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Macroeconomics Needs SMUT

Subjective marginal utility is missing from most analysis.

SEPTEMBER 20, 2011 by SANDY IKEDA

I would like to talk about a fundamental problem with the macroeconomic thinking of mainstream political pundits.  My last column addressed a similar issue – the importance of choosing the appropriate unit of analysis – but there I was focusing broadly on macroeconomic theory in general.  My beef here is related but narrower.  It was something that occurred to me last week as I taught my introductory microeconomics students about the meaning of value in economics.

SMUT

SMUT is the acronym I use in my classes to refer to the Subjective Marginal-Utility Theory of value.  A little crude perhaps but memorable, which is the point.  It says that the value to a person of any good or service, water for example, is the usefulness (subjective utility) of the last unit of it she obtains.

If she’s dying of thirst in the desert, the last or marginal liter of water probably (though not necessarily) has very high value to her because it is likely the first and only liter she commands and so would be useful in satisfying her most urgent want – presumably to sustain her life for another hour or so.  A second liter would also be very useful in this sense, though it would satisfy a want a little less highly ranked than the first and so less subjectively valuable to her.  And so on.

The idea here is that the value to her of water, not water in general but of the marginal unit, depends on how many units she already has command over.  Back in civilization, water would probably have much less value to her because she would have a lot of water at her fingertips (sometimes literally); so another liter of it would be useful only in satisfying a want that is very low on her scale of wants.

Note something else important here: Value is not something disembodied; it depends on the end to which a particular person puts the good or service, be it water or labor.

Modern economics is based on SMUT – price theory, capital theory, monetary theory – which arose as a result of its simultaneous and independent discovery in 1871 by the Austrian economist Carl Menger and the English economist William Stanley Jevons, and in 1874 by the French economist Leon Walras in Switzerland.

(For elaboration of SMUT, see Sheldon Richman’s “Value, Cost, Marginal Utility, and Böhm-Bawerk.”)

The Labor Theory of Value

In time, SMUT-based economics replaced the edifice of classical economics, which was based on the so-called labor theory of value.

In it’s simplest terms, the labor theory of value, or LTV, states that the value of any good or service depends on the amount of labor that goes into its production.  While it makes some intuitive sense – the more labor we put into something the more valuable the output seems to be – it encounters all sorts of problems.

For example, if the LTV is true, spending four hours digging a hole and then spending another four hours filling it back up would be worth eight labor hours of value.  It should therefore trade for, say, a wooden table that took eight hours of labor to manufacture.  But I’m guessing that it would be to very hard find anyone willing to trade the latter for the former, although as P.T. Barnum is credited with saying there’s a sucker born every minute.

Also, putting in a lot of hours in a job that doesn’t produce anything useful, such as building houses when housing demand is slack, doesn’t make those houses more valuable.  In fact, it makes houses in general less valuable.  No, we would work hard building houses only if we expected those houses when they’re finished to be subjectively valuable enough (to us or someone else) to cover the (subjective) costs of their manufacture.

Rejecting SMUT

The macroeconomics of mainstream pundits is essentially a rejection of SMUT.  Although not exactly the same, it’s still a throwback to the discredited labor theory of value.  Let me explain.

In simple terms, their theory says gross domestic product (Y) consists of three aggregate variables:  private consumption spending (C), private investment by businesses (I), and government spending (G).  This gives the widely used formula for the entire macroeconomy as

Y = C + I + G.

The problem, according to simple Keynesian macrotheory (and that seems to be the predominant version guiding public intellectuals these days), is that Y is in the doldrums because the private sector, C + I, just isn’t growing.  So it’s up to government to increase spending to raise G and stimulate Y.

(Actually, according to the data, C has been doing pretty well since the beginning of 2010.  See the Robert Higgs’s analysis of the data in “One More Time: Consumption Spending HAS Already Recovered.”)

Now, increasing G is supposed to “create” more jobs.  What kind of jobs are the best to do this “stimulating”?  The answer, according to one Nobel-Prize-winning economist, is that it doesn’t really matter (as this YouTube video strongly suggests): war, natural disasters, fighting space invaders, anything.  Creating jobs, any jobs, is an end in itself.

The Kind of Jobs Matters

From the point of view of SMUT this is all pretty nuts.  Remember, the value of anything, including labor and what it produces, is never disembodied: It is always valuable to someone for something.

For instance, unless you at least recognize that value issues from the subjective perception of individuals, the idea of economic efficiency goes out the window.  Economic efficiency depends on benefits being greater than costs, but again it’s never benefits and costs disembodied from purposeful action.  Benefits and costs are always benefits and costs for someone from doing something.

Likewise a job is a job for someone to do something.  Building a house or a bridge or a car has to have a value to someone, expressed in terms of a market price someone is able and willing to pay that will cover its cost. Otherwise building it is a pure waste.  Unfortunately, macro-pundits don’t care about efficiency or producing value in this sense.  It’s just jobs, jobs, jobs!

Really, it’s the modern equivalent of digging a hole and filling it back up again, the modern version of the LTV, and it’s just as wrong as the old one.

***

(If you’re wondering what a sound macroeconomics looks like, check out, among others, these books by Steve Horwitz, Roger Garrison, and Peter Lewin.)

ABOUT

SANDY IKEDA

Sandy Ikeda is an associate professor of economics at Purchase College, SUNY, and the author of The Dynamics of the Mixed Economy: Toward a Theory of Interventionism. He will be speaking at the FEE summer seminars "People Aren't Pawns" and "Are Markets Just?"

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