Carl Menger's Theory of Exchange

In his Principles of Economics Carl Menger presented the causal laws by which individuals alone and in association with others provide for their needs. (1) Menger offered an explanation of how basic exchange institutions are formed in response to the economizing actions of individuals. His teaching and manner of approach became the pillar of a school of thought that achieved international reputation around the turn of the century and is undergoing somewhat of a renaissance today. (2) In the first part of this paper I summarize what Menger had to say about the formation of exchange institutions and the part they play in economic development. It is in the context of economic development that exchange institutions take on a precise and important meaning in Menger's intellectual system. In the second part of this paper, I concentrate on those technical aspects of Menger's theory of exchange that contributed to what is now termed "orthodox," or "neoclassical," price theory. I am especially concerned with specifying the ways in which Menger's theory of price formation differed from the now-current neo-Walrasian theory of price determination. In the final section I explain why Menger did not consider the determination of market price to be the principal problem in the science despite his own substantial contributions to the subject. I Thoughout his Principles Menger compared modern civilization and its advanced methods of production and exchange with primitive, or what he termed "isolated household" economies. (3) Among primitive peoples engaged in economic activity the success of any single household's plans was largely independent of the plans and choices made by other households. The problem of what I shall call "coordinative uncertainty" simply did not exist. This is not to say that the life of primitive man was idyllic. On the contrary, his superstitions and ignorance of basic science left him pitifully at the mercy of nature. He lacked what Menger termed defnite knowledge about the "causal connections between goods" (53, 55 and 58). Primitive man planted his seeds in the earth and stood helplessly by praying for a bountiful harvest. One year the harvest was rich and abundant, the next year scarce and tragic. The range of variation of output both in quality and quantity was, according to Menger, enormous and unpredictable. As civilization progressed and man acquired the scientific know-how to manipulate physical processes and achieve technical objectives, he was able to bring the relationship between certain inputs and outputs more closely under his control. (4) At the same time he learned how "indirect" methods of production are used to achieve greater output levels. Capital-using methods of production involve the application of one collection of (capital) goods to produce other (capital) goods that are used to produce still other goods, and so on, until eventually goods emerge in a form that is directly serviceable to human needs. Menger termed goods far removed from final consumption "goods of the higher orders" and goods closer to the point of final consumption "goods of the lower orders" (56-58). Menger's successor, Eugen von Bohm-Bawerk summarized this notion when he offered the historical observation that capital-using methods of production become increasingly more "roundabout." Capitalistic methods of production, while extremely productive of a wide range and quality of goods, are inherently more "time consuming." This means that goods that could be applied toward the satisfaction of present, or current, needs are instead tied up in a process that yields greater benefits, but only at a future date. This extension of the construction period increases uncertainty because the likelihood of uncontrollable forces upsetting the process once it is set in motion is enhanced. Fortunately, the disadvantages of extending the construction period are offset by an increased willingness on the part of individuals to expand their planning horizons and adopt these roundabout methods of production. …