Intrinsic Value is RealSubmitted by Goldspan on Sun, 08/11/2013 - 22:53
If you don’t know Richard Cantillion you don’t anything about economics.
Many crucial Austrian insights have been found in the economics of Irish banker Richard Cantillon (1680–1734) and his lone surviving publication, Essai sur la Nature du Commerce en General. It seems clear that Cantillon was an important influence on the development of Austrian economics, and that he can be considered a member of the Austrian School. Carl Menger had a copy of the Essai in his library prior to the publication of The Principles of Economics.
Indeed, the origins of economic theory itself can be traced to CantilIon. William Stanley Jevons, one of the cofounders of the marginalist revolution, and the economist who is generally credited with rediscovering Cantillon, called the Essai "a systematic and connected treatise, going over in a concise manner nearly the whole field of economics…. It is thus the first treatise on economics." He dubbed the work the "Cradle of Political Economy." Joseph Schumpeter, the great historian of economic thought and student of Eugen von Bohm-Bawerk, described the Essai as "the first systematic penetration of the field of economics." In his treatise on the history of economic thought, Murray N. Rothbard named Cantillon "the founding father of modern economics."
It is true that ultimately real goods exchange for real goods, with money as an intermediary, and that everyone is both a consumer and a producer in the market. While there is a “real cost”, the cost of a product is its “intrinsic value”, this is a rudimentary version of “Austrian” view that all costs are really “opportunity costs”, this represents sacrifices foregoing a certain amount of resources that could have been used to produce some other product. "Value” is a judgment that economizing men make about the importance of the resources at their disposal for the production of real goods in exchange for real other good.
Opportunity cost is one of the cornerstones of the capitalist system. It not only includes accounting profits (revenue –costs = profits) but it also includes the concept of economic profits (revenue –cost- (the opportunity cost of capital) = economic profits) which gets lost in the debate of intrinsic value.
Capital will go to where it is treated best, if a producer is not producing an economic profit, capital will flee for a better return. Think of it this way, when the VCR came on to the scene, the units sold for five to six hundred dollars. If you were to take all the cost to manufacture the machines and to get them in the customers hands and the opportunity cost of capital, the return on investment were outrageous. Because the economic profit was so attractive this brought lots of competitor to the market, providing more and more machines to the consumer. Competitors fought for market share by cutting the price to the consumer, but economic profits were still above the natural rates until the market was saturated and all the economic profit was gone….. this drove competitors out of the market……the ones that remained, their return on investment normalized to an economic profit, at what was then, the current cost of capital.
When a producer makes a choice to go into any business he is making a subjective value and judgment just as a consumer is making when he decides whether to pay the price for an item or forego that item for more attractive opportunity. He is making a choice on the price input on his business.
It is said that “what is rare is a greater good than what is plentiful”. Thus gold is a better thing than iron, though less useful. These statement provide an indication of the correct influence of different levels of supply on the value of a good, and at least a hint of the later fully formed Austrian marginal utility theory of value, and was a solution to the 'paradox' of value. But a more interesting harbinger of Austrianism came to the attention of historians: the groundwork for the Austrian theory of marginal productivity - the process by which the value of final products is imputed to the means, or factors, of production. This is true supply side economics.
Richard Cantillon (1680s – May 1734) engaged in the first sophisticated modern analysis of market pricing, showing in detail how demand interacts with existing stock to form prices. He was largely interested in price formation in the real world, i.e. actual market prices. Cantillon at least in so far as holding that market prices tend in the long run to approach the “intrinsic value” of a good, that is, the cost of production, in terms of land and labor inputs, of the product(opportunity cost). This was the Smith-Ricardo theory of 'equilibrium' pricing, which has been basically expanded into Walrasian 'general equilibrium' theory.
But while there are passages in Cantillon justifying this approach, and the term “intrinsic value” is in reality, pre-Austrian, Cantillon's market price analysis was an Austrian view of given existing stock of goods evaluated and demanded by consumers. Quoting from Cantillon: 'It is clear that the quantity of product or of merchandise offered for sale, in proportion to the demand or number of buyers, is the basis on which is fixed or always supposed to be fixed to the actual market prices. Demand, in turn, is subjective, dependent on 'humors, fancies, mode of living', etc. These subjective valuations are what communicate value to the products offered for sale. It is the “consent of mankind”, says Cantillon, which gives value to 'lace, linen, fine cloths, copper and other metals'. For Cantillon, actual market prices are determined by demand. It often happens that many things which actually have intrinsic value are not sold in the market at that value. While Cantillon considers the “intrinsic value” of a thing the measure of the Land and Labor (opportunity cost) which enter into its Production', he concedes immediately that subjective valuation by consumers rather than “intrinsic value” determines price, and that depends on the humors and fancies of men and on their consumption. Thus the value of products is conveyed by consumer valuation: a crucial proto-Austrian insight derived from medieval and late Spanish scholastics. For centuries, in fact, the scholastic and post-scholastic position had been that the value of goods is determined by “utility” and “scarcity”, by subjective valuation of a given supply. The more utility the higher the value, and the more abundant the supply the lower the value and price of any good on the market. Cantillon's theory is a sophisticated and elaborated development of the scholastic approach.
Going into detail on intrinsic value, Cantillon refers to the hypothetical case of an American who travels to Europe to sell beaver skins for hats, but is then “rightly” astonished to learn that wool hats are as serviceable as those made of beaver, and that all the difference, which causes so long a sea
journey, is in the fancy of those who think beaver hats lighter and more agreeable to the eye and the touch. In short: the entire cost of production, all the labor and effort that went into the production and transport of beaver skins, means nothing unless the product satisfies the consumer enough to pay
for the costs, and to enable the product to compete with another commodity made more cheaply at home. It is consumer demand that determines sales as well as price.
Cantillon, did not foreshadow the classical equilibrium theory that cost of production constituted
the long-run, and presumably therefore the most important, determinant of market price. On the contrary, for Cantillon, cost of production had a very different function: deciding whether a business could make profits or else have to suffer losses and go out of business. If consumer value and therefore
the selling price of a product is high enough to more than cover costs, the firm makes a profit; if not high enough, it suffers losses and eventually has to go out of business. This is an important part of the Austrian view of the role of costs. Hence the movement toward long-run equilibrium is not a process of adjusting market prices to intrinsic long-run costs of production, but one of laborers and entrepreneurs moving in and out of various lines of production until costs of production and selling prices are equal. For Cantillon then it is not so much that intrinsic values exist automatically and spontaneously and that market prices are drawn towards them, as that the prices offered in the market determine whether or not it is worth producing things. In other words, it is the prices offered that determine what production costs can be incurred not that production costs determine what the prices must be. Money arises out of this exchange as a commodity serving as a much-needed medium of exchange and measure of values.
A highlight of Cantillon's “theory of money” is his treatment of the value of money as a special case of the value of market commodities in general. As in the case of any product, the “intrinsic value” of gold is the cost of its production. The value of gold and silver, like other commodities, is set by the values and hence the demands of users in the market - by the “consent of mankind”. As in the case of other commodities, too, Cantillon has no cost of production theory of the value of gold and silver; he simply holds, as elsewhere, that these products can only be produced if costs can be covered by the value of the product.
Cantillon provided a sound analysis of how the market determines the ratio of the values of gold and silver. The process of aligning costs and values in gold, takes a relatively long time since its annual output is a small proportion of the total stock in existence. If the nominal value of gold falls below its cost of production, it will cease being mined; and if costs fall sharply, production of gold will be
stepped up, thus tending to align costs and natural value. Cantillon recognized that government paper and bank money virtually have no costs of production, and therefore no “intrinsic value”, but he pointed out that market forces keep the value of such fiduciary money at par with the value of the gold or silver in which that paper can be redeemed. As a consequence, an increase in the supply of “fictitious or imaginary” money has the same effect as increase in the circulation of real money. But, Cantillon noted, let confidence in the money be damaged, and monetary disorder ensues and the fictitious money collapses because it has no intrinsic value, virtually no cost of production. He pointed out, too, that government is particularly subject to the temptation to print fictitious money - a lesson he had undoubtedly learned from or at least seen embodied in, the John Law experiment.
Let’s analyze recent events with the concepts described above, Mortgage Backed Securities ( MBS). If according to the concept that “intrinsic value” does not exist then the MBS were fairly valued at the prices they were sold……since the only value represented in the price the buyer is willing to pay. Then the crisis should not have occurred. While there is an abundance of material written about this topic, value and pricing is the center of the debate in the article.
The concept of “marked to market” accounting was to blame for the “mispricing” of the MBS’s in the market place. The fraud that occurred was the basis’s that the “intrinsic value” was never analyzed and only thing that represented value was the price at which the bond were sold to investors…..i.e marked to market.
Had investor used “marked to method” analysis’s to determine the “intrinsic value” of the MBS the fraud would have been exposed and the “true value” would have been discovered. Does the “true value” represent the “intrinsic value” of the MBS…….I conclude ……yes in fact it does. The “intrinsic value” of the input of production of the MBS was the underlining mortgages. Had they been analyzed properly an “intrinsic value” (a value within itself the definition of intrinsic value) would have been discovered and differed a great deal from market price, the sub-prime mortgages would have been discovered in the packages of MBS and filtered out. The consumer relied only on market price to determine the value of the security…….is price really the only way to assign value? Price represents the willingness of the customer to part with something else the consumer values …..Mostly his money.
The cost of production represents the “intrinsic value” of the only three sources of capital, natural resources, human capital & capital formation….which is what Richard Cantillion stated…...intrinsic value is real and it is tangible because of the input values of the “cost of production”
If you are interested in the “marked to method” of valuation see this post of bond valuations.
My bond valuation post is on the second page of this thread and it under the subject “Thanks Dduck for posting this”