Man, Economy, and State with Power and Market
A. The Consumer
We have not yet explained one very important problem: the ranking of money on the various individual value scales. We know that the ranking of units of goods on these scales is determined by the relative ranking of the marginal utilities of the units. In the case of barter, it was clear that the relative rankings were the result of people’s evaluations of the marginal importance of the direct uses of the various goods. In the case of a monetary economy, however, the direct use-value of the money commodity is overshadowed by its exchange-value.
In chapter 1, section 5, on the law of marginal utility, we saw that the marginal utility of a unit of a good is determined in the following way: (1) if the unit is in the possession of the actor, the marginal utility of the unit is equal to the ranked value he places on the least important end, or use, that he would have to give up on losing the unit; or (2) if the unit is not yet in his possession, the marginal utility of adding the unit is equal to the value of the most important end that the unit could serve. On this basis, a man allocates his stock of various units of a good to his most important uses first, and his less important uses in succession, while he gives up his least important uses first. Now we saw in chapter 3 how every man allocates his stock of money among the various uses. The money commodity has numerous different uses, and the number of uses multiplies the more highly developed and advanced the money economy, division of labor, and the capital structure. Decisions concerning numerous consumer goods, numerous investment projects, consumption at present versus expected increased returns in the future, and addition to cash balance, must all be made. We say that each individual allocates each unit of the money commodity to its most important use first, then to the next most important use, etc., thus determining the allocation of money in each possible use and line of spending. The least important use is given up first, as with any other commodity.
We are not interested here in exploring all aspects of the analysis of the marginal utility of money, particularly the cash-balance decision, which must be left for later treatment. We are interested here in the marginal utility of money as relevant to consumption decisions. Every man is a consumer, and therefore the analysis applies to everyone taking part in the nexus of monetary exchange.
Each succeeding unit that the consumer allocates among different lines of spending, he wishes to allocate to the most highly valued use that it can serve. His psychic revenue is the marginal utility—the value of the most important use that will be served. His psychic cost is the next most important use that must be for-gone—the use that must be sacrificed in order to attain the most important end. The highest ranked utility forgone, therefore, is defined as the cost of any action.
The utility a person derives or expects to derive from an act of exchange is the marginal utility of adding the good purchased, i.e., the most important use for the units to be acquired. The utility that he forgoes is the highest utility that he could have derived from the units of the good that he gives up in the exchange. When he is a consumer purchasing a good, his marginal utility of addition is the most highly valued use to which he could put the units of the good; this is the psychic revenue that he expects from the exchange. On the other hand, what he forgoes is the use of the units of money that he “sells” or gives up. His cost, then, is the value of the most important use to which he could have put the money.16 Every man strives in action to achieve a psychic revenue greater than his psychic cost, and thereby a psychic profit; this is true of the consumer’s purchases as well. Error is revealed when his choice proves to be mistaken, and he realizes that he would have done better to have pursued the other, forgone course of action.
Now, as the consumer adds to his purchases of a good, the marginal utility which the added good has for him must diminish, in accordance with the law of marginal utility. On the other hand, as he gives up units of a good in sale, the marginal utility that this good has for him becomes greater, in accordance with the same law. Eventually, he must cease purchasing the good, because the marginal utility of the good forgone becomes greater than the marginal utility of the good purchased. This is clearly true of direct goods, but what of money?
It is obvious that money is not only a useful good, but one of the most useful in a money economy. It is used as a medium in practically every exchange. We have seen that one of a man’s most important activities is the allocation of his money stock to various desired uses. It is obvious, therefore, that money obeys the law of marginal utility, just as any other commodity does. Money is a commodity divisible into homogeneous units. Indeed, one of the reasons the commodity is picked as money is its ready divisibility into relatively small homogeneous units. The first unit of money will be allocated to its most important and valued use to an individual; the second unit will be allocated to its second most valued use, etc. Any unit of money that must be given up will be surrendered at the sacrifice of the least highly valued use previously being served or which would have been served. Therefore, it is true of money, as of any other commodity, that as its stock increases, its marginal utility declines; and that as its stock declines, its marginal utility to the person increases.17 Its marginal utility of addition is equal to the rank of the most highly valued end the monetary unit can attain; and its marginal utility is equal in value to the most highly valued end that would have to be sacrificed if the unit were surrendered.
What are the various ends that money can serve? They are: (a) the nonmonetary uses of the money commodity (such as the use of gold for ornament); (b) expenditure on the many different kinds of consumers’ goods; (c) investment in various alternative combinations of factors of production; and (d) additions to the cash balance. Each of these broad categories of uses encompasses a large number of types and quantities of goods, and each particular alternative is ranked on the individual’s value scale. It is clear what the uses of consumption goods are: they provide immediate satisfaction for the individual’s desires and are thus immediately ranked on his value scale. It is also clear that when money is used for nonmonetary purposes, it becomes a direct consumers’ good itself instead of a medium of exchange. Investment, which will be further discussed below, aims at a greater level of future consumption through investing in capital goods at present.
What is the usefulness of keeping or adding to a cash balance? This question will be explored in later chapters, but here we may state that the desire to keep a cash balance stems from fundamental uncertainty as to the right time for making purchases, whether of capital or of consumers’ goods. Also important are a basic uncertainty about the individual’s own future value scale and the desire to keep cash on hand to satisfy any changes that might occur. Uncertainty, indeed, is a fundamental feature of all human action, and uncertainty about changing prices and changing value scales are aspects of this basic uncertainty. If an individual, for example, anticipates a rise in the purchasing power of the monetary unit in the near future, he will tend to postpone his purchases toward that day and add now to his cash balance. On the other hand, if he anticipates a fall in purchasing power, he will tend to buy more at present and draw down his cash balance. An example of general uncertainty is an individual’s typical desire to keep a certain amount of cash on hand “in case of a rainy day” or an emergency that will require an unanticipated expenditure of funds in some direction. His “feeling safer” in such a case demonstrates that money’s only value is not simply when it makes exchanges; because of its very marketability, its mere possession in the hands of an individual performs a service for that person.
That money in one’s cash balance is performing a service demonstrates the fallacy in the distinction that some writers make between “circulating” money and money in “idle hoards.” In the first place, all money is always in someone’s cash balance. It is never “moving” in some mysterious “circulation.” It is in A’s cash balance, and then when A buys eggs from B, it is shifted to B’s cash balance. Secondly, regardless of the length of time any given unit of money is in one person’s cash balance, it is performing a service to him, and is therefore never in an “idle hoard.”
What is the marginal utility and the cost involved in any act of consumption exchange? When a consumer spends five grains of gold on a dozen eggs, this means that he anticipates that the most valuable use for the five grains of gold is to acquire the dozen eggs. This is his marginal utility of addition of the five grains. This utility is his anticipated psychic revenue from the exchange. What, then, is the “opportunity cost” or, simply, the “cost,” of the exchange, i.e., the next best alternative forgone? This is the most valuable use that he could have made with the five grains of gold. This could be any one of the following alternatives, whichever is the highest on his value scale: (a) expenditure on some other consumers’ good; (b) use of the money commodity for purposes of direct consumption; (c) expenditure on some line of investment in factors of production to increase future monetary income and consumption; (d) addition to his cash balance. It should be noted that since this cost refers to a decision on a marginal unit, of whatever size, this is also the “marginal cost” of the decision. This cost is subjective and is ranked on the individual’s value scale.
The nature of the cost, or utility forgone, of a decision to spend money on a particular consumers’ good, is clear in the case where the cost is the value that could have been derived from another act of consumption. When the cost is forgone investment, then what is forgone is expected future increases in consumption, expressed in terms of the individual’s rate of time preference, which will be further explored below. At any rate, when an individual buys a particular good, such as eggs, the more he continues to buy, the lower will be the marginal utility of addition that each successive unit has for him. This, of course, is in accordance with the law of marginal utility. On the other hand, the more money he spends on eggs, the greater will be the marginal utility forgone in whatever is the next best good—e.g., butter. Thus, the more he spends on eggs, the less will be his marginal utility derived from eggs, and the greater will be his marginal cost of buying eggs, i.e., the value that he must forgo. Eventually, the latter becomes greater than the former. When this happens and the marginal cost of purchasing eggs becomes greater than the marginal utility of addition of the commodity, he switches his purchases to butter, and the same process continues. With any stock of money, a man’s consumption expenditures come first, and expenditures on each good follow the same law. In some cases, the marginal cost of consumption on a consumers’ good becomes investment in some line, and the man may invest some money in factors of production. This investment continues until the marginal cost of such investment, in terms of forgone consumption or cash balance, is greater than the present value of the expected return. Sometimes, the most highly valued use is an addition to one’s cash balance, and this continues until the marginal utility derived from this use is less than the marginal cost in some other line. In this way, a man’s monetary stock is allocated among all the most highly valued uses.
And in this way, individual demand schedules are constructed for every consumers’ good, and market-demand schedules are determined as the summation of the individual demand schedules on the market. Given the stocks of all the consumers’ goods (this given will be analyzed in succeeding chapters), their market prices are thereby determined.
It might be thought, and many writers have assumed, that money has here performed the function of measuring and rendering comparable the utilities of the different individuals. It has, however, done nothing of the sort. The marginal utility of money differs from person to person, just as does the marginal utility of any other good. The fact that an ounce of money can buy various goods on the market and that such opportunities may be open to all does not give us any information about the ways in which various people will rank these different combinations of goods. There is no measuring or comparability in the field of values or ranks. Money permits only prices to be comparable, by establishing money prices for every good.
It might seem that the process of ranking and comparing on value scales by each individual has established and determined the prices of consumers’ goods without any need for further analysis. The problem, however, is not nearly so simple. Neglect or evasion of the difficulties involved has plagued economics for many years. Under a system of barter, there would be no analytic difficulty. All the possible consumers’ goods would be ranked and compared by each individual, the demand schedules of each in terms of the other would be established, etc. Relative utilities would establish individual demand schedules, and these would be summed up to yield market-demand schedules. But, in the monetary economy, a grave analytic difficulty arises.
To determine the price of a good, we analyze the market-demand schedule for the good; this in turn depends on the individual demand schedules; these in their turn are determined by the individuals’ value rankings of units of the good and units of money as given by the various alternative uses of money; yet the latter alternatives depend in turn on given prices of the other goods. A hypothetical demand for eggs must assume as given some money price for butter, clothes, etc. But how, then, can value scales and utilities be used to explain the formation of money prices, when these value scales and utilities themselves depend upon the existence of money prices?
