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example, the supply of the commodity has been abruptly halted by the
sudden unavailability of a vital raw material, then many buyers will find
that the price they had confidently expected to obtain the commodity at
is no longer in effect. If, to take a different possibility, the emergence
of some new product abruptly reduces the dependency of consumers upon
the commodity we are considering, then sellers will find that their offers
to sell will no longer be accepted at the old prices. In short, any kind
of abrupt change will immediately increase the degree of disequilibrium
existing in the market, and will therefore initiate fairly rapid and extensive
adjustments in the plans of buyers and sellers in the direction of the
state of equilibrium corresponding to the new state of affairs.

THE MARKET SYSTEM AS A WHOLE
Our discussion of the pattern of adjustment in the market for a single
commodity serves to clarify the nature of the market process as it governs
activity throughout the entire market economy. We have seen that it is
permissible to consider the market system as a whole, as being made up
of many separate markets that have definite and powerful strands of
relationship. For the market system as a whole to be in equilibrium, it
is necessary for equilibrium to exist within each separate market. Within
the market for each commodity, buying and selling plans must dovetail
so that no disappointment occurs in the execution of any plan made
throughout the system.
So long as the market system as a whole is not yet in equilibrium”
that is, so long as "general equilibrium" has not yet been attained”some
plans are being disappointed. The disappointed buyers or sellers may
30 MARKET THEORY AND THE PRICE SYSTEM


revise their plans in several ways. They may offer better terms in the
same markets, or they may decide to cease (or reduce) activity in these
markets and increase activity in fresh markets altogether. Disequilibrium
in any one of the separate markets will thus cause adjustments in the
plans made first of all by participants in that market, and then secondarily
in the plans made by participants in related markets”whether horizontally
or vertically related.
In any event the course of the market process is fairly clear, assuming
for the moment that consumer tastes and basic production possibilities are
maintained unchanged. As each separate market adjusts to bring cor-
respondence in the buying and selling plans directly affecting it, the ripples
of disappointed plans spread gradually into the related markets. Each
separate market thus adjusts to disappointments in plans due to both its
own initial disequilibrium, as well as to the impact of changes in plans
brought about by the adjustments being made in related markets.
In the process of adjustment within each separate market, and between
the separate markets making up the entire system, a principal role is played
by the entrepreneur. Conditions may exist in separate markets so that
adjustments can take place to improve the positions of all concerned. The
entrepreneur becomes aware of this situation and undertakes the risk of
attempting to make the necessary adjustment. It is through his activity
that the relationships between separate markets transmit ripples of change.
If, for example, on the market for a finished product, its price is in excess
of the sum of the prices of all the resources necessary for its production,
as prevailing in the separate resource markets, it is entrepreneurial activity
that is at once set into motion by the inconsistency, constitutes itself the
condition of disequilibrium, and is responsible for the tendency to bring
about ultimate equilibrium in the market.
An important change that occurs at any point in the market system as
a whole brings about direct alterations in its immediate market vicinity.
Entrepreneurial activity transmits the consequences of these changes to
related markets. Through the impersonal medium of altered prices, par-
ticipants in other, possibly remote, parts of the market system are forced
to adjust their plans to the changed conditions. The ceaseless agitation
that is characteristic of a market economy becomes now for the market
theorist a determinate process that is set into motion in a very definite
way in response to fundamental changes in the basic data with which the
market grapples. Movements of prices; growth of new industries; expan-
sion or contraction of existing firms; the adoption of new methods of pro-
duction; the search for new resources, techniques, and products; all become
explainable for the theorist in terms of the totality of the market process of
which they are a part.
In the next chapter we review briefly what the market process achieves.
THE MARKET: ITS STRUCTURE AND OPERATION 31


In the later chapters we turn back to examine in greater detail how market
forces are transmitted, make themselves felt, and initiate adjustments. In
addition we will see more specifically how each participant in the market
economy plays a definite role in the whole process.

SUMMARY
Chapter 2 surveys the over-all operation of a market system.
A market system is characterized by a framework of law that broadly
recognizes individual freedom, responsibility, and private property rights.
Market theory assumes the use of a medium of exchange.
In a market system individuals may fill the roles of consumer, resource
owner, and/or entrepreneur. The chains of cause and effect that are
expressed through market forces operate through the typical structural
interdependence existing between the decisions made by consumers, re-
source owners, and entrepreneurs. Vertical relationships between market
decisions exist when goods and services are bought for later sale; for ex-
ample, when resources are bought by entrepreneurs from resource owners
to be used in production and sold in the form of the product to consumers.
Horizontal relationships exist, for example, when two different products
require the use of the same resource in their production; or where a product
may be produced with either of two resources that are substitutes for one
another.
A market is in equilibrium when all decisions dovetail with each other.
Disequilibrium exists when some decisions cannot be executed because they
have been planned on the basis of mistaken assumptions concerning the
decisions of others. The market process consists in the adjustments that
are enforced upon individual decisions by the disappointments experienced
in a disequilibrium market. The economic theorist may confine his at-
tention to limited series of adjustments that may be wrought out within
the market system. He will recognize that the situation where all these lim-
ited series of adjustments have fully worked themselves out is one of only
partial equilibrium. For the entire market system to be in equilibrium”
that is, for a general equilibrium to prevail”each of the separate sectors
of the market must be in harmony with each of the others. Market theory
recognizes the existence of chains of cause and effect between all the market
sectors as well as within each of them. The general market process com-
prises all the adjustments enforced upon the market activities of resource
owners, consumers, and entrepreneurs throughout the system by an initial
failure of all their decisions to dovetail perfectly with each other.
32 MARKET THEORY AND THE PRICE SYSTEM


Suggested Readings
Menger, C, Principles of Economics, Free Press, Glencoe, Illinois, 1950, Chs., 1, 2.
Stackelberg, H. v., The Theory of the Market Economy, Oxford University Press,
New York, 1952, Chs. 1, 2.
Hayek, F. A., "Economics and Knowledge," in Individualism and Economic Order,
Routledge and Kegan Paul Ltd., London, 1949.
Efficiency, doordination, and the
JMarket Economy



chapter we complete our broad
AN THIS
preliminary survey of the theory of the market system, its operation and
achievements. Chapter 2 attempted to provide a bird's-eye view of the
way the market transmits economic forces through the system, tending to
make the actions of all market participants dovetail more closely in the
system. The present chapter demonstrates how these interactions in the
market economy enable it to fulfill the basic functions of any system of
organization. We are not concerned here with what the market process is
or with the patterns of relationships the process consists of, but with how it
accomplishes what it is supposed to accomplish. Some remarks are neces-
sary to make clear, at the very outset, the point of view from which such
an appraisal can be undertaken.

THE ECONOMIC PROBLEM
Social phenomena can be examined from two distinct points of view.
First of all, they can be examined merely positively. Chains of cause and
effect can be proved to exist; the likely effects of particular changes can be
foretold; the probable responsibility of particular prior events for definite
current phenomena can be explained. Social phenomena, however, can
be examined in addition from a normative point of view. The way prior
causes bring about subsequent events can be judged by the success with
which the process fulfills definite goals (believed by the investigator to be
cherished by someone concerned with the usefulness of the process). A
breakdown in a commuter bus service may be seen positively as responsible
for highways swarming with an unusual number of private cars. It may
33
34 MARKET THEORY AND THE PRICE SYSTEM

be "blamed"”normatively”for the inconvenience experienced by those who
use the bus service for a convenient means of transportation.
The economic theorist, too, is able to view his subject matter from
both these perspectives. He may simply trace through the operation of
market forces. Or he may, in addition, appraise the market from the
perspective of one or other aspects of the "economic problem." Although
the concept of an economic problem is most frequently discussed with
respect to an entire society, the idea is fundamentally one relating to the
individual. For an individual, the economic problem consists in ensuring
that the resources at his disposal be utilized in the most effective manner
possible”from the point of view of the goals which he has set up. Success-
ful solution of this economic problem requires that the individual appor-
tion resources to promote his various adopted goals in a pattern that will
faithfully reflect the hierarchy of importance to him of the various goals.
If he desires goal A more urgently than goal B, and the available resources
are insufficient for both goals, a "correct" solution of the economic problem
requires that he allocate his resources to A rather, than to B; and so on.
From the perspective defined by the goal of correctly solving his eco-
nomic problem, an individual may judge his actions as being either efficient
or otherwise. From the point of view of his own chosen goals, considering
the varying degrees of urgency that he has assigned to these goals, the indi-
vidual may frown at a particular course of action as being at variance with
his goal program. Such a course of action is "inefficient," "wasteful," and
"irrational"; it fails to aim at the most important of the chosen goals.
The goal of "efficiency" is not really a separate goal in its own right.
Efficiency is nothing else, in the present context, that the consistent pursuit
of other goals. Consistency in the pursuit of goals calls for a refusal to
apply resources to achieve one goal when this implies forsaking a still more
highly cherished goal. Inefficiency is thus synonymous with inconsistency.
An inefficient course of action is one that is inconsistent with a given pro-
gram of goals. A course of action that is inefficient with respect to one set
of goals may be highly efficient with respect to a different set. But the
point is that, in making plans, individuals have in mind given sets of goals.
With respect to this set of goals, they seek a consistent, efficient course of
action.
SOCIETY AND THE ECONOMIC PROBLEM
Economists frequently speak of the economic problem facing society.
What they usually have in mind is something closely similar to the eco-
nomic problem faced by individuals. But the legitimacy of this interpreta-
tion of the term "economic problem" is by no means clear, and the
limitations on its use in this sense must be understood. Discussions that
deal with the economic problem facing society assume a group of human
EFFICIENCY, COORDINATION, AND THE MARKET ECONOMY 35


beings, on the one hand, having numerous different desires for consumer
goods and services and, on the other hand, having command of a body of
productive resources. The economic problem facing the society is, once
again, that of securing efficiency. The problem consists in constructing an
organized social system that will most efficiently utilize the limited resources
of "society" for the satisfaction of the desires of "society" for consumer goods
and services. Once again a successful solution of this problem calls for
"consistency"”a pattern of activity and production that should faithfully
reflect the respective weights assigned to each of the goals that it is desired
to satisfy.1
The limitations surrounding this use of the term "economic problem"
arise from the fact that society is made up of numerous individuals. Each
individual can be viewed as independently selecting his goal program. And
in a market economy especially, each individual adopts his own courses of
action to achieve his goals. It is therefore unrealistic to speak of society
as a single unit seeking to allocate resources in order to faithfully reflect
"its" given hierarchy of goals. Society has no single mind where the goals
of different individuals can be ranked on a single scale.
Nevertheless, there is a sense where one form of societal organization
can be termed "more efficient" than another. For example, a market
economy, as we shall see, is unquestionably more "efficient" than a system
of self-sufficient individual "economies," because each individual shows
by his voluntary participation in the market that he is better off under the
former than the latter. Thus, each individual finds he can most efficiently
solve his own economic problem by cooperating with other individuals
through division of labor and the market. Any form of voluntary social
cooperation emerges only because each participant seeks in this way to
further his own goals. If he participates in a social system of any kind, he
does so in the interests of his own efficiency; his participation is a method
of solving his own economic problem.
We will be speaking of the efficiency or inefficiency of a social system
in this sense. We are not invoking the notion of a society having its goals
in any sense apart from the goals of the individuals making up the society.
Efficiency for a social system means the efficiency with which it permits its
individual members to achieve their several goals.

l This statement of the nature of the economic problem facing a society is worthy of
notice. Most nineteenth century economists (and many laymen today) use the adjective
"economic" to denote a relationship to tuealth (more or less carefully defined). Most
economists today, however, recognize that the term "economic problem" is fundamentally
suited to denote the problem discussed in the text.
36 MARKET THEORY AND THE PRICE SYSTEM


THE PROBLEM OF COORDINATION
However, when individuals seek to fulfill their purposes through some
form of social cooperation, the efficiency of the social system in the above
sense depends on the degree of coordination with which the separate activ-
ities of the participants are carried on. The cooperation of individuals
requires that their actions fit into an over-all pattern of organization. The
fundamental point is that the source of the advantages of social coopera-
tion over individual autarky exists in the possibilities that social co-
operation opens up for specialization and division of labor. It is efficient,
for example, to participate in a market economy (instead of being a self-
sufficient Robinson Crusoe) because the value of one's specialized services
to the market is higher than the value of all that one could produce by
spreading one's efforts over numerous branches of production for one's own
consumption.2
Now, the very factor specialization, which can make social cooperation
"efficient" for each of the cooperating individuals, itself introduces problems
upon whose successful solution the worthwhileness of specialization depends.
Clearly, if everyone specialized in the same kind of production, specializa-
tion would be worse than useless. A social system will emerge only if the
system promises individuals a way of cooperating with others in an efficient
way; that is, only if the system coordinates the specialized activities of the
participants.
In this chapter we discuss the market economy with respect to the way
it coordinates the activities of its participants. We do not "judge" the
degree of success that the market economy attains in this regard either as
compared with other economic systems or as to its own "efficiency." We
are concerned with finding out how the patterns of relationships existing in
the market process succeed at all in organizing numberless, independently
planned actions into a social system that efficiently serves the purposes of
its participants.
The general problem of coordination can be reduced, for a market
economy, into a number of fairly distinct special problems. First, we will
outline these problems, and then proceed in subsequent sections to discuss
how these problems are solved by the market.
1. The economy must somehow or other develop a system of "priorities"
governing what goods and services should be produced. Resources are
clearly insufficient to produce everything that the participants would like to
enjoy. There must be someway to decide on the kinds and quantities of
products to which resources should be allocated; this involves the notion of
2 The classic statement of the advantages to be derived from the division of labor is
in the opening chapter of Adam Smith's Wealth of Nations. See also Mises, L. v., Hu-
man Action, Yale University Press, New Haven, Connecticut, 1949. pp. 157-164.
EFFICIENCY, COORDINATION, AND THE MARKET ECONOMY 37


"priorities." If Mr. Smith wants a new coat, and Mrs. Jones wants a new
dress, then there must be some method of ranking these two wants so as to
guide producers in making their decisions as to what to produce. If one
viewed society as having wants that, in principle, can be ranked on a single
scale of absolute "importance," then this problem would be simply that of
discovering this ranking. Such a view of things recognizes the possibility
of declaring Mr. Smith's need for a coat to be somehow or other more or
less "urgent" from the standpoint of society than Mrs. Jones' need for a
dress. Efficiency in the operation of the economy requires that, in this view
of things, the system find out which want is the more urgent and then direct
producers to give it corresponding priority.
But even when it has become clear that no objective way exists of de-
termining the relative importance of the wants of different individuals
"from the point of view of society" in any such absolute sense (if any mean-
ing at all can be attached to this term), the problem of ranking must and
can be solved. For participation in a market economy to be attractive,
individuals must be assured that some reasonably satisfactory”and definite
”method will be used to assign priorities to the wants of all the different
participants. From the point of view of coordination, participants must be
assured that the decision of any individual entrepreneur to produce a given
commodity is consistent with this priority system. The priority system used
need not be able to lay claim to the achievement of ultimate justice or fair-
ness. Participants must merely be convinced that the degrees of importance
that the market attaches to different wants are such as to make the market
system profitable from their own individual point of view.3
2. A second problem of coordination relates to the way resources are
combined to produce those goods or services to which priority in production
has somehow been assigned. Once it has been decided that a certain good
is to be produced, the next step is to decide on the method of production to
be used. Very often there are a number of different methods of production
that are technically capable of yielding a desired commodity. Drinking
water can be brought from the mountains or extracted from the sea. The
economic system requires a device that will guide the producer of the com-
modity to use the most efficient method of production”efficiency in produc-
tion being measured with respect to the economy as a whole. The "correct"

3 The notion of priority in satisfying the wishes of market participants should be
interpreted very broadly. Under this heading should be included, for example, at least
part of the function frequently assigned to an economic system of providing for growth.
Insofar as growth involves a problem of resource allocation (for example insofar as it
involves denying Mr. Smith's wants today in order that Mrs. Jones' grandchildren should
enjoy a better life in the future), the market must determine the rate of growth of the
economy on some basis of priorities. It is also true that the priority attached by con-
sumers to present consumption over future consumption may be such that no growth
at all (or even economic decline) may be the most "efficient" outcome.
38 MARKET THEORY AND THE PRICE SYSTEM


method of production means the correct combination of resources. The
correct combination of resources used to produce a given commodity will
leave as a remainder, out of the entire available stock of resources, that body
of resources able to produce the greatest quantity of goods in their order
of priority. In other words, production is carried on efficiently, from the
viewpoint of society, when it interferes least with the rest of production.
Clearly, with innumerable producers making independent decisions as
to production techniques, the economy must coordinate these decisions so
as to ensure that each producer uses those resources least needed elsewhere
in the economy. Just as products can be produced in different ways, so
resources can be used to produce different products. It is in the interest of
each market participant that each unit of each resource be directed toward
the production of that product where it will be used most efficiently”in the
sense stated above.
3. The essence of the market economy is specialization and division of
labor in production; production, moreover, invariably involves the co-
operation of the productive services of several different resources. For both
these reasons it follows that, in a market economy, resources are generally
used in processes of production which go to satisfy the wants of others than
the owners of the resources themselves, and/or do not permit the productive
contribution of any particular unit of a resource to be distinguished or
identified. A truck driver transports food from one city to another. He
himself may need very little of this food; and it is quite impossible to
identify what portion of the utility of transportation is attributable to his
services, what portion is attributable to the truck, to the highways, and so on.
All this creates a problem of compensating each participant in the system
for his productive contribution as a resource owner (or entrepreneur). If an
individual is to participate in the economy, some definite system must exist,
which will insure that he will receive a share of what is being produced.4
An efficient system will provide sufficient reward to each participant to en-
able all participants to enjoy the benefits of the widest possible range of
resource services.

HOW THE MARKET SOLVES THE PROBLEMS
OF COORDINATION
In a market economy these problems of coordination find their solution
in the market process. The key role is played by market prices. The
reasonable success that a market economy is able to attain in the solution
of the three coordination problems outlined in the previous section is the
4 From a short-run viewpoint this coordinating problem is frequently seen as the
problem of distributing the national product. Some of the early economists saw the
principal task of economics as being the elucidation of the laws governing distribution.
EFFICIENCY, COORDINATION, AND THE MARKET ECONOMY 39


consequence of a market process that determines prices. Market prices
guide individual decision makers toward decisions that tend to consider
implicitly all the relevant conditions prevailing in the market.
Thus, the single process that determines the course of the various prices
in a market continuously works toward the simultaneous solution of the
three problems of coordination. These three, analytically distinct tasks
are fulfilled as aspects of the same market process market prices emerge from.
This will become apparent in the following paragraphs as we discuss the
different aspects of the market solution.
1. In a market economy the task of production is carried out by entre-
preneurs in search of profits. Where an entrepreneur has the choice of
producing two products at equal cost, he will produce that which promises
to sell for the highest price. Thus, priorities in a market economy are
assigned to different goods by the process that determines their prices.
Where equivalent combinations of resources can produce different products,
it is the product that can command the highest market price that top
priority is automatically assigned to.
Much of our study is concerned with the process by which the market
price of products is determined. Generally, it is obvious even at this point,
however, that those products for which consumers are prepared to undergo
the greatest pecuniary sacrifice will tend (other things being equal) to com-
mand the highest prices; so thus, the market tends to consider these
products as socially more "important." Resources will tend to be pur-
chased by entrepreneurs for use in the production of the relatively higher-
priced goods. Changes in the urgency with which consumers are anxious
to obtain specific goods will tend to be reflected in changes in their prices
and hence in the priority that the market attaches to their production. The
more responsive the price system is to changes in consumer preferences,
the more accurately will the decisions of producers be in conformity with the
priority system based on pecuniary sacrifice.
This kind of priority system is frequently described as consumer
sovereignty. It is the consumers' acts of purchase, translated into market
forces, which determine market prices, and thus give directions to the pro-
ducers as to what should be produced. Changes in consumer preferences,
which are responsible for the price changes, compel producers to alter their
production processes. Any non-market obstacles placed in the way of the
pricing process thus necessarily interfere with the priority system that con-
sumers have set up. It must always be borne in mind that such a priority
system cannot necessarily lay claim to any kind of ethical excellence. All
that can be claimed for the priority system is that it offers potential market
participants more attractive alternatives than are available to them other-
wise.
2. That production in a market economy is undertaken for profit also
40 MARKET THEORY AND THE PRICE SYSTEM

has definite consequences with respect to the second task of coordination.
When a given product can be produced by different methods of production, it
is most profitable to use the cheapest method of production. The entrepre-
neur will therefore tend to use this method of production. The cheapest
method of production is that which requires the smallest expenditure for
the resources used. Whether or not one production process is cheaper (and
therefore more likely to be employed) than another depends not only on the
quantities of resources required for the processes, but also on their prices.
The market value of different resource combinations influences the decisions
of producers to use more machinery or less, more skilled labor or less, a
larger plant or a smaller; and so on.
Now, as with the prices of products, the analysis of the determination
of the prices of resources must wait until later chapters in this book. But
generally it is not difficult to see what factors are at work in the determina-
tion of resource prices, and to appreciate how these factors relate to the
coordination problem of securing the use of "socially efficient" methods of
production. Market prices are the basis of cost calculation by producers.
The price of each resource tends toward the point where all supplies of
the resource available at this price are bought by producers.5 Producers
tend to bid up resource prices in order to secure resources for the production
of given products for as long as it is profitable to do so; thus, at the market
price, the resource will be used by producers of those products in whose
production the resource yields greatest profits. Producers bidding for the
resource to produce a product in which the resource will be relatively less
profitable will soon find it impossible to compete with the producers of
more valuable products. In buying the cheapest resources (among all those
resources that are for him technically equivalent), the producer will there-
fore tend to be buying those resources least valuable elsewhere in the econ-
omy”"valuable," that is, in the sense of being able to cater to consumer
wants having higher (pecuniary sacrifice) priority.
It cannot be expected, to be sure, that at any one time the market
process should have succeeded in securing complete coordination of deci-
sions concerning methods of production. Inevitably, at any one time,
certain processes of production will be carried on using resources some units
of which could be used more valuably in other production processes. So
long as the market is competitive, however, the existence of such oppor-
tunities for increased efficiency will tend to be discovered and exploited by
profit-seeking entrepreneurs. The market process will constantly tend to
rearrange and reshuffle the allocation of productive resources so as to con-
5 The sentence in the text needs to be qualified to some extent. It is possible that a
resource is so plentiful or so low in productivity that even if the price falls to practically
zero, it does not pay to employ the entire supply for production.
EFFICIENCY, COORDINATION, AND THE MARKET ECONOMY 41


form more closely with the most recent changes in the patterns of available
resources and consumer preferences.6
3. The price system a market economy has its setting in is responsible
also for the solution of the third problem of coordination, that of determin-
ing the individual rewards to be received by each of the resource owners
cooperating in the productive process. This function is fulfilled as a
different aspect of the same pricing process that determines resource alloca-
tion and the organization of production. Resource owners selling the
services of their resources in the market secure prices that are determined
by the interaction of resource supply and entrepreneurial demand. Acting
in their capacity of consumers, the resource owners will in turn use the
money prices, which they receive in the resource markets (their "incomes"),
to buy goods in the product markets. Thus, the market value of the goods
and services a consumer can buy with his income is determined by the
value that the market places upon the services that, in his capacity of re-
source owner, he has furnished to the production process.
The real incomes received by consumers are therefore determined by
the prices that emerge in the market for the services of the various resources.
In general, the price of a resource depends on its productivity in the differ-
ent branches of production. When a resource owner is otherwise indif-
ferent to the use his resource will be applied to, he will sell its services to the
highest bidder. The highest bidder will tend to be that entrepreneur to
whose profit calculations the services of additional quantities of the re-
source add most. The market process therefore tends to ensure the appor-
tioning of rewards among cooperating resource owners in a way that attracts
resources to their most productive uses. At the same time each individual
resource owner participating in the market process is able to enjoy the
fruits of the production of the market to an extent depending on the useful-
ness to the market of the productive services that he is willing to supply on
these terms. That portion of production that is not earned by resource
owners is received by entrepreneurs as pure profit. We now consider briefly
the factors that determine the size of profits, and especially the coordinating
functions that profits fulfill.

THE COORDINATING FUNCTION OF PROFITS
IN A MARKET ECONOMY
In the previous sections it was seen that the market process simulta-
neously solves the three fundamental problems of economic coordination
through the price system. The emergence of a price structure reflects a
priority system that guides resources to (what this priority system pronounces

6 See more on this point in Ch. 13.
42 MARKET THEORY AND THE PRICE SYSTEM

to be) their most productive uses. But the price system is not "automatic,"
it functions only as the expression of human actions. In particular the
price system is the expression of entrepreneurial decisions consciously
planned and executed. Entrepreneurial decisions are made with the pur-
pose of winning profits.
Profits are to be won whenever something can be sold for a price higher
than the price it can be bought at (or higher than the sum of the prices of
everything needed for its production). For an entrepreneur to win profits it
is necessary, first, that such a price discrepancy exist; and second, that the
entrepreneur know that it exists. Now, for a price discrepancy to exist, it
is necessary that those willing to sell the commodity (or the factors neces-
sary for its production) for the lower price and those willing to buy the
commodity at the higher price be unaware of each other's attitudes. If
these sellers and buyers knew each other's attitudes, these would soon be
altered to eliminate the price discrepancy. The entrepreneur wins profits
by becoming aware, earlier than others, of the hitherto unknown discrepancy
(reflected in the price differential) between the attitudes of those willing
to sell for less and of those willing to buy for more.
It is the characteristic of the real world to which the analysis of market
theory may be applied that, at any one time, numerous instances occur of
the kind of ignorance that makes it possible for price discrepancies and
profits to emerge. Each market participant knows some of the market
facts relevant to his own situation, but is ignorant of a great many more.
Among the alternatives from which Market Participant A believes he has
to choose, some particularly attractive alternative is usually missing (obtain-
able by dealing with Market Participant B) which might have been included
if only A and B would have known of each other's situation and attitude.
From the point of view of an imaginary, disinterested outsider knowing all
these facts, both A and B are the losers due to their ignorance of some
market facts. From the point of view of the omniscient outsider, the
market always has room for a reshuffling of resources or goods according to
the pattern that would take place if the market participants themselves
were not in ignorance of the opportunities available to them.
It is here that we can see the essential character of the coordinating
functions performed by the market process. The market process tends to
present market participants with alternatives that approximate those oppor-
tunities they would choose if they possessed all the relevant information.
The market process achieves this without making it necessary for market
participants to learn all this detailed information. Instead, the market re-
veals any lack of coordination resulting from ignorance by market partici-
pants of potentially available opportunities, through the emergence of price
discrepancies. Ignorance of available opportunities then equates to igno-
rance of price discrepancies. Where this kind of ignorance persists, the
EFFICIENCY, COORDINATION, AND THE MARKET ECONOMY 43


opportunity exists for the first discoverers of the price discrepancy to step
in and win profits. In doing this they wipe out the price discrepancy
itself, and thus remove the lack of coordination that resulted from the
limited market knowledge of market participants.
The quest for profits thus serves as a complete substitute for the search
for conditions where ignorance exists on the part of market participants of
the opportunities available to them. In the quest for profits the latter
search has been replaced by a simple search for price discrepancies. Where-
ever discrepancies exist between prices paid for identical goods, or between
prices paid for goods and those paid for everything required for their pro-
duction, then the imaginary omniscient economist could point out possi-
bilities for reallocation of goods of resources that would benefit all
concerned. The market tends to act to achieve precisely this reallocation by
offering prizes (profits) for the detection and removal of price discrepancies.
It is thus the activity of the entrepreneur in his search for profits that serves
as the driving force of the price system, enabling it to solve the problems of
coordination outlined in the previous sections of this chapter.

SUMMARY
Chapter 3 examines the operation of a market system, with respect to
the way it achieves the goals or functions that its participants may seek to
fulfill through this means of social organization.
An "economic problem" consists for an individual in ensuring that the
resources at his disposal be utilized in the most effective manner possible,
from the point of view of his own cherished goals. With some reserva-
tions, it is possible to speak of an economic problem facing society in gen-
eral, and of the "efficiency" with which a form of social organization fulfills
the goals set for it.
For a system of social cooperation, efficiency requires the coordination
of separate activities. Social cooperation opens up the way to the improved
fulfillment of individual wants through division of labor; but division of
labor is beneficial only where carried on in a coordinated fashion. Coordi-
nation involves (a) the development of a priority system for the satisfaction
of wants; (b) someway of determining the method of production to be em-
ployed for each adopted project, and (c) a way of assigning rewards to the
individuals cooperating jointly in productive activities.
The market simultaneously solves these coordinating problems through
the price system. Prices determine the priority with which the various
possible products will be produced on the basis of consumer demand work-
ing through the entrepreneurial search for profits. The same process guides
entrepreneurs to the employment of definite methods of production (those
which can achieve a given result at the lowest money cost). At the same
44 MARKET THEORY AND THE PRICE SYSTEM


time the pricing process assigns prices to the services of those cooperating
in production. The driving force in the process is thus the entrepreneurial
search for profits, leading to the production of products commanding the
highest prices (for given production costs) and to the employment of the
resources involving least cost (for a given productive purpose).

Suggested Readings
Knight, F. H., The Economic Organization, Kelley and Millman Inc., New York,
1951, pp. 3-30.
Mises, L. v., Human Action, Yale University Press, New Haven, Connecticut, 1949,
pp. 694-697, 258-323.
Utility Theory


I and the succeeding chapters we
N THIS
discuss the theory of the demand side of the market. Our task will be to
explain the way the alternatives presented to each consumer by the market
determine the way he spends his income and the quantities of each good
that he decides to purchase.
In the present chapter a framework is set forth within which individual
consumer demand theory intuitively "fits." This is the notion of marginal
utility. It must be stressed that utility theory provides no explanation in
terms of any external observable criteria. It merely provides a logical
means of mental orderliness in bringing coherence into a description of
individual behavior. It provides a framework by which an internal con-
sistency can be introduced into the explanation of consumer adjustment
to changes in market data. The fact that this framework is intuitively and
introspectively valid makes it extremely valuable in explaining the actions
of market participants.
This chapter provides the conceptual apparatus that is then put to
work in Chapter 5 in interpreting individual allocation of income. In
Chapter 6 the analysis is extended to cover the demand for particular
commodities as expressed by the market as a whole and as it reacts to
given changes. The analysis will be built on the basis of understanding the
individual demand behavior of which market demand is itself the resultant.
In Chapter 7 we apply our analysis to a market process that might develop
in an economy where only consumer goods are bought and sold.

THE SCALE OF VALUES
The fundamental premise the theory of demand (and, therefore, also
market theory in its entirety) is built upon is that men do not consider all
45
46 MARKET THEORY AND THE PRICE SYSTEM


their desires to be of equal importance. Each of us wishes to enjoy the
services of innumerable types of commodities, to achieve a variety of cher-
ished goals. For the analysis of human action, it is of the first moment
that we rank these inclinations and desires as either more or less urgent.
Whenever we are forced to choose between the satisfaction of two inclina-
tions, one of them takes precedence over the other.
That men are able to arrange their preferences in order of importance
is inherent in the nature of man himself; that men are forced to make such
a ranking is imposed by the brute fact of scarcity that places man constantly
in the position of being unable to satisfy all his desires. It is this scarcity
that thrusts on man the necessity to choose. And it is in the act of choice
that man does, in fact, rank the available alternatives. The renounced
alternatives, by their very renunciation, are declared less urgent than the
alternative that is chosen.
At any given time, a man finds himself possessed of a multitude of
desires. He would like to eat, drink, read, walk, or simply sleep. The
foundation of the theory of demand is the recognition that all his desires,
all the goals he deems worthy of achievement, may be considered as making
up a scale of values, arranged in their order of importance. This ordered
array is set up, for any number of man's desires, whenever he is forced to
choose between them. When man eats, then he pronounces the goal of eat-
ing to be superior on the value scale of this moment to any of the other
activities he might have engaged in. When, at another time, he goes on
a hike, then it is this form of recreation that has been set aside as more
urgently desired at the moment than other forms of activity.1
Acting man, at every moment of his consciousness, is forced to choose
among a number of possible courses of action. It is of the essence of action
that it aims at encompassing the fulfillment of as many of the actor's desires
as is possible, in the order of their urgency. That is, a man always acts
to ensure that no desire is satisfied at the expense of the satisfaction of some
more important want. This, after all, is only a different way of expressing
the fact that man is intent on successfully achieving his goals. "Achieving
one's goals" means renouncing the achievement of a specific goal should it
interfere with the achievement of a goal considered more important.
In the actuality of the everyday world, human beings are able to
satisfy their wants only through directing their efforts toward appropriate
means for such satisfaction. A man who wishes to eat may purchase food,
cook food, or simply put on a hat and coat and go to a restaurant. His

l It is unnecessary, and may in fact be misleading, to consider a scale of values as
existing for a consumer, in any sense, apart from his acts of choice. All that is meant
here is that when man is forced to choose, he is at that moment forced to arrange his
values in order of importance. In particular, the notion of a given scale of values does
not imply any necessary permanence for the rankings under consideration.
UTILITY THEORY 47


actions have been intermediary to the goal of eating. "Eating" is the
end of his present endeavors; the means that he adopts for the attainment of
his end can be an act of purchase, cooking, or walking to the restaurant.
It is rare indeed that any act a man undertakes can be considered only an
end in itself; in most cases actions are aimed at some goal that, upon
examination, proves to be only intermediate to the attainment of some more
"ultimate" purpose; and so on.
For our purposes it is not so much the distinction between ends and
means that is of importance. Rather it is desired to emphasize that when
men act to obtain the means necessary to fulfill their more ultimate goals,
they are actuated by the same kind of calculation as when they aim at their
goals directly. In particular, it is noted that the very considerations that
constrain man to arrange his desires in order of their importance force him
to make an identical arrangement among the means necessary to the ful-
fillment of these desires. In his attempts to obtain the means for the satis-
faction of his wants, man directs his first efforts to the attainment of those
means that minister to ends highest on the value scale. When forced, as
in fact he constantly is forced, to choose between alternative bundles of
"means," man places the means in their appropriate rankings within the
value scale. He is careful not to follow any course of action that would
secure him the means of satisfying any desire, where this would be at the
expense of items higher on the value scale”that is, at the expense of wants
(or means for the satisfaction of wants) considered more urgent.
It is this complete scale of values that man at once sets up and follows,
whenever he is called upon to choose. Man's actions are invariably carried
out under the constraint of some such value scale. Our analysis of demand
theory is built on the logical consequences of the existence of such a scale”
of the fact that man's desires and the means to the satisfaction of these
desires are not of equal "significance." By "significance" we mean simply
"importance," judged by the yardstick set up by a man's value scale. The
terms "significance," "importance," "urgency," and the like are used
throughout demand theory to allow the idea of value ranking to embrace
oil objects and courses of action that man considers as desirable or worthy
of attainment. A man may be in a position where he must choose between
quite heterogeneous objects or values. He may be forced to choose whether
to rush over his breakfast or to miss his train; whether not to tell the truth
or to lose his job; whether to increase his costs by granting a salary increase
to an employee or to risk being labeled a "skinflint." No matter how un-
matched the relevant alternatives may appear, the very fact that he is called
upon to choose between them means that man must somehow rank them
on the same scale. Thus, this scale must be far wider than one intended
merely to rank values as more physically pleasurable or less, as more morally
acceptable or less, as more esthetically appealing or less; it must, or more
48 MARKET THEORY AND THE PRICE SYSTEM


accurately, does rank objects and courses of action as simply more worthy
of action or less. An item higher on the value scale, for action, is more
"significant" than an item below it.

MARGINAL UTILITY
In the theory of demand, the term utility is to be understood as denot-
ing simply "significance," in the sense set forth in the previous section. As
such the utility concept is fundamental to the theory of demand and to the
understanding of the determination of prices. In this and in the next
chapters we use the utility concept to analyze the actions of the consumer
and the way his actions are adjusted to changes in basic market data. Our
discussion begins with an illustration of the notion of marginal utility as it
is reflected in a simple exchange transaction between two men and then
proceeds to use marginal utility as a tool in the subsequent analysis.
Imagine two men A and B. Each possesses a quantity of both fish and
fruit. However, A would gladly give up some of his fish if this would
secure him more fruit; B is ready to give up some of his fruit if this will
increase his supply of fish. When A and B become aware of this situation,
exchange ensues. We will suppose that A gives 3 lbs. of his fish to B and
obtains 10 lbs. of B's fruit in exchange. Let us restate this simple case
using utility terminology, from A's point of view.
Both fish and fruit have utility for A; A would prefer, other things
being equal, to have more fish than less fish and more fruit than less fruit.
However, the utility to A of the 10 lbs. of fruit that he obtains from B is
greater than that of the 3 lbs. of fish that A yields in exchange. For B, of
course, the case is the reverse. The utility to him of the 3 lbs. of fish that
he obtains is greater than that of the 10 lbs. of fruit that he yields.
Now, it must be noticed, that when we compare for A the utilities of
fruit and fish, we are not comparing the significance of fruit-in-general
with that of fish-in-general. Such a comparison clearly has no meaning
for a science of human action, since nobody is ever forced to choose between
two such alternatives. All that is involved in the utility comparison is the
utility of the quantity of fruit that A acquires with that of the quantity of fish
that he yields. These are the relevant "fruit" and "fish" involved in the
comparison. To emphasize this limitation, we describe the situation for A
by saying that for him the marginal utility of fruit is higher than that of fish.
We are able to assert that, on A's scale of values, the marginal utility of 10
lbs. of fruit is higher than that of 3 lbs. of fish. The significance to A of
the prospective 10 lbs. of additional fruit is placed higher than the signifi-
cance of the 3 lbs. of fish that are to be renounced.
When the transaction has been completed, A has successfully pursued a
course of action that has substituted a more valuable package for one less
UTILITY THEORY 49


valuable. He was not called upon to choose between fish and fruit. He
had no need to compare fish-in-general with fruit-in-general, nor even to
compare all his own fish with all his own or B's fruit. The only choice
forced on A was to compare the significance of fish and fruit at the margin.
At issue was the loss of some fish as compared with the gain of some fruit.
What A was called upon to decide was whether the difference to him in-
volved in the loss of the 3 lbs. of fish meant more or less to him than the
difference involved in the gain of the 10 lbs. of fruit. The fact that A chose
to exchange signifies that the marginal utility to him of 10 lbs. of fruit was
greater than the marginal utility to him of the 3 lbs. of fish.

DIMINISHING MARGINAL UTILITY
We can now develop a principle of far-reaching significance in eco-
nomics generally and in demand theory in particular. This principle
is usually referred to as diminishing marginal utility. A clear understand-
ing of this principle will provide the key to much of the subsequent dis-
cussion.
Imagine a man who has had to decide how much of a particular com-
modity to buy. Let us suppose that he was able to obtain as many units
of the commodity as he pleases at a fixed price of $F per unit and that
he has finally purchased N units. We say that his action demonstrates
that he prefers N units of the commodity to the amount of $P — N, which
he has to pay for them. He has chosen between the alternatives of either
paying the sum $PN (and gaining N units) or going without the quantity
N of the commodity.
This way of expressing the choice that faced the man, while correct
as far as it goes, does not fully set forth the actual complexity of the
decision he has made. Our buyer, who actually buys N units, could have
bought, if he had desired, either more than A7 units or less than N units.
The full range of alternatives open to him include:
Buying Possibilities Cost
Buying none of the commodity no money
Buying 1 unit $P
Buying 2 units $2P

Buying N-¬ units $(N ” \)P
Buying N units $NP
Buying AT+1 units ¢(AT + \)P

In comparing these successive alternatives one with another, the pro-
spective buyer assesses the differences (marginal utility) that successive ad-
50 MARKET THEORY AND THE PRICE SYSTEM


dítional units of the commodity would make to him; and he weighs these
differences against those involved in the prospective loss of successive ad-
ditional sums of money. The principle of diminishing marginal utility
focuses attention on the marginal utility attached to successive additional
units of the commodity.
The acquisition of additional units of a commodity enables the buyer
to satisfy a successively larger number of wants. The acquisition of the
mth unit of a commodity by one who already possesses m”\ units means
that he will now be able to satisfy a want that, if only m”\ units would
be possessed, must have gone unsatisfied. It is clear, upon reflection, that
this want whose satisfaction is made possible by the acquisition of the mth
unit must rank higher on the man's scale of values than the want that
depends for its satisfaction on the acquisition of the (m + l)8t unit. For
when a man acquires the mth unit, he will have to choose”out of all the
wants that must go unsatisfied when only m”\ units are possessed”that
particular want whose satisfaction the acquisition of this mth unit should,
in fact, make possible. And, of course, it will be the most important of
these wants that will be chosen. Furthermore, of the still remaining
unsatisfied wants, it will be the next most important one that will be
selected for satisfaction upon acquisition of the (m -j- l) st unit.
Similarly, looking at the same situation from the opposite direction,
it is obvious that if the man who possesses m”\ units were to lose one
of them, then he would see to it that the want that must now go un-
satisfied will be the least important of all hitherto satisfied wants. Of
the remaining yet satisfied wants, it must be the next least important that
would be sacrificed, were yet another unit to be lost.
To restate the contents of the preceding paragraphs compactly, we
can say that the
Marginal utility of the mtn unit is lower than that of the (m ” l’* unit
and higher than that of the (m -J- \ÿ* unit.
This conclusion is the principle of diminishing marginal utility.
The principle readily lends itself to illustration. Consider, for ex-
ample, an air passenger packing his valise and allowed to take with him
baggage of only limited weight. He surveys the articles he would like
to take but which weigh, let us say, 5 lbs. in excess of the limit. Clearly,
the 5 lbs. of his possessions that will be excluded will be those the pas-
senger believes to be least urgently required for the trip, among all the
5-lb. groups of articles that can be removed. Suppose that a sudden change
in regulations reduces the permitted weight by 5 lbs.; then yet another
5 lbs. of articles will have to be excluded. The latter will be possessions
that, while more desired for the trip than those previously excluded, are
yet not as indispensable as the articles still packed in the valise. The
UTILITY THEORY 51

marginal utility of allowed baggage, in terms of 5-lb. units of impedimenta,
increases as the baggage allowance dwindles and diminishes as the baggage
allowance increases.
Some words of clarification are in order with respect to the meaning
of "marginal." Let us imagine six physically similar shirts each bearing a
different number. A man owns the shirts numbered 1, 2, 3, and 4. He
contemplates the purchase of the shirt numbered 5 and then of the shirt
numbered 6. His decision requires the comparison of three situations;
(a) possession of shirts 1, 2, 3, and 4; (b) possession of shirts 1, 2, 3, 4,
and 5; and (c) possession of shirts 1, 2, 3, 4, 5, and 6. As discussed, such
comparison involves the marginal utility of "a fifth" and of "a sixth"
shirt. If each shirt is priced at $5, then the decision whether or not to
purchase the fifth shirt will hinge on whether a fifth shirt has greater
utility than }5 or not. The marginal shirt in this case happens to be
the shirt bearing number 5. And similarly for the sixth shirt.
The law of diminishing utility tells us that the marginal utility of
the sixth shirt will be lower than that of the fifth. The acquisition of the
fifth shirt, let us say, enables the man to fulfill a particular engagement
without appearing in a soiled or frayed shirt. The sixth shirt will ob-
viously make no difference at all to this engagement; it can affect only
some other occasion, less important than this engagement.
It must be made clear that the fifth and sixth shirts, as well as each
of the four already possessed, being different units of the same good, are
perfect substitutes for one another. The shirt numbered 6 has lower
utility than that numbered 5 only because it is to be acquired later. Once
the man has bought the sixth shirt, it may well be that the shirt numbered
6 may actually be worn for the most important occasion. When we say
that a sixth shirt has lower utility value than a fifth, what we actually
mean then is that the utility of any one shirt, when six shirts are owned,
is lower than that of any shirt in a five-shirt wardrobe. This is so because
the utility of any shirt in a man's wardrobe means simply the difference
its loss would make to him. A man owning shirts numbered 1 to 6, con-
templating the loss of shirt number 3, is in exactly the same position as
if he would be contemplating the loss of shirt number 6. Any use shirt
number 3 would be put to, were shirt number 6 to be sacrificed, can be
perfectly served by one of the other shirts, when it is shirt number 3
that is to be given up. The marginal utility of any one particular unit
in a stock of shirts, or any other good, even the marginal utility of the
unit devoted to a more important use than any of the other units, is
exactly the same as the marginal utility of the unit devoted to the least
important use”since it is this least important use that is at stake.
This rather obvious fact can be fruitfully borne in mind throughout
economics whenever the adjective "marginal" appears.
52 MARKET THEORY AND THE PRICE SYSTEM


THE MARGINAL UTILITIES OF RELATED GOODS
It is useful for many purposes to distinguish between goods that, for
a given consumer, are unrelated and goods that are related. Unrelated
goods are those whose marginal utility depends only on the quantity of
it possessed, not on the quantity possessed of the others. Related goods,
on the other hand, are any group of goods whose marginal utility depends,
in someway, not only on the quantities of the good itself possessed, but
also on the quantities possessed of the other goods in the group.
The relationship between related goods can be one of two kinds.
Related goods can be either complementary to one another or substitutes
for one another.
Goods that are complementary to one another are those the consumer
in someway considers as cooperating together in the satisfaction of a
particular want. Automobiles and gasoline, for example, are comple-
mentary goods. Pens, paper, and ink are complementary goods. Usually
complementary goods may combine in different proportions to satisfy the
particular want they are complementary to. Where they are useful only
when combined in some fixed proportion, it is useful to consider them
as constituting parts of one good. It is hardly more worthwhile to
consider separately the items making up a pair of shoes than it would be
to consider the utility of water as made up of the utility of hydrogen and
oxygen. (Of course, where goods are complementary with respect to
one use, but are independently useful elsewhere, it is convenient to keep
them distinct.) Complementary goods are distinguished in that for each
such good, its marginal utility to the consumer rises, other things being
equal, as the quantities possessed of the goods complementary to it in-
creases. The more paper that the owner of a pen acquires, the more
significant a bottle of ink may appear to him.
Goods that are substitutes for one another are those the consumer
considers capable, to some degree, of satisfying the same particular want.
Potatoes and bread, for example, are to a degree capable of satisfying the
same wants that are satisfied by the other. Airline transportation and
railroad transportation are substitutes, to a degree, each for one another. It
is to be noted that when two physically dissimilar commodities are perfect
substitutes for one another”where, that is, there is no purpose served by
a given quantity of the one that cannot be served equally well by a given
quantity of the other”then, from an economic point of view, they are not
"different" goods at all. If, for example, there were no purpose for which
a blue pencil is used that is not perfectly served by a red pencil, and vice
versa, then it would not be expedient to distinguish economically between
red and blue pencils at all; they would be used interchangeably. If two
nickels could perform all the uses required of a dime, and vice versa, then
UTILITY THEORY 53


the two coins would make up an economically homogeneous kind of good.
Within this economically homogeneous group there would be, it is true,
physical differences”some members of the group being made up of two
nickels, the other being each one dime. But this would be as irrelevant
as, say, the different registration numbers on two identical automobiles
where the difference in number is the only physical means of distinction
between them.
Most substitute goods are, however, only imperfect substitutes for one
another. A characteristic of goods that a consumer considers as substi-
tutes for one another is that the marginal utility to him of any such good
declines, other things being the same, as the quantity possessed of the
substitute goods increases. The more rapidly the marginal utility declines
in this manner, the more perfect is the substitute relationship between
the goods. The special case, as we have seen, of perfect substitutes is one
where the marginal utility of the one good declines, with increased pos-
session of the other, exactly as rapidly as it would decline were the
quantities possessed of this good itself to be increased in the same pro-
portions.

MARGINAL UTILITY”SOME FURTHER REMARKS
It is worthwhile at this point to emphasize a number of points con-
cerning the marginal utility concept as we have used it thus far. These
points will serve to clarify the content of our utility analysis and, at the
same time, point to the way our analysis is related to the very earliest at-
tempts to use the tool of marginal utility.
The Paradox of Value Modern utility theory emerged in the 1870's
at the hands of Jevons, Menger, and Walras. One of the earliest uses of
the theory was to sweep away a misunderstanding that had prevented the
earlier classical economists from using the utility concept to explain prices.
The earlier writers found themselves unable to explain the prices of
goods by reference to the use-value or utility of these goods. To be sure,
the prices of many goods seem to reflect their relative degrees of usefulness
to men; the classical economists would have welcomed such a theory. But
they were troubled by the many goods whose prices seemed to defy any
such explanation. Diamonds, for example, are clearly much less impor-
tant for human life than water, yet the price of water is quite negligible
compared with that of diamonds. This paradox had forced the classical
economists to seek an entirely different method of explaining prices.
Marginal utility theory is able to dispose of the problem quite simply.
The basis for the paradox was the premise that water is more significant
for man than are diamonds. This premise is no doubt correct, but not in
a way that can support the classical conclusions. Water, in the abstract,
54 MARKET THEORY AND THE PRICE SYSTEM


is no doubt more important than diamonds in the abstract. But for human
action the greater importance of water over diamonds must be demon-
strated through choice among alternatives. For an analysis of human
action no other meaning can be attached to the term "more important."
From this point of view the greater importance of water must mean that
we assume if a man has to choose between water and diamonds, he will
choose water. But for the statement of alternatives a man must choose
among, it is clearly insufficient to specify only that these are water and
diamonds. One must specify the terms and conditions on which he is
to choose. And here the irrelevance of the "greater importance of water
over diamonds" for understanding their relative prices becomes immediately
clear.
Water is more important than diamonds only where a man must choose
between renouncing all water or renouncing all diamonds. Faced with
such a choice it is indeed likely that a man will place diamonds distinctly
in second place. But this kind of choice is one that the market does not
confront the consumer with and therefore cannot have bearing on the
determination of market prices. In the market a man buying or refrain-
ing from buying water is choosing not merely whether to have water or
not to have water, but whether to have some additional quantity of water
or not; and similarly, of course, for diamonds. Thus, the law of diminish-
ing marginal utility provides the key.
The marginal utility of water cannot be said to be either higher or
lower than that of diamonds until there are first specified (a) the size of the
marginal unit and (b) the margin at which marginal quantities of water
and diamonds are being compared. The marginal utility of water is
indeed lower than that of diamonds”when a small quantity of water is
compared with a similar weight of diamonds and when the loss of this
small quantity of water would still leave the consumer with ample water.
These are, in fact, the conditions under which consumers choose whether
to buy water or diamonds. The quantity of water usually available is
ample; thus, the margin at which an additional quantity of water is
valued is such as to make its marginal utility low, according to the law
of diminishing marginal utility. On the other hand, diamonds are usu-
ally possessed in sufficiently small amounts to ensure that the typically
sized marginal unit still possesses high marginal utility.
If conditions were otherwise, prices would indeed reflect the altered
conditions. If, for example, a thirsty owner of diamonds were to bargain
in a desert with the owner of a quantity of water, we would indeed expect
to find the price of water far from negligible. Clearly, in these circum-
stances, the marginal utility of water must be immensely higher than under
normal conditions. Here, indeed, water would show itself as "more
important for man than diamonds."
UTILITY THEORY 55


The Subjective Character of Utility The concept o£ utility as we have
developed it thus far in this chapter, and as we shall use it to analyze the
demand side of the market, is essentially a subjective concept. We must
not consider utility as in anyway intrinsic to an object or service. A good
is not to be thought of as bearing a tag inscribed with some degree of
utility. We do not require any philosophical sophistication to distinguish
sharply between the utility relevant to the analysis of human actions and
such qualities as the mass, extension, and even color or beauty of an object.
For the analysis of demand this distinction is of the greatest importance.
For the economist, what is relevant is merely that a consumer prefers
some specific quantity of a good or service to some specific quantity of
the same or another good or service. One alternative is considered to
satisfy a want that is more urgent than that which could be satisfied by
the rejected alternative. The relatively greater want-satisfying power of
the first good or service is called its greater utility. Of course, "want-satis-
fying power" springs from some quality, real or imagined, associated with
the use or enjoyment of the good or service. The utility of coal springs
from its heating powers, that of a painting from its artistic merits; the
utility of a shoeshine is associated with an appropriate glossiness, the utility
of a textbook with the knowledge it confers. But all these are the specific
qualities that characterize goods or services on the basis of which one good
is preferred over another. Acting man considers these "objective" qualities
of the goods among which he chooses; he weighs, with more or less expert
knowledge, the relative objective merits of the goods and then arranges
them on one scale”the scale of preference.
Man cannot "objectively" compare the glossiness of a newly shined
pair of shoes with the thermal capacity of a quantity of fuel, but he must
sometimes choose between them. When he chooses he is arranging them
in order of "importance." There is a homogeneous common denominator
that makes it possible to compare them: that of their relative positions on
the utility scale. The one is more urgent, significant, and important than
the other. The economist, concerned exclusively with the logic of choice,
needs only to be indirectly conscious of the "objective" qualities of goods.
It is not the intensity of these qualities, but the degree of subjectively
felt significance with which the law of diminishing marginal utility is con-
cerned, and from which demand analysis takes its start.
Several corollaries follow immediately from the establishment of the
subjective character of utility. Most important is the implication that
the utilities of the same good for two different people cannot be compared.
This, it is noted, is saying considerably more than that it is possible for
the same good to have different utilities to two different people. It is even
saying more than that there is no conceivable way of discovering for which
of two people a given good has more utility. The impossibility of inter-
56 MARKET THEORY AND THE PRICE SYSTEM


personal utility comparisons implies that no meaning at all can be at-
tached to a statement comparing the utilities of the same (or different) goods
to two people.
Utility refers to relative position on a value scale. A good of greater
utility is higher on the scale and thereby preferred over a good of lower
utility. There is no single value scale on which a specific "good-for-/4"
can take up a position relative to a "good-for-ZT'; there is no conceivable
act of "choice" that should "prefer" a good for A rather than for B.
The impossibility of comparing the utility of a good for two people
does not affect, of course, the fact that each of us frequently engages in
comparisons concerning the relative "usefulness" of a good to different
people. We say that a hungry man "needs" food more than one who has
just dined. We try to give charity "where it will do most good"; we
distribute gifts among our friends or children where we think they will
be the most useful or pleasurable. All this is quite in order, but it does
not involve any comparisons of that utility demand analysis depends upon.
An outsider C is entitled to his opinion, however irrational, as to how a
quantity of a good "ought" to be shared out between two other people, A
and B. Frequently he does so by placing himself mentally in the positions
of both these people simultaneously. But it is always his choice, always
his assessment of relative "urgency," which operates in such decisions.
Another, and a related, implication of the subjective character of
utility is that utility must be clearly distinguished from both ethical values
and psychological pleasure-pain sensations. As far as ethics is concerned,
the matter is straightforward. In studying demand, we are interested in
the patterns of action that follow from given tastes, no matter what these
tastes may be. Utility refers to the importance attached by man to pos-
session of goods. What degrees of importance a man attaches to different
goods is indeed a matter determined in part by his ethical values. But
just as the economist analyzes the demand for coal not by reference to its
technological thermal capacity but to the subjective significance that men
attach to coal (of course chiefly on technical, objective grounds), quite
similarly the economist analyzes the demand for goods (flowers or bullets,
knowledge, or liquor) by starting out in a quite "positive" way, and with-
out the need for any moral evaluation, from men's demonstrated preferences.
The distinction between the utility used in demand theory and
pleasure-pain sensations should be equally clear cut. The distinction must
be especially stressed because many of the earliest expositions of utility
analysis did fail, in fact, to recognize such a distinction or were phrased
as if they failed to do so. This failure was both unfortunate and un-
necessary. The utility of a loaf of bread, insofar as demand theory is
concerned, is not to be identified either with the hunger pangs suffered
for lack of the bread or with the sensation of satiety experienced upon its
UTILITY THEORY 57


consumption. These sensations may be "real" and important enough,
but like ethical values, underlie the preferences that men reveal in their
actions. A man's value scale and the utility to him of given commodities
are doubtless dependent on the intensity of these sensations. But the
economist must be satisfied to commence from the colorless fact of prefer-
ence.
Utility as a Relative Concept We conceive of utility as a purely relative
notion. In saying that a good has utility to a man, we mean that it pos-
sesses importance, or significance, to him because of its power to remove
uneasiness. As we have seen, "importance" and "significance" take on
meaning only in the context of a comparison with other goods. Utility
reveals itself only in acts of choice when two or more goods are being
compared. Thus, it is quite meaningless to conceive of the utility of a
loaf of bread, as it were, in a vacuum. All we can say is that a loaf of bread
may have either more or less utility than a glass of beer, a news magazine, or
twenty cents.
If utility could be identified with some "objective" property of a good,
say its mass, calorific value, or even moral worth, then the concept would not
depend on the relationship between one good and another. But the utility
of demand analysis refers to none of these objective qualities and does, there-
fore, by its very definition, imply a comparison with other goods or services.
Utility refers to position on a scale of values. Without other goods or serv-
ices, there is no scale of values and hence no utility concept at all.
The relative character of utility means that men's preferences can be
the subject of interpersonal comparisons. There is, as we have seen, no
value scale upon which the relative positions of a loaf-of-bread-for-v4 and
a loaf-of-bread-for-jß can be observed. But it may be possible for an
observer to discover whether a loaf of bread bears the same relationship
to twenty cents on A's scale of values as it does on B's; and it may be
possible to assert that a loaf of bread has greater utility to A than twenty
cents, but that for B the situation is reversed. In fact, this kind of as-
sertion is, as we shall discover, the foundation of market theory.
The Ordinal Character of Utility Two conflicting approaches to utility
theory are met in the literature. The older (but by no means extinct)
approach was to treat the utility of a good for an individual as a magnitude
to which, in principle, a cardinal number could be assigned. An apple
has, let us say, 10 units of utility; a shirt, 50 units; and so on. Such an
approach involves the postulation of a numerical scale of utility against
which the utilities of goods might”again only in principle”be measured
with precision.- The theoretical concept of numerical quantities ol
2 As can be imagined, cardinal utility theorists encountered serious difficulties in at-
tempts to devise methods of measuring this utility. The earliest notions of cardinal
58 MARKET THEORY AND THE PRICE SYSTEM


utility involves, again, the notion that a larger "quantity of utility" (one,
that is, comprising a larger number o£ "units" of utility) is built up
through the addition of smaller quantities of utility or of units of utility.
A good with utility of 10 possesses 10 times the utility of a good with unit
utility; and so on. The cardinal utility approach would consider a man
enlarging his stock of a good as, at the same time, increasing his store of
utility afforded by possession of the good. The total store of utility af-
forded by the entire stock would be the sum of the successive increments
of utility obtained as the stock successively expanded from the acquisition
of the first unit up to the addition of the last acquired unit. The rate at
which the addition of successive physical units of the good increases the
total utility of a stock of the good is termed (in the cardinal terminology) the
"marginal utility" of the good.3
The ideas, however, underlying the cardinal approach present con-
siderable conceptual difficulty. Without attempting to enlarge on this
difficulty, we can contrast this approach with the currently more accepted
ordinal approach. This view denies the very notion of cardinal quantities
of utility. The only numbers that can be assigned to utilities are ordinal
numbers. Utilities can be arranged in order; for example, first, second,
and so on. They cannot however be assigned numerical magnitude. A
shirt may be said to have greater utility than an apple; one may not
say how many times the utility of the shirt is greater. A "unit" of utility
has no meaning for the ordinal approach. When men value goods, they
arrange them in order of value; they do not attach cardinal numbers to
them.
The discussion we have presented in this chapter follows the ordinal
approach to utility. For us, the utility of a good corresponds to a ranking
on the scale of values; to speak of the utility of a good is to involve only
the comparison of its significance with that of some other good. An im-
portant consequence of our adopting this ordinal viewpoint is that the
term "marginal utility" is used in this book in a somewhat different sense
from its use in a "cardinal" approach. This matter of terminology needs
a brief explanation.

utility arose out of the vain attempts to build an economic theory of consumer choice
based on the psychological content of the feelings of satisfaction (associated with differ-
ent acts of consumption) that account for a man's preference of one good over another.
On the other hand, ordinal utility, as we have seen, is quite distinct from such psycho-
logical magnitudes.
3 The statement that a man acts so as to achieve his goals in order of their impor-
tance to him is translated directly, in cardinal-utility terminology, into the statement that
he acts so as to maximize his total utility. In this context marginal utility is employed
most conveniently as a mathematical tool simplifying the analytical task of finding the
maximum position.
UTILITY THEORY 59


Total Utility and Marginal Utility For a cardinal utility theorist, we
have seen, the term "marginal utility" is used in contradistinction to "total
utility." Total utility refers to the quantity of (cardinal) utility afforded
by a stock of a commodity. Marginal utility refers to the rate at which
total utility changes as the size of the stock of the commodity changes. An
approximation to this rate of change of total utility is given by the amount
of change in that utility resulting from a one-unit increase in the stock of
the commodity. (Sometimes cardinal utility theorists loosely refer to this
approximation as "marginal utility.") 4
For ordinal utility theory, such a distinction between total and mar-
ginal utility is not called for. Since there is no cardinal quantity of utility
that increases, there can be no such concept as a rate of change of such a
quantity. For an ordinal theory, marginal utility means the significance
attached to the addition to (or decrease of) the quantity possessed of a good
by the marginal unit. It does not, it must be noticed, refer to a change
in the significance of the stock of the good, but to the significance of a change
in the size of the stock. But total utility, too, for the ordinal theorist
means the significance attached to the acquisition or loss of a given stock
of the commodity. Both the utility of a stock of a good and the marginal
utility of a marginal unit being added (or subtracted) from the stock "are
total utilities" (in that they do not refer to "rates of change"); but, and
more important, at the same time they are both "marginal utilities" in
the sense that the utility of any quantity of a good, large or small, implies
that this quantity is being considered "marginally"”that is, that somebody
is contemplating the acquisition or loss of this quantity.
The "marginal unit," in fact, is never anything else than the unit
that happens to be under consideration. It is the unit relevant to the
act of choice confronting a man. The size of this unit depends only on
the circumstances of the situation where a choice has become necessary. A
man may be contemplating the purchase of several shirts. For certain
sums of money, he can buy one, two, or several shirts. In choosing among
the alternatives open to him, the man will be comparing the marginal
utilities of the appropriate number of shirts”that is, the smallest number
of shirts separating one possible decision from another. If any number
of shirts can be bought, then a single shirt is the marginal unit; if shirts
can be bought only in packages of three, then three shirts make up the
marginal unit”and the decision whether or not to buy additional shirts
will involve the difference that three more shirts will make to the pur-
chaser's sense of well-being. Suppose a situation where a man is forced to
choose between purchasing all of a supply of shirts or of obtaining none at
all; then the entire supply would be the relevant "unit." The man must
4 The total utility of a stock of a commodity is thus the sum of the marginal utilities
of the units making up the stock, taken successively.
60 MARKET THEORY AND THE PRICE SYSTEM


assess the difference that the entire supply would mean to him in con-
sidering the attractiveness of the price it can be had at. In such a situation
the marginal unit is the entire supply, and the man is in a position where
the "marginal utility of shirts" means nothing else than the significance
to him of this entire shirt supply.

MARGINAL UTILITY AND THE CONDITIONS FOR EXCHANGE
The utility analysis discussed in this chapter provides a framework
within which to understand the emergence of exchange between individuals.
Interpersonal exchange is the essence of the market process, and market
theory is devoted to the explanation of the way objects will be produced
for exchange, the quantities that will be offered for exchange, and the rates
at which different exchanges will take place. Here we analyze the basic
conditions that exist when two individuals exchange goods. This analysis
will be fundamental to much of the subsequent material in this book.
The conditions for exchange exist between two individuals A, B, when-
ever a specific quantity of a good possessed by A is ranked lower on his
value scale than a specific quantity of a good possessed by B, while the
ordering is the reverse on B's value scale. That is, wherever the marginal
utility of a quantity of one good possessed by A is lower for A than that of
a quantity of another good possessed by B, while for B the marginal utility
of the latter quantity is the lower, then each of the two gain by giving up
what is less important to him in exchange for what is more important.
If these conditions are absent, no exchange can take place. It is not
sufficient that A ranks B's brand new automobile higher than his own
ancient jalopy; if B concurs in A's relative valuation, both vehicles will
remain where they are. No exchange will take place freely unless each
party believes that he will be better off having made the exchange. This
fundamental and self-evident truth is the central theme of the market
process and of its theory.
The implications of these conclusions are far reaching. Where two
men each possess both of two goods, then, as we have seen, any difference
in the rankings that specific quantities of the two goods occupy on the
value scales of the two men will result in exchange if the two men are "in
the same market" (that is, if they are each in contact with the other and
aware of the other's relative ranking). This is so because it will benefit
each man to give some of the good he values less for some of the good he
values more. A state of rest, where both men, although in the same market,
do not barter, can exist therefore only when both men rank both goods in
the same order on their individual scales of value. But if this is so for two
goods, it is so for any two goods. Thus, for two men to be in a state of
rest with respect to each other, each must rank the marginal quantities of
UTILITY THEORY 61


all the goods, which both possess, in exactly the same order as does the
other.
Moreover, if this is the condition for absence of exchange between two
men, it must be so also for any two men. Thus, for a market to be at
rest, each participant in a market must rank each one of the goods he
possesses in exactly the same order of significance, at the margin, as does
every other participant in the market.
To put the same proposition in a different and more useful form, in
any market a tendency will exist for each participant to barter in the
market place so long as the relative marginal utilities to him of all the goods
he possesses is in anyway different from those of any other participant with
respect to those that he possesses. As each participant exchanges, the
marginal utility of given quantities of the goods that he sacrifices rises (in
accordance with the law of diminishing utility), while that of given quanti-
ties of the goods that he acquires correspondingly falls. The process of ex-
change thus raises those marginal utilities that had been relatively low (that
is, of the goods that the owners for this reason wished to sell) and lowers
those marginal utilities that had been relatively higher (that is, of the goods
that the owner for this reason wished to buy). Hence, as the exchange
process continues, the value scale of each member of the market tends
toward consistency with that of every other member, with respect to the
goods possessed by each member.
As men's tastes change, as for various reasons the quantities and kinds
of the commodities and services each man possesses changes, the relative
marginal utilities of the goods he possesses alter for each participant in the
market and thus, again and again, diverge from the rankings of other
participants. There is thus constant recurrence of opportunities for each
participant to exchange profitably.
The rates exchanges will take place at, of course, are closely bound up
with the degree of divergence between the value scales of different partici-
pants. These are matters that will concern us in later chapters. Our dis-
cussion has been carried on in barter terms consistent with our assumption
that exchange is carried on with the assistance of a medium of exchange
that only facilitates, and in no way distorts, the expression by men of their
relative valuations of real goods and services.

SUMMARY
Acting men, in choosing between available alternatives, arrange them
in order of preference. The scale of values made up in this way indicates
the relative marginal utilities of different specific quantities of different
goods and services. Men act so as to replace a good of lower marginal
utility by one of higher marginal utility.
62 MARKET THEORY AND THE PRICE SYSTEM


The marginal utility of successively available additional units to a
stock of a commodity steadily diminishes, other things being equal. This
is the law of diminishing marginal utility.
Goods are either related or unrelated. Related goods may be either
complementary to one another or substitutes (rivals) for one another. Com-
plements are goods whose marginal utility rises, other things being the same,
as the quantity possessed of the others increases. Substitutes are goods
whose marginal utility falls, other things being the same, as the quantity of
the others increases. Unrelated goods are those whose marginal utilities
are unaffected by the quantities possessed of the other.
The marginal utility view is able to resolve the classical paradox con-
cerning the relative values of diamonds and water. The utility concept
is subjective and relative in character. The utility of a good refers to
nothing inherent in the good itself and is meaningless unless it refers to a
comparison with the utility of something else. Utility is an ordinal con-
cept. No cardinal "units" of utility are implied in utility theory. "Mar-
ginal utility" is therefore to be interpreted not as the "rate of change of
total utility," but as the (total) utility afforded by an increment of a good
or service.
The utility theory provides the framework to understand exchange
between market participants. Exchange will take place wherever the value
scale rankings of two goods possessed by one man are different for him than
the corresponding ranking for another man. In a market there is therefore
a constant tendency for participants to exchange so that the value scale of
each represents rankings identical with that of every other participant, for
goods possessed by each of them.

Suggested Readings
Wicksteed, P. H., The Common Sense of Political Economy, Routledge and Kegan
Paul Ltd., London, 1933, pp. 1-125.
Mises, L. v., Human Action, Yale University Press, New Haven, Connecticut, 1949,
p. 119-127.
Rothbard, M., "Toward a Reconstruction of Utility and Welfare Economics" in
On Freedom and Free Enterprise, D. Van Nostrand Co., Inc., Princeton, New
Jersey, 1956, pp. 232-243.
Consumer Income Allocation



VVE HAVE developed
thus far the tool of
marginal utility. We must now put this tool to use in analyzing the
pattern of consumer behavior in spending his income in the market
place on the goods and services he desires. Such an analysis (a) will
enable us to understand the forces of demand as they are felt in the
market, and (b) will help explain the ways demand may be expected
to adjust to changes in relevant market facts. The analysis will thus
give us perhaps the most important link in the chain of causation
through which the market mechanism works.

MARGINAL UTILITY AND THE ALLOCATION OF INCOME
The consumer decides at any given time on what goods to buy,
and in what quantities to buy them, on the basis of three sets of
factors. First, the consumer consults his own scale of values, built
upon his personal tastes, and the requirements of his own particular situa-
tion. Second, the consumer at any given time finds himself with a limited
amount of money with which to buy (or, considering purchases over time,
finds himself with limited money income per unit of time).1 Third, the
1
A consumer finds himself with given money income only after he has made his de-
cisions concerning the quantity of his labor services, for example, that he will offer to
the market at going wage rates. Taking a broader perspective, it should be clear that
the terms on which a resource owner will make offers to sell resource services to the
market depend on the direct satisfaction that he might himself derive, as consumer, by
not selling them (for example, the utility to him of leisure), as compared with the con-
sumer satisfaction that he can secure from their proceeds in the market. The analysis
of consumer decisions can be extended to take explicit notice of all this. In such an
analysis money income would not be one of the ultimate determinants of consumption
expenditures; its place would be taken by the "income" the consumer is endowed with
in his capacity of resource owner; that is, the flow of resource services he is naturally
endowed with and free to sell in the market if he wishes. See p. 226.
63
64 MARKET THEORY AND THE PRICE SYSTEM


consumer faces a market where each good he is interested in is obtainable
only at a definite price. The consumer finds, that is, that the expenditure
of all his income on a particular good will provide him with a definite and
limited quantity of the good; but, more important, that the expenditure of
this amount might also provide a large number of alternative combinations
of purchases, the contents of each combination being, with given expendi-
ture, rigidly determined by the prices of the goods entering into the com-
bination, and the proportion of expenditure allocated to each of the goods
in the combination.
The essence of the problem facing the consumer thus consists in choos-
ing one out of an immense number of alternative assortments of goods. A
man may spend all his income per unit of time on good A, or all of it on
good B, or good C, and so on. But he may spend all his income on some
combination of the goods A, B, C. He must decide on which goods to
include in his combination of purchases.2 Confining our attention to the
man's consumption expenditures, it is clear that with his own given value
scale of the moment, he will act to secure, so far as is possible, as many of the
goods and services he desires in their order of importance to him. In
other words, he will act to make sure that no one item of the available
goods, which he does not buy, is of greater significance to him (that is, is of
higher utility) than any item, obtainable for the same expenditure, which
he does buy. Let us ponder the implications of this proposition.
Our consumer, with, let us say, $100 to spend on consumption, may
if he desires spend everything on shirts at, say, $4 per shirt. But if he
spends $4 on a shirt, this is because he can find no article, available for $4,
of greater utility. If he can buy a steak dinner for $4, and a steak dinner
has greater utility than a shirt, he will buy the dinner, not the shirt. If
he spends all his $100 on shirts, this can only mean that having even a
twenty-fifth new shirt is more important than a single meal. Now several
new shirts may have greater utility than eating, but the law of diminish-
ing utility tells us that, relative to a first steak dinner, each additional shirt
will have lower and lower utility. At some point, it is likely, the consumer
will feel that another shirt has less utility than a first dinner, and expendi-
ture will have somehow to be divided between dinners and shirts.
In fact, consumers usually buy a host of different kinds of goods: shirts,
meals, haircuts, TV sets, college tuition, theatre tickets, and cigarettes. The
important point to observe is that the movement from selecting one possible
combination of goods to the selection of a differently proportioned combina-

2 He must further decide, of course, what portion of his income to allocate to saving.
Although the analysis of this chapter can be applied to deal explicitly with this question,
our discussion will apply most simply to the situation where the consumer does not wish

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