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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search has been replaced by a simple search for price discrepancies.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

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