Economics 101: Value Is Subjective

The other day, a friend of mine told me living in Texas is better than living in Florida. I corrected him.

Better for you.

This reveals a fundamental economic principle – value is subjective.

The subjective theory of value holds that the value of a good or service isn’t based on its inherent properties, nor by the cost of the goods and labor used to create it. Instead, value is determined by the perceptions and opinions of individuals.

Economist Carl Menger explained it this way.

Value is nothing inherent in goods, no property of them, nor an independent thing existing by itself. It is a judgment economizing men make about the importance of goods at their disposal for the maintenance of their lives and well-being. Hence value does not exist outside the consciousness of men.

Because each individual has different preferences, needs, and desires, the “value” of something can vary significantly depending on whom you ask.

For instance, my friend highly values living in Texas. I’m sure he has a long list of reasons he prefers the Lone Star State. In my view, Texas wouldn’t be the worst place to live, but I would rather reside in the Sunshine State. Of course, I have my reasons. And I have friends who think living in Texas would be a fate worse than death.

Who is right?

Nobody. Or everybody. Because value is subjective.

Here’s another example. I have friends who would happily pay hundreds of dollars for a comic book. I, on the other hand, generally wouldn’t drop 50 cents on a comic book. They don’t interest me.

But to my surprise, not long ago, I bought a comic book!

Why?

Because a friend of mine produced it, and I wanted to support his work.

This reveals another ramification of subjective value. The value we place on something can change dramatically depending on the circumstances.  

Muddled Economic Thinking

Failing to understand that value is subjective can lead to muddled economic thinking.

You have likely heard somebody proclaim, “That price is too high! It’s ridiculous.”

These statements assume that there is some “correct” price floating around out there somewhere, and the current price isn’t it. But in fact, there must be people out there who value that good or service enough to pay the “ridiculous” price. Otherwise, the price would fall.

In other words, just because you perceive the price as ridiculous doesn’t mean everybody does. Different people value goods or services differently. Some people might look at that very same price and proclaim, “What a bargain!”

Subjective value is a key factor in any transaction. In order for the transaction to occur, the parties must agree to the relative values of the things being exchanged. For example, if I am buying apples from you, I have to value the number of apples you’re offering at a given price more than holding on to that amount of money. From your perspective, you must value having that amount of money more than keeping the number of apples. If we can come to an agreement, the transaction occurs. If we cannot agree on the relative value, no transaction will take place.

Because most people don’t understand subjective value, they perceive all kinds of unfairness in the marketplace. They’ll say people in a certain industry are “underpaid.” But the fact of the matter is there aren’t enough employers who value that particular skill set enough to raise the industry pay scale. Or, more simplistically some people claim that product X is “too expensive,” but the fact of the matter is there are enough people who value X at that price to maintain it.

Undercutting Socialism

The subjective theory of value undercuts one of the classical pillars of socialism.

Socialist theory fixates on labor. One of the fundamental ideas in socialist economics is that profits earned by capitalists represent theft from the workers who produce the goods or services.

This is based on the “labor theory of value.”

As summarized by Britannica, Karl Marx argued that the value of a commodity can be objectively determined by the amount of labor required to produce it. Under this framework, if it took twice as long to build a shed as it took to build a fence, the shed would have twice the value of the fence.

To be fair, this isn’t purely a socialist premise. Many classical economists prior to Menger, including Adam Smith, developed objective value theories based on costs. Many classical economists argued that the value of any good or service could be determined by adding together all the input costs that went into making it.

Within this framework, it should be pretty simple to determine the “correct” price for any given good or service. Just do the math. Add up the costs of the goods required to make the product or service along with the labor.

But you quickly run into problems when trying to put this theory into practice.

The first question that arises is - what is the value of labor?

You can’t answer that question because value is subjective.

Right now, a plumber has no value to me at all. But if a pipe bursts under my kitchen sink, a plumber suddenly becomes extremely valuable. On the other hand, people who can do plumbing themselves will probably never value a plumber as highly as I do. But even if I can do plumbing, I might value a plumber more highly if a pipe bursts while I finish a project on a tight deadline.

So, if there is no objective value for the labor of a plumber, how can we plug the value of her labor into the costs of a house?

We can’t.

Second, a quick thought experiment makes it clear that the value of a product has zero correlation with the amount of labor that goes into it.

Imagine I spend eight hours making mud pies (a mixture of dirt and water). For the sake of argument, let’s say my labor has an objective value of $20 per hour. I don’t know how we would determine that, but I’ve heard it said it is a “living wage,” so we’ll run with it. In eight hours, I produce 80 mud pies (Ten pies per hour). That would make the value of each mud pie $2 ($20 per hour divided by 10 pies).

When I go set up my mud pie booth, how many people do you think will pay $2 for a mud pie?

The answer is somewhere in the neighborhood of zero.

It's hard to imagine that anybody values a mud pie at $2, or any price for that matter.

Now, somebody might hand me $2 in exchange for a mud pie because they feel sorry for me, and they value the good feeling they get by helping my poor soul. But that doesn’t have anything to do with my labor. The value derives from that person’s psychology, not anything inherent in the nature of mud pies.

It should be clear that my labor has nothing at all to do with the value of mud pies.

The labor theory of value is clearly bogus.

In fact, today, most honest Marxists will even concede this point.

Economics might seem dry and boring, but it is important to understand basic economic concepts if you want to avoid muddled thinking.