A Little Known Essential Aspect of Austrian Economics: Böhm-Bawerk and Wieser on the Determination of Price by Cost of Production

Preface

by George Reisman

Unfortunately, not very many people consider themselves to be Austrian economists. Equally unfortunate is the fact that a large proportion of those who do so consider themselves are unaware of an essential aspect of what Austrian economics teaches. This is the case in regard to the vital subject of cost of production and its relationship to the prices of products. It is mistakenly assumed that Austrian economics categorically denies all possibility of cost of production being a determinant of price and that any claim of such determination is incompatible with it--that such a claim belongs exclusively to an entirely different system of thought, namely, classical economics, to which Austrian economics is allegedly irreconcilably opposed on this subject.

The truth is that Austrian economics fully recognizes cases in which product values and prices are determined in the first instance by cost of production, and that such cases are, indeed, commonplace. For example, Friedrich von Wieser, the second most important Austrian economist of the generation that followed that of Carl Menger, flatly declares ". . . on the whole, the cases where costs directly determine value predominate."¹ What is much more significant is that a painstakingly careful development of the reasons for this phenomenon was provided by no less than Eugen von Böhm-Bawerk, the most important Austrian economist of that era, and the leading theorist of marginal utility bar none. Böhm-Bawerk was also the teacher of Ludwig von Mises, who alone surpasses him in importance in the Austrian school. What follows is an extensive quotation from Capital and Interest, Böhm-Bawerk's most important work.²

Böhm-Bawerk's Demonstration That Cost of Production Often Directly Determines Price, and, in So Doing, Operates as the Transmitter of Marginal Utility*

"Up to this point in our discussion the law of the value of production goods was developed subject to the simplifying hypothesis that every group of means of production admits of utilization only to one very definite purpose. That hypothesis is in real life only very rarely in agreement with the facts. It is preeminently production goods, far more than consumption goods, which are characterized by egregious heterogeneity. The overwhelming majority of them will be capable of service in several productive fields, some are adaptable to thousands of such productive services. Examples are iron, coal, and above all, human labor. Of course, we have to take these factual circumstances into account in conducting our theoretical investigation. We must observe what modifications, if any, affect the law that the value of a group of goods occupying remote orders is governed by the value of their product.

"Let us alter the order of the presuppositions of our typical example accordingly. Someone possesses a rather large supply of means of production of second order (G₂). From each of these groups he can produce at will a consumption good of the category A, or one of category B or finally, of category C. He desires, of course, to take advance measures toward balanced provision for his various wants, and will therefore draw simultaneously on various parts of his supply of means of production to produce consumption goods of all three categories. And he will produce amounts in each in accordance with his needs. If there is genuinely balanced provision, the quantities produced will be so regulated that needs of approximately equal importance depend upon the last specimen in each category, and that thus the marginal utilities are approximately equal. In spite of that it is not impossible that there will be differences--possibly even quite considerable differences--in the marginal utilities because, as we already know, the gradation of concrete wants occurring in any one category is not always either uniform or continuous. The first stove in my room will afford me a very considerable utility, say one we might designate with an index of 200. A second stove will afford no utility at all. I shall most emphatically call a halt in providing stoves when I have a single specimen with its marginal utility of 200, even though in other areas provision for needs may see a dropping off of the average of marginal utility to as little as 120 or even 100. And so it is permissible and necessary, if our example is to be true to nature, to assume that the marginal utility of a specimen will be different in each of the categories A, B and C. Let us call it 100 for A, 120 for B and 200 for C.

"Now the question arises, "What is the value, under these circumstances, of a group of means of production, G₂?"

"We have had so much practice with selective decisions of a similar nature that we can give the answer without hesitation. The value will be equal to 100. For if one of the available groups of means of production should be lost, the owner would naturally shift the loss to the least sensitive area. He would not curtail production in category B where he would be sacrificing a marginal utility of 120, and certainly not in category C where the sacrifice would go as high as 200. He would quite simply produce one specimen fewer of category A where the reduction in well-being is only 100. Let us express it in general terms. The value of a unit of means of production is governed by the marginal utility and the value of that product which has the least marginal utility among all those products for the making of which the unit means of production could have justifiably been used.

"All the relations which we had declared to be plainly in force with regard to the value of means of production and their products under the simplifying assumption of only a single possible disposition, are therefore generally valid as between the value of means of production and value of its least valuable product.

"And what is the situation with respect to the other categories of products, B and C? That question brings us to the origin of the `law of costs.'

"If under all circumstances the marginal utility attainable by a good within its own category were determinative, then the categories B and C would have to receive a value divergent not only from that of category A, but also from the value of its costs G₂. B would then have a value of 120, C a value of 200. But here we are confronted with one of the cases where, through substitution, a possible loss in one category is transferred to another, and as a result, the marginal utility of the latter becomes determinative for the other as well. Thus, if a specimen of category C is lost, it is not necessary to forgo the marginal utility of 200 which the specimen would have delivered directly. Instead, it is possible to convert one unit of the means of production G₂ into a new specimen C, and in its place rather produce one specimen fewer in that category in which the marginal utility, and hence the loss in utility is least. And indeed that possibility becomes a reality. The category in question in our example is the category A. Because of the opportunity which production offers for substitution, a specimen C is therefore not valued in accordance with its own marginal utility of 200, but in accordance with the marginal utility of the least valuable related product, the product A; its value is therefore 100. The same applies, naturally, to the value of category B, and would apply generally to every category of good which is `productionally related' to A, and of which the direct marginal utility is also greater than that of category A.

"This leads to some important consequences. The first is that in this way the value of goods having a higher individual marginal utility occupies the same rank as the value of the `marginal product';³ and hence also the same rank as the means of production from which both emanate. The identity which exists in principle between "value" and "costs" therefore obtains in this instance as well. But it is to be carefully noted that here the coinciding is brought about in quite a different way from that which was followed in the case of costs and marginal product. In the latter instance the two coincide because the value of the means of production accommodates itself to the value of the product. The value of the product is the determinant factor, the means of production is the factor that is determined. In our present case it is the other way around, and it is the value of the product that must do the accommodating. Ultimately it accommodates only to the value of another product. But initially it accommodates also to the value of the means of production from which it emanates and which brings about its substitutional connection with the marginal product. The transmission of value proceeds, so to speak, along a broken line. First it goes from the marginal product to the means of production, fixes the value of the latter, and then ascends in the opposite direction from the means of production to the other products which it is possible to produce from them. In the end product, then, the products of higher immediate marginal utility derive their value from their means of production. Let us translate the abstract formula into terms of concrete practice. Good B or good C is, in general, a product of higher immediate marginal utility. If now we consider what good B or C is worth to us our first response is, "Just exactly as much as the means of production are worth to us from which we can at any moment replace the product." If we then inquire further and ask how much the means of production themselves are worth, we arrive at the marginal utility of the marginal product A. But on innumerable occasions we can spare ourselves this further inquiry. Time and again we already know the value of the goods that comprise the cost, without any necessity for working it out from its foundation and proceeding onward from case to case. And on all these occasions we simply determine the value of products by their costs, and in doing so we are taking advantage of an abbreviation which is as accurate as it is convenient.

"And now the whole truth about the celebrated law of costs is revealed. It is indeed quite correct to say that costs govern value. Only it is imperative to remain aware of the limits within which this `law' is valid and of the source from which it derives its virtues. In the first place it is only a particular law. It is valid only so long as the possibility is present of furnishing, through production, substitute specimens in any quantity and at any time they are desired.⁴ If there is no possibility of substitution, then in the case of each product, value must be determined by its immediate marginal utility in its own category. In that case its value no longer coincides with that of the marginal product and of the intermediate means of production. Therein lies the explanation of the empirically established principle that the law of costs is valid only for the goods that are "reproducible at will," and that it is a law of only approximate validity. For it does not bind the goods over which it holds sway to slavishly meticulous adherence to costs. On the contrary, it permits fluctuations above and below such costs, depending on whether production at the moment lags behind demand or outstrips it.

"A second and still more important consideration is that even where the law of costs is valid, those costs are not the final, but only an intermediate cause of the value of goods. In the last analysis, they do not give value to their products, but receive it from them. That is clear as crystal in the case of production goods for which there is only one productive use. Surely no one will wish to deny that it would be erroneous to assert that Tokay wine is valuable because Tokay vineyards possess value; everyone will concede that the truth is the other way around, and those vineyards have a high value because their product is highly valued. It is just as hopeless to deny that the value of a quicksilver mine depends on that of the quicksilver, the value of a wheatfield on that of wheat, the value of a brickkiln on that of brick, and not vice versa. Only because of the manysidedness of most cost goods is it possible for the situation to present the opposite appearance. As the moon reflects the light of the sun upon the earth, so do the manysided cost goods reflect the value which they receive from their marginal product on their other products."⁵

Concluding Comment

(The following two paragraphs are from George Reisman, Capitalism: A Treatise on Economics (Ottawa, Illinois: Jameson Books, 1996), p. 416. Consequently, they are to be understood as designated as: Copyright © 1996 by George Reisman. All Rights Reserved.)

What Böhm-Bawerk has shown in these passages is that when the price of goods such as [automobile] fan belts, or anything else whose own, direct marginal utility is extremely high, is determined on the basis of cost of production, precisely then is its value determined on the basis of marginal utility--the marginal utility of the means of production used to produce it, as determined in other, less important employments. The buyer of a fan belt, or whatever, does not pay a price corresponding to the value he attaches to his car, but a much lower price corresponding to the marginal utility of the materials and labor required to produce fan belts or whatever--a marginal utility that in turn is determined by the marginal utility of products other than fan belts or whatever. As Böhm-Bawerk develops the law of diminishing marginal utility, it is no more surprising that the price of vital components and parts, or any necessity, is in conformity with its cost of production rather than its own direct marginal utility than it is that the marginal utility of the water on which our physical survival depends is no greater than the utility of the marginal quantity of water we use. Determination of price by cost is merely a mechanism by means of which the value of supramarginal products is reduced to the value of marginal products. The only complication is that the marginal products in this case are physically different and lie in other lines of production. . . .

It should be clear that the notion that cost of production has no significant explanatory role in economics does not come from Böhm-Bawerk and Wieser. It comes from Jevons. It was Jevons who held that the only possible connection between cost of production and price was through the intermediary of variations in supply and that every price is actually determined by the specific demand for and supply of the individual good in question.⁶

Notes (Supplied by George Reisman)

1. Friedrich von Wieser, Natural Value (London and New York: The Macmillan Company, 1893), p. 181n. See also Wieser's Ursprung und Hauptgesetze des Wirtschaftlichen Werthes (Vienna: 1884), pp. 15051.)

2. Eugen von Böhm-Bawerk, Capital and Interest, trans. George D. Huncke and Hans F. Sennholz (South Holland, Illinois: Libertarian Press, 1959), vol. 2, pp. 173-76. The identical quotation appears in my book Capitalism: A Treatise on Economics (Ottawa, Illinois: Jameson Books, 1996), pp. 414416. The previous and remaining four notes are reproduced unchanged from that source.

3. Böhm-Bawerk uses the term "marginal product" here to refer to a distinct product of a different type, not, as is the practice in contemporary economics, to the gain or loss of a product of a given type attributable to the presence or absence of a unit of a factor of production.

4. It must be pointed out that the existence of inventories, which can be drawn down in response to an increase in demand, before additional production succeeds in increasing supplies, and which can be temporarily built up in response to a decrease in demand, before production is cut back, makes it unnecessary that production be adjusted instantaneously to changes in demand. The extent to which demand is postponable also introduces a measure of flexibility in how quickly production must be adjusted to changes in demand in order to maintain a connection between prices and costs.

5. Along the same lines as this long quotation, see also Böhm-Bawerk, Capital and Interest, vol. 3: Excursus 8, and Böhm-Bawerk's untranslated article "Wert, Kosten, und Grenznutzen," Jarhbuch für Nationalökonomie und Statistik, Dritte Folge, 3:328.

6. See W. S. Jevons, The Theory of Political Economy, 4th ed. (London: Macmillan and Co., 1924), p. 165.

Addendum: A Note to Readers (2/16/97)

The above material appears in Chapter 10 of my book Capitalism. If you found it surprising and to be worthwhile reading, then there is a good chance that you will find the material equally surprising and worthwhile if you read my section "The Conceptual Framework of the Exploitation Theory" (pp. 476-479, in Chapter 11 of my book), and the section "The Role of Saving and Productive Expenditure in Aggregate Demand" (pp. 682-685, in Chapter 15).

A Little Known Essential Aspect of Austrian Economics: Böhm-Bawerk and Wieser on the Determination of Price by Cost of Production Preface

A Little Known Essential Aspect of Austrian Economics: Böhm-Bawerk and Wieser on the Determination of Price by Cost of Production

Preface