The question of the origin of the value of goods is one of the fundamental problems of economics. For a long time, the prevailing view was that value was an objective, measurable fact. The French physiocrats of the 18th century believed that value emanated from the land. This view was later developed by classical economists, who elaborated the theory of labor value, according to which the exchange value of a good is proportional to the labor incorporated in its production.

Adam Smith, David Ricardo and Karl Marx championed this approach. David Ricardo illustrated this theory with a famous example: if it takes two hours to hunt a beaver and only one hour to capture a turkey, then the beaver is worth twice as much as the turkey. However, this theory came up against Adam Smith's diamond-and-water paradox. Why is it that water, essential to life, generally has a low value, while diamonds command a high price? And why, in the desert, does water become more precious than diamonds? This paradox revealed a fundamental flaw in the theory of labor value.

In the 1870s, three European economists, working independently, simultaneously developed a new theory based on the concept of marginal utility. William Stanley Jevons in England, Léon Walras in Switzerland and Carl Menger in Austria proposed a radically different explanation of value formation. Marginal utility is defined as the satisfaction an individual obtains from consuming an additional unit of a good.

The basic point is simple: once a need has been satisfied, an additional unit of the same good no longer represents the same value for the consumer. Let's say we offer a computer to two different people: even when faced with the same apparent needs, they won't make the same choice, because the labor required to manufacture the computer is of little importance to the consumer. The only thing that matters is the ability of the good to meet his or her own needs. What's more, those who already own a computer will not place the same value on a second device. With each additional consumption, marginal utility decreases progressively.

Despite their agreement on the concept of marginal utility, Walras, Jevons and Menger differ profoundly in their approach to measurement. The cardinal conception, defended by Walras and Jevons, assumes that utility can be measured in quantifiable units: a first computer unit would represent ten utility points, a second five points. Utility could thus be measured and added up.

Carl Menger rejected this attempt to mathematize human preferences. He understood that the complexity of human behavior made formal analysis impossible. Menger preferred the ordinal concept, based on subjective preferences. In his view, it is impossible to measure the quantitative difference between intensities of need. We can order our preferences by saying that we prefer A to B and B to C, but we can't measure how much we prefer A to B. This difference in intensity remains a reality. This difference in intensity remains an internal psychological reality, inaccessible to any objective measurement.

This distinction gave rise to the methodological subjectivism that would characterize the Austrian school of economics. For Menger, value does not exist intrinsically in goods. It emanates entirely from the individual's judgment of the good as a means of satisfying a personal need. As he writes in his Principles of Political Economy, things become economic goods only when they are recognized as capable of satisfying a human need. Scarcity plays a role in determining value, but it is only relevant in relation to the individual's subjective need.

This theoretical revolution resolves the paradox of diamond and water. A person dying of thirst in the desert will value water over diamonds, because the urgency and relative scarcity of water in this context determines value. It doesn't matter that diamonds are objectively rarer, or that they require more labor to extract: what counts is the subjective need and the individual's unique relationship with his or her immediate environment. Menger's methodological subjectivism thus constitutes the first fundamental pillar of the Austrian school: economic reality can only be understood on the basis of individuals' subjective assessments.