Lesson 4 of 7
Where a machine's value comes from
Value runs backwards along the chain of production, from the expected value of the product to everything used to make it. It never runs forwards from cost.
By Javier Sanz
Founder of ValueScreener. Built Ninety Nine, a securities services provider, and sold it to a tier-one global bank; ran operations and internationalization at Alpaca, the brokerage API.
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In one minute
- A good of higher order gets its value from the expected value of the product it helps make, not from what it cost to build.
- The value is prospective, so it moves when expectations about the product move, and a machine can lose most of its value on a day nothing physical happened to it.
- The direction of causation is the whole point: cost does not determine value, value determines what it is worth paying as a cost.
A press cost money to build. A field was bought at a price. The question this lesson answers is whether either of those facts has anything to do with what the press or the field is worth, and Menger's answer is no.
Which direction the causation runs
- 1Expected value of the productWhat people are expected to pay for the bread
- 2Value of the flourFollows from the bread, not from the mill
- 3Value of the wheat and the millFollows from the flour
- 4Value of the fieldFollows from all of it, and from nothing behind it
Menger's principle, stated exactly
In chapter III of Principles of Economics, section 3, Menger sets out what he calls the universally valid principle for goods of higher order. Their value is governed not by the value of the corresponding lower-order goods available today, but by the prospective value of the product.
Two words in that are doing work. Prospective: the value that the product is expected to have when it arrives, not what similar products fetch now. And governed: this is not a correlation, it is the source. Menger's account has value starting at the satisfaction, attaching to the good of first order, and being attributed backwards from there to every higher order in turn.
What that rules out
It rules out cost as an explanation of value. A press that cost $400,000 is worth whatever the output it can produce is expected to be worth, and the $400,000 is a historical fact about cash that has no vote.
It also rules out the reverse inference people make constantly: that because a company spent a great deal, it must have acquired something valuable. On this account the spending tells you what somebody expected, not what is there.
Why the value can collapse without anything happening
Because the value is prospective, it moves when the expectation moves. A machine whose product stops selling loses its value on the day that becomes clear, and the machine is unchanged. Nothing was consumed, nothing broke.
This is also why Menger insists the causation cannot be reversed for convenience. A rise in the value of a good of lower order available today does not mechanically raise the value of the higher-order goods already in hand; it is the expectation about the product that governs.
Check yourself
What governs the value of a good of higher order?
- What it cost to produce
- The prospective value of the product it helps make
- The current market price of similar goods
Show the answer
Answer: B.
Chapter III section 3 of Principles of Economics makes the prospective value of the product the governing principle, and treats cost as a consequence rather than a cause.A machine loses most of its value when its product stops selling. On this account, what happened?
- The machine depreciated
- The expectation about the product changed, and value is attributed backwards from that
- The cost of the machine was written off
Show the answer
Answer: B.
Value is prospective and travels back along the chain. Nothing had to happen to the machine for its value to change.What inference does this principle rule out?
- That a machine can be worth more than it cost
- That heavy spending must have produced something valuable
- That two firms can value the same asset differently
Show the answer
Answer: B.
Spending records what somebody expected. On this account it establishes nothing about what is now there, because the direction of causation runs the other way.Sources
- Menger, Principles of Economics, 1871, English translation 1950, chapter III, section 3, on the principle determining the value of goods of higher order and on value being attributed backwards from the satisfaction.
- Menger, Principles of Economics, chapter I, section 2, for the chain of orders the value travels along.
What this leaves out
- This is a heterodox tradition. The mainstream account of the same phenomenon differs, and nothing here is a forecast or a view on any security.
- The two machines are an invented illustration with round figures. Neither is a valuation method and neither describes any asset.
- Imputation says where value comes from. It does not tell you how to split the value of a product among several higher order goods used together, which Menger treats separately and which remains contested.