Does cost of production determine price or does price determine cost of production? In the world of economic caricatures, the classical economists (Smith, Ricardo, et al.) took the former position, the Austrians the latter. Specifically, the Austrian view supposedly is that that demand driven by marginal utility determines the price of consumer goods, which is then imputed backward to the factors of production.
But like all caricatures, the picture is an imperfect reflection of reality. Regarding the classicals, it will suffice to quote David Ricardo: “[C]orn is not high because a rent is paid [but] a rent is paid because corn is high.” So whatever else he might have written on the subject, he was aware (at least with respect to land) that the means ultimately get their value from final consumer goods. We value the means because we value the end, not vice versa.
And then there is this quotation: “A thing cannot have value, if it is not a useful article. If it is not useful, then the labor it contains is also useless, does not count as labor and hence does not create value.”
Karl Marx wrote that in Das Kapital, volume one. I found the quote in a footnote in Eugen von Böhm-Bawerk’s writings refuting Marx’s exploitation theory. It should put to rest the claim that according to Marxian economics, a mud pie requiring one hour’s labor should have the same price on the market as a cherry pie requiring the same amount of labor. Somebody has to find the darn thing useful first.
The question is: What forces govern value and price on the market (assuming a freed market without government privilege and monopoly)?
Böhm-Bawerk (1851-1914), one of the pioneers of Austrian economics, Ludwig von Mises’s teacher, and an unrivaled authority on the theory of subjective marginal utility, had an answer that has received surprisingly little attention since he first offered it. I draw on his paper “Value, Cost, and Marginal Utility” (1892; pdf). (One economist who has given this matter a great deal of attention is George G. Reisman. See his commentaries here [pdf] and here. Reisman received his Ph.D. under Ludwig von Mises and is the author of Capitalism: A Treatise on Economics, which, among other objectives, attempts the seemingly impossible task of integrating Misesian and Ricardian economics. See Israel M. Kirzner’s critical review of the book [pdf].)
“Costs Govern Value”
We learn from Böhm-Bawerk that it is misleading to say that marginal utility always or usually directly governs the price and value of consumer goods, which in turn governs the prices of the factors used to produce those goods. “One is in fact correct, when one says that costs govern value,” Böhm-Bawerk wrote (emphasis added).
That got my attention.
He elaborated in response to criticism that the marginal-utility school rejected the law of costs,
We too recognize the necessity of “supplementing” the universal law of marginal utility by means of special provisions that relate to the value of goods reproducible at will and that the substance of these is precisely the law of costs. And we have accomplished this “supplementing” in full detail, both for the field of subjective value and for that of objective value and prices. [Emphasis added.]
But he quickly pointed out that this is not the end of the story:
The law of costs is no fulcrum on the basis of which the rest of the explanation can be supported, without it itself needing a support. Rather, it stands in the middle of the course of explanation: it explains certain phenomena, but must itself be first further explained on the basis of certain other, more general phenomena. In order to provide the explanation with this necessary conclusion, we marginal-value theorists make an addition. Be it noted, not an addition which would run counter to or detract from the validity of the law of costs, but one which supports it and makes it intelligible. Namely, we supplement the theory of the value of products with a theory of the value of the means of production, or cost goods, whereby we reach the conclusion that this value itself is ultimately once again grounded in marginal utility. As far as we are concerned, therefore, costs apply not as an ultimate cause, but only as an intermediate cause of the value of products—though a very important and widespread one. [Emphasis added.]
So by a roundabout route, Böhm-Bawerk ends up where he started: at subjective marginal utility. Cost of production governs price. Marginal utility governs costs. How so?
What’s an iPod Worth without Earbuds?
An example will be helpful. Imagine the earbuds that came with your beloved iPod have broken. Now an iPod with no earbuds is useless (for private listening). Therefore, other things equal, you would be willing to pay almost as much for replacement buds as you would for a new iPod. In other words, if the price of replacement earbuds were governed by the marginal utility of the iPod, that price would have to be only as far below the price of a new iPod as necessary to attract you. So if a new iPod costs $300, those replacement buds might cost, say, $200.
But earbuds can be purchased for under $10. [Update: Under $4.] How can that be? Here’s the Böhm-Bawerkian explanation: In a competitive market for earbuds (even a hampered one), anyone who tried to charge $200 for (basic) buds would invite competitors who would charge less. The competitive process would drive the price further and further below the price that the marginal utility of iPods would set.
But how low could the price go? To answer that, imagine that you wanted to go into earbud manufacturing. You would need to buy inputs such as wire and plastic, and you would need to hire labor. To bid those inputs away from their current uses, you would only need to outbid the manufactures of the marginal products made from those inputs, that is, of consumers’ least-valued alternative products.
Thus the marginal utility of the marginal product governs the prices of those materials. And under competition, those prices – those costs of production – provide the lower limit toward which the price of above-marginal (supra-marginal) products will tend.
As Böhm-Bawerk wrote:
[T]he value of all production-related goods together is determined by the utility of the “last,” most easily dispensable product which is brought forth from the common production source, or, as we call it, by the marginal utility of the “marginal product.” This provides the measure both for the value of the common cost good as well as, via this last, the value of all other products produced by means of same.
In the market, everything is interrelated with everything else. It’s the original World Wide Web.
Marginal Utility Intact
Reisman emphasizes that Böhm-Bawerk’s theory in no way violates the theory of marginal utility: “[C]lassical economics mistakenly held cost of production to be the ultimate explanation of the value and price of goods, which it is not, being in fact, as Böhm-Bawerk shows, merely the vehicle for the transmission of marginal utility from the value of marginal products to that of supra-marginal products” (emphasis added).
Friedrich von Wieser, the other second-generation giant of Austrian economics, agreed: “Between cost and utility there is no fundamental opposition. Utility remains the sole source of value, and the law of cost is the most usual form of the general law of value” (Natural Value, 1889).
We’ve been talking about price, but what about value? Just as the cost of production governs price, so it governs value. This might seem un-Austrian, but remember the law of diminishing marginal utility: As the supply of a homogeneous good increases, other things equal, the value of any given unit falls and vice versa. Here’s Böhm-Bawerk:
[T]he less the material and labor that the production of a jacket costs, the more jackets, of course, can one produce with the means of production available. Thus the more completely can the need for clothing be satisfied. And thus, other things being equal, the lower will be the marginal utility of a jacket. The technical conditions of production are, therefore, to be sure a cause of the value of goods lying further back, a “more ultimate” cause, than marginal utility.
Thus marginal value varies with supply, which is governed by the cost of materials and labor, which is governed by the marginal utility of the marginal product of those inputs. (I realize I’ve left out the disutility of labor, or the value of leisure, another subjective element.)
Austrian economics never fails to fascinate.