in the approaches of the classicists and the moderns to the fundamental issues of economics, a fact which, as the “Methodenstreit” (conflict over methods) has demonstrated, flows from the internal logic of things. Moreover, there is no great difference in the conclusions arrived at by the two schools, even though their underlying premises are, in part, quite different (e.g., with respect to the law which causes prices, under competition, to fall towards the costs of production). In several instances, indeed, classical theory anticipated the basic notions of modern theory (e.g., in international trade theory). The acumen which enabled the classical school, in spite of its false foundation and its tortured constructions, to come to useful conclusions deserves admiration. Where modern theory showed the greatest advance over the classical school was in the practical sphere. The stiff classical machinery of “natural laws” has been made so much more flexible that economics has gotten closer to reality, become more capable of adaptation, and more largely human. Purified of the premature economic policy conclusions professed by the classical school (laissez-faire liberalism), modern theory has not only become less partisan politically, but in virtue of that very fact has developed into an indispensable instrument in the solving of current problems of economic policy. Classical theory was philosophical in character while modern theory is primarily instrumental in character.

An extended analysis of the principle of marginal utility will raise difficulties too numerous to be dealt with here. Then too, the process of analysis in this instance is itself subject to the law of diminishing marginal utility, that is, as economic analyses are increasingly refined, they tend to produce less and less interesting results. Much of the criticism of the marginal utility principle is, upon closer inquiry, seen to be aimed at such exaggeratedly long and psychological marking of time at the point of departure. The same impression, indeed, is created by the true, but otherwise not very helpful intellectual architectonics found at the other extreme in the mathematical equilibrium models of the Lausanne school. At all events, these are difficulties which must one day be resolved.

A good survey of the relevant discussion on these matters may be found in the article “Value” in the Encyclopedia of the Social Sciences and in D. H. Robertson, Utility and All That (London, 1952). To bewail such clarification would be just as unintelligent as to let ourselves be irritated by the footnotes in a book. (Though he who believes he can skip the footnotes is quite at liberty to do so). On the other hand, a book should consist of something else besides footnotes. If this point of view were more widely adopted, many a sterile dispute over the principle of marginal utility would be avoided.