Principles of Economics 2
This lecture establishes subjective value and marginal analysis as the foundational concepts distinguishing Austrian economics from other schools. Saifedean argues these principles, introduced by Carl Menger in 1871, transformed economics entirely and remain essential for understanding all economic phenomena.
Core Definitions from Menger
Good: Something useful that can be directed to satisfy human needs. For something to become an economic good, four conditions must be met: a human need exists, the good's properties can satisfy that need, humans understand this causal connection, and they can command the good to direct it toward need satisfaction.
Utility: The capacity of a good to satisfy human needs. Only goods offering utility can be valued.
Economic vs. Non-Economic Goods: An economic good has demand exceeding supply; a non-economic good has supply exceeding demand. Air is a non-economic good because it is plentiful everywhere—no market exists for it. Water in a flowing river is non-economic; bottled water in a desert is economic.
Scarcity and Economizing
Scarcity—where demand exceeds supply—is the permanent condition forcing humans to economize: maximizing goods that satisfy needs, conserving useful functions, prioritizing pressing needs, and obtaining greatest satisfaction from limited quantities.
Saifedean emphasizes scarcity is inescapable because it is a mental construct: "It is a lot easier to want something than to produce it." Desires are limitless and costless; fulfilling them is neither. Even if Ferraris became plentiful, people would want supersonic jets, then rocket ships.
Subjective Value: The Central Thesis
Value is not inherent in goods. It is a judgment economizing individuals make about importance for their lives and well-being. As Menger stated: "Value does not exist outside the consciousness of men."
The Oil Example (Most Striking Illustration)
| Period | Value of Oil | Cause |
|---|---|---|
| Pre-1800s | Negative (trash) | No known use; landowners paid to remove it |
| Post-engine invention | Highly positive | Could provide locomotion, warmth, energy |
| April 2020 | Briefly negative | Lockdowns destroyed demand; storage capacity became scarce; contractually obligated buyers paid others to take oil |
The chemical properties of oil never changed—only human understanding of its relationship to needs changed.
Ordinal vs. Cardinal Value
Austrians reject cardinal valuation (assigning precise numbers like "3.5 utils") because value lacks objectively defined units. You cannot bottle a "util."
Instead, value is ordinal: arranged in preference rankings (A > B > C). As Ludwig von Mises stated: "A judgment of value does not measure; it arranges in a scale of degrees, it grades."
Value Is Not Price
Price indicates only an upper and lower bound of valuation at exchange moment—not the value itself. If you pay $10 for shoes, you value the shoes more than $10; the seller values $10 more than the shoes. Both parties benefit—impossible under objective value theories.
Critique of Alternative Theories
| Theory | Critique |
|---|---|
| Mathematical economics ("utils") | Fabricated metric with no physical reality; enables equations and exam questions, not understanding |
| Marxist labor theory of value | Mud pie problem: three hours baking mud ≠ three hours baking apple pie in value. Labor creates goods, not value. Marxists then claim price-labor gaps justify confiscating capital, destroying value for workers and capitalists alike |
Marginalism: The Decisive Insight
Menger's breakthrough: identical goods have different values depending on which needs they satisfy. The first unit meets your most pressing need; subsequent units meet progressively less pressing needs.
Law of Diminishing Marginal Utility
After a week without food:
- 1st meal: life-or-death value (extremely high)
- 2nd meal: extremely valuable, but slightly less than 1st
- 21st meal in a week: marginal utility near zero
Total utility rises with consumption; marginal utility falls.
The Counterintuitive Conclusion: Valuation by Least Valuable Use
You value goods according to their least important marginal use, not their total importance.
This explains the Water-Diamond Paradox:
| Good | Total Importance | Marginal Use | Price |
|---|---|---|---|
| Water | Essential for survival | Washing car, watering lawn (plentiful) | Cheap |
| Diamonds | Decorative/luxury | Wedding ring (scarce) | Expensive |
Iron is more essential to infrastructure than gold, yet gold costs more—because the marginal unit of iron is an unnoticed building component, while the marginal unit of gold is fine jewelry.
If stranded on a waterless island, water's marginal use shifts to survival, and it becomes vastly more expensive than diamonds.
Significant and Surprising Points
- Oil had negative value twice in history—as literal trash before engines, and briefly again during 2020 lockdowns when storage scarcity made it costly to hold.
- Scarcity is permanent because desire is easier than production—not a temporary condition solvable by working harder.
- You never choose between "all water" and "all diamonds"—only between the next marginal unit of each. This seems obvious once stated but resolves centuries-old economic puzzles.
- Water is cheap despite being essential—because we value it at the margin for trivial uses, not survival.
- Both parties benefit in every voluntary trade—impossible if value were objective. This makes Austrian economics "coherent" where others tie themselves in "mental knots."
- Value exists only in human consciousness—not in physical or chemical properties. The same oil molecule went from negative to positive value without changing.
- Marxist theory justifies confiscation based on a mud pie error—confusing labor input with value creation leads to destructive policies harming workers and capitalists.