The Austrian School of Economics, which is also known as the Vienna School or the Psychological School is based on the concept of methodological individualism; which looks at how social and economic occurrences can be explained by the actions of individuals rather than groups. This concept was developed by the founder Carl Menger (1840-1921) and explained in his book ‘Principles of Economics’ which was first published in 1871.
One of Menger’s main contributions to economics is associated with the marginalist revolution. And it was in his book that he challenged classical cost-based theories of value presented by economists such as Adam Smith and David Ricardo and instead put forward his theory of marginality. It was Menger’s book, along with those of William Stanley Jevons (1835-1882) and Leon Walras (1834-1910), all of which were published independently, that supported the founding ideas of marginalist economics (later to become neoclassical economics).
It is clear that factors such as the level of satisfaction gained from purchasing a good or service played a huge part in whether someone where to buy a good or service. ‘Economists call this satisfaction utility’(Sloman, Hinde & Garratt, 2013, pg 83.). Furthermore, marginal utility is the extra satisfaction gained from one extra unit of a good or service being consumed-within a given period of time. But for years economists were undecided as to what exactly determined a good’s value.
The theory of marginal utility assisted in solving the diamonds-water paradox also known as the paradox of value , which was come across when looking at the demand side to the question of what exactly determines a good’s market value. When looking at the demand side of this problem, the paradox was discovered, but never solved, by Adam Smith in the 1760s. Smith presented the contradiction that although water has a higher level of importance in terms of survival, diamonds, which have a much lower value in terms of survival, have a much higher price in the market. It wasn’t until over one hundred years later that a solution to this paradox was given. Carl Menger, along with the economists Walras and Jevons independently claimed that ‘the source of the market value of a good was its marginal utility and not its total utility’ (Sloman, Hinde & Garratt, 2013, pg 85). Total utility is defined as the total satisfaction gained by a consumer from the consumption of all the units of a good. Due to the fact that diamonds are scarce and the demand for them high, the possession of additional units was a high priority, meaning their marginal utility was high, and therefore, consumers were willing to pay a comparatively high price for them. In contrast, water is much less valuable, and because it is much less scarce the buyers of water all possess enough to satisfy their need for it. This results in decreasing satisfaction or utility as additional purchases beyond the consumers need for water are consumed. This will continue to decrease until all utility will be lost, which is once the consumer is hydrated.
Menger summarised the marginal utility analysis as follows:
‘This limit is reached when one of the two bargainers has no further quantity of goods which is of less value to him than a quantity of another good at the disposal of the second bargainer who, at the same time, evaluates the two quantities of good inversely.’ (1871, pg 187.)
The solving of this paradox, contributed to Menger being one of the founding fathers of what is now known as neoclassical economics. One of the foundations of neoclassical economics is the subjective theory of value, in which the value of any given good is in relation to the degree of satisfaction gained from consumption by the individual. This is in contrast to the objective value, adopted by most classical economists, where the value of a given good was based on the amount invested in the production of said good. The second foundation is marginal reasoning, whereby the marginal utility is what influences a consumers choice when buying goods. The final foundation is price information, which assumes that consumers act independently due to having full and relevant information.
Carl Menger has achieved the title of the founder of the Austrian school of Economics, due to the fact that he created the system of value and price theory that sits at the core of Austrian economics theory. His work also went on to influence other great economists of his time such as, Eugen von Bohm-Bawerk, Ludwig von Mises and Friedrich von Wieser.