Hello and welcome to lecture two of the Principles of Economics online course on saifedean.com. Today's lecture topic is value. The concept of subjective value is the fundamental premise of Austrian economics and is what sets it apart from other schools of economics. Marginal analysis, a very related concept which we are going to be discussing today as well, is the foundational concept of modern economics. Perhaps the mark that distinguishes between old economics and modern economics is the concept of marginal analysis. Once Carl Menger, the father of the Austrian school, came up with marginal analysis, economics became very different from what it was before. We are going to see why in today's lecture. This is a foundational and fundamental lecture for the rest of the course because understanding the concept of subjective value and marginal analysis is key toward understanding how we think of all economic problems and all economic concepts in this course, and in life in general. From the Austrian perspective, understanding subjective value is enormously pivotal. Everything follows from the fact that valuation is subjective, and that is what distinguishes the Austrian school from everything else.

## Basic Definitions

To begin with, we are going to look at some basic definitions that Carl Menger came up with. In 1871, over 150 years ago, Carl Menger wrote a book called *Principles of Economics*, and in this book, he laid down the foundations of the principles of economics. Since then, there have been many other economists who have written books titled *Principles of Economics*. Mine might be the latest of these, but I think Menger's old book is still excellent. It is still a very readable and relevant book, and the concepts he introduced are still very useful for understanding how economics functions even today.

We begin with some of the definitions that Menger uses. A *good* is something useful that we can direct to the satisfaction of human needs. That is the definition of a good. For something to become a good, it first requires that a human need exists. Second, that the properties of the good can cause the satisfaction of that need. Third, that humans have knowledge of this causal connection. And finally, that commanding the good would be sufficient to direct it to the satisfaction of the human need. That is what makes something an economic good.

*Utility*, on the other hand, refers to the capacity of a good to satisfy human needs. Only if something can offer utility can it be viewed as a good by human beings. Utility is when a good is able to satisfy our subjective human needs. That is what makes something a good: it gives us utility and the ability to meet our needs.

What we mean by an *economic good* is a good for which the demand is greater than the quantity supplied. A *non-economic good* is a good for which the demand is less than the quantity supplied. This is a very important distinction. Anything that helps us meet our needs is a good. However, in order for it to be an economic good, the demand for it has to be larger than the supply of it. For a non-economic good, the demand is less than the quantity supplied. Air, for instance, is a non-economic good because it is plentiful everywhere; therefore, there is no market for air. You do not have to buy it. If you lived on a river with plenty of clean water gushing through all the time, water would not be an economic good. You would just be able to get all the water you need from the river. All of these are examples of things that are goods but are non-economic. For the vast majority of things, if they provide us value, they become scarce. The demand for them is larger than the quantity supplied, making them economic goods.

## Scarcity and Economizing

Scarcity is the condition in which the demand for a good is greater than the supply. Scarcity is what forces us to economize. It is what forces us to make choices between alternatives. This is where economics comes from; this is what economics is. Remember, in chapter one we said economics is the study of human action under scarcity. The reason we have to economize is that things are scarce; there is more demand for things than there are things out there. To economize is to try to maximize the quantity of goods that satisfy our needs, to conserve the useful functions of these goods, to prioritize the most pressing needs over less pressing ones, and to obtain the greatest satisfaction from a good's quantity. That is what we refer to by economizing. This is what economics is about, and this is what Menger said over 150 years ago.

The act of economizing comes about because of scarcity. If there was no scarcity, if everything was plentiful, then we would not need to economize. We would not need to worry about the quantity of goods. We would be in a Garden of Eden of sorts where we could just get everything we want in unlimited quantities whenever we wanted it. Unfortunately, we do not live in a bountiful Garden of Eden. We live in a world of scarcity. So, we have to try to maximize the quantity of goods, conserve their functions, prioritize our most pressing needs, and get the most satisfaction possible.

Economics focuses on analyzing how humans attempt to find solutions to the problem of disparity between what they have and what they want, and the consequences of their choices. Scarcity is a permanent condition because it is a lot easier to want something than to produce it. A lot of people think, "If we just work hard for a couple of weeks, can't we just make enough stuff so that scarcity ends?" We are never going to get rid of scarcity because scarcity is a mental construct. Everything is subjective. Because it is a lot easier to want and desire something than it is to make it, our wants outstrip our production.

It is very easy to want a Ferrari. Millions, probably billions, of people around the world want a Ferrari. It is costless to want one. You just see a Ferrari and you think, "I'd like to have that." But it is very difficult and expensive to make a Ferrari. You need very smart engineers to spend a lot of time figuring out how to build it and make it operate safely. You need to source materials from all over the world, build an expensive engine, and assemble complex parts. So, we are always going to have a scarcity of Ferraris. Even if we managed to live in a world with plentiful Ferraris, everybody would suddenly want a supersonic jet, and then a rocket ship. Our desires are limitless and costless; fulfilling them is not. Therefore, we are constantly making choices between different courses of action.

## Subjective Value

To make these choices, we need to juxtapose the utility of different courses of action. The act of comparing the utility of different courses of action is the act of valuation. This is why value is a construct of our mind. We give things value because we look at the different utility they offer us and juxtapose them against each other. Value is our subjective assessment of the satisfaction we derive, or expect to derive, from a good.

It is important to understand that value is a result of our economizing. We attribute value to things as we seek to economize between them. Value is thus nothing inherent in goods. It is not an independent physical or chemical property. It is a judgment economizing men make about the importance of the goods at their disposal for the maintenance of their lives and well-being. Things only attain value when humans assess them. As Menger puts it, value does not exist outside the consciousness of men.

My favorite example for communicating this is the value of oil. Before the 1800s, oil was quite literally the scum of the earth. If:

 you owned a piece of land that had oil on it, you had to pay to get the oil removed so you could use the land for building a house or growing crops. Oil had a negative value. It was basically trash. It satisfied none of our needs and actively got in the way of satisfying them.

Then engines were invented, and we realized we could take that ugly material, put it in an engine, and have that engine move things around or warm up our house. Suddenly, this material became extremely valuable because it could offer us locomotion, warmth, energy, and power. The same chemical went from having a negative value to a positive value. Nothing changed in the inherent properties of the oil itself. It went from negative to positive value solely because human beings went from thinking of it as useless to understanding that it could satisfy a lot of our needs.

Another great example is that in the year 2020, oil again briefly returned to having a negative value. Because of the lockdowns, there was an enormous decline in the demand for oil. Oil is generally something people consume, not something they have a large capacity for storing. When demand for oil declined enormously, there was an immense increase in the demand for oil storage capacity. People contractually obliged to take delivery of oil had nowhere to store it. You cannot just get rid of it; it must be stored safely. Therefore, they were paying people to take that oil off their hands. The same chemical, with unchanged properties, went back to having a negative valuation for a few days in 2020 because storage was in such high demand. Now, of course, it is back to a positive valuation.

As Menger says, the value of goods arises from their relationship to our needs and is not inherent in the goods themselves. With changes in this relationship, value arises and disappears. Thinking of value as subjective is a very powerful tool for understanding how the world actually works.

## Ordinal vs. Cardinal Value

Within the Austrian school, we think of value as being ordinal and not cardinal. This is an important distinction between Austrian economics and mainstream economics. Ordinal refers to the concept of arranging valuation in terms of preference. You could say that you like good A more than good B, and you like good B more than good C. There is an order of preference. You can say, "I like apples more than oranges, and I like oranges more than bananas." That is an ordinal preference.

In other schools of economics, they think of valuation as being cardinal. Cardinal means you can assign precise numerical values to the valuation. For example, A would be equal to 3.5, B to 2.3, and C to 1.2. This suggests the ability to measure valuation in a precise numerical fashion. However, value cannot be expressed cardinally according to the Austrians because we have no units with which to express it.

You can measure length because you have the meter, inch, or kilometer. You can measure houses all over the world because a meter is an interpersonally objective measure. You can measure temperature with Celsius or Kelvin, and weight with kilograms or pounds. All of these are consistently defined units with very clear definitions. But how do you measure value? You cannot measure value; you can only compare it. Valuation is a psychic property that is constantly changing.

As Ludwig von Mises said:
> "There is a more and a less in the removal of uneasiness felt. But how much one satisfaction surpasses another one can only be felt; it cannot be established and determined in an objective way. A judgment of value does not measure; it arranges in a scale of degrees, it grades. It is expressive of an order of preference and sequence, but not expressive of measure and weight. Only the ordinal numbers can be applied to it, but not the cardinal numbers."

## Subjective Value vs. Alternative Theories

Some people will argue that value is price. But value is not the same as price. The price tells us an upper and lower bound of valuation at the particular moment in time when an exchange happened, but it does not measure the value itself. If I buy a shoe for $10, that does not mean I value the shoe at exactly $10. If I valued the shoe at $10, why would I waste my time exchanging $10 for it? I would view the two as identical. Clearly, if I gave up $10 in order to obtain the shoe, I must value the shoe *more* than I value the $10.

This explains why people willingly trade. We trade because it allows us to exchange things we subjectively value lower for things we subjectively value higher. Anytime two people freely choose to exchange economic goods, they both believe they will benefit. If value were objective, one party would necessarily be the loser in every exchange. The shoe seller benefits because he values the shoe at less than $10, and I benefit because I value the shoe at more than $10. This makes Austrian economics coherent; everyone else ties themselves into mental knots trying to argue that value is objective.

Mathematical economists attempt to measure value with a made-up unit called a "util." If you have studied university-level economics, you have likely come across the util. It is a fabricated metric that serves no purpose other than to create equations for mathematical economists and test questions for students. You cannot put a util in a bottle or identify it in the real world. No mathematician worth their salt would measure things without a real, physically grounded unit.

Marxist economists, on the other hand, think that value is a function of labor input. This is called the labor theory of value. It posits that the value of economic goods is dictated by how much labor goes into them. This is completely fictitious. Just because labor goes into doing something does not give it value. A classic example is the mud pie. It could take you three hours to bake a pie out of mud, and three hours to bake an apple pie. Are those two things valued the same because they took the same amount of time and labor to prepare? No. Nobody likes to eat a mud pie, so you will not be able to sell it for the price of an apple pie, regardless of the effort invested.

This is the basic error from which all Marxist confusion flows. They begin by assuming value is determined by labor. Then, if they find a good selling at a price higher than the amount of labor that went into it, they assume that the difference is being extracted and stolen by the capital owner. This is used as justification for taking capital away from productive people. Historically, this kind of criminal sophistry merely results in the destruction of value, devastating both the capitalist and the worker anywhere it has been tried.

Labor goes into the production of things that are valuable, but labor does not *create* the value. Goods are only valued to the extent that they meet our subjective human needs.

## Marginalism and Marginal Utility

This brings us nicely to marginalism. Since value is subjective, it depends on the time and place at which the valuation takes place. Menger analyzed how valuation declines for different units of the same good as the quantity of the good increases. The identical good will have different values to the same person depending on what needs it satisfies.

The first unit meets your most pressing need. The second unit meets a less pressing need, and the third unit meets an even less pressing need. As the quantity of a good increases, each marginal unit is less valuable than the previous one. We make economic decisions at the margin about the *next* unit, not in the abstract or the aggregate about all units. You are never required to choose between all the money in the world and all the water in the world. You are always required to choose between your next marginal unit of water and your next marginal unit of money.

This gives us the Law of Diminishing Marginal Utility. Imagine I locked you up for a week without food. You would be starving. If I then offered you a meal, how much would you value it? You would value it very highly, probably willing to pay everything you own for that first meal, because going from zero meals to one meal:

 is the difference between life and death.

The second meal in a week is obviously also extremely valuable, as one meal a week is barely enough to survive, but it is not quite as valuable as the first meal. The third meal is a little less valuable than the second. By the time you reach the 21st meal in a week (three meals a day), the next marginal meal might not be worth anything to you at all. You are full and not looking to eat more.

It is important to understand the difference between marginal utility and total utility here. Total utility increases with each meal you eat; you are happier and more nourished having five meals compared to four. But the *marginal* utility declines: the extra satisfaction you get from the fifth meal is smaller than the extra satisfaction you got from the fourth.

## Valuation by Least Valuable Use

This brings us to a counterintuitive conclusion that helps us understand economic decision-making perfectly: when you purchase something, you are valuing it according to the least important satisfaction it meets. At the margin, you are only making a decision about the least valuable marginal use.

You never have to pay for food in the abstract for the rest of your life. You are always paying for the next meal. This explains why extremely important things can be very cheap. Water is essential for our survival, yet it is very cheap. Unless you are on a deserted island, you never have to make a choice about your biological survival when buying water. If you live in a modern human society, water is plentiful. You are valuing water based on your low marginal value needs: washing your car, watering the lawn, or splashing around in the backyard.

Another good example is iron versus gold. Most of our modern infrastructure depends on iron, making it arguably more essential to modern life than gold. Yet gold is far more expensive. Why? Because we never have to choose between all the gold in the world and all the iron in the world. We have to choose between the least valuable *marginal* existing uses of iron and gold.

The marginal unit of iron is an extra metal bar in a building—something so plentiful that adding a few grams to a house won't make a noticeable difference in its strength or value. But because gold is so scarce, most people do not have much of it. The marginal unit of gold is an extra piece of fine jewelry, which is highly valued.

This solves the classic Water-Diamond Paradox. If you ask anyone whether water or diamonds are more important, they will say water. Yet water is cheap and diamonds are expensive. Before Menger, economists had no way of explaining this. With marginal analysis, we understand that humans live around plentiful water sources. You have water in abundance to meet your most pressing survival needs, so any newly purchased unit goes toward a low marginal utility use. Diamonds, however, are very scarce. When a small amount of diamond is acquired, it goes toward a very high subjective use case, like a wedding ring. If we reversed the situation and put you on an island with no water, water would become extremely scarce, its marginal use would shift to pure survival, and it would suddenly become vastly more expensive than diamonds.

That is all for this second lecture of the course. Thank you so much for joining me, and I hope to see you in the discussion seminars on Thursdays. Thank you very much.