According to this type of ‘classical’ economics, prices rise when demand increases and supply remains steady, or when demand holds steady and supply decreases. Prices drop when supply increases against a steady demand, or when demand decreases against a constant supply.
These familiar axioms are intuitive, and they correspond to actual experience and data. This classical understanding is now the core of economic thought.
But there are some questions for which classical economic reasoning has no good answers.
One question is about the concept of value: food, which is necessary for life, and which everyone desires, often costs little; sapphires and pearls, which serve no practical purpose and meet no need, often cost much. Why?
The demand for food is large, universal, and steady; the demand for jewels is small, limited to a segment of the population, and can soften when competing demands expand. Yet the gems find a higher price than food. Why?
Classical economic understandings were correct as far as they went, but they did not go far enough to answer such questions. The science of economics would have to advance to a new level.
Carl Menger would discover the principles which allowed for new understandings of economic phenomena.
Born in 1840, Menger would do most of his work at the Universität Wien. He died in 1921.
Menger noticed that classical economic thought treated supply and demand as monolithic and irreducible forces, like magnetism or gravity. The original founders of classical economics - Smith, Hume, Ricardo - may have attempted to follow the paradigm of Newtonian physics or Cartesian philosophy, and tried to find a systematic solution based on a few axiomatic concepts.
Instead, Menger analyzed economic demand as being composed of many individual decisions. Different individuals will be purchasing the same product at the same time - but their choices are different.
Consumers may buy the same product, but for different reasons. The value which they place on the product will vary. ‘Value’ is a measure of the strength or intensity of demand - in common language, “how much” and “how bad” the customer wants the product.
Classical economics could not answer these questions: How does a person assign a value to an object? A person decides to pay a certain amount for the object, presumably because the object will fill, or help to fill, certain desires; how does a person make that decision? Why does a person decide to pay some specific amount? Joseph Salerno writes:
Menger brilliantly answered the question by restating it: “Which satisfaction would not be attained if the economizing individual did not have the given unit at his disposal - that is, if he were to have command of a total amount smaller by that one unit?” In light of Menger’s discussion of economizing, the obviously correct answer to this question is “only the least of all the satisfactions assured by the whole available quantity.” In other words, regardless of which particular physical unit of his supply was subtracted, the actor would economize by choosing to reallocate the remaining units so as to continue to satisfy his most important wants and to forego the satisfaction of only the least important want of those previously satisfied by the larger supply. It is, thus, always the least important satisfaction that is dependent on a unit of the actor's supply of a good and, that, therefore, determines the value of each and every unit of the supply. This value-determining satisfaction soon came to be known as the “marginal utility.”
Menger’s discovery was this: goods have values because they serve various purposes, and the importance of these various purposes differ. This is step toward answering the question about why gems are more expensive than food.
Menger argued that it is not the case that the value of goods derives from the value of the labor used to produce them. On the contrary: the value of labor derives from the value of the goods it produces.
Against the idea that financial transactions are always an exchange of equal values - like an algebra equation or a chemical equation - , Menger pointed out that people will give up what they value less in order to gain what they value more. It is this asymmetry which produces wealth: both sides gain from the transaction.
One sees here again the fascination which the founders of classical economics had with the advancements in natural science made by people like Newton and Boyle.
Carl Menger launched a new area of economic investigation, which kept many of the discoveries of ‘classical economics,’ but which also created possibilities for more advanced analyses.
