Chapter 8: Fundamentals of Value and Price

Ludwig von Mises (1881–1973) was born on September 29, 1881, in the city of Lemberg (present day Ukraine), then part of the Austro-Hungarian Empire, where his father, Arthur Edler von Mises, a distinguished construction engineer working for the Austrian railroads, was stationed. Growing up in Vienna, Mises entered the University of Vienna at the turn of the century to study for his graduate degree in law and economics. He died October 10, 1973, in New York City.

Mises was born and grew up during the high tide of the great “Austrian school” of economics, and neither Mises nor his vital contributions to economic thought can be understood apart from the Austrian school tradition which he studied and absorbed.

By the latter half of the nineteenth century, it was clear that “classical economics,” which had reached its apogee in England in the persons of David Ricardo and John Stuart Mill, had foundered badly on the shoals of several fundamental flaws. The critical flaw was that classical economics had attempted to analyze the economy in terms of “classes” rather than the actions of individuals. As a result, the classical economists could not find the correct explanation of the underlying forces determining the values and relative prices of goods and services; nor could they analyze the actions of consumers, the crucial determinants of the activities of producers in the economy. Looking at “classes” of goods, for example, the classical economists could never resolve the “paradox of value”: the fact that bread, while extremely useful and the “staff of life,” had a low value on the market; whereas diamonds, a luxury and hence a mere frippery in terms of human survival, had a very high value on the market. If bread is clearly more useful than diamonds, then why is bread rated so much more cheaply on the market?

Despairing at explaining this paradox, the classical economists unfortunately decided that values were fundamentally split: that bread, though higher in “use value” than diamonds, was for some reason lower in “exchange value.” It was out of this split that later generations of writers denounced the market economy as tragically misdirecting resources into “production for profit” as opposed to the far more beneficial “production for use.”

Failing to analyze the actions of consumers, classical economists earlier than the Austrians could not arrive at a satisfactory explanation of what it was that determined prices on the market. Groping for a solution, they unfortunately concluded (a) that value was something inherent in commodities; (b) that value must have been conferred on these goods by the processes of production; and (c) that the ultimate source of value was production “cost” or even the quantity of labor hours incurred in such production.

It was this Ricardian analysis that later gave rise to Karl Marx’s perfectly logical conclusion that since all value was the product of the quantity of labor hours, then all interest and profit obtained by capitalists and employers must be “surplus value” unjustly extracted from the true earnings of the working class.

Having thus given hostage to Marxism, the later Ricardians attempted to reply that capital equipment was productive and therefore reasonably earned its share in profits; but the Marxians could with justice offer the rebuttal that capital too was “embodied” or “frozen” labor, and that therefore wages should have absorbed the entire proceeds from production.

The classical economists did not have a satisfactory explanation or justification for profit. Again treating the share of proceeds from production purely in terms of “classes,” the Ricardians could only see a continuing “class struggle” between “wages,” “profits,” and “rents,” with workers, capitalists, and landlords eternally warring over their respective shares. Thinking only in terms of aggregates, the Ricardians tragically separated the questions of “production” and “distribution,” with distribution a matter of conflict between these combating classes. They were forced to conclude that if wages went up, it could only be at the expense of lower profits and rents, or vice versa. Again, the Ricardians gave hostages to the Marxian system.

Looking at classes rather than individuals, then, the classical economists not only had to abandon any analysis of consumption and were misled in explaining value and price; they could not even approach an explanation of the pricing of individual factors of production: of specific units of labor, land, or capital goods. As the nineteenth century passed its mid-mark, the defects and fallacies of Ricardian economics became even more glaring. Economics itself had come to a dead end.

It has often happened in the history of human invention that similar discoveries are made at the same time purely independently by people widely separated in space and condition. The solution of the aforementioned paradoxes appeared, purely independently and in different forms, in the same year, 1871: by William Stanley Jevons in England; by Léon Walras in Lausanne, Switzerland; and by Carl Menger in Vienna. In that year, modern, or “neo-classical,” economics was born. Jevons’s solution and his new economic vision was fragmented and incomplete; furthermore, he had to battle against the enormous prestige that Ricardian economics had accumulated in the tight intellectual world of England. As a result, Jevons had little influence and attracted few followers. Walras’s system also had little influence at the time; as we shall see in what follows, it was unfortunately reborn in later years to form the basis of the fallacies of current “microeconomics.” By far the outstanding vision and solution of the three neo-classicists was that of Carl Menger,1 professor of economics at the University of Vienna. It was Menger who founded the “Austrian school.”

Menger’s pioneering work bore full fruition in the great systematic work of his brilliant student, and his successor at the University of Vienna, Eugen von Böhm-Bawerk. It was Böhm-Bawerk’s monumental work, written largely during the 1880s, and culminating in his three-volume Capital and Interest,2 that formed the mature product of the Austrian school. There were other great and creative economists who contributed to the Austrian school during the last two decades of the nineteenth century; notably Böhm-Bawerk’s brother-in-law, Friedrich von Wieser, and to some extent the American economist John Bates Clark; but Böhm-Bawerk towered above them all.

The Austrian, or Menger–Böhm-Bawerkian, solutions to the dilemmas of economics were far more comprehensive than those by the Ricardians, because the Austrian solutions were rooted in a completely contrasting epistemology. The Austrians unerringly centered their analysis on the individual, on the acting individual as he makes his choices on the basis of his preferences and values in the real world. Starting from the individual, the Austrians were able to ground their analysis of economic activity and production in the values and desires of the individual consumers. Each consumer operated from his own chosen scale of preferences and values; and it was these values that interacted and combined to form the consumer demands that form the basis and the direction for all productive activity. Grounding their analysis in the individual as he faces the real world, the Austrians saw that productive activity was based on the expectations of serving the demands of consumers.

Hence, it became clear to the Austrians that no productive activity, whether of labor or of any productive factors, could confer value upon goods or services. Value consisted in the subjective valuations of the individual consumers. In short, I could spend thirty years of labor time and other resources working on the perfection of a giant steam-powered tricycle. If, however, on offering this product no consumers can be found to purchase this tricycle, it is economically valueless, regardless of the misdirected effort that I had expended upon it. Value is consumer valuations, and the relative prices of goods and services are determined by the extent and intensity of consumer valuations and desires for these products.3

Looking clearly at the individual rather than at broad “classes,” the Austrians could easily resolve the “value paradox” that had stumped classicists. For no individual on the market is ever faced with the choice between “bread” as a class and “diamonds” as a class. The Austrians had shown that the greater the quantity—the larger the number of units—of a good that anyone possesses, the less he will value any given unit. The man stumbling through the desert, devoid of water, will place an extremely high value of “utility” on a cup of water: whereas the same man in urban Vienna or New York, with water plentiful around him, will place a very low valuation or “utility” on any given cup. Hence the price he will pay for a cup of water in the desert will be enormously greater than in New York City. In short, the acting individual is faced with, and chooses in terms of, specific units, or “margins”; and the Austrian finding was termed the “law of diminishing marginal utility.” The reason that “bread” is so much cheaper than “diamonds” is that the number of loaves of bread available is enormously greater than the number of carats of diamonds: hence the value, and the price, of each loaf will be far less than the value and price of each carat. There is no contradiction between “use value” and “exchange value”; given the abundance of loaves available, each loaf is less “useful” than each carat of diamond to the individual.

The same concentration on the actions of the individual, and hence on “marginal analysis,” also solved the problem of the “distribution” of income on the market. The Austrians demonstrated that each unit of a factor of production, whether of different types of labor, of land, or of capital equipment, is priced on the free market on the basis of its “marginal productivity”: in short, on how much that unit actually contributes to the value of the final product purchased by the consumers. The greater the “supply,” the quantity of units of any given factor, the less will its marginal productivity—and hence its price—tend to be; and the lower its supply, the higher will tend to be its price. Thus, the Austrians showed that there was no senseless and arbitrary class struggle or conflict between the different classes of factors; instead, each type of factor contributes harmoniously to the final product, directed to satisfying the most intense desires of the consumers in the most efficient manner (i.e., in the manner least costly of resources). Each unit of each factor then earns its marginal product, its own particular contribution to the productive result. In fact, if there was any conflict of interests, it was not between types of factors, between land, labor, and capital; it was between competing suppliers of the same factor. If, for example, someone found a new supply of copper ore, the increased supply would drive down the price of copper; this could only work to the benefit and the earnings of the consumers and of the cooperating labor and capital factors. The only unhappiness might be among existing copper mine owners who found the price declining for their own product.

The Austrians thus showed that on the free market there is no separation whatever between “production” and “distribution.” The values and demands of consumers determine the final prices of the consumer goods, the goods purchased by consumers, which set the direction for productive activity, and in turn determine the prices of the cooperating units of factors: the individual wage rates, rents, and prices of capital equipment. The “distribution” of income was simply the consequence of the price of each factor. Hence, if the price of copper is 20 cents per pound, and a copper owner sells 100,000 pounds of copper, the owner will receive $20,000 in “distribution”; if someone’s wage is $4 an hour, and he works forty hours a week, he will receive $160 per week, and so on.

What of profits and the problem of “frozen labor” (labor embodied in machinery)? Again working from analysis of the individual, Böhm-Bawerk saw that it was a basic law of human action that each person wishes to achieve his desires, his goals, as quickly as possible. Hence, each person will prefer goods and services in the present to waiting for these goods for a length of time in the future. A bird already in the hand will always be worth more to him than one bird in the bush. It is because of this basic primordial fact of “time preference” that people do not invest all their income in capital equipment so as to increase the amount of goods that will be produced in the future. For they must first attend to consuming goods now. But each person, in different conditions and cultures, has a different rate of time preference, of preferring goods now to goods later. The higher their rate of time preference, the greater the proportion of their income they will consume now; the lower the rate, the more they will save and invest in future production. It is the fact of time preference that results in interest and profit; and it is the degree and intensity of time preferences that will determine how high the rate of interest and profit will be.

Take, for example, the rate of interest on a loan. The scholastic philosophers of the Catholic Church, in the Middle Ages and in the early modern period, were in their way excellent economists and analyzers of the market; but one thing they could never explain or justify was the simple charging of interest on a loan. They could understand gaining profits for risky investments; but they had learned from Aristotle that money itself was barren and unproductive. Therefore, how could pure interest on a loan (assuming no risk of default) be justified? Not being able to find the answer, the church and the scholastics discredited their approach in the eyes of worldly men by condemning as sinful “usury” all interest on a loan. It was Böhm-Bawerk who finally found the answer in the concept of time preference. For when a creditor lends $100 to a debtor, in exchange for receiving $106 a year from now, the two men are not exchanging the same things. The creditor is giving the debtor $100 as a “present good,” money that the debtor can use at any time in the present. But the debtor is giving the creditor in exchange, not money, but an IOU, the prospect of receiving money one year from now. In short, the creditor is giving the debtor a “present good,” while the debtor is only giving the creditor a “future good,” money which the creditor will have to wait a year before he can make use of. And since the universal fact of time preference makes present goods worth more than future goods, the creditor will have to charge, and the debtor will be willing to pay, a premium for the present good. That premium is the rate of interest. How large that premium will be will depend on the rates of time preference of everyone in the market.

This is not all for Böhm-Bawerk went on to show how time preference determined the rate of business profit in the same way: in fact that the “normal” rate of business profit is the rate of interest. For when labor or land is employed in the process of production, the crucial fact is that they do not have to wait, as they would in the absence of capitalist employers, for their money until the product is produced and sold to the consumers. If there were no capitalist employers, then laborers and landowners would have to toil for months and years without pay, until the final product—the automobile or bread or washing machine—is sold to the consumers. But capitalists perform the great service of saving up money from their income ahead of time and then paying laborers and landowners now, while they are working; the capitalists then perform the function of waiting until the final product is sold to the consumers and then receiving their money. It is for this vital service that the laborers and landowners are more than willing to “pay” the capitalists their profit or interest. The capitalists, in short, are in the position of “creditors” who save and pay out present money, and then wait for their eventual return; the laborers and landowners are, in a sense, “debtors” whose services will only bear fruit after a certain date in the future. Again, the normal rate of business profit will be determined by the height of the various rates of time preference.

Böhm-Bawerk also put this another way: capital goods are not simply “frozen labor”; they are also frozen time (and land); and it is in the crucial element of time and time preference that the explanation for profit and interest can be found. He also enormously advanced the economic analysis of capital; for in contrast not only to Ricardians but also to most economists of the present day, he saw that “capital” is not simply a homogeneous blob, or a given quantity. Capital is an intricate latticework that has a time-dimension; and economic growth and increasing productivity comes from adding not simply to the quantity of capital but to its time-structure, to building “longer and longer processes of production.” The lower people’s rate of time preference, the more they are willing to sacrifice consumption now on behalf of saving and investing in these longer processes that will yield a significantly greater return of consumer goods at some date in the future.

[Reprinted from The Essential von Mises (1973); reprinted in Scholar, Creator, Hero (1988); and The Essential von Mises (Auburn, Ala.: Mises Institute, 2009), pp. 3–11.]

• 1See Carl Menger’s Principles of Economics, James Dingwall and Bert F. Hoselitz, trans. (Glencoe, Ill.: The Free Press, 1950); reprinted 2007 (Auburn, Ala.: Ludwig von Mises Institute); original German edition, Grundsätze der Volkswirtschaftslehre (1871). See also Menger’s Problems of Economics and Sociology, Francis J. Nock, trans. (Urbana: University of Illinois Press, 1963); original German edition, Untersuchungen über die Methode der Socialwissenschaften und der Politischen Oekonomie insbesondere (1883).
• 2See Eugen von Böhm-Bawerk’s three-volume Capital and Interest: vol. I, History and Critique of Interest Theories; vol. II, Positive Theory of Capital; vol. III, Further Essays on Capital and Interest, George D. Huncke and Hans F. Sennholz, trans. (Grove City, Penn.: Libertarian Press, 1959); this was the first complete English translation of the third and fourth German editions. German title for Böhm-Bawerk’s opus is, Kapital und Kapitalzins (first edition of vol. I in 1884 and vol. II in 1889; second edition of vol. I in 1900 and vol. II in 1902; third and completely revised edition of vol. I in 1914 and part of vols. II and III in 1909; balance of vols. II and III in 1912; fourth (posthumous) edition, I, II, III in 1921).
• 3See Eugen von Böhm-Bawerk, “The Ultimate Standard of Value” in Shorter Classics of Böhm-Bawerk (Grove City, Penn.: Libertarian Press, 1962).