[This article is excerpted from chapter 3 of Economics for Real People.]
I’m going to ask you to imagine a slightly different conclusion to the first season of Survivor. In the original television show, the winner — the fellow who “survived” the longest — was a guy named Rich. In our alternate universe Rich is still the winner, but, as the film crew packs up, they decide that they are fed up with his antics.
Instead of transporting him home, they quietly slip off of the island while Rich is getting in a last session of nude sunbathing. Rich arises to find that he is alone. He is now facing the most elementary human problem, how to survive, in the most basic of settings.
For those who don’t follow what’s on TV, or who might be reading this twenty years after its publication: Survivor was a show where a number of contestants were placed, by a TV network, on a desert island. Then they were presented with a series of “survival” challenges. A voting process eliminated contestants until only the winner was left. This turned out to be a fellow named Rich. The particular details of the show are unimportant to this article, as Rich is merely used as an example of an isolated individual and the economic problems he faces. (Hey, using Robinson Crusoe has become a cliché, so I had to think of something else.)
Rich, in his effort to change what is into what ought to be, may realize that his ability to acquire food and water could be increased. Perhaps, by building a few traps, he could have six roasted rats a day instead of four. And, he thinks, if he had a barrel for collecting rainwater, he could use that water for cooking, and enjoy boiled rats as an occasional change from roasted rats. He sets about constructing those items.
In order to build them, Rich will have to sacrifice something else. Since his time is not unlimited, the construction of such items has a cost: the value Rich places on what he could have been doing instead of building traps and barrels. This is true even if he just gives up time that would have been spent relaxing. Having grasped the principle of marginal utility, we can see that, whatever activity Rich puts aside to make time for building traps and barrels, it will be the activity of which the next unit had the lowest marginal utility, for him. (To reiterate, “utility” should not be taken to mean some measurable substance. “Lowest utility” is just shorthand for “what pleases Rich the least.”) And he will give up units of that activity only so long as the value of additional traps and barrels is greater, to him, than what he is giving up.
Perhaps Rich is working on traps, when he could have been relaxing. Each trap takes an hour to build. When the value to Rich of the next trap he could build is less than another hour of relaxation, Rich will stop work for the day. The marginal utility of an additional trap has fallen below the marginal utility of an additional hour of leisure.
But where does the value of goods like traps and barrels come from? Rich cannot eat a trap, or (comfortably) wear a barrel. And yet it is clear that these goods do have value to Rich, because he has decided to sacrifice other things of value in order to acquire them.
The value of the goods such as food, water, shelter, and rest springs from their ability to immediately alleviate some dissatisfaction. Rich values food because he values life, and food helps to directly satisfy his desire to stay alive. Although less than he values life itself, he may also value comfort in that life. Therefore, food is also valued because it directly satisfies the pangs of hunger. (Economics does not claim that Rich should value his life more than anything else, or that everyone does so. It does not claim even that everyone does or should value life at all. Economics is about the consequences of the fact that we evaluate our world.)
Upon a little reflection, we can see that the value of goods such as traps and barrels comes from their ability to produce goods that do directly bring satisfaction. Rich values the trap for the rats, and the barrel for the cooking water. Carl Menger termed goods that directly relieve some dissatisfaction, such as water or food, goods of the first order.
They can also be called consumer goods. Goods whose value comes from their aid in producing goods of the first order, such as traps and barrels, are called goods of a higher order, producer goods, or capital goods. Note that this distinction does not exist in the goods themselves, but in human thought and planning. If I collect barrels as objects of art, then they are, for me, consumer goods. If I own a grocery store, then food items I stock are, for me, producer goods. As the Austrian economist Ludwig Lachmann put it in Capital and Its Structure:
The generic concept of capital … has no measurable counterpart among material objects; it reflects the entrepreneurial appraisal of such objects. Beer barrels and blast furnaces, harbour installations and hotel-room furniture are capital not by virtue of their physical properties but by virtue of their economic functions.
When Rich decided to produce higher-order goods, he began saving. Saving can be defined as the decision to guide actions toward satisfactions more distant in time, even though more immediate satisfactions are known to be available. The higher-order goods that Rich accumulates through saving comprise his capital stock. At some point in time, we find that he has five traps and two barrels. At this point there is no way to total Rich’s capital goods other than listing the items of which it consists.
We cannot add up traps and barrels. The value that Rich assigns to them is subjective. We don’t have any sort of yardstick, scale, or stopwatch by which we might measure this “quantity” of satisfaction. In fact, the value of these capital goods is what Rich estimates to be their value for satisfying future, uncertain needs. Even if we could stick a “satisfaction meter” on Rich and determine how intense certain satisfactions are to him, it would not solve the problem Rich faces at the moment of choice: he must estimate how much satisfaction his choice will bring to “Future Rich,” whose knowledge and tastes are unknown to “Present Rich,” and who will be living in a world that, for Present Rich, is filled with uncertainty.
As his effort to build traps and barrels continues, Rich may decide that having a hammer, a saw, and some nails would be useful. He sets about making them. Now Rich is working two orders of goods removed from consumption. He will value the hammer, the saw, and the nails for the aid they will provide in constructing traps and barrels, which are valued for the food and water they help produce. All goods of higher orders derive their value from the goods of the next lower order that they help create. Ultimately, any producer good is valuable only because it finally yields one or more consumer goods.
That dependence can be illustrated by considering what happens when Rich’s valuation of a consumer good changes. Perhaps Rich discovers that the rats on the island are diseased, and that eating them is harmful. Rich will no longer value the rats. So long as there is no other use Rich can make of the traps, they will lose their value as well. Rich will no longer be willing to sacrifice anything to get more traps, and he will not care about the fate of the ones he has already made. (Of course, if he has some other use for the traps — perhaps as kindling — they will retain some of their value.)
An interesting question arises when we begin to look at the valuation of goods of a higher order. Let’s say that, without the aid of traps, Rich can catch four rats a day. With his traps, he hopes to catch eight a day. Given the productivity advantage that trap making has over catching rats by hand, why doesn’t Rich spend 100 percent of his working time making traps?
The first answer that pops to mind is that he will starve to death with that work schedule. Certainly, any saving for the future that involves cutting back current consumption below the level needed to sustain life doesn’t make sense — unless one is saving solely for one’s heirs! However, we can imagine that Rich might be able to get by on only two rats a day, albeit with some discomfort. Why doesn’t he postpone all consumption beyond minimal sustenance in order to save?
All around us, every day, people consume far more than they need to survive, therefore saving far less than they could. Yet, we all know that saving is the road to wealth. Why don’t top Wall Street traders live in tiny shacks, eat canned beans, and ride old bicycles to the train station? Why do movie stars go on mad shopping sprees and stay at fabulous vacation resorts? Shouldn’t they live as paupers in order to save every penny they can?
The questions should suggest the answer. There would be something very curious about a world in which people worked hard so that they could save for future consumption — yet never engaged in that future consumption, because when that future arrived, they were saving for consumption in an even more remote future. It would be a looking-glass world, such as the Red Queen described to Alice: jam tomorrow, and jam yesterday, but never jam today. (In fact, there wouldn’t have been jam yesterday, either.)
Humans can only consume in the present. It is our present dissatisfactions that call out for relief. It is in the present that we experience pleasure and pain. Saving in the interest of infinitely postponed consumption is not saving at all — it is pure loss.
Now we are faced with explaining the other side of the saving question — given that we can only consume in the present, why does anyone ever save? The answer is that, while we cannot consume in the future, we can imagine it. We can envision that in this future, we also will feel dissatisfactions and will want to alleviate them. In addition, we can imagine that a high enough degree of satisfaction on some future day might compensate us for some additional dissatisfaction today.
The key to understanding saving is to recognize that the image of future dissatisfaction is itself a source of present unease. The notion that I might find myself starving next week is disturbing. I can alleviate the feeling by saving. However, if I am in danger of starving to death today, eliminating my worry about starving next week will not appear as urgent to me as getting some food right now. The satisfaction in knowing that I have made provision for eating next week is minimal compared to the dissatisfaction of knowing that I’ll be dead by dinnertime.
Likewise, the imagining of future satisfaction is itself a source of present satisfaction. The swimmer training to win an Olympic gold medal keeps herself going by imagining how magnificent she will feel when she touches the wall first. If we could not bring a sense of these future pains and pleasures into our present deliberations, we would have no way of orienting our actions toward that future.
The extent to which an individual will save is explained by his time preference, meaning the degree to which he prefers a present satisfaction to the same satisfaction in the future. With time preference we are again dealing with a subjective factor.
The degree of time preference will differ from person to person, and, for the same person, will differ from one moment to the next. A person’s time preference at thirty might be lower than the same person’s time preference at eighty. At thirty, he may be quite willing to hold off on that trip to the Alps in order to save for a house for his new family, whereas at eighty he is much more likely to think, “Hey, I’d better get over there now!” However, that does not imply that there is some “function” that “determines” time preference as one ages. The opposite progression of time preference could just as well occur: At thirty, one might think of nothing but “living for the moment,” while at eighty, one’s entire focus is on building up the grandchildren’s trust funds.
Those are some of the psychological factors influencing time preference. But time preference itself is implied by the existence of human action, quite aside from any psychological influences. If we didn’t prefer, all other things being equal, the same satisfaction sooner rather than later, we would never act. Inert existence would be sufficient for us. For any given satisfaction, we wouldn’t care whether it arrived tomorrow or took all of eternity to come around. As Mises said in Human Action:
We must conceive that a man who does not prefer satisfaction within a nearer period of the future to that in a remoter period would never achieve consumption and enjoyment at all.
There is no economic sense in which we can say that one degree of time preference is better than another. Therefore, from an economic point of view, there is no “correct” level of saving. Some people may want to “live for the moment,” whereas others save with the idea of starting a perpetually endowed foundation. Economics cannot say that one of them is right and the other wrong. It can, however, clarify the conditions under which an individual will choose to save, and point out some consequences of those circumstances.
We are now in a position to examine Rich’s decision to save with more precision. Let’s say that Rich must sacrifice one rat a day of present consumption for one week to gain the time to build one trap. In addition, we’ll suppose that he expects the trap to last for one week, during which time he will catch 14 more rats than without the trap. Roughly speaking, we can say that he must sacrifice seven rats now to gain fourteen a week from now. His rate of return on this investment is 100 percent per week.
If Rich chooses to go ahead and produce the traps, we can say that he values one rat available now less than two available a week from now. A 100-percent weekly rate of return was sufficient to persuade him to exchange present for future consumption. If he does not make the traps, we know that he values one present rat more than two future rats. A 100-percent rate of return was not sufficient to persuade him to trade present for future rats.
It is important to note that Rich’s valuation depends on his circumstances. If he were to suddenly find a crate of canned sardines and crackers left behind by the TV crew, his decision might be altered significantly. Recall that, per the law of marginal utility, each succeeding unit of a good is considered less valuable to an individual than the previous unit. I might pay $50 to buy one cat, but by the time I had 300 I’d be paying to get rid of them.
Therefore, well stocked with food for present consumption, Rich would be much more likely to forgo catching a rat today in order to build capital goods that promise a greater supply of food in the future. The additional rat today would have less value to him than it had before he found the crate, since the sardines and crackers satisfy the same physical need as the rat — and probably taste better, too.
That must not be taken to indicate some universal rule such as “the rich will save more than the poor.” There are no constant laws that determine what valuation a particular person will place on future satisfactions as opposed to present ones. We have all heard stories of some little old lady who has worked as a secretary her whole life, for a moderate wage, living in modest circumstances. Upon her death, her friends are shocked to discover that she had amassed a fortune in stocks and bonds. Equally familiar are the stories of the profligate rich, who squander a fortune in riotous living.
The law of marginal utility applies to savings as well as to consumption. Each additional dollar saved will have less value, to the saver, than the previous dollar did. You can easily relate that to your own circumstances. If you have $50 in the bank, the chance to put away another $50 will seem much more important to you than if you have $50 million in the bank.
Even in this extremely simple economy, Rich’s capital goods have a structure. We imagined that he made a hammer, nails, and a saw. The hammer and nails have a noteworthy relationship — they are complementary goods. Without the hammer, there is nothing with which to drive the nails, and without the nails, there is nothing for the hammer to drive. Every day we deal with goods that are useless without other, complementary goods: a portable radio and batteries, an amplifier and some speakers, a lamp and a light bulb. In every one of these cases, such goods lose some or all of their value without the complementary good available. If some inventor develops a way to use shower mold as a cheap, plentiful source of lighting, and manufacturers cease to produce light bulbs, existing electric lights will have value only as nostalgia pieces.
That could be termed the horizontal structure of capital. We have already introduced the vertical structure: capital can be arranged into goods of the second order, which are used to produce consumer goods, and goods of the third order, which are used to produce goods of the second order, and so on. Rich’s economy has not, so far, passed beyond producing goods of the third order, but it is easy to see how our principle extends through as many orders of goods as people employ.
The value of a capital good is related to its position in the capital structure. A good of a higher order will lose its value if all goods of lower orders that it can be used to produce lose their value. If Rich no longer had a use for traps or barrels, and he could not think of anything else to build with a hammer and nails, then the hammer and nails would also lose their value to him.
As we noted above, ultimately, all capital goods only have value due to their finally yielding some consumer good. The importance of capital structure increases tremendously as we begin to examine more complex economies. Capital structure will be crucial to our examination of socialism. But it is here, in the most primitive of economies, that we can see such basic economic concepts most clearly — which is why, as I mentioned, that we bother looking at such an economy at all.
