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The Actuary The magazine of the Institute & Faculty of Actuaries

The price is right?

In the mid-nineteenth century, Austrian academics initiated a revolution in economic thought: the development of a new concept of value. Earlier, it had generally been held that the value of any object, or any service, was basically the cost of producing or providing it. This value, adjusted for transaction costs and profits, denoted the price at which anything should normally change hands. So we were told by those pioneers of economics, Adam Smith and David Ricardo.

The Austrians overturned all that, and today, their doctrines are generally accepted, yet their notion of value was not entirely new. In 1831, Richard Whately, Anglican archbishop of Dublin, anticipated the Austrians by stating that: “Pearls are not highly valued because men dive for them; on the contrary, men dive for them because they are highly valued.” (Richard Whately, Introductory Lectures on Political Economy, 1831) He did not elaborate this theory, however, the basic idea being that things are worth what buyers are willing to pay for them, rather than what they cost to produce.

Carl Menger (1840–1921), professor of political economy in Vienna, was the first to systematise this doctrine. It is more complex than it appears at first sight, since various potential buyers may value the same thing differently. He used the example of horse-copers selling horses to farmers but for us it is perhaps simpler to consider the Dutch flower-market, an auction with decreasing prices. The auctioneer starts a ‘clock’ that shows prices; starting at a high level, it descends until the price is low enough to attract bids from the florists (or wholesalers who sell on to them). Florists, with shops in widely varying locations, sell at somewhat differing prices, depending on the purchasing power of their customers. Thus, the florist from the most chic district of Amsterdam can offer the best price for a given quantity of tulips.

A big lot, comprising hundreds or thousands of flowers of the same grade, will often be divided among several buyers and, normally, all the sub-lots sell at very similar prices. These will be close to the price that the florist, among those who actually buy, from the least affluent district is willing (can afford) to pay. Hence we have Menger’s principle: “The value of any article in commerce is the price conceded by the buyer whose ‘best price’ is the lowest.” This buyer is called the marginal buyer and we say that the price is formed at the margin.

Free competition
While this principle applies to markets where quantities of identical items are traded, the theory of ‘subjective’ value is also relevant to unique items such as antiques or works of art. It explains why objects can change hands at prices that bear no relation whatever to their cost of production. Damien Hirst’s latest masterpiece The Golden Calf — a bullock with gold horns and hooves, preserved, as usual, in formaldehyde — was sold at Sotheby’s for £10.35m. In 2006, Christie’s sold three bottles of Romani-Conti 1978 for $211 500.

Menger also explained how free competition between traders removes any incentive for them to try to boost prices by restraining sales volumes and, therefore, encourages maximum consumption. He called any such restraint verderblich, that is, pernicious, corrupt or perverse. However, in today’s world, which tends to over-consume its resources, we may well have doubts about the validity of this judgment. Menger was writing around 1870, when the world population was in the region of 1.3 billion, a fifth of today’s level.

A seemingly academic change in the theory of value has had far-reaching effects on the way we think about economic matters and, ultimately, on our actions. It is a shift from an objective to a subjective valuation basis. For the cost of making an article is an objective fact — the price that a buyer is willing to pay for it is a subjective opinion. Although Austrian theory has won the approval of economists, it has been slow to spread into business practice. Even today, German life offices generally value their investments at acquisition cost, a relic of the old idea that value should be based on historical cost of production (or acquisition), rather than on the current market. Until very recently, UK pension funds valued assets on a non-market-price basis, by discounting future income flows. Since these flows are much more stable than market prices, the change to FRS17 was misguided, and has seriously destabilised the world of pensions.

Pay is another topic affected by Austrian thought. Classical economists held that the natural and normal remuneration of unskilled labour was just enough for survival. Turgot, finance minister to Louis XVI and friend of Adam Smith, wrote: “In all kinds of labour it must, and does, happen that the worker’s wage is limited to what he needs for his subsistence.” (Anne-Robert-Jacques Turgot, Réflexions sur la Formation et le Distribution des Richesses, 1769). That was a harsh view but at least there was a basic minimum, the amount needed to keep the workers alive and fit to work, in other words the ‘cost of production’ of labour.

With Menger, however, this floor collapses under the poor fellows: “Neither the means of subsistence, nor the minimum subsistence level can be the direct cause or the principal determinant of the price of labour.” (Carl Menger, GrundsÄtze der Volkswirtschaftslehre, 1871). The idea that wages are whatever employers are willing to pay, rather than the cost of supporting the workers, seems to be endorsed by Menger, who observes on the very same page that: “A seamstress in Berlin, even if she works fifteen hours a day, cannot earn enough for her subsistence.”

Further implications
At the other end of the pay scale, the Austrian theory may be seen to support the practice of paying extraordinary amounts to certain ‘star’ employees. After all, if the value of a person’s work is purely subjective, and if an employer can be persuaded to subjectively value it at $50m a year, then why not? There are further implications. The subjective theory was strikingly described by Ludwig von Mises (1881–1973), one of the leading economists of the Austrian school: “The value is not intrinsic; it is not in things, it is in us.” (Ludwig von Mises, Human Action, 1949)

Von Mises was a non-religious Jew but, seen from a religious standpoint, his words seem to tell us that things created by God have no value unless they command a price on some human market. This is clearly not Jewish, or Christian, or Islamic — indeed, it sounds much like blasphemy. One does not have to be devoutly religious to see that there are grave practical objections to ascribing no value to anything that does not have a market price. Things that are not readily sellable, such as gas flared from oil wells, materials that cannot be reused at a viable cost or machinery that is ‘not worth repairing’, we discard as worthless.

My wife, in a photographic shop in London, once asked to have a camera repaired. The puzzled salesman replied with a memorable question: “Repair, madam, what does that mean?” How many millions of tons of materials are junked yearly as a result of this attitude? All this in a world that is consuming many natural resources at unsustainable rates.

In the world of nature, plant and animal species that have no commercial value tend to be crowded out by the activities of us turnover-obsessed humans. These problems can be tackled. Many rare species are protected by law. In France, a small tax is levied on new electrical goods to finance the obligatory recycling of old equipment. The Russian and Nigerian governments — whose countries are the biggest gas-flarers — are trying to stamp out this wasteful atmosphere-polluting practice. However, such solutions entail state interference in the economy, which is — in general — abhorrent to rigorous followers of the Austrian school.

It would be absurd to blame all our profligate habits on a group of deceased Viennese academics. Yet it is fair to say that the doctrine of subjective valuation has encouraged our current tendency to allow our lives to be ever more dominated by markets, these being the places where subjective valuation rules. Austrian theory is, in general terms, a realistic description of how untrammelled, free markets work. However, the practical and ethical difficulties linked to this theory demonstrate the limitations of the free-market philosophy.

Angus Sibley, a retired actuary and former member of the London Stock Exchange, now lives in Paris. He writes regularly on www.equilibrium-economicum.net