Value and Exchange: Recent Episodes
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Value and Exchange includes the basic principles of valuation, and the introduction of money on exchange. Trading of goods. Value of exchange. Perceived value.
In contrast to the imaginary way that mainstream economists present value, Austrian economists properly use ordinal rankings to determine value.
Original Article: "How People Determine the Value of a Good"
“Our civilization is inseparably linked with our methods of economic calculation. It would perish if we were to abandon this most precious intellectual tool of acting.”
Download lecture slides at Mises.org/MU23_PPT_28.
Recorded at the Mises Institute in Auburn, Alabama, on 27 July 2023.
"We would not expect money to be paper, national, or under the control of any entity."
Download the slides from this lecture at Mises.org/MU22_PPT_07.
Recorded at the Mises Institute in Auburn, Alabama, on 24 July 2023.
"The free market and the division of labor does not promote hyper-atomized individuals. It creates social harmony and community."
Download the slides from this lecture at Mises.org/MU23_PPT_06.
Recorded at the Mises Institute in Auburn, Alabama, on 24 July 2023.
This concept of economic calculation is really the foundation of all economic theory, and price theory is the cornerstone of economic calculation.
Download lectures slides at Mises.org/MU23_PPT_04.
Recorded at the Mises Institute in Auburn, Alabama, on 24 July 2022.
Menger discovered much more than the principle of marginal utility—he created an entire system of economics based on subjective value and individual choice.
Download lecture slides at Mises.org/MU23_PPT_03.
Recorded at the Mises Institute in Auburn, Alabama, on 24 July 2022.
On this episode of Good Money, Tho Bishop is joined by Wesley Schlemmer, president and co-founder of Bitcoin Bay. Wesley discusses the benefits of creating local professional networks around common values and how Bitcoin Bay is helping Tampa residents convert Bitcoin into real goods and services, including locally raised beef.
Learn more about Bitcoin Bay at Bitcoinbay.live.
Good Money listeners can order a special $5 book bundle that includes How To Think About the Economy and What Has Government Done to Our Money? with free shipping using promo code "GoodMoney" at Mises.org/Good
Receive a free subscription to The Austrian magazine at Mises.org/Magazine
Per Bylund joins Bob to discuss his new paper at the QJAE, which points out several flaws in the MMT claim that money is valued in order to pay taxes.
Per's QJAE article: Mises.org/HAP398a
Money is simple. The political program of monetary "policy" is not.
Original Article: "Money versus Monetary Policy"
This Audio Mises Wire is generously sponsored by Christopher Condon.
The roots of Austrian economics go back to the great theologian Thomas Aquinas, whose view of what constitutes a good was a prototype of Menger's pathbreaking theory of the good.
Original Article: "Defining a Good: The Intersection of St. Thomas Aquinas and Carl Menger"
This Audio Mises Wire is generously sponsored by Christopher Condon.
Standard neoclassical definitions of money call it a means of exchange and a store of value. But is this correct?
Original Article: "Cryptocurrency as Money—Store of Value or Medium of Exchange?"
This Audio Mises Wire is generously sponsored by Christopher Condon. '
"The free market and the division of labor does not promote hyper-atomized individuals. It creates social harmony and community." Download the slides from this lecture at Mises.org/MU22_PPT_04.
Recorded at the Mises Institute in Auburn, Alabama, on 25 July 2022.
This concept of economic calculation is really the foundation of all economic theory, and price theory is the cornerstone of economic calculation.
Download lectures slides at Mises.org/MU22_PPT_02.
Recorded at the Mises Institute in Auburn, Alabama, on 25 July 2022.
"We would not expect money to be paper, national, or under the control of any entity."
Download the slides from this lecture at Mises.org/MU22_PPT_05.
Recorded at the Mises Institute in Auburn, Alabama, on 25 July 2022.
Menger discovered much more than the principle of marginal utility—he created an entire system of economics based on subjective value and individual choice.
Download lecture slides at Mises.org/MU22_PPT_01.
Recorded at the Mises Institute in Auburn, Alabama, on 25 July 2022.
Arguments for equal pay are popular in our body politic, but what happens if some of those arguments are based upon the faulty logic of the labor theory of value?
Original Article: "Are Equal Pay Arguments Based upon the Labor Theory of Value?"
This Audio Mises Wire is generously sponsored by Christopher Condon.
Because people strive to improve their condition, they exchange goods and, in this sense, they create the necessary conditions for the emergence of prices. Prices are simply an unintended consequence of the human quest to improve one's life.
Original Article: "Where Prices Come From: Menger Explains"
This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Michael Stack.
In a developed economy, the satisfaction of desires can be obtained not only by goods in use, but also by goods in exchange.
Original Article: "Using Goods vs. Exchanging Them: Menger Explains the Difference"
This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Michael Stack.
Abstract: In her paper “Corporate Risk Evaluation in the Context of Austrian Business Cycle Theory” recently published in this journal, Joanna Kruk aims to investigate how artificially low interest rates resulting from central bank intervention distort individual investment appraisals and ultimately result in both entrepreneurial misjudgment and resource-wasting malinvestment, fueling the business cycle. She identifies entrepreneurs’ net present value calculations, supposedly unadjusted for risk, as a major issue and suggests adjusting those calculations for risk via both the duration method and the Capital Asset Pricing Model to mitigate the distorting effects. Her argumentation is, however, trapped in neoclassical reasoning and is adversely affected by several misconceptions of the net present value criterion. This comment seeks to reveal those fallacies and explain how to address uncertainty when using net present value calculations to make those calculations part of the solution rather than part of the problem of entrepreneurial misjudgment. The findings are derived from German investment theory rooted in the Austrian school of thought, meaning that they differ compared to those of neoclassical finance theory.
JEL Classification: B31, B41, B53, G32 Thomas Hering (hering@fernuni-hagen.de) is a professor of business economics and holds the Chair of Investment Theory and Business Valuation at Fern-University in Hagen, Germany. Michael Olbrich (olbrich@iwp.uni-saarland.de) is a professor of business economics and chair of the Institute of Auditing at Saarland University, Saarbrücken, Germany. David J. Rapp (david.rapp@imt-bs.eu) is an associate professor of accounting and management control at Institut Mines-Télécom Business School and member of the research lab LITEM, Univ. Paris-Saclay, Univ. Evry, IMT-BS, Evry/Paris, France.
INTRODUCTION In her paper “Corporate Risk Evaluation in the Context of Austrian Business Cycle Theory” recently published in this journal, Kruk (2020) seeks to explain why and how artificially low interest rates brought about by central bank intervention distort individual investment appraisals and eventually lead to clustered entrepreneurial misjudgment, malinvestment, and capital consumption, that is, the business cycle. Her perception of previous research is that “little attention was paid to the analysis of corporate finance and the causes of companies’ erroneous decisions about initiating and carrying out unprofitable undertakings,” which indicates she believes that investigating “the motivation of financial decisions on a micro-level can shed new light on the foundations of the emergence of the business cycle” (Kruk 2020, 131–32). Certainly economic calculation in general, and entrepreneurial investment decisions in particular, are yet to be thoroughly explored from the perspective of the acting individual and those areas should be stringently investigated owing to their significance for both Austrian theorizing (e.g., Austrian business cycle theory [ABCT]) and practice. However, there has already been far more discussion on the topic than Kruk (2020) suggests, both in general terms and with explicit links to ABCT.See, in particular, Rapp (2015); Olbrich, Quill, and Rapp (2015); Herbener and Rapp (2016); Olbrich, Rapp, and Venitz (2016); Rapp, Olbrich, and Venitz (2017); Follert et al. (2018); Rapp, Olbrich, and Venitz (2018); Olbrich, Rapp, and Follert (2020).
In essence, Kruk (2020) asserts that the economy shifts toward a riskier position in response to artificially low interest rates and that decision-makers fail to incorporate that risk appropriately in their investment calculi. By neglecting investment risk, entrepreneurs invest in projects that are only seemingly profitable. To aid in mitigating this issue, Kruk suggests adjusting net present value (NPV) calculations, which serve as the basis of investment decisions, for risk. Kruk’s underlying idea is to decrease resulting NPVs by applying mathematical adjustments to make investment projects look less feasible in order to deter entrepreneurs from making poor investments. Specifically, Kruk suggests NPVs risk-adjusted based on both duration and the Capital Asset Pricing Model (CAPM).
However, entrepreneurs calculating an NPV must consider their individual circumstances if they are to receive a figure that is realistically supportive of the decision-making process, and naturally, this includes the consideration of what Kruk labels risk. Mises (1952, 126, italics added) explains:
One of the items of a bill of costs is the establishment of the difference between the price paid for the acquisition of what is commonly called durable production equipment and its present value. This present value is the money equivalent of the contribution this equipment will make to future earnings. There is no certainty about the future state of the market and about the height of these earnings. They can only be determined by a speculative anticipation on the part of the entrepreneur.
Contrary to Kruk’s reasoning, neither duration nor CAPM serves to support entrepreneurs’ speculative decision-making well. This comment aims to uncover the misconceptions inherent in Kruk’s argument and to present alternative ways of addressing uncertainty when using the NPV as a tool to support entrepreneurial decision-making. To do so, we build on Prussian-German business economics, especially investment theory, which has been developed in the German-speaking world based on Austrian economics (Schmalenbach 1919, 334; Mises 1933, 9; [1960] 2003, 226; Schmidt 1933, 106; Herbener and Rapp 2016, 13; Olbrich, Rapp, and Follert 2020) and which fully adopts the perspective of the acting individual rather than building on the well-known escapist assumptions of neoclassicism.
RISK, UNCERTAINTY, AND INVESTMENT DECISIONS Kruk’s (2020, 138) diagnosis is that “wealth maximizing investors are evaluating projects only using risk-free NPV [and that, hence,] they may underestimate the risk associated with their investment decisions.” That is why “we cannot exclude risk from its role in the profitability of the investment projects, and this factor should be included in further analysis” (Kruk 2020, 137).
However, rather than failing to take account of the “risks” associated with a particular investment, investors largely do attempt to consider them in their investment calculi. Kruk (2020, 145–46) herself emphasizes that not only academics but also investment practitioners by and large rely on the CAPM, which is believed to provide a reasonable risk-adjusted discount rate for NPV considerations. In other words: the problem Kruk seemingly identified is a mere straw man and the solution she proposes in response to it exactly corresponds to how most decision-makers already decide on their investments. Nevertheless, the issues of entrepreneurial misjudgment and malinvestment have not been mitigated, let alone resolved. Hence, adjusting NPV calculations for “risk” via the CAPM will evidently not offer a means to reduce clustered entrepreneurial malinvestment. Rapp (2015) indicates that neoclassical models such as the CAPM are part of the problem rather than the solution. In particular, they fuel the business cycle due to their strong interdependence with market data.
Kruk, moreover, is mistaken when associating regular entrepreneurial investment decisions with risk. Rather than probabilistic, calculable risk, it is Knightian uncertainty (Knight 1921) that gives rise to entrepreneurship (Mises 1949) and, hence, entrepreneurial decision problems in the first place. Kruk conveys the impression that entrepreneurial decision problems could—with some assumptions (146, 147) here and there—be solved mathematically. However, in the presence of Knightian uncertainty, decision problems are not well-structured and optimal solutions out of reach (Wilson and Alexis 1962; Adam and Witte 1979; Adam 1983; 1996; Rapp and Olbrich 2020) of even the most elaborate math. Rather, entrepreneurs (must) imagine how the future might look and apply judgment to ultimately make their (investment) decisions (Klein 2008; Foss and Klein 2012; Packard, Clark, and Klein 2017). Such judgment can certainly be informed by genuine economic calculation; given they are unrelated to the real world, however, models springing from neoclassicism, in particular the CAPM, are beyond the scope of any toolbox reasonably applicable for that purpose (Olbrich, Quill, and Rapp 2015; Follert et al. 2018).
ON COMBINING NPV, DURATION, AND CAPM Duration describes the sensitivity of the price of a security to changes in the interest rate in the case of a flat interest rate structure. In a perfect capital market under certainty, the price corresponds to the NPV of the future earningsWe deliberately choose not to apply the term “cash flow” used by proponents of finance theory to describe the numerator in NPV analysis. Proponents of investment theory, as well as Mises (1952, 126), speak of “future earnings,” “future benefits,” or “future income” instead and emphasize the numerator’s subjective nature. “Future benefits must be forecasted from the perspective of the person who is valuing and choosing. Predictions of future benefits depend upon personal factors, such as the dividend policy, individual tax rates including potential tax loss carry-forwards, and individual synergies” (Herbener and Rapp 2016, 16). The importance of synergies in particular for entrepreneurial success has been intensively discussed within the Austrian school; see, e.g., Lachmann (1956, 13), Cwik (2008, 66), Klein (2010, 110), Boettke and Piano (2019, 22). and the duration equals the absolute amount of the interest (factor) elasticity of the price. Duration can be interpreted as an “average capital commitment period,” too, which reflects the average time at which one unit of the NPV flows to the investor (Matschke, Hering, and Klingelhöfer 2002, 173–75; Kruk 2020, 138–39).
A stream of future earnings with a low ratio is interpreted as less “risky” than one with a higher ratio, since the investor is interested in the earliest possible return on his initial investment. In this respect, the duration does indeed contain some information related to the uncertainty of future earnings.
However, the informational value of this key figure is clearly limited. In contrast to investments in traded securities, entrepreneurial ventures usually require investments in tangible assets. In such cases, however, a negative correlation between the interest rate and NPV is anything but a given. Referring to Rothbard (1962 [2009], 62–63), Kruk (2020, 135–38) too assumes a decreasing NPV when interest rates rise. A simple example reveals, however, that this assumption need not be met: Suppose a business in the field of large-scale plant construction accepts a considerable early customer down payment, which leads to the following expected future income stream (–$19,000, $69,000, –$80,000, $28,000, $2,000). The resulting NPV curve of this project is shown in Figure 1 (Hering 2017, 294–95):
Figure 1. Interest rate impact on NPV in our example (Hering 2017, 295)
If the current interest rate is 10 percent, for example, an expected rise in the interest rate does not result in a decreased NPV and, hence, less willingness to invest on the part of the entrepreneur; instead, an increased NPV makes the project appear more attractive than previously. This simple yet realistic example alone shows how an artificial and arbitrary manipulation of the relevant discount rate (which should actually be determined by the entrepreneur’s time preference) intended to reduce NPVs and, thus, decision-makers’ willingness to invest, ultimately fails to do so. Despite this, Kruk (2020, 145–47) recommends discounting with an interest rate adjusted for a risk premium via the CAPM.
Kruk (2020, 139) is correct to point out that the duration estimates NPV reactions to the change in interest rates proportionally. It thus commits an estimation error owing to the relationship being nonlinear. Therefore, the larger the interest rate change, the less is its explanatory power. Additionally and above all, the duration suffers from the unrealistic assumption of a steady interest rate (both before and after the interest rate change) in all periods (Matschke, Hering, and Klingelhöfer 2002, 175). In reality, that is, in imperfect capital markets, such flat interest rate structures are merely rare exceptions rather than standard occurrences.
While the informational value of duration is in itself fairly limited and essentially confined to theoretical borderline cases, linking it to the finance theory-based CAPM as suggested by Kruk (2020, 145–48) worsens matters. In contrast to both NPV and duration, which are decision models, the CAPM is a neoclassical equilibrium model initially established to explain particular market outcomes ex post. For that reason alone, it is entirely pointless for decision-making purposes from an ex ante perspective (Hering 2017, 303–10; 2021, 236–40); the CAPM was simply not designed to support entrepreneurial decision-making (yet has been largely unsuccessful in fulfilling its intended purpose too; hence, it has failed miserably on all counts). Kruk (2020, 145–46) points to CAPM’s popularity among both practitioners and academic proponents of finance theory to justify recourse to it; however, no matter how popular the CAPM has been, that popularity cannot overcome the fundamental issues associated with the model’s application in investment appraisal.
The linking of NPV, duration, and CAPM suffers from another logical flaw: while both NPV and duration are multi-period models, that is, they (in most cases) cover more than one time period and can often span decades, the standard CAPM as described and recommended by Kruk (2020,146) is limited to the consideration of just a single period. In other words: Kruk suggests using a risk-adjusted discount rate derived from a static one-period equilibrium model for the appraisal of uncertain multi-period investment projects in the real world, that is, in dynamic disequilibrium.
HOW TO ACCOUNT FOR UNCERTAINTY IN INVESTMENT APPRAISAL Preparing for investment decisions by acting as if a future state of affairs were fully knowable seems decidedly inappropriate. We thus wholeheartedly agree with Kruk (2020, 146, 148) that (reasonably) considering the uncertainty associated with investment projects in NPV (or duration) calculi can contribute to the entrepreneur’s Verstehen and, thereby, inform his ultimate judgment. Knightian uncertainty neither allows for exact calculations of NPVs in terms of point values nor seemingly definite decision suggestions. The best investment appraisal can do to support entrepreneurs in their decision-making under conditions of uncertainty is to reveal the financial consequences of the range of uncertain future states of affairs imagined by the entrepreneur. Therefore, methods transparently uncovering the uncertainty associated with investment projects, as suggested by proponents of investment theory, rather than hiding uncertainty’s implications in condensed point values, as suggested by neoclassical finance theory, best serve decision-making (Hering 2017, 273–75; Olbrich, Quill, and Rapp 2015, 25–27; Herbener and Rapp 2016, 19–20). Sensitivity analyses and simulations are particularly suitable methods to support the entrepreneur. Figure 2 shows an example (Hering 2017, 334–53) resulting from one such analysis based on a Monte Carlo simulation (Hertz 1964; Coenenberg 1970), which compares NPV distributions of two investment alternatives (A1, A2) given individual entrepreneurial estimations of both future earnings and period-specific discount rates.
Figure 2. Comparison of two simulated NPV distributions (Hering, Schneider, and Toll 2011, 424)
In contrast to the risk premium concept, which manipulates NPV calculi on the level of the input data and immediately presents a seemingly certain point value (Kruk 2020, 147–48), a simulative approach to considering uncertainty in investment appraisal calculates and visualizes the financial consequences of thousands and thousands of combinations of future earnings and discount rates based on the entrepreneur’s estimate, illustrating the possible outcomes of each alternative path of action and thus providing a transparent basis for decision-making. Whether, as figure 2 suggests at least at first glance, alternative A1 should actually be preferred over A2 on the basis of its profile being located somewhat further to the right cannot be decided upon in general terms; instead it ultimately remains an entrepreneurial decision under uncertainty demanding judgment. Needless to say, the entrepreneur may complement the quantitative results provided by investment appraisal with qualitative, non-calculable considerations when formulating his final decision (Herbener and Rapp 2016, 20; Hering 2017, 398–400; Hering 2021, 40–45).
CONCLUSION Neoclassical finance theory follows a (seemingly) objective, market value-based concept and hence, in some sense, resembles “the naive conception of the layman that things have value in themselves, i.e., intrinsic value” (Ritenour 2016, 192). Considering uncertainty in investment appraisal on the basis of escapist models derived from that theory, and particularly the CAPM, therefore cannot support acting humans making investment decisions in the real world. It would be more productive to apply scenario analyses (Hering 2017, 359, 375) and simulations to reveal the possible effects of uncertainty on future states of affairs in imperfect capital markets based on individual entrepreneurial imagination. Doing so would offer entrepreneurs the most transparent source to inform their judgment. The final decision to invest, however, certainly remains a purely entrepreneurial one that eludes mathematical formulation (Hering 2021, 12–13, 44–45, Herbener and Rapp, 2016, 20).
Applying models derived from neoclassical finance theory to support investment appraisal fuels the business cycle. Entrepreneurial evaluations based on actual individual circumstances and estimations of the future (taking into account subjective assessments of the stage of the business cycle) seem superior both on an individual level and in terms of the ability to mitigate the issue of clustered malinvestment as a whole. Although that approach cannot resolve the underlying problem of distorted interest rates and market prices initiated by central bank intervention, it can at least limit its effects (Rapp 2015).
Recorded live at Mises University on 24 July 2021.
Find Startup Stories: Lessons for Everyday Entrepreneurs at: Mises.org/Startup
Menger discovered much more than the principle of marginal utility—he created an entire system of economics based on subjective value and individual choice.
Download lecture slides at Mises.org/MU21_PPT_01.
Recorded at the Mises Institute in Auburn, Alabama, on 19 July 2021.
"The free market and the division of labor does not promote hyper-atomized individuals. It creates social harmony and community." Download the slides from this lecture at Mises.org/MU21_PPT_05.
Recorded at the Mises Institute in Auburn, Alabama, on 19 July 2021.
Download the slides from this lecture at Mises.org/MU21_PPT_06.
Recorded at the Mises Institute in Auburn, Alabama, on 19 July 2021.
This concept of economic calculation is really the foundation of all economic theory, and price theory is the cornerstone of economic calculation. Download lectures slides at Mises.org/MU21_PPT_03.
Recorded at the Mises Institute in Auburn, Alabama, on 19 July 2021.
Saifedean Ammous, famous for The Bitcoin Standard, has a remarkable new book detailing the effects of fiat money on virtually every aspect of society. In the tradition of Guido Hülsmann's The Ethics of Money Production, Ammous returns with The Fiat Standard. From a framework of Austrian economics, this book explains the sordid history of central banks severing currencies from gold redemption—both to finance war and enjoy the political benefits of default. But it also considers the far-ranging effects of inflation on civilization: as time preference increases, everything gets worse. Education, food, architecture, family, and science all suffer, as inflation makes us live today at the expense of tomorrow.
On the 50th anniversary of Nixon's gold shock, The Fiat Standard is an amazing explication of how the West fell to its current state. You don't want to miss this show, especially Saifedean's epic takedown of fiat academia at the end!
Do huge wealth redistribution schemes like Biden's new plan actually make people better off? Some people will get a net benefit. How how numerous are they? How many millions will take a net loss? The government has no idea.
Original Article: "The Fundamental Economic Problem with Biden's Rescue Plan"
This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Michael Stack.
I ended my article last week with a rash assertion. Marx says that capitalists exploit workers, and I countered that this claim depends on the false labor theory of value. It is vital to bear in mind that when Marx talks about exploitation, he has a technical sense of the concept in mind, rather than the popular sense, in which “exploitation” means unfair treatment. To claim that capitalists exploit workers in this sense need not rest on the labor theory of value.
The technical sense arises from a deep question that Marx asks: Why do capitalists earn profits? He does not mean here “profit” as Austrian economists use the term but rather what we would call “interest.” Marx’s question, then, is: Why does capital earn interest? The capitalist starts out with money, which he invests in a business. In the production process of the business, his money turns into commodities. These he sells for money, and he winds up with more money than he had at the start of the process. (This is the famous M—C—M’ formula, where M is money, C is commodities, and M’ exceeds M.)
To specify Marx’s question, what he wants to know is how it is possible, given that in equilibrium all commodities exchange at their labor values, that the capitalist ends up with an increase in money. To reiterate, Marx is talking about equilibrium. Sometimes, capitalists can take advantage of fluctuations in supply and demand to earn more than the going rate of return, and other capitalists earn less than this; but Marx’s question is why there is a rate of return on capital at all.
His answer is ingenious. He says that workers sell their labor power, that is, their ability to produce commodities once given access to the means of production, to the capitalists. The worker is putting himself at the disposal of the capitalist for a certain number of hours each day. Because each commodity sells at its labor value, and labor power is a commodity, a new question arises: What is the labor value of labor power? Marx’s answer is that it is the cost of labor, i.e., the costs of the goods the laborer needs for subsistence and, Marx adds, reproduction. This is in turn determined by the labor values of these goods. Suppose the cost of labor, understood in this sense, is eight hours per day, but the worker has contracted to work for the capitalist for ten hours per day. The extra two hours are “surplus value” and are the source of interest. In Marx’s account, workers are not paid below their value, as measured by the labor theory of value, but the gain to the capitalist comes from the workers’ extra hours; and this is Marx’s technical sense of “exploitation.”
As Wolff realizes, Marx’s account of profit is wrong. I won’t go into the details of Wolff’s mathematical argument for this, but he concludes, “I proved an extremely important theorem that shows that Marx was wrong to impute the exploitative capacity of capitalism to the labor/labor power distinction.” (Unfortunately, he later discovered that someone else had proved the same theorem two years before he did.)
Despite his proof, Wolff remains convinced that Marx was right. Capitalists do exploit workers and this is the most important fact required to understand capitalism. He thinks that where Marx failed, he has succeeded; he has a new proof of exploitation.
His proof is in essence the following. In the capitalist system, all the factors of production have a profit markup. If a capitalist earns below the going rate of return, he can cash out his investment and reinvest in something that pays better. But workers cannot do this. They own nothing besides their own bodies, and they cannot detach themselves from these. They cannot, then, cash out their bodies and invest them more productively elsewhere if they are earning below the profit markup for labor. They thus earn below what the equilibrium price of labor would be if they could make this switch, and this corresponds to the extra profits that capitalists make. In this way, workers are exploited.
Wolff explains his argument in this way:
Now, in a free market, a competitive market, a capitalist market—so all the classical Political Economists agreed—there is a single ruling rate of profit which is adjusted and regulated by the free choices that capitalists make to move their capital from sector to sector in pursuit of the largest return on their investment. If a capitalist who owns a factory that weaves woolen cloth observes that capitalists in the furniture business make a higher rate of return (and, let us recall, that in the classical school perfect information is assumed), then over time and with some adjustment that capitalist can cash in his investment in the woolen factory and shift it … to a furniture factory. To be sure, this is not a switch that can be made overnight for there is a problem with what is called “fixed capital,” but over time and more or less bumpily, the capital gets transferred to the new sphere of production. This has the double effect of increasing the amount of woolen cloth available in the market and decreasing the amount of furniture available for sale. Changes in the relative size of demand and supply alter the prices at which these goods sell which in turn reduces somewhat the rate of return in the cloth industry and increases it in the furniture industry. So by an unceasing series of such individual capitalist decisions and actions the profit rate is perpetually equilibrated. This is the familiar picture painted by Ricardo and his lesser contemporaries. The system of price equations representing the operations of a capitalist economy provides a mathematical model for this story of what goes on in the normal functioning of capitalism…. Ah, but the labor producers, unlike the furniture producers and the cloth producers, cannot shift their capital to a different line of production when they observe that it pays a higher rate of return, for their capital is nothing other than their bodies and the only way they can cash in their investment in their bodies is by… cashing it in, which is to say dying. This is nothing against capitalism, of course. Capitalism places no legal or other constraint on the choices of the workers. It is just an unfortunate metaphysical accident, perhaps laid at the door of Descartes if someone must be blamed, that the workers’ body and soul are inseparable this side of the grave…. Suppose we were to write a system of equations for an economy in which the workers genuinely are treated as free petty commodity producers of the commodity labor. And suppose we were to express mathematically this unfortunate constraint on the workers’ ability to move their capital into other lines of production, thus in a manner of speaking—and only in a manner of speaking—building the ironic treatment of capitalism as a free market system into the equations. Well, because of the unfreedom of those condemned to produce labor, the rate of return in that sector may not be equal to the rate of return in the other sectors and so it must be represented by a different variable…. Without troubling you overly with the mathematics, and, I might say, hardly surprisingly, it turns out that the total profit appropriated in the system by all of the capitalists exactly equals the profit forgone by the workers on their capital—their bodies—by the fact that they cannot shift that capital about in pursuit of a better rate of return and hence are forced to sell their output below what would otherwise be its equilibrium price.
I do not doubt the details of Wolff’s mathematics; his competence in such matters far exceeds my own. But he has not given us a sufficient reason to accept his analysis as a good account of either wages or interest. Marx’s account of interest fails, but at least he asks the right question: Why is there a rate of interest? Wolff does not ask this question but just postulates a profit markup for all factors; he then inquires why workers earn less than this markup. Austrian economics, by contrast, tries to account for the prices of all the factors of production. It is easy to assume what you should be trying to explain, but, as Bertrand Russell long ago said, “The method of ‘postulating’ what we want has many advantages; they are the same as the advantages of theft over honest toil.”
Many readers will be familiar with Robert Paul Wolff’s In Defense of Anarchism, a brilliant criticism of the state’s authority that arrives at conclusions similar to those of Lysander Spooner. Wolff is probably best known for his work on Kant, but he has published penetrating accounts of Marx and Rawls as well. He thinks that Marx offers an analysis of capitalism that is largely correct, and in a recent series of posts on his blog, The Philosopher’s Stone, he offers a characteristically incisive way of looking at Marx’s labor theory of value. I’ll try to show that, however ingenious it is, Wolff’s interpretation does not rescue Marx from absurdity.
Wolff lets us know his high opinion of Marx’s Das Kapital here:
I have devoted extended periods of time to the study and interpretation of the writings of two great thinkers: Immanuel Kant and Karl Marx. To the thought of each I devoted two books and a number of lengthy essays. Kant was my first love and my first great challenge. When I had come to terms with his thought, I was sure I would never encounter another thinker as difficult to master or correctly to interpret. However, when I plunged into Das Kapital three years after publishing my second book on the philosophy of Kant, I found myself confronted with a task even more demanding and multidimensional than that posed by the Critique and the Grundlegung [Groundwork of the Metaphysics of Morals].
As Wolff explains, Marx took over from Adam Smith and David Ricardo the notion that supply and demand aren’t fundamental in determining the price of commodities, i.e., goods produced in mass quantities and sold on the market. Changes in supply and demand will cause prices to fluctuate to restore equilibrium, but this equilibrium is determined by a “natural price” that underlies supply and demand and acts like a Newtonian gravitational force in drawing market prices to it. This natural price is the cost of labor: commodities will tend in equilibrium to exchange in proportion to the labor time needed to produce them. To the objection that capital goods are also costs of production, Ricardo replies that capital goods can be considered “stored-up” or frozen labor, so it remains true that labor costs determine price. There’s a complication involving rent that I won’t go into here. Rent according to this theory isn’t a cost of production; it is a payment capitalists make out of their profits to landlords.
As Wolff notes, there are severe problems with this theory:
In the simple case to which Marx [ha]s restricted himself in volume 1, commodities according to Ricardo exchange in proportion to the quantities of labor required directly or indirectly for their production, or what came to be called “embodied labor.” But if we think about that for a moment we realize there is a very elementary problem. Suppose that we are talking about the exchange of 10 yards of woolen cloth for a wooden chair. The labor required to produce the woolen cloth is quite different from the labor required to produce the chair. Making the woolen cloth involves shearing sheep, washing and drying wool, carding the wool, spinning it into thread, weaving the thread into cloth, and cutting the cloth into a piece 10 yards long. Making the chair involves sawing wood, turning it on a lathe, sanding it, nailing it or joining it with pegs, and so forth. Clearly if we are to compare the labor that produced the cloth with the labor that produced the chair we must abstract from all of these differences. So at the very least, we must be claiming that the wool and the chair exchange in proportion to the quantities of abstract labor required for their production…. But even this is not enough to capture what is mysterious about Ricardo’s seemingly transparently clear theory. For not all abstract labor counts when we are comparing boots and linen or wool and chairs. Suppose that a chair has been made by an apprentice carpenter who has not yet learned the trade. That young man … might spend 10 hours making a chair that a master carpenter could make in five. The buyers of chairs in the market would laugh at a carpenter who charged a higher price for chair because it had taken his apprentice longer to make. Only such labor as is “socially necessary” at any given stage in technological development counts when calculating the relative price of goods in the marketplace. Indeed, the problem is more complex even than I have suggested. Suppose that the carpenters making the chairs are averagely expert in their woodworking skills but find themselves under the direction of a novice manager who has not yet mastered the technique of combining the labor available to him in an averagely efficient manner. The time spent by the carpenters making the chairs may be devalued not because of any lack of skill on their part but because of problems elsewhere in the firm.
Thus, when Ricardo says that in the simple case (remember, we are still in volume 1[of Das Kapital] goods exchange in proportion to the quantities of labor directly and indirectly required for their production, he must be interpreted as actually meaning (although he himself failed to recognize this fact) that goods exchange in the market in proportion to the quantities of abstract socially necessary labor embodied in them.
You might think that this is sufficient to show that Marx is using the wrong theory. Wolff does not think so. He points out that the first few chapters of Das Kapital are written ironically, in a dense and difficult style. Marx is fully aware of the difficulties involved in “abstract labor,” but it is precisely the absurdity of capitalism that it compels capitalists and workers to look at value in this way:
Such talk is, Marx argues, thoroughgoingly mystified but, he insists, we must not commit the error of supposing that it is therefore mistaken. Quite to the contrary…. Marx writes “the categories of bourgeois economy consists of such like forms. They are forms of thought expressing with social validity the conditions and relations of a definite historically determined mode of production, viz., the production of commodities. The whole mystery of commodities, all the magic and necromancy that surrounds the products of labor as long as they take the form of commodities, vanishes therefore, so soon as we come to other forms of production.”
What does Marx mean when he says that this absurd form of thought has social validity? His meaning is profound and goes to the heart of his critique of capitalism. The form of thought whose absurdity he has just revealed has social validity both on the side of the capitalist and on the side of the worker. This mode of thought has social validity for the capitalist because only by conforming his thought and action to it can he function in a competitive marketplace and earn the going rate of return on his investment. If he makes the mistake of thinking of these commodities actually as useful objects made by the labor of real men and women and designed to satisfy human needs, he may become distracted by the reality of the factory or workplace and find himself lavishing more labor on a fabric than will be justified in the market by the price he can get for it…. On the side of the workers, the necessity that they stifle their natural desires, instincts, and creative efforts in their labor in order to work steadily, efficiently, and in a fashion that produces an adequate profit for their employers will of course have a severely destructive effect on their human being.
Though this is ingenious, it rests on a mistake. It isn’t the capitalist market that compels capitalists and workers to think absurdly in units of abstract labor. It is the false labor theory of value that does this. Without the assumption of a natural price that explains what is “really” going on beneath the veil of supply and demand, there is no mystification involved in capitalist production. As Murray Rothbard says, “[V]alues always fluctuate, and there is no invariable fixed base of value from which other value changes can be measured.” (Classical Economics, p. 91) In the Austrian theory of subjective value, there is no resort to this wrong assumption. Wolff at one place suggests that the notion of equilibrium price that modern economists use shows that natural price has not been abandoned, but this isn’t correct. The use of equilibrium concepts, such as Mises’s evenly rotating economy, doesn’t introduce anything other than subjective values in determining prices.
Marx, and Wolff following him, has projected the absurdities of the labor theory of value into the capitalist system of production and on that basis declares capitalism absurd. We should bypass this tangle and instead accept the clear analysis that Austrian theory provides. Austrian economics, to anticipate a rejoinder, does not rest on the unrealistic assumptions of neoclassical economics about which Wolff has elsewhere complained. He would no doubt respond that Austrian theory disguises the realities of capitalists’ exploitation of workers, but it is the false labor theory, not capitalism, that generates an “exploitation” that doesn’t exist.
Using a recent Dave Smith interview of Michael Malice as a springboard, Bob elaborates his understanding of anarcho-capitalist principles to the thorny issues of vaccine passports, court rulings, and desegregation of the Old South.
Mentioned in the Episode and Other Links of Interest: Part of the Problem episode from February 20, 2021, “They Don’t Care About You” featuring Michael MaliceBob’s book The Politically Incorrect Guide to Capitalism (featuring his analysis of racism in business)Bob Murphy Show ep. 176, “A Framework for Analyzing Big Tech Censorship.”Bob’s essay against mandatory vaccinationsBob’s Mises U talk, “The Market for Security” (explaining private law enforcement)Khan Academy page on the Rosa Parks bus boycottBob’s critique of an AIER article on private mask mandates
For more information, see BobMurphyShow.com. The Bob Murphy Show is also available on Apple Podcasts, Stitcher, Spotify, and via RSS.
Bob helps to clarify the Bitcoin debate. On the one hand, the “no intrinsic value” skeptics are ignoring how Austrians deal with gold, while on the other hand, the “HODL forever” enthusiasts would never allow Bitcoin to become a money.
Mentioned in the Episode and Other Links of Interest: Bob (and Silas Barta’s) guide to BitcoinBob’s book Contra Krugman For more information, see BobMurphyShow.com. The Bob Murphy Show is also available on Apple Podcasts, Stitcher, Spotify, and via RSS.
The assertion that “tax-financed public goods can make us all better off” is just that: an assertion. As Rothbard showed, there is no reason to just assume consumers would pay for these amenities were they not forced to through taxation.
Original Article: "Rothbard's Underappreciated Contributions to Public Goods Analysis"
This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Michael Stack.
Centrally planned economies often stick with terrible ideas for many years. But markets can take bad products, learn from them, and turn them into great products that give the public what it wants and needs.
Original Article: "How Markets Turn Lousy Products into Great Ones"
This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Michael Stack.
Just as central planners cannot know how individuals will value a product or service, so too are central planners unable to calculate or plan for the endless array of risk assessments made by potential victims of covid-19.
Original Article: "Covid-19 and the Socialist Calculation Problem"
This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Michael Stack.
Hayek’s last proposal for monetary reform calls for privately issued, competing fiat currencies. It's debatable whether or not this is a good idea.
This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Michael Stack.
Original Article: "Hayek's Plan for Private Money".
In the Ron Howard movie "A Beautiful Mind," Russell Crowe plays John Nash, a major figure in game theory. Although it was a good movie, it totally misconstrues Nash's doctoral dissertation and how it fit into the pre-existing literature. In this episode, Bob sets the record straight.
Mentioned in the Episode and Other Links of Interest: John Nash’s doctoral dissertation.Bob’s link for Liberty Classroom. (If you click this link and then register, the site will know you came from me.)Sylvia Nasar’s book that inspired the Ron Howard movie about Nash. #CommissionsEarned (As an Amazon Associate I earn from qualifying purchases.)A good explanation of the Allais Paradox (which shows limits of expected utility theory).Bob Murphy Show ep. 96, which starts with critique of use of game theory. For more information, see BobMurphyShow.com. The Bob Murphy Show is also available on iTunes, Stitcher, Spotify, and via RSS.
Economist Robert Murphy joins the show to cover Rothbard's excellent treatment of money in Chapter 11 of Man, Economy, and State. Dr. Murphy and Jeff cover why "hoarding" money is socially beneficial; why the velocity of money (and the famous MV=PT equation) is a useless concept, and how new money in society is never neutral. How and why does money maintain purchasing power, and does the interest rate really show the "price" of money? Why do we want "hard" money anyway? This is the show you need to better understand Rothbard's landmark exposition of money in an Austrian framework.
Read the book free of charge in searchable HTML format here.
Use the code HAPOD for a discount on Man, Economy, and State from our bookstore: Mises.org/BuyMES
Additional Resources Hans-Hermann Hoppe on Hutt's "The Yield from Money Held": Mises.org/HoppeHutt
Bob Murphy's study guide to Man, Economy, and State: Mises.org/StudyMES
Man, Economy, and State: Mises.org/MES
Download the slides from this lecture at Mises.org/MU20_PPT_05.
Recorded at the Mises Institute in Auburn, Alabama, on 13 July 2020.
Download lectures slides at Mises.org/MU20_PPT_02.
Recorded at the Mises Institute in Auburn, Alabama, on 13 July 2020.
Download lecture slides at Mises.org/MU20_PPT_01.
Recorded at the Mises Institute in Auburn, Alabama, on 13 July 2020.
Download the slides from this lecture at Mises.org/MU20_PPT_04.
Recorded at the Mises Institute in Auburn, Alabama, on 13 July 2020.
Today's solo show kicks off our reading of Rothbard's landmark Man, Economy, and State with a look at Chapter 1, "Fundamentals of Human Action." So much of what economics texts get wrong is laid out brilliantly here by Rothbard, who gives readers the basics of action, means/ends, time, ranking, factors of production, and capital in this 77 page master class. The short appendix at the end of the chapter alone is a bombshell—demystifying the correct form for economic analysis, and explaining why psychology is not praxeology. Don't miss this introduction to the book you know you need to read!
Use the code HAPOD for a discount on Man, Economy, and State from our bookstore: Mises.org/BuyMES
Additional Resources Man, Economy, and State: Mises.org/MES
Bob Murphy's Study Guide to Man, Economy, and State: Mises.org/StudyMES
Prices and purchasing power are determined by how individual consumers value goods and services. The "velocity of money" won't help us understand prices or the money supply.
This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Millian Quinteros.
Original Article: "Money Velocity and Prices"
Professor Mark Thornton and Jeff Deist finish Part Four of Human Action with a look at Chapters 21–24 of the book—a powerful exposition of how social cooperation and market exchange create far more harmony in society than state power. Here Mises explains how we all choose labor or leisure every day, and why wages are not the exploitative pittance socialists imagine. Land and rents have been misconstrued as special factors of production, when in fact market exchange helps us understand their prices just like any other good.
These chapters serve as a nice summation of several themes in the book, and set the stage for considering full socialism in Part Five.
Use the code HAPOD for a discount on Human Action from our bookstore: Mises.org/BuyHA.
Additional Resources Human Action: Mises.org/HumanAction
Bob Murphy's Study Guide to Human Action: Mises.org/Study
We continue our series on Human Action with Professor Per Bylund of Oklahoma State University.
Dr. Bylund and Jeff Deist consider Part Three of the book, "Economic Calculation," considering Mises's conception of value and the folly of attempting to define a "unit of value" in a highly subjective world. They discuss socialism and the elementary theory of value and prices; inputs and outputs in barter vs. under monetary exchange; prices as exchange ratios; why change is constant and price "stabilization" efforts fail; why mathematical calculation of money prices may rival the wheel as among the most important human inventions; and why Mises thought praxeology emerged when man started thinking about monetary calculation.
Use the code HAPOD for a discount on Human Action from our bookstore: Mises.org/BuyHA.
Additional Resources Human Action: Mises.org/HumanAction
Bob Murphy's Study Guide to Human Action: Mises.org/Study
Our friend and economist Dr. Robert Murphy joins the show for a discussion of Part Two in Human Action, "Action Within the Framework of Society."
This is a great discussion of Mises's view of society and cooperation; Mises on Darwin; the Ricardian Law of Association; the case for treating ideological differences as purely ideological; Mises's utilitarianism as it relates to democracy and anarchism, and the critical importance of exchange and monetary calculation in developing society.
Use the code HAPOD for a discount on Human Action from our bookstore: Mises.org/BuyHA.
Additional Resources Human Action: Mises.org/HumanAction
Bob Murphy's Study Guide to Human Action: Mises.org/Study
In the second installment of our series on Mises's Human Action, Dr. David Gordon joins the show to walk us through Part One. The beginning of the book is considered its most "philosophical" material, where Mises lays out the basics of praxeology and epistemology as fundamental to understanding economics.
Dr. Gordon and host Jeff Deist consider each of the book's first seven chapters, with topics including: Mises's categories of action and causality, a priori disciplines, polylogism, "felt uneasiness," value and preferences, praxeology as it relates to time and uncertainty, probability and its application to human action, and the nature of production.
If you've wanted to read Human Action, this is your opportunity to hear it explained by great economists and scholars!
Use the code HAPOD for a discount on the pocket edition of Human Action from our bookstore: Mises.org/BuyHA.
Additional Resources Human Action: Mises.org/HumanAction
Bob Murphy's Study Guide to Human Action: Mises.org/Study
I. INTRODUCTION The economics profession has recently neglected the connections between the purchasing power and the quality of money. In order to cover this gap, I will analyze the quality of money and how its changes affect the purchasing power of money. I will argue that changes in the quality of money can be far more important for the value of money than changes in its quantity. This conclusion is in line with the subjectivist approach of the Austrian school. In fact, the quantity of money is an objective and measurable aggregate. The quantity theory of money is the heart of neoclassical monetary theory, but does not reconcile well with the Austrian approach. In contrast, the quality of money is a subjective concept and should stand at the center of a monetary theory based on human action. Money serves people in attaining their subjective ends more efficiently and it fulfills certain functions for people. The better these functions of money are fulfilled in the eyes of actors the higher they value money. The quality of money is, consequently, defined as the capacity of money, as perceived by actors, to fulfill its main functions, namely to serve as a medium of exchange, as a store of wealth, and as an accounting unit. Hence, the theory of the quality of money maintains that the demand for money does depend on the quality of money. In fact, the quality of money is one of the important factors, along with uncertainty, financial innovations (credit cards, ATM machines, MMMFs), frequency of payment, etc. that affect the reservation or cash-balance demand for money. The theory of the quality of money, thus, contrasts with a one-sided quantity theory of explaining the price level.
I will first review the treatment of the quality and quantity of money by economists. I will then analyze different properties of money influencing money’s quality and how they can change. In the process I focus on the function as a medium of exchange and as a store of value. I conclude with a summary of my findings.
II. THE THEORY OF THE QUALITY OF MONEY IN HISTORY The theory of the quality of money, even though not under this label, has a long tradition. While many authors have discussed the factors influences the quality of money, no unifying consensus has ever been established. Juan de Mariana (1609) explains that the deterioration of the quality of gold coins must be considered an (unjust) tax. Sir William Petty ([1662] 1889) considers the deterioration of the quality of coins by the government a tax. Adam Smith (1776) speaks of the origin of money and important qualities like durability and divisibility. Jean Baptiste Say ([1802] 1855) states that a good money must be divisible, of the same quality, resistant to friction, sufficiently rare, and malleable. He also analyzes the adulteration of the quality of money in historical instances as in the case of Philip I of France. Nassau William Senior ([1850] 1853) and John Stuart Mill ([1848] 1965) are two classical authors who discuss qualities of commodities that made them suitable to become money. Carl Menger (1871) explains the emergence of money as a spontaneous market process in which commodities with specific qualities prevail. Thus, the treatment of the qualities of money had been widespread before the twentieth century as William Stanley Jevons’s (1875, p. 30) passage states:
Many recent writers, such as Huskisson, MacCulloch, James Mill, Garnier, Chevalier, and Walras, have satisfactorily described the qualities which should be possessed by the material of money. Earlier writers seem, however, to have understood the subject almost as well. Harris explained these qualities with remarkable clearness in his “Essay upon Money and Coins,” published in 1757, a work which appeared before the “Wealth of Nations,” yet gave an exposition of the principles of money which can hardly be improved at the present day. Eighty years before, however, Rice Vaughan, in his excellent little “Treatise of Money,” had written a brief but satisfactory statement of the qualities requisite in money. We even find that William Stafford, the author of that remarkable dialogue of the Elizabethan age (1581), called “A Brief Conceipte of English Policy,” showed perfect insight into the subject. Of all writers, M. Chevalier, however, probably gives the most accurate and full account of the properties which money should possess, and I shall in many points to follow his views.
Austrian economists such as Mises (1953, chap. 1) and Rothbard (2004, pp. 189–93) have followed Carl Menger in their analysis of the origins of money. While Mises does not list the specific qualities that help a commodity to become money, Rothbard (2008, p. 6) mentions the “proper qualities of money”: commodity money is in heavy demand, highly divisible, portable, durable, and has a high value per unit weight.
However, Mises and Rothbard do not advance beyond this insight and do not mention—at least not explicitly—the importance of the quality of money for money’s demand. In fact, Mises neither in The Theory of Money and Credit (1953, pp. 131–37) nor in Human Action (1998) in his chapter on the demand for money (chap. 17) mentions the quality of money as a factor that influences money’s demand. As Salerno (2006, p. 39) states: “Mises (1998, pp. 398–402) provided only a very sketchy discussion of the demand for money which cannot bear the full weight of a theory of money prices.”
Rothbard (2004, p. 756) advances beyond Mises in his conceptualization of the demand for money and states: “The total demand for money on the market consists of two parts: the exchange demand for money (by sellers of all other goods that wish to purchase money) and the reservation demand for money (the demand for money to hold by those who already hold it).”
Rothbard (2008, p. 39) emphasizes that changes in the demand for money (as cash holdings) change money’s purchasing power. In chapters on the demand for money Rothbard (2008, chap. 5; 2004, chap. 11, sec. 5) like Mises does not mention the quality of money as a factor that influences the demand for money explicitly. However, Rothbard (2008, pp. 65–74) mentions two factors that are important for the quality of money: the confidence in money and inflationary and deflationary expectations.
In reviewing Mises’s and Rothbard’s contributions, one question comes to mind: Why did these authors not advance further and develop an explicit theory of the quality of money as a factor that influences money’s demand?This question is intriguing considering that Mises (1953, part II, chap. 2) and Rothbard (2004, pp. 831–42) criticize the mechanistic quantity theory of money. In fact, Mises (1953, pp. 128–30) even criticizes the quantity theory for failing to go behind supply and demand to explain what ultimately determines the value of money. By analyzing the quality of money we will, thus, build on the monetary theory of Mises and Rothbard. The answer lies most probably in their neglect of the function of money as a store of wealth. This function is essential for money’s quality and is more sensitive to changes than the medium of exchange and accounting unit functions.
In fact, Mises (1953, p. 35) follows Menger (1871, p. 278), and maintains that the store of wealth function is a derived and not a necessary function of money. Indeed, Mises (1998, p. 401) focuses even more exclusively on the exchange function of money than does Menger:
Money is the thing which serves as the generally accepted and commonly used medium of exchange. This is its only function. All the other functions which people ascribe to money are merely particular aspects of its primary and sole function, that of a medium of exchange.
Mises (1953, pp. 107, 110, 129; 1990, chap. 4) and Rothbard (2004, pp. 764–65) focus on the exchange function. Thus, they neglect important factors for the value of money. As they do not analyze in detail the store of wealth function, they neither point to the effects that changes in it or that money’s quality in general can have for money’s demand.
In contrast to the hesitant qualitative monetary analysis by the economists mentioned above, there is also a current in the economic literature that does not treat qualitative issues at all. This is the simple quantity theory of money defended by David Ricardo.For an analysis of Ricardo’s monetary theory and his version of the quantity theory see, Rist (1966), esp. chap. 3. For Ricardo it does not matter if gold coins, a chicken, a cocoa bean, a stone token or a paper note is money. Quantity is the only thing that matters. Quantitative issues explain all monetary phenomena. In fact, for Ricardo, all qualities of money are to be found within the limitation of money’s quantity.
Ricardo and the followers of the simple quantity theory strongly emphasize the exchange function of money set forth by John Law and Adam Smith for whom money is basically a voucher to buy goods. Money is simply an instrument of circulation. These quantitative theorists thereby neglect completely the function of money as a store of wealth. Ricardo also implies that there is no difference between inconvertible paper money and convertible money certificates. He, consequently, neglects the demand for money. For him convertibility is just a practical method to ensure a limitation of the quantity of money.
For the believers of this quantity theory,
the value of money is a function of its quantity, it is entirely independent of the value of the material from which coins are made and derived solely from its peculiar uses….(p. 49)
According to that theory, so long as the number of exchanges and the rapidity of the circulation of money remain the same, nothing can affect the value of the unit, and with it the level of prices, except changes in the volume of currency. (Scott 1897, p. 56)
As a consequence, quantity theorists tend to neglect the importance of the demand for money. As Carver (1934, p. 188) points out:
Most quantity theories of money are ostensibly demand and supply theories. Unfortunately, less attention has been given to the demand for than to the supply of money. In fact, some expounders of the quantity theory ignore altogether the demand for money, and proceed on the assumption that it is only the supply that counts. This ignoring of the subject of demand and concentration on the subject of supply seems to be based on the further assumption that the demand for money is, at a given time and under a given set of circumstances, fixed; that it consists exclusively in the number of commodities and services that are for sale.
The quantity theory of money continues to dominate in popular economics textbooks to this day. Some of the more widely used texts are: Mankiw (2004), Blanchard (2006), Stockman (1999), Hyman (1994), Slavin (1994), Boyed and Melvin (1994), Sachs and Larrain (1993), Ekelund and Tollison (2000), Case and Fair (1994), Dornbusch and Fischer (1990). Only a few textbook authors (Colander 1995 and Sloman 1994) mention qualities of money while Melotte and Moore (1995) claim that a good money must be divisible, portable, durable, and stable in value. The textbook by Abel, Bernanke, and Croushore (2008) does not even discuss the qualities of money at all.
Williamson (2005, p. 536) goes so far as to discuss several problems with the qualities of commodity money: First, its quality would be difficult to identify. Second, it would be costly to produce. Third, the use of the commodity as money diverts it from other uses.See also Burda and Wyplosz (2005, p. 176).
Williamson (2005) may have given the real reason why only a few lines, if any, are put forward in support of the quality of money, for it was the advent of fiat paper money that led economists to believe they found the perfect money. Thus, Lewis and Mizen (2000, p. 47) state that paper money can, in principle, do better than commodity money. They argue that paper money’s value can be better stabilized and involves lower resource costs.
A second reason for the virtual disappearance of the quality of money from economic analysis is general equilibrium analysis and mathematization in economics. In general equilibrium analysis, there is no process. With equilibrium analysis the evolution and the origin of money, which would need an analysis of the quality of money, cannot be explained. In fact, the quantity theory of money can explain neither the rise nor the demonetization of money. Moreover, the mathematization in economics and the accompanying rise of the quantity theory of money allowed for measurement. As the quantity of money is more usable for mathematics and measurements, the quality of money was disregarded.
Insights into the theory of the quality of money existed prior to the twentieth century. These insights, however, only enumerate the characteristics of what a good medium of exchange must have, neglecting to point out the importance of the characteristics for the purchasing power of money. In other words, they do not investigate the effects of changes in these characteristics on the purchasing power of money and do not set forth a unified theory of the quality of money. Money has other functions than serving as a medium of exchange. Money serves also as a store of value and a unit of account. A complete theory of the quality of money, must therefore also investigate the qualities of a money in respect to these two other functions. The function of money as a unit of account will not be dealt with. Instead the focus will be on the function of money as a medium of exchange and a store of wealth.
III. THE QUALITY OF MONEY AND ITS PURCHASING POWER The price of money is its purchasing power. As any price, the price of money is determined by its supply and demand. The demand for money is determined by its marginal utility.On a free market the supply of money, as the supply of any good, is indirectly determined by the subjective valuations of consumers. While neoclassical economists maintain that the supply of a good is determined by its historical costs of production, Austrian economists have maintained that the supply of a good is determined by alternative uses of the factors of production for the satisfaction of consumer wants and, thereby, by subjective factors. The utility of money is, in turn, determined by money’s quality, i.e., its capacity to fulfill its services. The quantity of money affects money’s marginal utility by increasing the number of monetary units. The quality of money affects money’s marginal utility by changing the position of monetary units on the value scale of actors in relation to other goods. As Salerno (2006, p. 52) summarizes the determinants of the purchasing power of money:
the stock of money is one of the immediate determinants of the structure of money prices and the purchasing power of money—in conjunction with its immediately past purchasing power, the existing stocks of goods, and the distribution of ownership and the relative rankings of goods and of money among market participants. (Italics added)
It is this relative ranking of goods and of money among market participants that is affected by the quality of money. The factors influencing the quality of money and, consequently, the relative ranking of goods and of money have been widely neglected. Their analysis is precisely the focus of this paper.
Thus, while the quantity of money is important for the purchasing power of money, it is not the only factor. As Henry Hazlitt (1978, p. 74) puts it:
The truth in the quantity theory is that changes in the quantity of money are a very important factor in determining the exchange value of a given unit of money. This is merely to say that what is true of other goods is true of money also. The market value of money, like the market value of goods in general, is determined by supply and demand. But it is determined at all times by subjective valuations, not by purely objective, quantitative, or mechanical relationships. (Italics in original)
Indeed, the quality of money is an essential factor in the process determining money’s price, i.e., its purchasing power. When the quality of money increases, money’s demand and, consequently, purchasing power will be higher than without this quality improvement. Money is, thus, no different than any other good. If the quality of a good increases, there will be more demand, and its price will be higher than without this increase of quality.
The importance of the quality of money can be seen in Eugen von Böhm-Bawerk’s analysis of price determination. Böhm-Bawerk (1884) names six individual determinants of prices in his price theory: the number of units of the goods offered; the number of units of the good demanded; the intensity with which the potential seller values the good; the intensity with which the potential seller values the monetary unit (or good of exchange); the intensity with which the potential buyers value the good; and the intensity with which the potential buyers value the monetary unit (or good of exchange).
The last four determinants can be summarized as the intensity of the valuation of money in relation to the valuation of other goods and services on the part of potential buyers and sellers. This intensity is not only influenced by the quantity of money and goods and services but also by the quality of money. The higher the quality of money is, the more buyers and sellers of money value the monetary unit in relation to other goods and services. The lower the quality of money is, the less buyers and sellers of money value the monetary unit in relation to other goods and services. This implies that the purchasing power of money can vary with a constant supply of money and of goods and services if the quality of money changes. When people start to value money higher, the purchasing power of money will be higher.
Actually, changes in the quality of money can have more abrupt and stronger effects on the price of money than changes in the quantity of money. In fact, changes in the quantity of money only have marginal effects on the value of money. Changes in the quality of money however can abruptly upset the subjective valuation of money in general. Apart from dramatic changes in the money supply, faster movements of the price of money can be expected by changes in the subjective valuation of money’s quality than by changes in its quantity.
One important ramification of the quality theory of money is that prices in general can rise or fall without a change in the quantity of money. Frank Shostak (2008) does not take into account the quality theory of money when he writes:
We know that a price of a good is the amount of money paid for the good. From this we can infer that for any given amount of goods, a general increase in prices can only take place in response to the increase or inflation of the money supply….Now, if the money stock did not increase, then consumers won’t have more money to support the general increase in prices of goods and services.
Shostak is wrong precisely because the quality of money can fall without an increase in the money supply.Subjective value theory shows that the price of pens can fall when the quality of pens decreases even with a constant supply of pens. The same is true for the price of money. The subjective valuation of money and, correspondingly, its marginal utility can fall as a result of a deterioration of money’s quality. As a consequence of the lower subjective valuation of money, money’s price falls. If my subjective valuation of money falls, I will try to reduce my cash balance. If I sold five apples for five dollars, now that the value of money is less I might sell one for five dollars. The same applies for the prices of other goods. As a result, I reduce my real cash balances.The opposite case is, of course, also possible. When people try to increase their real cash balances due to an increase in the quality of money, prices will be lower than otherwise. The effect holds independent of the quantity of money. The phenomenon of falling prices due to a generalized wish to increase cash balances has been called “cash building deflation” (Salerno 2003). See also Hülsmann (2003). Dollar prices have risen because of a change in subjective valuations and not a change in the quantity of money. This rise in prices is due to a fall in the quality of money that resulted in a fall in the demand for money. The fall in the demand for money means that money’s position on value scales relative to other goods’ positions has deteriorated.
In the following section we will discuss factors that influence the quality of money and, consequently, money’s subjective valuations. Some of the factors are related to expected increases in money’s quantity, a possibility not considered by Shostak. Other factors are completely disconnected from quantitative considerations.At this point, consider some examples provided by Carver (1934, p. 194):The desire for [money] is, in turn, made up of several elements. First, there is the fact that the Government will accept it in payments to itself; secondly, there is the fact that creditors must accept it; thirdly, there is the fact, sometimes, that the Government will give gold for it; fourthly—a resultant of the first threethere is the fact that custom has made it acceptable in private purchases. Remove any of these elements and the purchasing power of money will decrease without any increase in the quantity of money or any decrease in the number of commodities and services available for exchange.
IV. QUALITY OF MONEY AND ITS FUNCTION AS A MEDIUM OF EXCHANGE We will first look at factors or properties that influence the quality of money in its function as a medium of exchange. When these properties change the quality of money improves or deteriorates and affects the purchasing power of money.
There are several properties of a good medium of exchange. Most of them have been discussed in the literature in another context, namely in explaining the origin of money. In fact, the quality theory of money can explain the emergence and disappearance of money while the quantity theory cannot explain these phenomena.Another deficiency of the quantity theory of money is that it resorts to the socalled “velocity of circulation;” a black box used ad hoc to explain price changes unexplainable via quantity changes. Yet, an increasing “velocity of circulation” or increasing volume of exchanges in a period does not imply that prices necessarily need to rise. In fact, an increase volume of exchanges on the stock market may coincide with rising or falling stock prices. I thank José Ignacio del Castillo for bringing this point to my attention. Moreover, as a consequence of changes in the store of wealth and medium of exchange function the demand for money may change for a multitude of reasons. To explain all these phenomena by referring to the “velocity of circulation” does not clarify anything. Thus, Mises (1990, chap. 5) calls the “velocity of circulation” a “nebulous metaphor” and Rothbard (2008, p. 29) an ill-defined concept. In any case, a higher “velocity” may be the result of a deterioration in money’s quality (or of a decline in uncertainty, or of financial innovations such as credit cards, ATM machines, etc.), but not its cause. As Salerno (2006, p. 51) puts it: “the aggregate flow of money spending is determined by the value of money and not the other way around.” Salerno rightly criticizes the “vacuousness of the quantity theory.” Similarly, Carver (1934, p. 191) states that when “paper money is no longer redeemable it becomes less desirable, and therefore is spent more promptly. It loses some of its desirability—as a store of value.” In other words, a lower quality as a store of wealth may lead to increased spending independent of quantitative issues. As Carver adds, the increased spending can, however, be compensated for by a decreased eagerness to sell, because sellers also value money less than before. Then, it is not clear at all if the velocity of circulation will increase or decrease. It is, therefore, not an increase in the “velocity of circulation” but the decrease in desirability that explains the fall in purchasing power. One of the most important properties for the quality of money is the existence of a non-monetary demand in society for the money. This demand can be in the form of consumption goods or factors of production. It is important for the quality of money that its non-monetary demand plays an essential role in society—everyone wants and needs it. The money is not only demanded as a medium of exchange but also for other purposes. Thus, for money, as a good, there exist many unsatisfied wants and the intensity of the wants are relatively high and permanent (Menger 1892, p. 5). The non-monetary demand is important because it gives the money holder an “insurance.” Even if the money gets demonetized, i.e., it loses its monetary demand, there is still considerable value to it. The non-monetary demand supports its value.When gold, in 1971, became demonetized, there remained a strong industrial demand, and also as a store of wealth. The price of gold in terms of dollars even soared as the quality of dollars was reduced. The quality of dollars was reduced by suspending the redemption in gold. The price of gold in dollars rose from the conversion rate of $35 in 1971 to a yearly average of $58 in 1972, to $97 in1973, to $159 in 1974, and to $613 in 1980. The increase in the quantity of dollars was also important when the price control on gold was removed. In sum, the higher the non-monetary demand, the higher the quality of money. If, for instance, gold is money and demand for gold jewelry increases, more gold will be used for these purposes and the marginal utility of gold is raised. In other words, the marginal utility of gold may change independent of the rapidity of circulation, the number of exchanges, and the quantity of gold (Scott 1897, p. 56).Carver (1897) also emphasized that the value of money is determined by the same general laws of value as any other good and, specifically, by its metallic value independent of the number of money units. Similarly, Conant (1904) mentions the importance of the intensity of the demand for money. He shows that an increased demand for gold for use in the arts reduces its supply for monetary use.
Furthermore, the more people that accept the money the better the money functions as a medium of exchange. In fact, the incorporation of new users improves the quality of the money. For instance, when people that are engaged in barter start using money its quality is increased. When the Soviet Union and China opened their economies and became a market for dollars, the quality of the dollar increased. The introduction of the euro, in ever more countries, can improve its function as a medium of exchange as more potential buyers accept it. Also legal tender laws influence the acceptance of money and, thereby its quality. As Carver (1934, p. 188) points out, it does matter for money’s purchasing power if paper money is legal-tender and accepted by the government for the payment of taxes and duties or not. By giving paper money legal privileges, the government subsidizes its quality by increasing its use in exchanges.
Other properties for money as a medium of exchange are low storage and transportation costs, easy handling, durability, divisibility, resistance to tarnish, homogeneity, and recognizability.Actually gold became useful as a world money only after advances in metallurgy made divisibility easier. See Fekete (1996, pp. 12–13). These advancements led to an increase in the quality of gold coins and to a higher purchasing power. Indeed innovations such as new melting techniques improved the quality of money (coins). Likewise innovations that decrease transportation costs, facilitate handling, resistance, recognizability or increase homogeneity, and durability also improve the quality of money. Changes in these properties affect the quality of money and thereby its purchasing power independent from money’s quantity or expectation about money’s quantity.
V. QUALITY OF MONEY AND ITS FUNCTION AS A STORE OF WEALTH One of the most important properties of good money is that it is a good store of wealth (Menger 1871, p. 277). Money is the most marketable or liquid good. Liquidity is higher or lower as the loss of value (or the loss of time) experienced in liquidating ever larger quantities of an asset is smaller or greater. The spread between bid and ask prices for a good is an increasing function of quantity. Rising spreads go along with increasing quantities offered.This does not contradict the fact, that spreads are high in some markets and lower in others. It is true that in “thin” markets spreads are high. However, when the quantities offered in “thin” markets increase, spreads also increase. When we buy and sell a book in Sanskrit we will have a high spread. When we buy and sell 1,000 books in Sanskrit, the spread tends to increase. In other markets like the stock market spreads are comparatively low. However, the stock market spreads increase with quantities offered. When we buy 1,000 shares of IBM and sell them the next second, the spread is usually very low. When we buy 100,000,000 shares of IBM and sell them the next second, the spread tends to increase. Different goods have different spreads. The speed with which spreads increase is determined by the speed with which marginal utility declines with increasing quantities.
As money is the most liquid good, people can easily store their wealth and profits from sales until needed for exchange. The stored money serves as purchasing power for the future. People can easily separate the moment of the sale of their product from the moment of the purchase of their needs. Money is, thus, a means to store wealth and preserve the value of goods and services (mainly labor) sold from price fluctuations. It is insurance against the uncertainties of the future. The store of wealth function is, consequently, crucial for the origin of money and for money’s quality. A medium of exchange that loses its storage function will also lose its exchange function.
For the purpose of our paper it is not important if the medium of exchange function or the store of wealth function is more important for the origin of money or if they are two sides of the same coin.It is true, that other goods besides money, such as commodities, serve as a store of wealth. If commodities become relatively more desirable as a store of wealth than money, money’s purchasing power decreases. The same is true for the exchange function of money. Other goods besides money, such as stocks (used as a means of payment in a buyout) or bills of exchange are used in exchanges and their desirability relative to money influences money’s purchasing power. In fact, anything may serve as a medium of exchange while not any object can serve as a store of wealth. The store of wealth function is key for the quality of money.Rist (1966, p. 329) is an example of an author that argues that the store of wealth function is more fundamental and prior to the medium of exchange function:In fact, and this point is fundamental, the function of acting as a medium of exchange, since time is necessarily involved (there is always a certain interval between the receipt of money and expenditure) presupposes the function of a store of value…[the storage and the exchange function of money are] as inseparable as the obverse and reverse of a medal. (Italics in the original) In fact, exchange always takes place in time. Production and consumption are not simultaneous.Rist (1966, pp. 107–8) emphasizes the time element. He explains the characteristics a good store of wealth must fulfill and how gold does so:it must be borne in mind that man lives in society, that social life implies exchanges of services and products, that the greater part of these exchanges can only be effects after an interval of time, and that the goods which offer the best possibility of guarding against the uncertainties of time, of taking precautions against its risks, of preserving, in order to provide against future misfortunes, the equivalent of the labour and the services provided, are precious, rare, durable and indestructible objects, such as gold….Stable money, metallic money, is the bridge between the present and the future. It is because of stable money, or, in its absence, of other stable and precious objects, that, within the economic sphere, man can wait, can reserve his choice and calculate his chances. Without that, he would be completely at a loss. (Italics in the original) Abstracting from time in economics has led to crucial errors in price theory, capital theory, etc., and it is equally misleading to abstract from time in monetary theory or exchange theory. When people sell their products they cannot, or do not, buy goods and services they need at the very same moment, but rather at a later time. A liquid good to store the wealth that does not lose in value is, hence, crucial.
There are several characteristics of a good store of wealth. One important characteristic is the hoardability or storability of a good (Fekete 2003, p. 2). A good is more storable the smaller the loss incurred when it is bought and sold in the smallest quantities—when it is possible to add and subtract small amounts from one’s store of wealth with minimal costs. It should be noted that hoardability is slightly different from liquidity. The more liquid a good is, the slower the increases of the spread between bid and ask prices with increasing quantities. Hoardability, however, refers not to the costs of selling and buying large quantities of a good but rather to the costs of selling and buying small quantities of a good. Thus, salt may be more hoardable than gold but less liquid. Hoardability is also different from divisibility. Divisibility is the ability to divide a good to make exact purchases, while hoardability refers to the economic costs of adding or subtracting from a store of wealth. Teleologically, these concepts refer to different ends, namely exchanging and storing.
Another important characteristic in relation to money’s function as a store of wealth is the possibility of changes in the quantity of money. Thus, the quality of money as a store of wealth is influenced by the possibilities of changing money’s quantity. It should be noted from the outset that the possibility of changing money’s quantity (and derived from this possibility is money’s expected quantity) is only one of several factors that influence the quality of money. Moreover, the expected quantity is relevant for human action precisely because it affects the quality of money. It is relevant because it influences money’s capacity to function as a store of wealth. The expected quantity of money is one of the important factors determining the quality of money.
Let us first look at how the quantity of money increases in free competition. Two characteristics of money production in the free market influence the quality of money as a store of wealth. First, the costs to produce the money are important. Money production costs are determined by the value that individuals place on additional money. The higher the production costs of the money in relation to its market value, the slower the quantity of money will increase. Second, the already existing stock of money in relation to potential production is important. The higher the existing stock in relation to potential production, the lower is the potential rate of increase in the money supply and the better the storage function of money is fulfilled.
We now look at the case of a monopolist money producer. When there is a monopolist producer of money an important property of the money is how its quantity is expected to change. In a fiat paper money standard with a central bank, for instance, the institutional setting of the central bank becomes relevant.The setup and the “formal” independence of the central bank can be changed, of course, and this can also be anticipated. The institutional setting of the currency, therefore, also determines money’s quality. For instance, a central bank that receives its orders directly from the government is more likely to be used to monetize government debt in order to finance spending. A formally “independent” central bank, consequently, improves the quality of the currency.In an empirical study, Spiegel (1998) argued that announcement of the independence of the Bank of England on May, 6 1997 led, on this very day, to a reduction of long-term interest rates by an average of 34 basis points, and thus a reduction of inflationary expectations. This reduction of inflationary expectations represented an increase in the quality of money. The statutes of the central bank, until they are changed, can to a certain extent limit the potential increase in the money supply. Incentives (like bonus payments for central bankers) to inflate the money supply less can also increase the quality of money. If central bankers are accountable and responsible for their policies, and if there is transparency, this can improve the quality of money.
The official goals or mandates of the central bank, as well as the minimum reserves they impose on banks, play a role in the way the quantity of money is expected to be increased and influence money’s quality. In other words, the philosophy of its monetary policy implied in the statutes of the central bank, or the philosophy of central bankers, influences the quality of money in the way that the quantity is expected to change.
A central bank, whose official policy is to stabilize consumer goods’ prices, stands for a higher quality of money than a central bank that in addition to the control of consumer goods’ prices tries to stimulate the economy, stabilize asset prices, or seek full employment.
The ideology of the central bank’s president and other central bank staff influences the quality of money. In addition, comments by central bankers and politicians can immediately alter the quality of money. For instance, when the chairman of the Federal Reserve board states that he is willing to do anything to prevent a recession, this will be interpreted as the promise of future monetary inflation. As a result, the quality of money decreases and there will be an immediate impact on prices, as the currency depreciates in terms of foreign currencies. The dollar price of all goods and services outside of the US increases. Moreover, the prices of commodities can be influenced by central bankers’ comments without a necessary change in money’s quantity. The announcement, as well as its anticipation, of a Paul Volcker or a Ben Bernanke as Federal Reserve president influences immediately the quality of money.
The integrity of the monetary unit is another important property of the quality of money. Money’s integrity, for instance, may be altered through wear and tear of metallic coins. While the nominal quantity of money remains the same, wear and tear leads to higher prices than otherwise. Coin clipping is another example. The government denigrates the quality of the monetary unit by cutting part of the coin away and replacing it with metal of an inferior value (such as copper), without changing the quantity of coins in circulation. For instance, the government can clip 10 percent of the gold coins in circulation and hoard the clipped gold or do whatever it wants with it. The quality of money may decrease independently of whether the government spends the hoarded gold or not. When people become aware of this practice it will lead to higher prices, since instead of coins of 100 percent gold, the coins are 90 percent gold and 10 percent copper.To make the point even clearer imagine that the government does not just hoard the golden ball but transports it in a ship over the ocean. The ship sinks in a storm and the gold is irretrievably lost. It is then likely that people value gold and copper, as well as other goods and services higher in relation to the currency unit than before. In this case prices do not rise because the quantity of money increases or is expected to increase but rather because the quality of the money unit’s gold content was diminished.
Another case of altering the integrity of money is a change in the redemption rate of a government-controlled commodity standard. When the US government changed the redemption rate for the dollar from 1/20.67 to 1/35 ounce of gold in 1933, the quantity of the outstanding dollars was not changed. However, the quality of the dollars changed as there was less gold backing (Carver 1934).
This leads us to the question of the backing of money in the broader sense, i.e., money proper and money-substitutes. Goods or rights of different qualities can be used to back money in the broader sense. The crucial question is, can a money-substitute be redeemed against goods or rights of higher quality? Do bank notes represent a right of redemption in specie? Are the notes just fiat paper money notes? Is the note a money-certificate that can be redeemed against assets of the banks or central banks or not?
A bank note that is a money certificate is of a higher quality than inconvertible paper money.As Carver (1934, p. 188) points out, quantity theorists erroneously must maintain that money would have the same purchasing power going off gold, provided the quantity of the paper money remains the same. This is so, because inconvertible paper money presents a claim on an indeterminate amount, while a (convertible) money certificate is a claim on a clearly defined sum. Inconvertible paper money presents a claim on something that is not specified, it fluctuates in value according to the holder’s estimation of what the inconvertible paper money will be able to buy. If this estimation is very low, the value may well fall to zero.This estimation is influenced by expected quantitative and qualitative monetary developments. Inconvertible paper money’s capacity to serve as a store of wealth is dominated by this uncertainty. Nothing of this sort happens with a (convertible) money certificate that, for instance, can be exchanged at any moment against gold. As Rist (1966, p. 200) summarizes: “In short, convertibility is not a mere device for limiting quantity; convertibility gives notes legal and economic qualities which paper money does not possess, and which are independent of quantity.”
Hence, when the redemption of bank notes in a gold standard is suspended, the quality of money, from one second to the next, is reduced (independent from what might happen to money’s quantity). Bank notes are traded at a discount in relation to gold. This discount grows when people fear redemption is less probable, while the discount shrinks when people regard redemption as imminent. Mises (1953, p. 52) points out, that the value of credit money fluctuates independently of the underlying commodity, depending on the expected probability that it will be redeemed in the future, and on the remoteness of the expected future date of redemption. An illustration is provided by the history of the greenbacks in the U.S.A similar case are the French assignats that fluctuated in value according to the opinions of the chances of redemption. See Rist (1966, p. 189). After the beginning of the American Civil War, redemption was suspended with the promise to resume redemption at some future point. As a consequence, prices rose in terms of greenbacks reflecting the deterioration in quality. During the Civil War, the purchasing power of greenbacks fluctuated with the military success of the Union, independent of quantity issues (Carver 1934, p. 203). With the resumption of specie payment in 1879, there was an expectation that the the quality of the money would increase resulting in an increase in purchasing power (Bagus 2008).
Another historical illustration of the importance of the backing of a currency is the “Bully Marks” in a German prisoners’ of war camp during World War II, as described in Radford (1945). The “Bully Marks” were backed 100 percent by food at the shop and the restaurant in the camp. When the camp was bombed, the restaurant was closed for a short while and food parcels were halved. As a consequence, it became apparent that the backing of the “Bully Marks” became insecure. “Bully Marks” lost ever more in value in relation to the more secure cigarette currency. At the end there was a flight from the “Bully Mark”—a fact, that was not caused by changes in its quantity but rather its quality.
When redemption is suspended indefinitely and there exists no hope that it will be resumed, as occurs in a fiat paper money, the assets and reserves that central banks and banks hold are still important for the quality of money. This is so, because those assets and reserves back the liabilities of the banks.
When a bank goes bankrupt, because of a bank run, the bank’s assets are taken over by the depositors and creditors. The more liquid and valuable the assets the less the money holders can lose and the better is the quality of money. For instance, consider two paper money fractional reserve banks who hold 10 percent reserves in cash and both experience a bank run leading to bankruptcy. Bank A holds foreign reserves, gold, and commercial bills as assets, allowing for a rapid sell-off and a recuperation of large amounts of the depositors’ money. Bank B holds low quality mortgages and other illiquid long-term loans that can only be sold at huge losses or cannot be sold at all. Of course, people would tend to prefer notes from Bank A to those from Bank B. Thus, changes in the assets banks hold affect the quality of their notes.
Similarly, the assets of the banking system as a whole influence the quality of money. Just imagine that Bank A or Bank B represents the aggregate balance sheet of the banking system. The assets of the central bank are especially important for the quality of money (Bagus and Schiml 2008). The assets of a central bank can be used to defend the value of a currency internally and externally. Furthermore, these assets can be used to support a collapsing banking system or a monetary reform. They back the liabilities of the central bank which is mainly the monetary base. A deterioration of the average quality of central bank assets might be called “qualitative easing.” A qualitative easing is possible without an increase in the quantity of money. For instance, a central bank may sell its gold reserves and in turn acquire loans granted to an insolvent bank or troubled government. This deterioration of the average quality of central banks assets while not affecting the quantity of money deteriorates its quality.An example is the subprime crisis. While the quantity of money did not change very much from January 2007 to August 2008, the average quality of assets that the Federal Reserve System held deteriorated substantially. Government bonds were substituted by assets of dubious quality. This process might explain part of the price inflation during the period. See Bagus and Schiml (2009). See Bagus and Howden (2009a) for an analysis of the quality of money as influenced by the actions of the European Central Bank during the financial crisis and Bagus and Howden (2009b) for a comparison of the balance sheet policies of the Federal Reserve System and the European Central Bank and the implications for the quality of the respective currencies.
A final characteristic of the quality of money as a store of wealth is the policies, the ideology, the personnel, credit, and status of government.See on this point also Hazlitt (1978, p. 76). When the fiscal condition of government improves (deteriorates), the danger that government will resort to a deterioration of the monetary standard is lower (higher) than it otherwise would have been. A deterioration of the money standard (improvement) can consist in abandoning (returning to) a commodity standard, a change in the redemption rate or in the increased (reduced) use of the printing press to finance its expenditures.
In fact, a budget deficit is like a “currency illness” and reduces the quality of money (Röpke 1954, p. 142). The amount of public debts is like a “currency cancer” and weighs on the quality of money. The condition of government actually can get very alarming and a fear arises that the government will cease to exist, e.g., the government could be overturned in a revolution or suffer defeat in a war.
In a fiat paper standard the bankruptcy or the end of the government likely means the end of the currency and renders it worthless. It is the confidence in the economy and the taxation capacities of the government that hold the value of the fiat money up. The taxation capacity is crucial, because a fiat paper money is backed by the reserves of the banking system and central bank, which are largely government debts. When government debts become worthless because of an end of government due to war or revolution, the fiat money will also lose in value and may cease to exist. An example would be greenbacks during the American Civil War. The depreciation of greenbacks in terms of gold increased after Northern defeats and was reduced by Northern victories (Studenski and Kroos, 1963, p. 147).
Another example is the development of the currency of the Philippines issued by the Japanese in World War II, as mentioned by Henry Hazlitt (1978, p. 76):
One of the most striking illustrations of the importance of the quality of the currency occurred in the Philippines late in World War II. The forces under General Douglas MacArthur had effected a landing at Leyte in the last week of October 1944. From then on, they achieved an almost uninterrupted series of successes. Wild spending broke out in the capital of Manila. In November and December 1944, prices in Manila rose to dizzy heights. Why? There was no increase in the money stock. But the inhabitants knew that as soon as the American forces were completely successful their Japanese-issued pesos would be worthless. So they hastened to get rid of them for whatever real goods they could get.
Not only wars influence the quality of money. Also economic development influences the quality of money. Anything that disturbs or disrupts development inhibits the taxation capacities of the government and, therefore, potentially the quality of a money. The importance of government policies for the quality of money implies that the government can improve the quality of money if it credibly can impose restrictions on its fiscal policies. Thus, the introduction of a new article in the constitution of a country, that makes a balanced budget mandatory, can increase the quality of money. A related example is the “Stability and Growth Pact” of the European Union. The “Stability and Growth Pact” mandates an annual budget deficit no higher than 3 percent of GDP and a national debt lower than 60 percent of GDP or approaching that value. This was instigated to raise confidence in the euro currency and give a guarantee of its quality. On the other hand, signing a treaty that will probably lead to reckless governmental policies and monetizing of debts, will decrease the quality of money. An example is the signing of the Treaty of Versailles after World War I (Bresciani-Turroni 1968, p. 54). Confidence in the future of Germany declined and a flight from the Deutsche Mark set in. Likewise, Charles Rist (1966, p. 152) emphasizes the importance of government finance for a currency:
when the convertibility of paper has to be re-establised and the exchanges stabilised, sound finance and a balanced budget count far more than limitation of the quantity of paper. The important thing in such a case is to reassure foreign holders of securities or currency as to the ultimate value of paper, and this can only be done by convincing them that the financial stability of the State has been re-established.
From all this we can infer that a fiscally irresponsible government reduces the quality of money. This is so, because by excessive taxation it destroys the productive capacities of the country, reducing the quality of existing government debts. It also increases the amount of government debts itself, which implies even higher future taxation or the monetization of debts. This implies a reduction of the quality of money. Hence, a change in the government itself, its personnel, philosophy, promises, etc., can change the quality of money without any change in money’s quantity.
VI. CONCLUSION The economic profession has largely neglected the quality theory of money concentrating mainly on money’s quantity. Changes in the quality of money are very important for the purchasing power of money and have an important explanatory power. The quality of money affects the purchasing power of money by first altering the demand for money, which reflects the changed valuation of a fixed quantity of money on the public’s value scales. The expected quantity of money is only one of many factors influencing the quality of money and derives its importance from its effects on the quality of money. Thus, an integrated theory of money must put emphasis on the quality of money and explain the importance of the expected quantity of money relating it to its effects upon money’s quality.
Money’s quality is continuously changing. The changes in the quality of money can be slow but also abrupt. Consequently, they can have stronger effects for the purchasing power of money than changes in money’s quantity, which are seldom abrupt. Actually, increases in the quantity of money are increasingly less important the higher the quality of the money is. This is so, because with a money of high quality there will be a strong demand to absorb the additional amount of money as a store of value or for industrial or consumption purposes. If its quality deteriorates or is expected to deteriorate, it can have strong effects on the purchasing power of money. Furthermore, increases in the quantity of a money of high quality such as a 100 percent gold standard do not result in a deterioration of the integrity of the money. The integrity of the previously existing gold coins is not harmed by new gold production. In contrast, increases in the quantity of a money of lower quality, i.e., a fractional reserve paper money, can cause money’s quality to deteriorate by diminishing the average backing of the previously existing monetary units.
In sum, it is time for economists to shift their focus onto the analysis of the quality of money and how it can be changed in line with the analysis in this article. For instance, the quality of different monetary and political regimes, the relevant properties of a good money, the role of expectations and the quality of media of exchange should be analyzed in more detail.
Immediately after he arrived home from fighting in the war in Vietnam, Vito Bialla started his executive recruiting firm, Bialla & Associates, from scratch. He built it into a professional partnership of the highest repute at the highest level (recruiting CEOs and other C-Suite positions) for the largest global corporations. He also started (and sold) a sportswear company and a Napa Valley winery, launched a venture capital fund, and he holds world records in endurance sports such as long distance swimming, desert trail running and ultra-marathoning. He shared his thoughts about the pathways to success in growing a business, recruiting high-performing executives, and identifying high-potential entrepreneurs.
Key Takeaways And Actionable Insights Grow Your Business No hesitation: Quickly identify your field and your customers. Vito started his own recruiting business just 6 months after starting work for the largest global firm in the field. He knew what he wanted to do, and didn’t wait too long to start the journey.
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Recruit Executive Leaders High Performance: Rather than personality traits or CV’s, Vito looks for performance indicators, especially under difficult conditions. An executive who has “bumped his or head against the wall” — i.e. encountered unexpected difficulties — has acquired experience that will be tremendously valuable in all future situations, however tough.
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Identify Entrepreneurs With High Success Potential Un-structured: You can’t learn entrepreneurship in business school, or by working at a large corporation. Structure and process induce a way of thinking that is insufficiently flexible in responding to marketplace changes. The successful entrepreneur knows what to do in a bar fight, when market conditions change radically, cash is running out and the current strategy isn’t working. (Don’t miss Vito’s own “bar fight” story.)
Un-plan: Plans are not particularly useful for entrepreneurs, especially those that are difficult to adjust. Adaptiveness beats planning every time. Vito looks for adaptive personalities (and evidence of previous adaptive behavior) in the entrepreneurs that he finances.
Un-deterrable: Vito’s number one rule is: No Fear. Fear of failure, he says, is unhealthy. Just do it, make something happen, set events in motion and learn from the results.
Additional Resource "Vito Bialla's Patterns to Entrepreneurial Success" (PDF): Mises.org/E4E_43_PDF
Good economic theory predicts effective, cutting edge business practices. For example, the dynamic flexibility of capital resource allocation predicted by Austrian Capital Theory is being realized today via digitization, dematerialization and agile organizational innovations. Entrepreneurs who fully embrace Austrian theory can be leaders in the field of business implementation.
At the same time, economic theory evolves and it’s important to keep up. This week, Hunter Hastings and Per Bylund talk about the economics of value and how this body of theory is superseding old mainstream economic theories from the industrial age. We focused specifically on the industrial-age concept of economies of scale.
Key Takeaways and Actionable Insights Economies of scale can feel daunting to small and medium sized business (97% of all businesses) because of the implication that big businesses enjoy unmatchable efficiencies, advantages in procurement and hiring, and asymmetrical bargaining advantages when negotiating with smaller business as vendors or suppliers.
But this industrial age economic law is not applicable to today’s entrepreneurial businesses. It applies to commodity businesses competing to make the same product and sell it to the same customers. It was historically possible to invest in capital to increase output per worker and lower variable costs to their lowest possible level, thus achieving a price and / or profit advantage, as well as an experience curve benefit of perfecting methods through extended high volume applications. Today, entrepreneurs don’t compete with commodity businesses, or in commodity markets.
Entrepreneurs compete on value, not on cost. Entrepreneurs put the customer in prime position, not production. They select a customer group to serve in the best possible way – so that those customers can experience maximum (subjective) value. Superior service to selected customers to facilitate value for them – not low cost - creates entrepreneurs’ competitive advantage.
Instead of pursuing greater and greater unit volume to lower unit costs, entrepreneurs utilize the customer empathy and feedback cycle to increase the level of value they can facilitate for customers. They process more and more customer feedback to understand better how to improve their experience.
Instead of scaling up, entrepreneurs scale down. Personalization and customization are increasingly effective routes to customer value experiences. Producing less unleashes scarcity, exclusivity, limited availability and uniqueness as value signals to selected customers.
And, when needed, scale can be rented. In the specialized areas where economies of scale are relevant – particularly in shareable infrastructure like the Amazon Marketplace platform or cloud computing – entrepreneurial businesses can “download scale from the internet”, i.e. take advantage of the platform’s scale without building it themselves.
The same customer-first, value-centric model applies In B2B markets. Entrepreneurs identify ways to fit in to the customer’s system in a unique or superior way to re-balance asymmetric bargaining power. Relationship, not scale, brings advantage. Entrepreneurs always put customers and their value experience first, in both B2B and B2C.
Scale is a choice for the entrepreneur. Choose which customers to serve at what scale. The cost connection with scale is far less important than in the past.
Additional Resource "Economics of Value vs. Economies of Scale" (PDF): Mises.org/E4E_42_PDF.
Austrian economics emphasizes the delivery of value for consumers and customers. Only they can define value, because it’s their subjective experience that is valuable to them. Stephen Denning, author of The Age Of Agile, explains how entrepreneurs can exercise the "Agile" mindset, and offers insight into how Austrian principles inform the latest generation of business strategies for the digital age.
Key Takeaways and Actionable Insights The revolution in value:
In the manufacturing economy, value was seen as making goods and selling goods.In the service economy, value was seen as service delivered to, and co-created by, customers.In the digital economy, all value is realized in the customer’s domain, and even they can’t imagine the value they’ll experience when they start using new digital technologies and methods. In Austrian economics, the theories of customer sovereignty and value in experience that sit behind this value revolution are well established. Now, entrepreneurs are finding ways to implement these Austrian principles. They call the new world of value “Agile”.
According to Stephen Denning, the agile value revolution is a mindset, with three guiding principles.
Obsession with facilitating great customer outcomes.Deliver the great customer outcomes at speed (work in small teams with short cycles)Organize the firm as a network not a hierarchical bureaucracy. Entrepreneurs can exercise this mindset in these ways:
Facilitate new value outcomes for customers.
Entrepreneurs don’t create value — value occurs in the customer’s domain based on their consumption, and their context.Entrepreneurs can’t plan the value outcome — it’s emergent.Even customers can’t imagine what value they’ll experience from a new service or new technology.Therefore, entrepreneurs can facilitate value — make it possible — but only customers can realize value. To facilitate value, fit into the customer’s life.
Responsiveness is not enough — you’ll always be behind the twists and turns of customers’ changing preferences and experience.The art is to keep up with customers in real time as they change.Practice customer anthropology — become part of their lives. Time is value — use it well.
Customers prefer faster over slower.Therefore, speed is value.Use time as a strategic weapon: faster wins. Eliminate all waste.
No value is created inside the firm.Many internal activities are pure waste — reversing value outcomes (e.g. decreasing speed).Estimates vary between 20%-50%+ of firm internal activities are waste.Eliminate all the waste you can identify.Export the savings to the customer. Flexible, dynamic capital allocation.
Move resources and capital around quickly, to value-facilitating applications.Be ruthless in eliminating non value-facilitating projects. Design and operate your firm as a network.
A flotilla of speedboats outperforms a big machine.Change processes from linear to networked — from lean to flow.Change organization from hierarchy to network — no reporting lines.Change leadership thinking — place leadership in the teams that are close to the customer Additional Resource "The Agile Value Revolution" (PDF): Mises.org/E4E_41_PDF
ABSTRACT: In the division of labor, economizing valuations require an appraisement of the structure of market prices of goods beforehand. Yet, investment decisions concerning the purchase of an entire business enterprise, for example, necessitate considerations beyond appraisement. An economizing valuation of businesses must be based upon both appraisement and a genuine investment appraisal which provides the valuing person with the marginal price he can barely accept. However, even though the computation of this marginal price is a necessary step towards an economizing investment decision, it is still not sufficient. In case of a company purchase, the price to be paid is unknown beforehand. Therefore, an economizing valuation of firms not only requires both appraisement and investment appraisal but also a negotiation of the final price to be paid. Because the corresponding negotiation process must be characterized as a terra incognita in Austrian economics, this paper investigates in depth the negotiation between the involved parties as the final step towards their economizing valuations and discusses purposive negotiation tactics.
KEYWORDS: value of the firm, investment appraisal, negotiation, value theory, subjectivism, purpose-orientation, Austrian school, neoclassicism JEL CLASSIFICATION: B53, C78, G32, G34 Florian Follert, M.Sc. (follert@iwp.uni-saarland.de) is a Research Associate and doctoral student with the Institute of Auditing at Saarland University, Germany. Dr. Jeffrey Herbener (jmherbener@gcc.edu) is Chairman of the Department of Economics and Sociology at Grove City College and a Senior Fellow at the Mises Institute. Dr. Michael Olbrich (olbrich@iwp.uni-saarland.de) is Professor of business economics and Director of the Institute of Auditing at Saarland University. Dr. David J. Rapp (rapp@iwp.uni-saarland.de) is an Assistant Professor with the Institute of Auditing and a regularly recurring Visiting Professor at Grove City College.
The authors wish to thank conference participants of the 2017 Austrian Economics Research Conference at the Mises Institute and two anonymous referees for constructive and helpful suggestions.
Quarterly Journal of Austrian Economics 21, no. 4 (Winter 2018) full issue, click here.
- INTRODUCTION In an autistic economy, valuation alone is a sufficient condition for economizing decisions (Mises, 1998 [1949], p. 329). In the market economy, however, things look different. In the division of labor, valuation needs to be based upon appraisement to result in economizing decisions (Mises, 1998 [1949], p. 329). While this insight holds true for each and every good to be valued, in the case of financial investment decisions, and particularly concerning the purchase of an entire business enterprise or a substantial share package, acting man’s final valuation must be based upon both appraisement and investment appraisal (Herbener and Rapp, 2016, pp. 10–11). Moreover, contrary to the typical purchase of a consumer good, the asking price of a business enterprise is unknown beforehand. In cases of particular investment decisions, therefore, valuing persons need to engage in a negotiation about the price to be paid (Matschke, Brösel, and Matschke, 2010, p. 6). Apart from appraisement and investment appraisal, this negotiation is the last condition necessary for this person’s final valuation. To date, the Austrian-informed literature lacks a comprehensive analysis of such negotiation process. This paper aims to fill this gap by thoroughly investigating what role negotiation plays for the valuation of, in particular, a business enterprise and how it can be operationalized purposefully.
In order to do so, the paper is structured as follows: In section 2, we will illustrate the requirements for economizing decisions in different economic settings and for different goods. Section 3 will serve to review the status quo of Austrian theorizing on the issue of negotiating in isolated exchanges, to analyze the negotiation process in depth, to illustrate its relevance for valuation, and to discuss tactics for successful negotiations. Finally, section 4 will present the main conclusions which can be drawn from our analysis.
- VALUATION, APPRAISEMENT, AND INVESTMENT APPRAISAL Value is neither intrinsic nor objective in any sense; rather, valuation is an individual act of comparing and, eventually, ranking alternative courses of action in aiming at particular ends, which is necessarily subjective in nature (Menger, 2007, pp. 120–121). Valuation is reflected in a value scale which varies both from one person to another and—for the very same acting human—as time goes by (e.g., Hering, Toll, and Kirilova, 2015a, p. 24; Olbrich, Quill, and Rapp, 2015, p. 20; Rapp, Olbrich, and Venitz, 2017, p. 16), and is demonstrated through action (Mises, 1998 [1949], p. 95). As a consequence of these facts, Mises (1990, p. 56) rightly rejects the very idea of intrinsic value as “the naive conception of the layman.”On the flaws and fallacies inherent in the investment strategy “value investing”, which claims and is built upon the existence of intrinsic value, see Rapp, Olbrich, and Venitz (2017) as well as Rapp, Olbrich, and Venitz (2018).
Mises (1998 [1949], p. 233) emphasizes that
[i]n order to conceive the market fully one is forced to study the action of hypothetical isolated individuals [...] [and in] studying interpersonal exchange one cannot avoid dealing with autistic exchange.
Mises (1998 [1949], p. 195) defines an autistic exchange as an “action [...] performed by an individual without any reference to cooperation with other individuals.”
In an autistic economy, then, economizing decisions are solely made through valuations without further ado, in particular without reference to money prices (e.g., Herbener and Rapp, 2016, p. 7). For example, if Robinson Crusoe had two options to choose from, say, to spend his time either (1) going fishing or (2) collecting berries to satisfy his hunger, he will make an economizing decision solely through preferring either (1) fishing to berry picking or (2) berry picking to fishing based upon his personal preferences.
In juxtaposing an autistic economy with society, Mises (1998 [1949], p. 195) asserts:
Within society cooperation substitutes interpersonal or social exchange for autistic exchanges. Man gives to other men in order to receive from them. Mutuality emerges. Man serves in order to be served.
The exchange relation is the fundamental social relation. Interpersonal exchange of goods and services weaves the bond which unites men into society. The societal formula is: do ut des.
Necessarily, interpersonal exchange both requires and reveals exchange ratios for the goods and services subject to market transactions. In a monetary market economy allowing for indirect exchange through the application of a generally accepted medium of exchange, these ratios become evident in market-clearing money prices (Mises 1998 [1949], pp. 206, 218, 287, 324). While valuation is a prerequisite for economizing decisions in the division of labor too, it is not by itself sufficient. Rather, it must be supplemented by appraisement, which aims at the anticipation of the structure of such market prices or—in other words—at the assessment of the purchasing power of the money concerned (Mises 1998 [1949],p. 329). To rank order in value a particular amount of money, say $1, against a particular good, say an apple, a consumer must know the alternative uses of the dollar, say the purchase of two oranges. Consequently, for decisions in the division of labor to be economizing they must not be based on valuation only; rather, valuation must be well-grounded on appraisement.
While combining both appraisement and valuation usually allows for economizing decisions of consumer goods, there are financial investments, in particular those concerning entire business enterprises, which require additional considerations (for this entire paragraph see Herbener and Rapp, 2016). In buying consumer goods, acting man aims at non-financial ends, for example, to satisfy hunger. A person can directly evaluate in his mind the contribution of a particular consumer good to reaching such ends. In contrast, financial investments are mostly undertaken to fulfill financial ends. How the possession of a firm, for example, contributes to reaching such ends cannot simply be assessed at first glance, that is, directly by one’s mind without economic calculation. In this respect, Menger (2007, p. 255) emphasizes that the “value [of factories] can be determined only after a careful investigation of all the relevant circumstances.” Therefore, acting man needs to apply a particular tool of economic calculation as a decision method, which allows him to evaluate the degree to which the firm contributes to reaching his (financial) ends. Specifically, this tool is to be found in a genuine investment appraisal.Note that the application of investment appraisal to compute the present value of the expected financial benefits of a particular course of action does not prohibit valuing man from complementing this financial analysis with considerations outside of the mere financial sphere. For the role of non-financial aspects in investment decisions and their impact on valuation, see Herbener and Rapp (2016, p. 11). Its purpose is to provide the decision maker with the most important financial piece of information he needs for his economizing decision: the marginal price he can barely accept in a transaction without suffering an economic loss (fundamentally Matschke, 1975; further, e.g., Hering, 2014, pp. 5–6). This marginal price is highly individual data, determined by the (financial) ends a person aims at and the (financial) means available to him in reaching those ends. Following investment theory, which is rooted in early Austrian economics (Schmalenbach, 1919, p. 334; Schmalenbach, 1937, p. 27; Hering, 2014, pp. 27–28; Olbrich, Quill, and Rapp, 2015; Herbener and Rapp, 2016, pp. 12–13), it equals the present value of the individually predicted future earnings, discounted with the correct individual discount rate, that is, the internal rate of return of the best alternative use of funds which is derived from the person’s consumption preference.In this respect, Herbener (2011, p. 14) notes: “As a temporal being, man distinguishes between sooner and later. He can, therefore, judge the value of attaining an end sooner differently than attaining it later. Just as the principle of preference is implied by man’s finitude, time preference is implied by his temporality.” In reflecting the present value of expected future earnings from a particular person’s perspective, the marginal price manifests the contribution a firm, for example, is expected to make in reaching particular ends and, therefore, allows for an economizing ranking against the asking price.
However, in contrast to the regular purchase of a consumer good, for example, an apple in a grocery store, in cases of the acquisition or sale of a firm, the asking price is unknown beforehand. Consequently, a person cannot establish his final value scale beforehand. Therefore, to rank the business concerned against a certain amount of money and, eventually, to act accordingly requires a negotiation about that price beforehand.
- NEGOTIATION AND ITS RELEVANCE FOR VALUATION 3.1 Catallactics and the Status Quo of Austrian Theorizing
Whately (1831, p. 6)—objecting to the formerly established term “political economy”—originally introduced the term “catallactics” to frame the sphere of economics and defined it as the “Science of Exchanges.”Rothbard (1951, p. 946) similarly defines catallactics as “The Theory of Voluntary Interpersonal Exchange.” Following Whately’s (1831, p. 6) definition of man as “[a]n animal that makes exchanges,” catallactics, then, ultimately deals with exchanges conducted by acting man in the marketplace. As Mises (1998 [1949], p. 233) describes it:
[T]he task of this branch of knowledge [is] to investigate the market phenomena, that is, the determination of the mutual exchange ratios of the goods and services negotiated on markets, their origin in human action and their effects upon later action.
It was Mises who revived the term “catallactics” (Rowley, 1994, p. 289) integrating it into his broader analysis of human action, that is, praxeology (Mises, 1998 [1949], p. 233). Mises (1998 [1949], p. 3) concludes:
The economic or catallactic problems are embedded in a more general science, and can no longer be severed from this connection. No treatment of economic problems proper can avoid starting from acts of choice; economics becomes a part, although the hitherto best elaborated part, of a more universal science, praxeology.
Ever since Carl Menger’s (1871) fundamental work, Austrian economists have approached market phenomena progressively by distinguishing various forms of interpersonal exchange, based on the structure of both the supply side and the demand side of markets. Apparently, the simplest case of interpersonal exchange one can imagine consists of one particular seller and one particular purchaser only and, thus, has been labeled “isolated exchange” (Menger, 1871, p. 179 [2007, p. 197]). The investigation of such isolated exchange has been used frequently as a starting point to gain deeper understanding of market transactions in more complex circumstances (e.g., Menger 1871, pp. 175–212; Mises, 1998 [1949], p. 324; Rothbard, 2001, pp. 106–126). However, Austrian economists characterize isolated exchanges as rather rare and occasional while mainly occurring at early stages of the emergence of civilization. For instance, Menger (2007, p. 197) notes:
This case, which could be termed isolated exchange, is the most common form of human trade in the early stages of the development of civilization. Its importance has survived to later times in sparsely populated backward regions and it is not completely absent even under advanced economic conditions, since it can be observed in highly developed economies wherever an exchange of goods that have value only to two economizing individuals takes place, or where other special circumstances economically isolate two persons.
Mises (1998 [1949], p. 324) describes such isolated exchange as “an occasional act of barter in which men who ordinarily do not resort to trading with other people exchange goods ordinarily not negotiated.”
However, even in highly developed economies, such as our own, isolated exchanges turn out to be much more than merely occasional acts. Most of the firms or larger share packages being bought and sold in the market are subject to situations, in which there is neither competition on the demand side nor on the supply side; the latter being impossible anyway due to the uniqueness of the asset concerned, at least as long as the potential exchange concerns a share package exceeding 50 percent of a company’s stocks. Therefore, the Austrian investigation of isolated exchange matches the circumstances in which most presumptive sellers and presumptive purchasers of a business enterprise find themselves. In consequence, it seems worthwhile to review the status quo of Austrian theorizing on the catallactics of isolated exchanges in order to ascertain which fundamental insights can be drawn from previous analyses for the assessment of the role of negotiations for the valuation of firms.
In a monetary market economy, “objective prices [...] are reflections of subjective values” (Ritenour, 2016, p. 21). Mises (1998 [1949], p. 324) explicates, prices
are determined between extremely narrow margins: the valuations on the one hand of the marginal buyer and those of the marginal offerer who abstains from selling, and the valuations on the other hand of the marginal seller and those of the marginal potential buyer who abstains from buying.
Due to the lack of competition on both the supply side and the demand side within isolated exchanges, however, “the ratio of exchange is determined only within broad margins” (Mises, 1998 [1949], p. 324). These margins result from the individual marginal prices of both the presumptive seller and the presumptive purchaser (e.g., Olbrich, Quill, and Rapp, 2015, p. 31). Austrian economists have concluded that catallactic analysis proper cannot say with certainty what the final price involved parties eventually agree upon will look like (Mises, 1998 [1949], p. 324; Rothbard, 2001, p. 109); one thing catallactics can tell us, though, is that if the exchange is finally conducted, the given margin must have allowed for a mutually beneficial agreement, and that the final price is established somewhere within that margin. For instance, Menger (1871, p. 177 [2007, p. 195]) concludes:
Hence, whatever the price that is finally established for 40 units of wine in an economic exchange between A and B, this much is certain, that it must be formed between the limits of 80 [the seller’s minimum price in this example] and 100 [the buyers maximum price in this example] units of grain, above 80 and below 100 units.
Böhm-Bawerk (1930, p. 199) forms the following general proposition:
In isolated exchange—exchange between one buyer and one seller—the price is determined somewhere between the subjective valuation of the commodity by the buyer as upper limit, and the subjective valuation by the seller as lower limit.
Accordingly, Mises (1998 [1949], p. 324) underscores that
[c]atallactics, the theory of exchange ratios and prices, cannot determine at what point within these margins the concrete ratio will be established. All that it can assert with regard to such exchanges is that they can be effected only if each party values what he receives more highly than what he gives away.
Similarly, Rothbard (2001, p. 109) emphasizes that
[a]ll analysis can say about this problem is that, since the exchange must be for the mutual benefit of both parties, the price of the good in isolated exchange will be established somewhere between the maximum buying price and the minimum selling price [...] We cannot predict the point that the two will agree on, except that it will be somewhere in this range set by the two points.
While any sound attempt to deduce a generally applicable law of how the price eventually established will look like in isolated exchange is doomed to failure,We classify the attempts to formulate a general bargaining theory as unsound for such “bargaining theory [is] rarely applicable in the real world” (Rothbard, 2011, p. 365). Austrian economists have at least named potential determinants of that price. Particularly, they have pointed to the fact that the opposing parties will engage in a process of negotiating about the final price (Menger, 1871, p. 177 [2007, p. 195]; Gross, 1884, pp. 46–47; Schullern-Schrattenhofen, 1889, p. 31; Böhm-Bawerk, 1930, pp. 198–199; Rothbard, 2001, p. 109) which will be influenced by both the negotiators’ abilities (e.g., Endres, 1995, p. 4) and their position within the negotiation (e.g., Gross, 1884, p. 131).With reference to Hermann (1874) and Schäffle (1873), Gross (1884, p. 131) argues that “whether or not the price will approximate the minimum or maximum limit, apparently depends on the position the entrepreneur has within the price duel, whether his position is superior to his counterparty’s one or not” (authors’ translation). For example, Menger (1871, p. 177 [2007, p. 195]) while coining the term “Preiskampf”This term has been frequently used by Menger’s disciples Gross (1884) and Schullern-Schrattenhofen (1889), see Streissler (1972, p. 437, footnote 54). For more recent applications see, for example, Spitznagel (2013, p. 22). (“price duel”; “price conflict”; “price war”) states that
it appears equally certain to me that the outcome of the exchange will prove sometimes more favorable to one and sometimes more favorable to the other of the two bargainers, depending upon their various individualities and upon their greater or smaller knowledge of business life and, in each case, of the situation of the other bargainer.
Similarly, Rothbard (2001, p. 109) analyzes that the finally established price “depends on the data of each particular case, on the specific conditions prevailing. In particular, it will depend upon the bargaining skill of the two individuals.”
Moreover, Böhm-Bawerk (1930, p. 199) explicates with more detail:
According as in the conduct of the transaction the buyer or the seller shows the greater dexterity, cunning, obstinacy, power of persuasion, or such-like, will the price be forced either to its lower or to its upper limit.
Rothbard (2001, p. 363) notes that “[l]ittle of value has been said about bargaining since Böhm-Bawerk” (footnote 27) and that “[e]conomists have always been very unhappy about bargaining situations of this kind, since economic analysis is estopped from saying anything more of note.”
Unlike economists in the tradition of Menger, Böhm-Bawerk, Mises, and Rothbard, however, neoclassical economists have attempted to overcome this barrier to economic analysis by formalizing the bargaining process. This development has been a natural extension of their formal-modeling approach to explaining human behavior. To construct a mathematically tractable model of human action, neoclassical economists assume economic agents, instead of human persons, whose simulated behavior is determined by stipulated underlying conditions, namely, the agent’s utility function and objective circumstances whose value in an agent’s behavior is determined by its utility function. Neoclassical economists have modeled every functional type of human action as optimization under constraint: consumption, production, and exchange. Price setting eluded formalization, however, until the advent of game theory after the Second World War. Before that time, neoclassical economists typically assumed the existence of an auctioneer compiling bids and offers made by all buyers and sellers in a market, then computing the equilibrium price, and finally announcing the price after which all trades would be made.See Hahn (2008) for an overview of the Walrasian auctioneer in general equilibrium theory and Negishi (2008) on advancements beyond tâtonnement as a process of price setting in neoclassical economics. Since the early 1950s, neoclassical economists have developed game-theoretic models of bargaining.See Serrano (2008) for an overview of game-theoretic bargaining.
As Rothbard notes in the quote above, economists in the tradition of Mises have considered bargaining an entrepreneurial activity not subject to economic-theoretical laws.The quote (Rothbard, 2001, p. 363) was originally published in 1962, before the game-theoretic treatment of bargaining gained ascendency in neoclassical literature. Such laws describe the universal, cause-and-effect structure of human action. Under adequately competitive conditions, for example, the level of the price of a good is completely determined by the preferences of buyers and sellers, which in turn are subject to the laws of utility. The preferences of the marginal traders are so near to each other that no bargaining range exists. Any seller can always sell to the marginal buyer if any buyer attempts to negotiate for a lower price. And any buyer can always buy from the marginal seller if any seller attempts to negotiate for a higher price. If a market is inadequately competitive, then a bargaining range will exist and the level of price will be determined, not solely by the laws of utility which are universal principles of human action, but by the particular conditions of person, place, and time in which bargaining takes place as noted above in isolated exchange, the extreme case of an inadequately competitive market.
Although it is indeed true that catallactics has no means to completely determine the actual final price in any isolated exchange, additional theoretical insights can be discovered about isolated exchange in cases of investment appraisal in contrast to cases of valuation (and appraisement) alone. The following two sub-sections are devoted to a praxeological investigation of the negotiation process between a presumptive seller and a presumptive purchaser in the special case of an entire business enterprise.
3.2 Negotiation Process and Possible Scenarios
The negotiation about the purchase/sale of a firm, basically, consists of price offers executed by the involved parties, either directly or indirectly through the proposal of an appraisal method or corresponding data (Matschke and Brösel, 2013, pp. 615–616). Every potential price offered by one of the parties is the outcome of that party’s valuation. Through the action of proposing a certain price, that party demonstrates its particular value scale, that is, how it has ranked the business concerned against the suggested price. Inversely, to the opposing party, the offered price serves as an input variable for its valuation. The opposing party compares the quoted price to its marginal price and, eventually, ranks the offered price against the business enterprise in question. Therefore, the negotiation process must be interpreted as a series of repetitive valuations reflected in the proposal, acceptance, or rejection of price offers, both from the presumptive buyer’s and the presumptive seller’s perspective.
In the potential transaction of an entire business enterprise, basically, we can distinguish three scenarios:
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The presumptive seller’s marginal, that is, barely acceptable price exceeds the presumptive purchaser’s marginal price; in other words, the presumptive seller needs to earn more than the presumptive purchaser is willing to pay.
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The presumptive purchaser’s marginal price is identical to the presumptive seller’s barely acceptable price; in other words, the presumptive buyer may at most pay what the presumptive seller at least needs to earn.
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The presumptive purchaser’s marginal price is greater than the presumptive seller’s barely acceptable price; in other words, the presumptive buyer can be willing to pay more than the presumptive seller needs to earn.
In scenario 1, no potential area of agreement exists, since the presumptive seller needs to earn more than the presumptive purchaser may pay:
Figure 1: Presumptive Seller’s Marginal Price > Presumptive Buyer’s Marginal Price
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Rothbard (2001, pp. 107–108) illustrates this scenario using two opposing parties’ value scales as follows:
Smith would be willing to acquire a horse from Johnson if he could give up 100 barrels of fish or less. One hundred barrels or less are less valuable to Smith than the horse. On the other hand, 101 or more barrels of fish are more valuable to him than the horse. Thus, if the price of the horse in terms of the fish offered by Smith is 100 barrels or less, then Smith will make the exchange. If the price is 101 barrels or more, then the exchange will not be made [...] Johnson will not give up his horse for less than 102 barrels of fish. If the price offered for his horse is less than 102 barrels of fish, he will not make the exchange. Here, it is clear that no exchange will be made; for at Johnson’s minimum selling price of 102 barrels of fish, it is more beneficial for Smith to keep the fish than to acquire the horse.
In this scenario, consequently, the negotiation process will be rather short, since there is no price both parties will accept voluntarily which they will realize fairly quick. In any case, one party will value the status quo higher than the transaction, which will be reflected in the rejection of the deal.
Contrary to scenario 1, in scenario 2 a potential area of agreement exists, since the presumptive purchaser may offer a price which is also acceptable to the presumptive seller:
Figure 2: Presumptive Seller’s Marginal Price = Presumptive Buyer’s Marginal Price
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If both the presumptive purchaser’s and the presumptive seller’s marginal prices equate to one another, however, the only price acceptable to both parties equals their common marginal price. Rothbard (2001, p. 109, footnote 23) discusses the same scenario and eventually concludes: “Thus, if Smith’s maximum buying price is 87, and Johnson’s minimum selling price is 87, the price will be uniquely determined at 87.”
Given the identical marginal prices, however, while both parties would not suffer engaging in the transaction which might indeed lead them to conduct it at their shared marginal price, neither can the presumptive purchaser benefit from the transaction by paying less than the business is worth to him nor can the presumptive seller benefit earning more than the business is worth to him respectively (e.g., Menger, 2007, p. 185). Consequently, as both parties cannot improve their state of affairs by means of the transaction, they might—as their equally valuable action alternative—simply abstain from undertaking it, that is, no price at all might be established. The fact that conducting the exchange does not make any of the involved parties better off, leads Menger (2007, p. 185, footnote 5) to classify “indifferent exchanges such as this as definitely non-economic since in them the provident activity of men is set in motion aimlessly quite apart from all the economic sacrifices they may entail.”
Hence, the process of negotiating between the involved parties might again be rather short, since none of them has an incentive to actually conduct the transaction. Either of the parties’ valuations will most likely become evident in the rejection of the deal eventually. Rothbard (2001, p. 108), thus, concludes that “[i]n order for an exchange to be made, then, the minimum selling price of the seller must be lower than the maximum buying price of the buyer for that good” since, as Menger (2007, p. 194) points out, “[both buyer and seller] will agree to an exchange only if it enables [...] [them] to make better provision for [...] [their] needs than would be possible without the exchange.”
Similarly, Böhm-Bawerk (1930, p. 193) argues that
[exchanges] are not made simply for amusement. People who take the—not always trifling—trouble to exchange the goods which they possess for other goods, do so for a rational and material end, and, in nine hundred and ninety-nine cases out of a thousand, this end is to better their economical condition by the exchange.
Unlike scenario 2, scenario 3 allows for more than one particular solution to the Preiskampf. The potential area of agreement is established because the purchaser’s barely acceptable price exceeds the seller’s minimum selling price:
Figure 3: Presumptive Seller’s Marginal Price < Presumptive Buyer’s Marginal Price
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Any price offer within the range between the marginal prices serves as a potential final price, since each of them is mutually beneficial (e.g., Matschke, Brösel, and Matschke, 2010, p. 10). In discussing the same scenario, Böhm-Bawerk (1930, p. 198), therefore, appropriately claims that “it is certain that there will be an exchange; in the assumed circumstances each of the contracting parties can make a considerable profit by the exchange.”
Owing to the existence of potential prices beneficial to both buyer and seller, the involved parties have an incentive to seriously negotiate with each other about the final price since both parties seek to improve their state of affairs through means of the transaction.
3.3 Negotiation Tactics and Appraisal Methods
Before engaging in negotiation, both presumptive seller and purchaser separately compute their strictly confidential (Matschke, 1975, p. 11; Matschke, 1976, p. 519; Matschke, 1979, p. 18) individual marginal prices applying investment appraisal (e.g., Hering, Toll, and Kirilova, 2015b, p. 1), which, then, limit the range of acceptable prices, that is, the potential area of agreement (Matschke, 1979, p. 57). Since man is a purposeful being (e.g., Herbener, 2011, p. 14), his action always aims at particular ends. Mises (1998 [1949], p. 11) emphasizes:
Human action is purposeful behavior. Or we may say: Action is will put into operation and transformed into an agency, is aiming at ends and goals, is the ego’s meaningful response to stimuli and to the conditions of its environment, is a person’s conscious adjustment to the state of the universe that determines his life.
The action of negotiating does not form an exception to this rule; rather, acting man engages in negotiation to reach a certain goal, his negotiation tactics serve a particular purpose. According to the end involved parties aim at, that is, wealth maximization (e.g., Mises, 1998 [1949], pp. 241–243; Rothbard, 2001, pp. 104, 213, 231), both buyer and seller intend to maximize their share of the transaction’s benefit through negotiating with each other (Matschke, 1975, p. 11; Matschke, 1976, p. 521; Olbrich, Quill, and Rapp, 2015, p. 32).For practice-oriented guidance on how to negotiate, see, e.g., Ury (1991); Fisher, Ury, and Patton (2011); Voss and Raz (2016). Herbst et al. (2018) as well as Nagler et al. (2018) provide some current insights on negotiation management. To do so, they will want to reach an agreement at a price as close as possible to the opponent’s marginal price, that is, one that is still acceptable since beneficial to him. Rothbard (2001, p. 109) explicates:
Clearly, Johnson will try to set the price of the horse as high as possible, while Smith will try to set the price as low as possible. This is based on the principle that the seller of the product tries to obtain the highest price, while the buyer tries to secure the lowest price.
Even though a price slightly below (purchaser) or slightly above (seller) the marginal price is beneficial and, hence, acceptable, both parties will engage in a purposive negotiation aiming to maximize their share of the gain to be established through the exploitation of the potential exchange. Menger (2007, p. 195) notes:
It is easily seen that A [, given his marginal price of 100 units of grain,] could provide better for the satisfaction of his needs even if he should have to give 99 units of grain for the 40 units of wine, and that B [, given his marginal price of 80 units of grain,] would be acting economically on the other side if he were to accept as little as 81 units of grain in exchange for his 40 units of wine. But since there is an opportunity for both economizing individuals to exploit a much larger economic advantage, each of them will direct his efforts to turning as large a share as possible of the economic gain to himself. The result is the phenomenon which, in ordinary life, we call bargaining. Each of the two bargainers will attempt to acquire as large a portion as possible of the economic gain that can be derived from the exploitation of the exchange opportunity, and even if he were to try to obtain but a fair share of the gain, he will be inclined to demand higher prices the less he knows of the economic condition of the other bargainer and the less he knows the extreme limit to which the other is prepared to go.
In order to reach a worthwhile agreement, involved parties, therefore, necessarily need not only know their own marginal prices but also need to form an assumption about the opponent’s marginal price (Matschke, Brösel, and Matschke, 2010, p. 6; Brösel, Toll, and Zimmermann, 2012, p. 95; Matschke and Brösel, 2013, p. 622).
Within the negotiation about the transaction of a firm, involved parties usually agree upon a certain appraisal method and negotiate about the corresponding input data rather than merely proposing actual price offers as commonly known from, for example, auctions or flea markets (Matschke, 1976, p. 520; Matschke and Brösel, 2013, pp. 615–616). A party’s negotiation tactics and its proposal for applicable appraisal methods being subject to the negotiation are neither arbitrary nor random; rather, acting man will select the appraisal method and choose the negotiation tactics he prefers purposefully in light of the overall end of the negotiation process, that is, to reach the most profitable agreement. Basically, every imaginable method, which serves to support the quoting party, can be reasonably applied for that purpose. However, methods that are widely known, generally accepted, arbitrarily adjustable, and considered to result in “fair” and “impartial” prices suit best to convince the opposing party of a particular agreement (Matschke, 1976, p. 523; Matschke and Brösel, 2013, p. 624). In other words, conventional appraisal methods are the best fit for negotiation purposes. In recent years, so-called market-value-orientedMises (1951, p. 113) emphasizes: “Only the individual thinks. Only the individual reasons. Only the individual acts.” Since individual action is the visualization of man’s valuations (Mises, 1998 [1949], p. 120), furthermore, only individuals value. Therefore, the prevalent term “market value” is—at best—delusive. Unlike any individual, the market in the aggregate does not and cannot value anything; rather, the market reflects prices resulting from individuals’ valuations and actions. Only under the rigid and unrealistic assumptions that underpin neoclassicism, values and prices equate to one another. Only then does a reference to “market value” make any sense. In the real world, however, the term is nothing but preposterous. methods dominate among business appraisals and, hence, are considered the state of the art (e.g., Olbrich, Quill, and Rapp, 2015, pp. 6–8). Market-value-oriented methods subsume both (1) neoclassical finance-theory-based discounted cash flow methods (DCF) and (2) methods of so-called relative valuation (e.g., Matschke and Brösel, 2013, pp. 125–126).
While both concepts suffer from various profound issues and are, hence, of no use to support valuing man in an investment decision (e.g., Olbrich, 2000, pp. 458–459; Hering, Olbrich, and Steinrücke, 2006, pp. 411–413; Brösel, Matschke, and Olbrich, 2012, pp. 241–242; Olbrich, Quill, and Rapp, 2015, pp. 12–17; Herbener and Rapp, 2016, pp. 20–23), they perfectly meet the demand for negotiation purposes (e.g., Brösel, Toll, and Zimmermann, 2012, p. 96–97; Matschke and Brösel, 2013, p. 624),Functional business valuation theory stresses the significance of purpose-orientation for each and any business appraisal. See, for example, Matschke, Brösel, and Matschke (2010) and Matschke and Brösel (2013). since they are (for whatever dubious reason)Olbrich, Quill, and Rapp (2015, pp. 7–8) provide some insights on the unbounded popularity of prevalent DCF methods. generally accepted, adjustable as needed, and seemingly objective. As long as market participants believe in the superiority of such “objective” methods of business appraisal, subjectivists can make use of that misbelief in order to reach a preferable negotiation result (e.g., Matschke and Brösel, 2013, p. 624; Hering, 2014, p. 222).
One exemplary DCF variant, the flow-to-equity method, can be illustrated as follows (similarly Matschke and Brösel, 2013, p. 725):
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To allow for face saving of the quoting party throughout the negotiation, an appraisal method suits best if it incorporates a certain degree of adaptability without seeming questionable (Matschke, 1976, pp. 523–524; Matschke and Brösel, 2013, pp. 620, 665). DCF methods’ adaptability can, for example, be shown by means of analyzing the popular and Nobel Memorial Prize awarded Capital Asset Pricing Model (CAPM) usually serving to deduce the so-called cost of equity,Even though frequently applied in the broader sphere of finance, the term “cost of equity” is meaningless. (Money) costs are caused by the input factors of, for example, a product, such as raw materials or labor. The dividends distributed to a company’s shareholders, however, reflect the appropriation of a firm’s net income, that is, the output of its operations. Therefore, to refer to (money) costs while actually meaning appropriation of net income mixes two entirely different things up and is, hence, both inaccurate and fallacious that is, (parts of) the discount rate (e.g., Fama and French, 1997, p. 153; Koller, Goedhart, and Wessels, 2015, p. 286). CAPM’s essential conclusion (the expected return of a particular security j (“µj”) equals a “risk-free” rate (“i”) plus a risk premium which reflects the surplus of the expected return of the market portfolio (“µM”) over the “risk-free” rate multiplied by the beta-factor (“βj”)) can be visualized as follows (e.g., Hering, 2015, p. 301):
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The practically applied data for the “risk-free” rate, the expected market return, and the beta-factor cannot perfectly match the theoretical demands of the CAPM (e.g., Hering, 2017, p. 309) simply because its assumptions are not met in reality as the model has an entirely hypothetical nature (e.g., Herbener and Rapp, 2016, p. 22). Hence, the input data are never correct or false; rather, they are the outcome of a willful choice. For instance, the appraiser will usually select a particular government bond (country, maturity, ...) as an approximation for the “risk-free” rate (Damodaran, 2012, pp. 154–155), and a certain stock index (country, industry, period, ...) as a substitute for the theoretically correct market portfolio (Hering, 2017, pp. 302, 309) which shall incorporate the performance of every risky asset rather than merely stocks (Damodaran, 2012, p. 66; Hering, 2017, p. 298). Therefore, CAPM’s inherent degrees of freedom alone—apart from other factors within a DCF appraisal such as the estimation of future cash flows or the computation of a weighted average cost of capital—allow for the justification of basically any price offer supporting the quoting party taking into account both its own and the opponent’s marginal price.
In contrast to the present-value-based DCF methods, so-called “relative valuation”The pleonastic term “relative valuation” fails to describe the special features of this approach sufficiently, since every valuation is in relative terms in the sense that it takes into account at least one alternative course of action. aims to capture the “market value” of a business either based on that business’s market capitalization or the market capitalization of or prices recently paid for (seemingly) comparable companies (Olbrich, 2000, pp. 455–457). For instance, one particular variant of “relative valuation” seeks to compute the appraised firm value of a particular company (“A”) through assessing the market capitalization of one comparable company or several comparable companies (“CC”), dividing it by a particular reference figure of the comparable company or the comparable companies, such as the EBIT, EBITDA, or net income, and to multiply the resulting factor with the respective reference figure of the company being appraised (Olbrich, 2000, p. 456). Hence, it can be visualized as follows:
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Comparable to the application of DCF methods, “relative valuation” suits well for negotiation purposes, since this approach incorporates a high degree of both adaptability and credibility. For example, the selection of comparable companies, the assessment of their market capitalization, and the selection of applicable reference figures allow for more or less arbitrary modeling (e.g., Olbrich, 2000, p. 459; Matschke and Brösel, 2013, p. 680). Moreover, the justification of “fair values” based on observable prices in the marketplace appears to be credible (e.g., Matschke and Brösel, 2013, p. 678). Therefore, this approach suits well for negotiation purposes too.
- CONCLUSIONS Robinson Crusoe engages in autistic exchange only. His actions aim at substituting one state of affairs by a more preferable state of affairs without referring to other individuals. In such an autistic economy, valuation alone is a sufficient condition for economizing decisions. In a market economy, in contrast, economizing decisions concerning, for example, consumer goods rely on both appraisement and valuation. While economizing decisions concerning investments, for example, the purchase of a firm necessitate both as well, however, they are different in two respects: First, appraisement and valuation are necessary yet not sufficient. Investment decisions require knowledge of the barely acceptable price, that is, the application of investment appraisal. Second, the final valuation of a business enterprise is infeasible in the first place, since one lacks knowledge of the asking price beforehand. The price, therefore, must be negotiated. Praxeologically, the negotiation process has to be interpreted as a repetitive series of valuations reflected in the proposal, acceptance, or rejection of price offers. To maximize their share of the benefit of the transaction, both buyer and seller will purposefully engage in a negotiation aiming to reach a price which ought to be as close to the opponent’s marginal price as possible. To accomplish such worthwhile agreement, application of DCF methods and “relative valuation” suit best as they are both highly adaptable and credible.
The Theory of Money and Credit—Mises's first major work—revolutionized economics by introducing a new theory of how and why money has value.
It deserves serious attention, and Dr. Jeffrey Herbener joins The Human Action Podcast for an extended discussion of this seminal work and the achievement it represented.
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The Economic Theory of Costs: Foundations and New DirectionsMatthew McCaffrey, Ed.London and New York: Routledge, 2018, xiv + 270 pp.
Karl-Friedrich Israel (KF_Israel@gmx.de) is lecturer at the Department of Law and Economics at the University of Angers, France.
Quarterly Journal of Austrian Economics 21, no. 3 (Fall 2018) full issue, click here.
This collection of essays edited by Dr. Matthew McCaffrey deals with one of the most fundamental fields of economic research: The Economic Theory of Costs. Indeed, it is so fundamental because of its close connection to all other central areas of research in theoretical economics, such as the theory of choice, value, price, capital, production, risk, uncertainty, and entrepreneurship. All of these are covered in some way in the book.
It spans over 263 pages and is separated into five parts, each containing two essays. Only the last part includes a third essay by the editor himself. Almost all of the eleven chapters are published for the first time in this collection and constitute pieces of original research. The one exception is chapter 4. It contains the first but ultimately discarded draft of Rothbard’s fifth chapter for Man, Economy, and State that was uncovered in the Rothbard archives at the Mises Institute a couple of years ago by Dr. Patrick Newman. He has re-edited and published it previously in this journal (Rothbard and Newman, 2015).In the volume it is also indicated that chapter 5 by Dr. Guido Hülsmann is a reprint of an earlier publication in the Quarterly Journal of Austrian Economics. This is incorrect. Hülsmann’s essay has only been published very recently as a GRANEM working paper (Hülsmann, 2017). The provided reference actually corresponds to the earlier publication of Rothbard’s draft chapter (fn. , p. 144). The page numbers in the earlier reference to the first publication of the draft chapter given in the book are wrong (fn. , p. 126). The reviewer earnestly promises that the rest of the review will be less pedantic. In fact, these are the only errors of this sort that have been spotted.
McCaffrey sets the stage with an introductory chapter, explaining that the contributions contained in the volume stand in the “causal-realist” tradition (McCaffrey 2018, p. 2), which is closely related to the distinctly Mengerian variant of the Marginalist Revolution and the research program that emerged out of it: Austrian economics. The purpose of the book is “to showcase a variety of research strands within the modern Mengerian tradition that relate in some way to the theory of cost” (p. 3). Menger and his intellectual heirs reconstructed economic theory on thoroughly subjectivist grounds, showing that costs in their various forms are derivatives of the subjective values of ends pursued or foregone. The subjective nature of costs is highlighted directly in the first part of the book entitled “Cost and Choice.” From there on the contributions proceed to different areas, applying the basic insights of the theory of costs to some relevant theoretical problems. We will go over them in the order maintained in the book, expanding on a number of selected issues that are of particular importance according to the undoubtedly subjective assessment of the reviewer.
PART 1 – COST AND CHOICE In the first chapter of the book, Dr. Jonathan Newman clarifies some of the foundations of the notion of costs, which he ultimately always considers to be opportunity costs. In particular, he highlights their subjectivity and forward-looking nature: “The ordinality and subjectivity of preferences applies to both value and cost. Just as value is appraised in action ex ante, so are costs” (p. 12). An opportunity cost, in this >ex ante sense, is the subjective value of the next best perceived alternative course of action, all expected consequences taken into account.
Newman identifies two common but contradictory notions of opportunity costs in the standard literature. The first simply defines them as the subjective value attached to the next best choice alternative. According to the second they are objective physical production trade-offs. Both notions are typically presented side by side in modern standard textbooks. This might account, as Newman persuasively argues, for some of the confusion on the topic identified in the literature and by experimental research (Ferraro and Taylor, 2005).
Probably more interesting for readers of this journal, however, is Newman’s discussion of George Reisman’s stance on opportunity costs as well as the recent back-and-forth between Dr. Eduard Braun and Dr. David Howden on the topic (Howden, 2015, 2016b, 2016a; Braun, 2016a, 2016b). Howden criticized Braun in a review of his book Finance Behind the Veil of Money (Braun, 2014), for among other things abandoning the opportunity cost concept. This critique triggered the debate. Newman sides with Howden and reiterates and expands on his convincing arguments for why the notion of opportunity costs, understood as forward-looking subjective expectations of the value of alternative courses of action, is important and useful to analyze human choice. Howden also showed why the ex post evaluation of opportunities is indispensable to find out whether one could have done better than one actually did. Yet these points are not even disputed by Braun. Both Howden and Newman fail to appreciate the actual problem hinted at in Braun’s analysis, namely, the identification of profit in human action and, more specifically, the ex post identification of monetary profits.
Taking ex post opportunity costs as the relevant benchmark for identifying monetary profit leads to a very strange result: A profit could only be made if one had actually invested in the best (or shall we say most profitable) project out there. Imagine tech investor Pete who happens to have picked the project FB for his investment. FB turns out to be the best among all the projects. Pete strikes it rich and actually makes a monetary profit. The latter is determined by the difference between the generated monetary income from FB and the unrealized monetary income Pete could have earned by investing an equal amount of money in the next best alternative.
Now assume that instead it turned out that there was an even better project. Let us call it Twttr. It has generated, for some other investors, an even higher monetary return than FB. This means that Pete would have made a loss instead, as Reisman and Braun lament by providing a number of other examples of this kind. Under this notion of opportunity costs, only investments in Twttr would have generated a monetary profit. This led Braun to focus instead on costs understood as historically incurred monetary outlays for his analysis of financial markets and interest rates. In fact, Newman implicitly acknowledges that Braun has a point when he considerably narrows down the applicability of the opportunity cost concept by stating “that opportunity costs cannot be identified in hindsight and that opportunity costs may only be identified for one choice at a time” (p. 20). If that is so, then good for Braun that he got rid of it for his purposes.
Moreover, it is not quite correct to accuse Braun of denying the importance of alternative uses of resources and foregone opportunities altogether. They are precisely what determines the monetary outlays necessary to acquire the means of production for any given investment project. The higher the expected subjective value of the alternative ends, to the attainment of which those factors could have been dedicated instead, from the perspective of the relevant market participants, the higher will be their money prices, and hence the monetary outlays necessary for the realization of the project.This argument is made, for example, in chapter 10 of the book by Dr. Per Bylund. The investor thus has to compensate for the alternative ends forgone. Costs understood as monetary outlays are indeed, in this very important sense, opportunity costs.
In the second chapter of McCaffrey’s book, Dr. Joseph Salerno presents a very dense theoretical discussion of the “unitary valuation process” (p. 32) that gives rise to money prices paid for goods on the market. He tries to show why there is no such thing as an income effect as a result of price changes along the demand curve for a specific good in causal-realist price theory, and thus responds to a long-standing debate in neoclassical economics.
He argues first of all, following the causal-realist approach to price theory, that an individual’s demand curve for a certain good is a higher-order abstraction. It can be derived on the basis of an ordinal value scale, on which all relevant goods including money are ranked, as well as the existing stocks of these goods in possession of the individual at the given moment. Second, the ranking of money relative to other goods presupposes a given purchasing power—“or rather, a definitely anticipated purchasing power of money” (p. 36). In other words, the purchasing power of money has to be held constant in order to derive the demand curve at the given moment in the first place.
All that happens in response to changes in prices along the demand curve are then substitutions with other goods according to the value scale of the agent. There is no income effect, or as Salerno terms it, purchasing power effect>, because a given purchasing power is a prerequisite for the derivation of the demand curve. The income effect is then merely an “illusion” (p. 35) stemming from the misapplication of demand curves.
However, the reviewer is puzzled by the question of how a price change could be possible without also changing the purchasing power of money. If the purchasing power of money is to be understood as the array of goods that can be bought with a given amount of money, then surely a price change for some good necessarily changes the purchasing power of money. But if a constant purchasing power is presupposed for the derivation of a demand curve, must the very idea of a price change along a given demand curve then not be considered bogus? Rather, under these assumptions, an exogenous change in the supply curve of a good that causes “price changes along the demand curve” must also trigger an alteration of the demand curve itself, to the extent that the subjective value of money changes in light of changes of its purchasing power.
To the reviewer it seems wrong to assume that the purchasing of money as such needs to be held constant in order to construct the demand curve for a specific good. Rather, one has to hold constant the purchasing power of money with respect to other goods and of course the actor’s subjective value scale. In other words, the opportunity costs of spending money on the specific good for which the demand curve is derived need to be held constant. If that is done, there seems to be a way to reconcile a kind of “income effect” with causal-realist price theory. In the reviewer’s eyes, a better term would be “wealth effect.”This idea is further developed in Israel (2018).
Salerno goes on to show why his result does not contradict the possibility of a backward-bending labor supply curve. The latter is possible without an income effect, solely on the basis of the law of marginal utility and a given value scale on which leisure is ranked against money balances. Salerno thus counters a critique raised by Caplan (1999) against Rothbard’s denial of the income effect, while still assuming that the backward-bending supply of labor is possible.
PART 2 – THE EVOLUTION OF CAUSAL-REALIST PRODUCTION THEORY The next two chapters are dedicated to production theory in the causal-realist tradition. Dr. Patrick Newman provides a review of Rothbard’s evolving thought on the topic in chapter 3, which is geared to Rothbard’s original draft chapter on production theory for Man, Economy, and State (Rothbard 2009), republished as chapter 4 in this volume. Rothbard ended up thoroughly revising his production theory and rejected this early version of the chapter. It therefore illustrates the evolution of Rothbard’s thought on the topic. Newman’s accompanying chapter is of great value for the student as well as the historian of economic thought as a brief comparative outline of different approaches to production theory.
Rothbard’s original draft chapter is much closer to the Marshallian partial equilibrium approach to production theory, although it already emphasized a number of weaknesses, such as the fact that one cannot develop a robust theory of investment from the perspective of an isolated firm. Rothbard’s final theory of production, however, adopts an Austrian general equilibrium approach as described by Newman. The latter is distinct from the Walrasian general equilibrium approach and essentially characterized by four features.
First, Rothbard rejects the conceptual distinction between competitive and monopoly prices for the analysis of a market economy as being arbitrary. The formal conditions that define a competitive situation are never met in the real world. As Rothbard pointed out even in his earlier draft chapter: “In this interpretation, every seller of an individualized commodity is a ‘monopolist’” (p. 85). Second, no firm can be a mere price taker. Every firm has some impact on the prices of its products and in that sense always acts under imperfect competition in neoclassical standard terminology.
Third, the standard isocost-isoquant derivation of factor demand curves is rejected as it obfuscates the causal link of price determination that runs from the money prices of the final product to the prices of the factors of production by backward imputation. In the causal-realist analysis, actual and expected output prices explicitly determine the capitalist-entrepreneur’s willingness to pay for factors of production according to their discounted marginal revenue product.
Lastly, the perspective taken in causal-realist production theory is not the one of a manager of some selected firm who in isolation—that is, at specified and constant factor costs—expands production until marginal revenue equals marginal costs. Instead, the vantage point of the capitalist-entrepreneur is taken, who can invest in a variety of different lines of production, which in a dynamic setting will have unequal rates of return. For any individual project it might therefore not be optimal to actually expand production to the point of optimality derived in the Marshallian partial equilibrium approach.
PART 3 – RISK, UNCERTAINTY AND COST In chapter 5 of the book, entitled “The Myth of the Risk Premium,” Dr. Guido Hülsmann sets out to defend a rather bold theoretical claim. He argues that
the prevailing conception of risk as related to the gross rate of interest is ill-founded. It is wrong to conceive of the gross interest rate as the sum of separate components. A closer analysis reveals that the whole idea of a risk premium within the gross rate of interest is a myth and should be discarded from economic science. (p. 134)
His analysis of risk is based on the Misesian distinction between class and case probability as well as the principle of subjective value. The most fundamental claim in Hülsmann’s essay is that probability is not an ontic category, but an epistemic one—that is, probability and more specifically risk is nothing out there in the real world, but it instead refers to our imperfect state of knowledge about the latter. The real world and its transformation is simply what it is: “It is subject to the inexorable laws of cause and effect” (p. 136). These laws are not risky or probable as such, but there is risk involved as far as our knowledge and value judgments about them are concerned.
Case probability refers to the type of imperfect knowledge relevant in the sciences of human action. It refers to cases where actors know some causal relationships, but they know neither all of the related causal chains nor everything there is to know about the relationships that they are aware of, such as their relative importance as compared to other casual factors. Hülsmann explains that subjective value judgments function as a filter through which our partial knowledge becomes relevant for human action. To the extent that one subjectively conceives of a case-probable risk associated with some investment project—that is, a factor that would negatively change its outcome—one attempts to eliminate or diminish that risk as far as possible. At the same time, one tries to amplify the factors that positively influence the outcome. This is the task of entrepreneurship or, as Hülsmann calls it, “the production of success” (p. 138). To the extent that subjectively conceived case-probable risks cannot be eliminated, they have an impact on one’s ex ante subjective assessment of the future value of that investment, and on the assessment of the marginal value product of related factors, but it has no impact on the discounting of these values as such.
Hülsmann argues that the differences in observable gross interest rates can thus not be explained by a risk premium as part of the gross interest rate. Instead, they simply “result from different subjective appreciations of available investment opportunities” (p. 142). He concludes that
the risk component in the gross interest rate is a sort of optical illusion. Different prices for different assets result from the fact that buyers and sellers appreciate them subjectively. From a microeconomic perspective, the implied differences in yield might be called risk premia. And one might use such premia in computations with an internal interest rate, to distinguish more interesting ventures from less interesting ones. But this does not alter the fact that the idea of a risk premium is an intellectual short-cut. It does not correspond to any real object. (p. 144)
The following essay by Dr. Jeffrey Herbener presents the theory of cost as an “example of the mistreatment of time in economic analysis” (p. 147). He incorporates cost curves, which Rothbard thought would not add anything, into the causal-realist framework of the analysis of production decisions and factor pricing. Herbener uses them very effectively to illustrate two implications of the passage of time.
In a pedagogically useful reconstruction of the theory of factor pricing, he first contrasts the timeless neoclassical general equilibrium theory, in which prices of factors of production correspond to the factor’s marginal revenue product and are determined simultaneously with final output prices, with the Austrian analysis of price determination in the evenly rotating economy (ERE). The latter takes production time, or the time structure of production, into account. Hence, factor prices correspond to the discounted marginal revenue product (DMRP). Future output prices determine the capitalist-entrepreneur’s demand for factors of production and thus determine factor prices in the present. Since there is no uncertainty in the ERE, the capitalist-entrepreneur’s factor demand is always such that the money prices paid for the factors used in production correspond to the DMRP and are thus consistent with future output prices. Any change in consumer preferences alters the equilibrium state as output prices change and hence factor demand and factor prices adjust accordingly.
As Herbener points out: “In actual markets, this adjustment process is rarely, if ever, completed, because the underlying causal factors are continuously changing” (p. 160), and because there exists uncertainty of the future. Uncertainty is the second implication of the passage of time for the theory of costs. The passage of time implies change, and change implies uncertainty. According to Herbener, this had not yet been satisfactorily incorporated into the theory of cost in the causal-realist tradition (pp. 160, 165). Capitalist-entrepreneurs discount the MRP, but in the real world they can only anticipate the latter. Hence, factor prices in the present are determined by the factor’s anticipated discounted marginal value product (ADMRP).
It is in Herbener’s words the “spectrum of foresight possessed by the various entrepreneurs” (p. 166) that determine the “speed and accuracy” of the adjustment process toward the equilibrium state as well as the distribution of profits during that process. As he summarizes:
Those with superior foresight move earlier into what prove to be profitable lines of production and earn profits which will then be capitalized into the prices of assets more specific to that line of production as the less-astute entrepreneurs follow suit. Even when the adjustment process reaches its climax and no additional profit can be earned from a further expansion of production because cost structures have been pushed up by rising prices for the more-specific assets used, the entrepreneurs with superior foresight will have earned capital gains by buying the more-specific assets earlier in the process than less-astute entrepreneurs. (p. 166)
PART 4 – CAUSAL-REALIST PRICE THEORY: DEBATE AND SYNTHESIS Chapter 7 of the collection contains a revision of the theory of monopsony, a concept that has been dismissed almost completely by both Mises and Rothbard. Dr. Xavier Méra argues that they and their followers “may have gone too far” (p. 170). Méra offers a brief overview of theories of monopsony, arguing that the new standard theory is essentially at a dead end in that it defines a monopsony in very much the same way as a monopoly is commonly defined, namely, in terms of a deviation from the pure and perfect competition model—that is, a situation in which supply and demand schedules from the perspective of the individual buyers and sellers, respectively, are less than perfectly elastic. Méra argues that this criterion “implies a nirvana fallacy,” since “such perfection is beyond anybody’s reach” (p. 174). Instead, in Rothbardian spirit, monopolies and monopsonies are to be regarded as the result of government intervention, whereby sellers or buyers are granted privileges over potential competitors. The consequences are to be analyzed in terms of more or less elastic supply and demand curves and how the interventions affect these elasticities.
Elaborating on one of his earlier publications on the topic (Méra, 2010), he argues that, when dealing with a producer, monopoly and monopsony are separable from each other only in so far as there could exist perfect competition on the other markets—that is, either the factor markets in case of a monopolist or the output markets in case of a monopsonist. Since perfect competition never exists, a producer is always both a monopolist and a monopsonist, or indeed neither of the two. A monopsony privilege on the factor markets always amounts to some form of monopoly privilege on the output market, albeit not in the absolute sense, and vice versa. Méra explains:
If it is often noticed that a monopoly is a monopsony or a monopsony is a monopoly, this is rarely considered a necessity. And it is true that, with an exclusive grant of monopoly privilege on the sale of a good, one may be its sole seller while still one among many buyers of its non-specific factors of production. However, even in this case competition is hampered on the factors’ markets since no competitor is allowed to hire them for the production of the monopolized good. With an exclusive grant of monopsony privilege, one may be the sole buyer of a factor of production while still one among many sellers of a good it helps to produce, provided this factor is not indispensable to its production. Yet even in this case competition is hampered in the product market, because competitors are not allowed to produce the product using this factor. (p. 178)
The important question is to what extent the granted privileges increase the price differential between factors of production and output in response to a restriction of output and factor demand, and thus to what extent they allow for monopoly-monopsony gains. Thus, Méra develops a “theory of monopoly price-gap” (p. 176).
In his discussion of non-specific factors (e.g., labor), Méra makes a very valuable theoretical contribution within the causal-realist framework. He shows that a monopolist-monopsonist could conceivably push money prices even for non-specific factors (e.g., wages) under certain conditions below the market-clearing rate. If the demand for the output that the monopolist-monopsonist sells is inelastic, then the buyers’ overall sum of money spent on that output will increase in response to a restriction of supply. This implies a reduction of money spent on other goods. The selling prices of those goods will fall along with the other producers’ demand for the non-specific factors of production. Hence, prices of the non-specific factors will, as a result, be pushed downward.
This, however, in and of itself, does not seem to be a sufficient condition for what Méra attempts to show. He neglects a potential offsetting effect. While nominal expenses of the buyers of the monopolist-monopsonist’s product on other goods will go down, nominal expenses of the monopolist-monopsonist on various other goods, in his or her capacity as consumer or investor, will go up as a result of the realized monopoly-monopsony gains. This will have exactly the reverse effect, increasing monetary revenues of other producers and hence their demand for the non-specific factors of production. It is not clear where the net effect lies.
Of course, this does not change the fact that Méra has nicely illuminated the mechanism by which prices for non-specific factors, such as wages, might be pushed below the market clearing level as a result of monopoly-monopsony power.
In the next essay, Dr. Mateusz Machaj deals with some Post-Keynesian criticisms of the neoclassical marginalist theory of product pricing and shows that the Austrian theory is mostly immune to those criticisms. Yet, he holds that “in some cases the Post-Keynesian contribution to price theory strengthens Austrian arguments about the market process, especially in those aspects where Post-Keynesians are anti-neoclassical” (p. 195).
Post-Keynesians tend to highlight the relative importance of quantity and inventory adjustments instead of price adjustments in response to changing conditions of demand. Prices tend to be more or less “sticky.” Moreover, they argue that output prices are rarely set in such a way that marginal revenue equals marginal cost. Machaj shows that Austrians have at least implicitly already addressed these considerations, which he argues could be interpreted as being “the result of a plain state of rest perspective” (p. 196). In contrast, neoclassical economists “seem to talk about the final state of rest,” which is another way of saying that they abstract from uncertainty, change and time as shown and discussed in Herbener’s essay in chapter 6 of the volume. The Post-Keynesian qualms stem from these unrealistic assumptions in the standard neoclassical theory, but “economic reasoning can rely on the realistic momentary equilibrium of the plain state of rest for analyzing the pricing process,” (p. 196) as Machaj argues.
In his discussion of the imputation process (pp. 198–200), Machaj gives the hypothetical example of shirt production. He supposes that blue and green shirts are produced and sold at the same price even though demand for blue shirts is much higher. Sellers have adjusted quantities instead of prices. He argues correctly that such a case would not prove the limitations of the marginalist approach, but his explanation strikes the reviewer as somewhat unsatisfactory. He writes:
According to Böhm-Bawerk, the law of costs is actually an idea about marginal utility in disguise. In the shirts example, for instance, it does not matter that demand (and marginal utility) for blue shirts is higher relative to green shirts. What matters are the marginal utilities of other goods and services that would have to be given up in order to reproduce blue shirts. And since green and blue shirts require basically the same sacrifice, virtually the same marginal utility would have to be lost. If we lose the last-produced blue shirt, we only have to give up the production of the last green shirt and switch green dye for blue (just as when we lose the most important blue shirt we only have to use the marginal shirt as the first). Therefore we have a perfect explanation of why the costs of both shirts are the same—in the end, their marginal utilities of reproduction are the same. (p. 199)
This does not really explain why their selling prices remain the same. In the plain state of rest analysis, they remain the same because of the price-elasticity of demand anticipated by the producers. If they anticipate that price-elasticity is high for whatever reason, they might not raise the price for blue shirts, and instead start to expand blue shirt production as far as this appears to be profitable—that is, simply to the point where marginal revenue equals marginal costs or demand is anticipated to be satisfied at the prevailing price. This in turn increases demand for blue dye and exerts upward pressure on its price. Whether or not “in the end, […] [the] marginal utilities of reproduction” of green and blue shirts are the same, depends on whether or not blue dye production can be expanded without significant increases in marginal costs.
In the end, the pricing of the factors of production depends on the prices of the final output. Indeed, Machaj puts this fundamental Böhm-Bawerkian insight very vividly:
From the perspective of an individual producer, it may seem that sellers practice cost-based pricing. Yet at the same time, this fact in no way validates the broad marginalist point that costs themselves result from other potential investment avenues that could be undertaken. Once we look at the economy as a whole, we see price-based costing despite the fact that firms attempt to engage in cost-based pricing. (p. 200)
PART 5 – ECONOMIC ORGANIZATION, ENTREPRENEURSHIP AND THE FIRM The first chapter of the last part of the book is by Dr. Mihai-Vladimir Topan. It contains a discussion of the compatibility of Austrian economics and “transaction cost economics” as developed most notably by Ronald Coase and Oliver Williamson. Topan comes to the conclusion that transaction cost is a “chameleonic instrument which raises more questions than it solves” (p. 220). Consequently, incorporating transaction costs as a general abstract notion into Austrian economics would in his eyes not improve the theoretical analysis, neither in the areas of economics of property rights nor the theory of the firm, which he specifically investigates.
The most obvious problem with the notion of transaction costs is that it is not well-defined. Topan argues that it is based on a misleading dichotomy between production and exchange, or the firm and the market. Transaction costs are somehow related to the latter but not the former. Topan explains the problem:
Praxeologically, as Mises would say, any human action has the structure of an exchange—autistic exchange or interpersonal (direct or indirect) exchange—involving the giving up of a certain state of affairs in favor of another that is expected to be more satisfactory. […] Thus, the general category of costs, understood as opportunity costs of the actions undertaken by human agents, cannot theoretically be split into two categories—production costs and exchange (or transactions) costs. They are simply part of the same general category of cost with no substantive difference to set them apart. (pp. 209–210)
The vague notion of transaction costs has thus been applied to all kinds of questions in economics. There is what Topan calls a “transaction cost imperialism” (p. 217), in which attempts are made to explain not only firms, but markets themselves as well as all kinds of market phenomena, such as money, in terms of transaction costs. The notion ends up proving too much: “Coase suggests that the effects of transaction costs are ‘pervasive in the economy.’ The problem is that if transaction costs explain everything, they end up explaining nothing” (p. 218).
The next essay in McCaffrey’s volume does not deal with the elusive concept of transaction costs, but rather applies the more common notion of opportunity costs in order to show, in a first step, that value logically precedes costs> even if understood as outlays for production. Indeed, Dr. Per Bylund explains that it is the anticipated value of investment projects that leverages the costs in existing lines of production in an entrepreneurial economy. This is because the demand for factors of production increases when new lines and methods of production are explored. This is again an application of Böhm-Bawerk’s theory of factor pricing via imputation that was discussed and applied previously in the book.
The new element in Bylund’s chapter, with respect to the rest of the book, is his discussion of entrepreneurship and management as distinct economic functions. He draws certain implications from this distinction for the socialist calculation debate. His analysis seems to be targeted towards rebutting a recent contribution to the debate by Denis (2015). The latter has argued that one could have public ownership of, but decentralized decision making and control over, the means of production. This arrangement, which he terms “several control,” would provide market prices and thus allow for economic calculation.
Without having studied Denis’s contribution and judging solely from Bylund’s brief description, the reviewer suspects that such an arrangement of “several control” could strongly resemble what we observe in the real world today, for example, in Sweden or the US. After all, there is no full-blown private property, but rather a “fiat property” arrangement. There is decentralized “ownership” or control over the means of production and their revenue product only to the extent that a centralized state, or, if you like, a democratic collective, grants it.
Bylund argues that in Denis’s world there could be no entrepreneurship. There would merely be management. The validity of this claim depends, of course, on the definition of the terms. However, from Bylund’s outline, one gets only an intuition, and by no means a clear-cut answer as to where exactly the line is drawn. At one point, he states: “The entrepreneurial function is here one that provides value creation relative to other types of production that already exist in the market” (p. 230). The entrepreneur develops “new supply functions that disrupt the market and discover previously unknown demands […] [T]hey require new uncertainty-bearing and are consequently entrepreneurial” (p. 232). In contrast,
within the firm’s production process, the manager can improve its technical efficiency […] or the effectiveness of the already-established production process by reducing waste and lead times, and consequently increasing overall resource utilization. […] The product can also be refined in its functionality, features, and quality, particularly as the firm learns about its customers’ specific wants and can therefore better target those most highly valued. (p. 235)
What precisely distinguishes refinement of an existing good and the creation of new ones is not perfectly clear, but surely both, if successful, create value and thus economic growth. So does the reduction of waste.
At one point, the distinction is made more specific, when Bylund claims that entrepreneurship, that is, the “creation of a new supply function entails the withdrawal of capital from its existing use and the subsequent investment in the new endeavor, which requires ownership” (p. 232). If ownership is a necessary condition, then indeed in Denis’s world there can be no entrepreneurs by definition.
However, a lot seems to depend on how such an arrangement of “several control” is exactly exercised. As mentioned above, it could look more or less exactly like the US or Sweden today, where presumably there are at least some entrepreneurs. To what extent there will be interference with the free exchange of rights to control, exchange, and combine resources and factors of production in different endeavors is simply an extra layer of uncertainty. Successfully bearing this uncertainty requires entrepreneurial skill.
Now, one might not want to call that entrepreneurship, but this is a semantic issue and actually not the most important point of the essay. More importantly, Bylund argues that a pure management economy would be regressing or shrinking even if there are market prices. It is important to note that he does not directly criticize and reject Denis’s claim that one could have market prices under “several control.” Thus, Bylund seems to accept the idea that a pure management economy could have market prices.
It seems to the reviewer that a well-managed economy without entrepreneurial innovation, where market prices exist, would not necessarily be shrinking. It could expand and grow in at least three respects, namely, as mentioned above, by the reduction of waste, the refinement of existing goods, and through the accumulation of capital and the expansion of the physical output of known goods in existing lines of production. If the relative demand in terms of known goods changes, a well-managed economy would also be capable of redirecting factors of production from one existing line to another. The managers who are confronted with increases in demand could bid away factors of production from others.
There are, of course, undeniable problems if there truly is no innovation in the economy. Exhaustion of non-renewable resources might serve as an example. But this does not change the fact that Bylund’s conclusion that in a management-driven economy “value will not only not be created but will be actively destroyed” (p. 239) is exaggerated. The theoretical discussion does not suffice to support this claim.
The last essay is entitled “Economic Calculation and the Limits of Social Entrepreneurship.” It is written by the editor of the volume. McCaffrey links the Misesian theory of economic calculation to aspects of “social entrepreneurship.” In the introduction, social enterprises are defined as follows:
Social enterprises are business organizations that are not motivated by the desire to generate monetary profits for traditional shareholders. Instead, the profits of social enterprise are used to solve “social” problems, often by addressing the same kinds of needs as charitable organizations. Social enterprises are special, however, because they support their missions through successful commercial ventures rather than through donations. (p. 244)
Indeed, the weasel word “social” requires further explanation here. McCaffrey explains that “action is ‘social’ to the extent it fosters cooperation and thereby encourages specialization and the division of labor” (p. 245). It is thus ultimately “inaccurate to contrast social with non-social enterprises” (p. 246) in this broad sense of the word. Enterprises are always social, but may be so in different ways.
Moreover, using Fetter’s notion of psychic income, and the Misesian derivative of psychic profit, McCaffrey shows that it is likewise untenable to call any enterprise strictly “not-for-profit.” Social enterprises are bound up with a kind of profit motive too. If the “social cause” pursued by the enterprise involves giving money in some form or another to certain groups, it must generate monetary income if it attempts to be more than a mere charity organization, as McCaffrey points out (p. 249).
These considerations show that it is much more difficult to clearly distinguish the social and mundane types of entrepreneurship. There is no clear-cut theoretical distinction between them that makes their analysis in terms of economic calculation fundamentally different. This is the underlying point of McCaffrey’s essay. He nonetheless maintains that “[e]conomics provides wide-ranging theories of social interaction, value, calculation, profit, and pricing that can be used to rigorously define the domain of social entrepreneurship” (p. 259). However, the “social element” is ultimately simply one form of consumption, which has to be financed in some way.
McCaffrey discusses complementary social enterprises, which operate exactly like mundane enterprises, except that they donate their profits to some “social” cause and let their costumers know it. Yet, when it comes to integrated social enterprises, the pursuit of the “social” cause is tied up into the production process itself. In practice, this means that the entrepreneurs are willing to pay morefor some factors of production. They might hire homeless workers and pay them a salary above their discounted marginal revenue product (p. 257).
In so far as the pursuit of the “social” cause is valued by the customers, the entrepreneurs will attract additional revenue. It might turn out after all that the homeless workers are really not paid above their marginal revenue product as McCaffrey shows. If the pursuit of the “social” cause does not attract additional revenue from costumer spending, it must be financed out of other sources. These could be the “entrepreneur’s profits, the capital of the enterprise, the land of the enterprise, or the wages of other employees if they are willing to forego part of their potential earnings, as in the case of volunteers for a charitable cause” (p. 257).
McCaffrey thus shows in his article that enterprises in pursuit of a “social” cause are limited by profit and loss and hence by economic calculation, just like mundane enterprises. If they generate monetary profits, they can better promote the cause. If they incur losses, the continued existence of the enterprise and promotion of the cause becomes a matter of charity on the part of the entrepreneurs or other stakeholders. One way or the other, the subjective value creation, that is, the psychic income or want satisfaction, created by the enterprise has to be strong enough to attract finance of its expenses.
ABSTRACT: Contrary to the Austrian community’s former perception, we revealed value investing’s incompatibility with Austrian economics (Rapp, Olbrich, and Venitz, 2017). However, Leithner (2017) disagrees with this conclusion. He primarily argues that an analysis of value concepts should be neglected in favor of a discussion of the methods value investors apply to “measure” value to diagnose whether or not they adhere to Austrian value theory. Moreover, he claims that value investors use terms imprecisely and that intrinsic value is actually meant to be subjective, even conceptually. However, we believe Leithner’s remarks suffer from fundamental misunderstandings and error. He is mistaken on Austrian value theory, subjectivity, and the conceptual foundations of value investing. Therefore, we gladly accept the offer to address his misapprehensions and to sharpen the Austrian understanding on investment decisions in general.
KEYWORDS: Value investing, Austrian economics, value theory, intrinsic value, subjectivism, arbitrariness JEL CLASSIFICATION: B31, B53, D46, D52, G11, G32 I. I. CONCEPTUALIZATION AND (IM)MEASURABILITY OF VALUE In a paper previously published in this journal (Rapp, Olbrich, and Venitz, 2017) we debunked the myth of an alleged compatibility between value investing and Austrian economics. Unsurprisingly, one of the advocates of that myth, namely Leithner (2017), disagrees with our conclusion. Apart from both untenable allegationsSpecifically, Leithner (2017, pp. 173–174) accuses us of overlooking important personalities and their work, one of whom is suggested to be John Burr Williams. However, we did not overlook anyone; our list of references is rather extensive. The reason for not citing Williams, for example, in our original paper is quite simple. We addressed the question of conceptualization of value rather than methods of investment appraisal. Williams did not contribute anything new to the former and, hence, his work is of no importance to our initial discussion. and demonstrably incorrect claims,For instance, Leithner (2017, p. 174) falls for the misconception that “John Burr Williams [...] wrote the first treatise that systematically applied the insights of the marginal revolution to the conceptualisation and measurement of securities’ values.” However, Williams’s (1938) treatise is neither the first of its kind nor is it—compared to its predecessors—systematic. For an earlier and more systematic treatise of the application of marginal utility to investment appraisal see, in particular, Liebermann (1923). his critique can be cut down to the following main argument: Leithner (2017, p. 172) rejects the emphasis we put on the fundamental conceptualization of value while favoring an analysis of “the concrete method by which the investor measures a given security’s value” to conclude whether or not he adheres to the subjective theory of value. Moreover, Leithner (2017, p. 175) alleges that value investors use terms, in particular the crucial term intrinsic value, “sloppily” but that what they “label ‘intrinsic value’ is, both conceptually and empirically, actually subjective.” Alas, Leithner’s remarks suffer from fundamental misunderstandings of and even some unfamiliarity with Austrian value theory, subjectivity, and value investing’s conceptual foundations. Therefore, we gladly embrace the opportunity to discuss Leithner’s critique in this reply to shed some light on the issue. By so doing, we seek to sharpen the understanding of both Austrian value theory and subjectivity in the context of investments, not least among the Austrian-friendly community of practitioners.
Leithner (2017, p. 172) criticizes us for solely discussing and contrasting value concepts rather than dealing with the technical application of methods with which “the investor measures [...] value.” He incorrectly believes that “if they did then they would undermine their key contention” (p. 172). However, the actual reason why we purposely focus on the conceptualization of value at the expense of what Leithner (2017, p. 172) refers to as “measurement” of value is twofold. First, Austrian economists not only pointed out that value is necessarily subjective; they also revealed that subjective value is inevitably immeasurable. For instance, Mises (1953, p. 38) unambiguously explains:
So long as the subjective theory of value is accepted, this question of measurement cannot arise. In the older political economy, the search for a principle governing the measurement of value was to a certain extent justifiable. If, in accordance with an objective theory of value, the possibility of an objective concept of commodity-values is accepted, and exchange is regarded as the reciprocal surrender of equivalent goods, then the conclusion necessarily follows that exchange transactions must be preceded by measurement of the quantity of value contained in each of the objects that are to be exchanged. And it is then an obvious step to regard money as the measure of value.
Therefore, if one accepts the Mengerian, subjective notion of value, one necessarily has to regard “[a]cts of valuation [...] [as] not susceptible of any kind of measurement” (Mises, 1953, p. 39) since there “is no [...] objective unit in the field of human valuation” (Rothbard, 2009, p. 19). Mises (2012, p. 9) notes: “Marginal utility does not posit any unit of value” and, thus, “the notion of a measurement of value is vain” (Mises, 1998, p. 205). The very fact that Leithner claims value investors (including himself) can and do measure value reveals both fundamental ignorance of one of the most basic cornerstones of Austrian value theory and sympathy for objective concepts of value due to their characteristic of being amenable to measurement.
Second, the underlying conceptualization can never be side-stepped in a serious and informed discussion about value. The question of whether or not particular methods of investment appraisalHerbener and Rapp (2016) not only present an Austrian approach to investment appraisal but also relate it to Austrian value theory. (which Leithner perhaps has in mind when erroneously discussing the “measurement” of value) serve their purposes, for instance, is inseparably linked to the concept of value (Schmalenbach, 1926, p. 297; Schmalenbach, 1956, p. 138; Matschke and Brösel, 2013, pp. 49–50). If the calculation is supposed to follow a hypothetical objective value concept, for example, for fiscal matters, methods resulting in highly subjective numbers are inadequate. In contrast, if the appraisal aims to provide a presumptive investor with his highly individual barely acceptable price, methods seeking to assess, for example, an objective “market value”—as attempted by prevalent contemporary DCF models springing from neoclassical finance theory—obviously fail (Matschke, Brösel, and Matschke, 2010, p. 35; Brösel, Matschke, and Olbrich, 2012, pp. 241–242; Matschke and Brösel, 2013, p. 50; Hering, 2014, p. 297; Herbener and Rapp, 2016, p. 22). In any case, analyzing methods of investment appraisal independently of the underlying value concept is pointless. Alas, Leithner (2017) overlooks the fact that methods of investment appraisal can only be judged in light of the underlying value concept, and mistakenly suggests instead that analyzing the process of “measuring” value alone allows for a conclusion regarding the underlying nature of value. Yet following Mises’s above-mentioned quote, the only thing the attempt to “measure” value reveals is the inconsistency with subjective value theory. Generally, the relevant object of analysis in contrasting Austrian theory with value investing’s foundations, however, is to be found in the underlying conceptualization of value only.
II. OBJECTIVE VALUE AND “SUBJECTIVITY” According to the concept of value investing, a firm’s (or rather a share’s) intrinsic value and its market price should equate to one another theoretically; however, primarily investors’ emotionally driven behavior (mistakenly termed “irrational”) is seen to cause temporary deviations—either “overvaluations”, that is, the market price exceeds intrinsic value, or “undervaluations”, that is, intrinsic value exceeds the market price.Bildersee, Cheh, and Zutshi (1993, p. 198)—empirically studying Graham’s net current asset value approach—note: “They [fundamental analysts] believe that stock prices sometimes deviate from ‘fundamental value’; the true underlying value that the security should have in the market, if properly valued” (italics added). Whenever such temporary periods of investors’ seemingly “irrational” actions come to an end, the market price is believed to approximate the share’s intrinsic value because of the “inherent tendency for these disparities to correct themselves” (Graham and Dodd, 2009, pp. 69–70). Value investors try to make a profit from this alleged relation by investing in temporarily “undervalued” companies whose share prices are supposed to rise.Value investor Vick (1999, p. 8) asserts “that undervalued situations, by definition, must end sometime.” In sum, while market prices can and do deviate from intrinsic value, they are believed to consistently tend toward intrinsic value which is, therefore, deemed to be the fundamental yardstick of price trends. Value investing’s conceptualization of value is hence purposely objective.Vick (1999, p. 4) emphasizes that “the notion of intrinsic value is not subjective but generic […] In the absolute sense, intrinsic value is the real worth of a company, the sale price investors could reasonably place on the company if they all possessed the same information and insight” (italics added). If intrinsic value was meant to be subjective—despite the term’s apparent meaning—by contrast, the market price would either have to oscillate around thousands of “intrinsic” values resulting from different market participants’ subjective appraisals of one and the same share at once, which is evidently impossible; or alternatively, the market price would have to oscillate around one particular subjectively appraised “intrinsic” value. However, which of the thousands and thousands of subjective appraisals for the very same share would then cause the market price to oscillate? Why should one particular subjectively appraised “intrinsic” value cause the market price, which can be the outcome of thousands and thousands of independent valuations, to oscillate? Hence, if intrinsic value were indeed a subjective concept, the very idea of value investing would go up in smoke. Leithner (2017, p. 175) seems to not even get these conceptual foundations of value investing right and, hence, is demonstrably in error when he alleges that what value investors “label ‘intrinsic value’ is [...] conceptually [...] actually subjective”—nothing could be further from the truth.
One thing Leithner (2017, pp. 175–176) correctly realizes, though, while referring to both John Burr Williams and Warren Buffett, is the fact that different value investors will arrive at different figures when trying to appraise a particular share’s intrinsic value. However, he misdiagnoses this fact as the result of the appraisal’s subjectivity and, hence, is barking up the wrong tree again. Value investing requires the assessment of a certain share’s intrinsic, that is, its one and only “true value” (Graham and Dodd, 2009, p. 69). Yet intrinsic value is nothing but a mere phantom.As Mises (1998, p. 96) puts it: “Value is not intrinsic, it is not in things.” Value investing’s perception of value, therefore, must be characterized as “the naive concept of the layman” (Ritenour, 2016, p. 192). The fact that such a phantom cannot be properly grasped by nature, however, does not at all allow for the conclusion that the concept of intrinsic value was actually subjective. Rather than subjectivity, intrinsic value’s non-existence causes differing appraisals among value investors. How could it be possible for independent investors to assess a particular figure equally if that figure does not even exist, and, hence, is incalculable? Apparently, the appraisal of intrinsic value is not subjective in the sense that it considers a particular individual’s actual (financial) ends and means guiding his actions; because intrinsic value does not exist and, hence, value investors stumble about in the dark when trying to appraise it, instead, it is nothing but entirely arbitrary.
The essential fallacy inherent in Leithner’s reasoning can be illustrated by analogy with the cost/labor theory of value as similarly applied by both classical economists and Marxists (Mises, 1998, pp. 204–205). While they undoubtedly “shared the desire to objectify value” (Cole, 2010, p. 216), different appraisals will result in differing figures too. For example, if a particular product requires certain input factors on a large scale (such as screws) that were obtained over a period of time at various costs, one has to pragmatically assess an average cost which will—due to plenty of possible ways to make the calculation—result in differing numbers. The same applies to both the allocation of overhead costs and the selection of the method of depreciation employed for the involved manufacturing tools. Not least, time spent to manufacture the product can be calculated to the split second or one might consider only full hours, for instance. However, does that space necessarily resulting in differing figures lead to the conclusion that the Marxist theory of value is conceptually actually subjective and, therefore, resembles the Austrian perception? While Leithner’s reasoning strongly suggests this conclusion, thus revising the history of economic thought, it is evidently fallacious. Both Marxism and value investing purposely apply objective perceptions of value; yet the attempts to appraise such value are, owing to its absence, solely characterized by arbitrariness.
III. SUBJECTIVE VALUE AND SUBJECTIVITY Contrary to the conceptual foundations of value investing, Austrian analysis holds that it “is ultimately always the subjective value judgments of individuals that determine the formation of prices” (Mises, 1998, p. 329). Menger (2007, p. 120) emphasizes that the “value of goods arises from their relationship to our needs, and is not inherent in the goods themselves.” Intrinsic value is, hence, considered an erroneous belief (Ritenour, 2016, p. 192). Rather than a company’s one and only “true, intrinsic, or ultimate worth” (Greenwald et al., 2001, p. 26) fundamentally determining price trends, Austrians have pointed to the fact that it is indeed the inequality of values causing exchanges and, thus, prices (Mises, 1998, pp. 328–329). In valuing two alternative courses of action, such as buying or abstaining from buying a particular share, an investor compares the benefits associated with both alternatives and ultimately ranks them in light of his ends (Mises, 1998, p. 94). A financial investment decision, then, requires knowledge of the marginal price the investor can just barely accept without suffering an economic loss as prerequisite for a nonarbitrary valuation (Herbener and Rapp, 2016, pp. 10–11). Such marginal price is not an objective indicator, and is even less reflected in intrinsic value; instead it will differ both from individual to individual and as time passes, because it is determined by a particular person’s alterable (financial) ends and means (Hering, Toll, and Kirilova, 2015, p. 24; Olbrich, Quill, and Rapp, 2015, p. 20; Rapp, Olbrich, and Venitz, 2017, p. 16). Hence, a genuine investment appraisal aiming to arm an investor with his barely acceptable price needs to take that individuality into account. Time preference makes it necessary to place a discount on future satisfaction (Herbener, 2011, p. 14; Herbener, 2018). Consequently, investment appraisal must discount an investment’s expected future benefits, that is, it must rely on the present value technique. The subjective nature of value and, hence, of a genuine investment appraisal is, then, reflected in a threefold manner (Herbener and Rapp, 2016, pp. 16–18, 19–20). First, the projection of future earnings is inevitably subjective due to both the necessity to form expectations given uncertainty and individually differing financial circumstances, particularly tax rates, tax loss carry-forwards, and the potential capability to control corporate policy as well as to gain from synergies if, for instance, an investor already owns one of the target firm’s competitors. Second, the only correct discount rate on imperfect—that is, real—capital markets equals the internal rate of return of a particular investor’s best alternative application of funds, either another investment or the settlement of a loan (fundamentally Schmalenbach, 1908/1909; Hering, 2014, p. 29). Since an individual’s best investment or funding alternative is determined by both that person’s financial ends reflecting his time preference and the overall pool of investment and funding projects available to him, it will necessarily differ from individual to individual. Third, uncertainty is an obstacle to optimal problem-solving; investors can only rely on heuristics. Contrary to the popular but fundamentally flawed risk premium concept (Hering, 2017, pp. 292–310; Hülsmann, 2018), one promising approach to structure uncertainty’s effects associated with an investment lies in the application of a Monte Carlo simulation (Hertz, 1964, pp. 95–97; Coenenberg, 1970, pp. 793–795). Both the forecast of future earnings and discount rates as well as the selection of the final marginal price out of the distribution provided by the simulation, then, are subject to highly individual entrepreneurial judgments.
Leithner’s (2017, pp. 172–173) summary of methods he and his fellow value investors apply to “measure” value, therefore, exposes nothing but the methods’ fundamental uselessness. Appraising “a company according to the external prices of its assets” (p. 173) is in fact flawed in three respects (Olbrich, 2000, p. 454; Rapp, 2014, p. 1067).Schmalenbach (1917/1918, p. 6) already uncovers such a procedure as a bad blunder. First, it entirely disregards a particular investor’s subjective ends and means, such as his planning horizon or alternative available financial opportunities. Second, it neglects the significance of both a future-orientation and combination effects as it exclusively considers the sum of past or present prices of individually appraised assets rather than the future earning power of the company as a whole. Third, it conflates two inevitably distinguishable things, namely values and prices. Leithner (2017, p. 173) also errs when he alternatively suggests using “some rate” to discount (undefined) “cash flows [...] to the present” in a DCF appraisal. As outlined above, there is only one correct discount rate for genuine subjective appraisals; nor is it proper to apply “some rate”, and nor does the discount rate reflect an “opinion” investors “believe in” as claimed by Williams (1938, pp. 16–17) whom Leithner (2017, pp. 174–175) invokes prominently. It instead stems from a sound causal chain deduced from the concept of marginal utility by advocates of investment theory developed in the German-speaking world whose lineage is consistently traceable to early Austrian economics (Schmalenbach, 1919, p. 334; Schmalenbach, 1937, p. 27; Matschke and Brösel, 2013, p. 6, fn. 11; Hering, 2014, pp. 27–28; Olbrich, Quill, and Rapp, 2015, pp. 15–16; Herbener and Rapp, 2016, pp. 12–13). Hence, while Leithner (2017, p. 175) seems to acknowledge the Austrian perspective when he explicates that value stems from “the importance an acting individual places upon the good (security) for the achievement of his desired ends,” he clearly is grievously mistaken on the methods he considers proper in preparing investment decisions from an Austrian perspective.
Needless to say, in conclusion, value investing remains fundamentally at odds with the Austrian school.
In the post-World War II period, a number of developing countries in Asia and Africa had just gained independence from their colonial masters. Raising living standards for their citizens became the focus of the leaders in these new countries. Development Economics emerged as a distinct field during this time, primarily devoted to economic growth. The focus of this course will be to present the Austrian perspective on Development Economics, with particular attention on capital accumulation and the structure of production.
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Quarterly Journal of Austrian Economics 20, no. 2 (Summer 2017)ABSTRACT: In four ways, say Rapp, Olbrich and Venitz (2017), “the seeming compatibility between value investing and Austrian economics must be characterized as a myth.” I disagree. The authors’ major contention—namely that “value investing’s definition of value is fundamentally at odds with the Austrian value concept”—is demonstrably false. Using fundamental sources, none of which Rapp, Olbrich and Venitz cite, it is easy to draw a direct intellectual line from the “marginal revolution”—in which Carl Menger figured prominently—to the founder and today’s most prominent practitioner of value investing. It is quite possible that Warren Buffett has never heard of Menger or the Austrian School. Yet Buffett’s actions as an investor, like Benjamin Graham’s, demonstrate the diametricopposite of what Rapp, Olbrich and Venitz claim. It is not a myth, it is a fact: value investors’ conception and assessment of value are congruent with the Austrian School’s.
KEYWORDS: Austrian School, Warren Buffett, Benjamin Graham, value, value investingJEL CLASSIFICATION: B12, B13, G11, G12
Quarterly Journal of Austrian Economics 20, no. 1 (Spring 2017)
ABSTRACT: Within the Austrian economists’ community, value investing is characterized as a useful investment strategy, and one that is in line with Austrian economics, in particular Austrian value theory. In fact, value investing shares some basic findings with Austrian value theory, especially the crucial distinction between values and prices. However, value investing also contradicts some fundamentals of Austrian economics. Therefore, the authors argue that value investing’s seeming compatibility with Austrian economics must be characterized as a myth. The aim of this article is to illustrate what makes value investing incompatible with Austrian economics and, hence, to terminate this myth.
KEYWORDS: Value investing, Austrian economics, value theory, intrinsicvalue, subjectivismJEL CLASSIFICATION: B31, B53, D46, D52, G11, G32
The minimum wage was a hot topic in the 2016 presidential campaign. By law, on January 1, 2017, the first group of Seattle workers reached $15 per hour with an average of $11 per hour in the rest of the state. Proponents in Washington and across the country claim that the increase will reduce poverty and income inequality, and finally allow workers to afford housing and everyday essentials. This is in spite of the accepted economic principle that wages are a result of the marginal productivity of the worker, not housing costs and disparity in incomes. Is this social interference economically sustainable?
In “Labor Economics: An Austrian Perspective,” you’ll get a clear, unpoliticized, understanding of what is being exchanged in labor contracts and where labor derives its value. In lectures by Peter Klein, Mark Thornton, Walter Block, and Ben Powell, you’ll learn about guiding principles for entrepreneurs’ hiring decisions, the pernicious effects of minimum wage laws and other labor market interventions, and why “sweatshops” are the best available option for many workers.
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The Quarterly Journal of Austrian Economics
Vol. 19 | No. 2 | 131–148Summer 2016
Economic Indulgences: Old and New Debates on Welfare and Freedom
David CowanDavid Cowan (david.cowan@bc.edu) is a visiting scholar at Boston College. The Henry Hazlitt Memorial Lecture was sponsored by Hunter Lewis.
Henry Hazlitt Memorial LectureAustrian Economics Research ConferenceLudwig von Mises InstituteAuburn, AlabamaMarch 31, 2016
INTRODUCTIONIn this lecture, I will look at a debate in the 1960s between Frank Knight, the subject of my new book (2016) in Palgrave Macmillan’s Great Thinkers in Economics series, and Henry Hazlitt, memorialized by this lecture. I will look at the dispute they had on welfare, freedom and power, which was an important debate then and now. I will take Knight’s observations and apply them to today’s debate on inequality, and what I suggest are the economic indulgences referenced in my lecture title.
FRANK KNIGHTFrank Knight was a curmudgeonly character, who I dare say, in our politically correct and overly-sensitive age, would not last long, and certainly would never make tenure, because as we know tenure means never having to say you’re sorry. Knight was not the kind of debater or discussant easily given to flights of fancy or expressing misgivings. I assume at least a passing acquaintance with Frank Knight on the part of this audience, but perhaps a lamentably short intellectual biographical note is in order. Within the economic world today he is chiefly noted for the notion of Knightian uncertainty featured in his first book Risk, Uncertainty and Profit, establishing his reputation in the pantheon of economic thinkers on a book that was essentially his Ph.D. thesis. Knight was brought up in a conservatively theological home, which was also a Republican household. His early undergraduate work was actually at evangelical colleges in the neighboring state to this one, he attended colleges in Tennessee. In spite of all this, he grew up to have distaste for much organized religion, though he attended the Unitarian church for much of his life.
Aside from being “kicked out” of Cornell’s Philosophy Department and a couple of stints at the State University of Iowa, Knight spent his academic career at the University of Chicago. He inspired an almost cult-like devotion among his students at Chicago, leading his students (which included most notably Milton Friedman, James Buchanan and George Stigler) to say there is no God but Frank Knight is his prophet. Knight was a co-founder of the “Chicago School” of Economics, but he was a teacher more than a theorist or producer of books. It is because Knight was essentially a teacher and a critic that he did not pen the major volumes one might have hoped for. Buchanan, who became a long-time friend and a Nobel Prize winner, notes in the foreword to the 1982 edition of Freedom and Reform that Frank Knight was a critic, and apart from Risk, Uncertainty and Profit his work “can be interpreted as a series of long book reviews.” His work is thus scattered across a host of economic journals in essay form standing on the base of his first and major work Risk, Uncertainty and Profit, published in 1921. What ideas he had were stated, restated and then refashioned multiple times in various essays. Hence to synthesize his work, which I have attempted to do in my own book (2016), means working through the remainder of his writings comprised of essays, lectures and book reviews, the most notable being collected in the single volumes of The Economic Organization (1933), The Ethics of Competition and Other Essays (1935), The Economic Order and Religion, with T.W. Merriam (1945), Freedom and Reform (1947), On the History and Method of Economics (1956), and lastly Intelligence and Democratic Action published in 1960.
Knight himself described his “social function” as one of “exposing fallacies, nonsense and absurdities in what was passed off as sophisticated scientific discourse.” (Knight, 1982 [1947], p. xi) His relevance as a great economic thinker for us today, apart from Knightian uncertainty and his status as a founding father of the Chicago School, can be stated in a threefold sense. First, he is arguably one of the most interdisciplinary of economists, and thus provides a basis on which thinkers can discuss economic issues from their own disciplines. Second, he raised issues that are prevalent in the latest stages of capitalism, and the issues we currently face and will continue to face in the future. Lastly, he was an economic realist who knew the weaknesses and strengths of capitalism, so while remaining a supporter of capitalism as the best system, he also addressed the limitations and difficulties thrown up by this imperfect way of organizing our economic affairs without overthrowing what he saw as an ultimately workable system. In pursuing this agenda, Knight found himself in a number of fights, specifically with Keynes and the Austrians, with protracted arguments in the 1930s with Friedrich Hayek. In many respects I would typify these not as full scale arguments, but instead boundary disputes, somewhat akin to members of the same club or union fighting over the rules of association. Which brings me to the boundary dispute that is the subject of this lecture, the one between Knight and Henry Hazlitt.
KNIGHT ON HAZLITT, APRIL 1966The journalist Hazlitt and the academic Knight had a short but fractious relationship in print, which started from the lecture podium at Mont Pelerin and was waged via the pages of the journal Ethics. For his part, Hazlitt thought Knight’s attack on him was one quite unprovoked on his side. Having initially fired a salvo or two at Hazlitt from the podium, Knight committed his more sustained attack to print in an essay published in April 1966, entitled “Abstract Economics as Absolute Ethics.” In the essay, he offered a critique of Hazlitt’s book The Foundations of Morality (1964). Knight refers to the work as a polemic, at the heart of which lie two chapters entitled “The Ethics of Capitalism” and “The Ethics of Socialism.”
Knight started out by stating that Hazlitt’s book demonstrated good workmanship and the makings of a good treatise on socio-political ethics. A kind of condescending “could do better” is the tenor of his remarks. This is because he surmised that Hazlitt’s work contained many of the faults he believed that defenders of capitalism tend to have, namely that it was the kind of oversimplified, extremist propaganda that ignored changing theory and practice. Hence, he wrote, Hazlitt’s work failed to deal with the complexity of modern society and defeated the purpose of the argument.
Knight outlines the content of the chapters as they apply to ethical rules, and turns to the question of justice, which he says is settled for Hazlitt by John Bates Clark’s argument in his 1899 book The Distribution of Wealth, with its thesis “that ‘Free competition tends to give to labor what labor creates, to capitalists what capital creates, and to the entrepreneur what the coordinating function creates…. [It tends] to give each producer the amount of wealth that he specifically brings into existence.’” This argument, Knight quickly points out, is fallacious for three reasons. First, there is only a general tendency, he says, to remunerate each productive agent. Second, society does not consist entirely of producers. Lastly, producers are not “economic men.” Apart from the key factors of economic capacity, labor power, and managerial skill and property ownership, Knight points out that production also involves a large portion of “luck.” Hence, individual production “is due much more to biological and social inheritance, for which the individual is not responsible, than to the individual’s past efforts.” Knight concludes that Hazlitt simply applies the principle of production too broadly.
Knight then turns to the ethical argument. Hazlitt summarizes capitalist ethics as a system of freedom, justice and productivity, which Knight argues cannot be precisely defined, besides which distributive justice has a number of meanings. The real point Knight wants to make is against Hazlitt’s individualist ethic, which he argues is individualistic to an extreme; to the point he never even mentions the family (Knight, 1966, p. 166). Knight goes on to say ethically one must “condemn the unfairness of an unequal start in the competition of life” and this “inequality inheritance” he argues tends to increase with each succeeding generation (Knight, 1966, p. 166).
It is this notion of “inequality inheritance” that is at the heart of the welfare question for Knight, and of course at the heart of notions of injustice tackled by many a socialist pamphleteer who wants to overthrow the capitalist system. Yet, to have socialism instead of capitalism is to replace business with politics, and Knight explains that many of the features most objected to in “capitalism” are in general similar in politics, though in his view “very obviously worse” (Knight, 1966, p. 168). They are very much alike in that functionaries in direct control inevitably have, he explained, “much arbitrary power and get their positions chiefly by competitive persuasion, or simply by accident.” Rivalry, which he calls an instrumentally irrational motive, “is more natural to men than rational co-operation.” Although it permeates both, Knight states this competitive persuasion takes the form of propaganda in politics and sales activity in business.
They do, however, also differ. Firstly, no-one has the power or effective freedom to form a state or jurisdiction, while there is some, albeit limited power, to start a business enterprise; obviously for Knight, limited by access to investment, skills, inheritance, and so on. Second, people are born into a state and family, but in capitalism they can choose membership among many organizations, and so for instance a laborer has a wide choice of employers to work for.
In pursuing our choices we seek better conditions, and Knight explains that when social groups seek better conditions, which they feel are rightfully theirs, their efforts can create social problems since social changes that benefit some can lead to a worsening situation for others. This can lead to a conflict between freedom and progress. For this reason, social conflict is not necessarily the oft-stated problem simply of order. It becomes a problem of power, and I will return to this later, but first let’s see how Hazlitt responded to Knight.
REPLY TO KNIGHT OCTOBER 1966For his part, Hazlitt (1966) said, “Space does not permit me an examination of Knight’s own obscure pronouncements, though they seriously need one.” He does, however, offer up a defense against Knight, with the opening salvo of calling Knight’s original attack at Mont Pelerin “a strange performance.” Hazlitt stated he did not recognize the opinions attributed to him by Knight in the written assault. He rebuts a number of the points Knight made, and explains that his book as a whole is neither polemic, nor are the two chapters Knight singles out at the heart of the book. Contrary to Knight, Hazlitt explained the heart of the book is the much earlier chapter 6 on “Social Cooperation,” although the same could be said he suggests of chapters 7 and 8, or even the conclusion, bur certainly not the chapters Knight singled out. He also rebuts a number of specific points; including the ones I have drawn attention to earlier. These are not important to go through, and I suspect they are simply a case of an academic and a practitioner talking past each other.
Hazlitt set out what he considered to be the essential justice of the capitalist method of distribution. As Knight noted, Hazlitt was drawing on The Distribution of Wealth by John Bates Clark (1908 [1899]). The central thesis Clark put forward was the point I quoted earlier, and merits repeating here, that “free competition tends,” a word Hazlitt italicizes, “to give to labor what labor creates, to capitalists what capital creates, and to entrepreneurs what the coordinating function creates…[It tends] to give each producer the amount of wealth that he specifically brings into existence” (Hazlitt, 1966, p. 60). This is the point Knight called fallacious. Hazlitt points out that Knight is at pains to make the qualification that this is a tendency, but as Hazlitt’s italics demonstrate, this qualification is in the original quote. To which Hazlitt adds that in his own book he explained certain qualifications were necessary, and he was well aware Clark’s thesis had been contested. However, he suggested much is overlooked in the dispute with Clark, and what he wanted to do was to correct this by drawing our attention to three matters.
First, Clark was rebutting the Marxian argument that capitalism systemically exploits labor and robbed the workman of his produce. He argued that Clark in fact proves that the capitalist method of distribution is not inherently unjust, which many people believe to this day, and he states that this falsehood has given rise to “unrest, resentment, demagogy, revolutions, and wars that now threaten to destroy not only “capitalism” but civilization itself.” Second, Clark in Hazlitt’s view demonstrated the tendency of the competitive market system to give to each what they create and this is in accord with the most generally accepted principle of distributive justice, at least in the first instance of economic reward for labor. He explained there is then nothing to stop people to redistribute their wealth voluntarily, and indeed capitalism does nothing to hinder or discourage charity and generosity. What is problematic is the attempt to coerce by means of a socialist or equalitarian rule a redistribution that ignores effort or efficiency, and destroys incentives and production. True justice, Hazlitt argues, is not achieved through a “leveling down.” Lastly, Clark was not really describing a purely economic system in his description of capitalism and its consequences, rather he was describing a legal system that protects property rights, promotes free labor, markets and wages, enforces contracts and regulates against fraud, violence and other illegalities.
Hazlitt argued capitalism evolved over centuries and had a moral origin. The evolution of capitalism, unlike the socialist and communist revolutions, was never instantaneous or expedient. And so the real oversimplifiers (and recall this is what Knight called Hazlitt) are those who contend ethical and legal considerations are irrelevant in judging capitalism. So, after an interesting passage of defense, Hazlitt returns to Knight and concludes ”I find Knight’s article rambling, fuzzy, and full of inconsistencies. Even after a second or third reading I cannot decipher.” (Hazlitt, 1966, p. 61). On this criticism, I certainly experienced Hazlitt’s sense of a terrain that was rambling and difficult, but I hope for my reader’s sake I have successfully deciphered his work.
KNIGHT’S RESPONSE OCTOBER 1967Exactly one year later, Knight’s response to Hazlitt’s defense was published, with the telling title “A Word of Explanation” (1967a). Knight does not attempt a formal rejoinder, he says, rather a clarification. While he notes the odd touché or two with Hazlitt, he responds by clarifying rather than admitting a defeat on the point. This is a little like when an Englishman says “with the greatest respect” and then proceeds to insult you. So having said, with the greatest respect, Knight states that the major fault with Hazlitt’s book is the “constant harping on co-operation,” which Knight argued was never defined and neglected its opposite, rivalry. For his part, Knight thought of cooperation as implying freedom and “discussion” as a means of reaching free agreement. Knight concluded his rejoinder by accusing Hazlitt of making sweeping statements of half-truths; and, I should point out here that Knight himself was accused of the same crimes by his own critics at various points during his career. He goes on to say, “I regret my critique being so negative; but some clearing away, even of rubbish, often precedes building; and social construction is a complex and hard problem. If Hazlitt-style propaganda is politically effective, I dread the consequences for the better society that might be had through wiser policies” (Knight, 1967a, p. 85). His last word in these exchanges is “And anyhow, blessed are they to whom all things are simple; and in pudd’nhead Wilson’s adage, it’s differences of opinions that makes hoss-races” (Knight, 1967a, p. 85).
Having looked at the demarcation dispute between Knight and Hazlitt, we can delve a little deeper into Knight’s notion of cooperation, which has the three aspects of welfare, freedom and power. There is not sufficient time to go in depth into each of these, but I would like to highlight some of the key points of each.
WELFAREAt the core of Knight’s conception of welfare “is the premise that economic welfare must not be identified with aggregate (i.e. allocative) economic efficiency. Rather, welfare must be seen as the sum of economic freedom, the balance of economic power, and economic efficiency” (Nash, 1998, p. 161). He also offered an argument that the outcomes of imperfect competition reflect the relative power imbalances in an industry, and these outcomes are fundamentally unfair. We can extrapolate from this the general conclusion for all markets that unconstrained self-interest will not always lead to fair outcomes, or outcomes beneficial for society as a whole. This is a challenge to the “invisible hand” of Smithian economic thinking, and provides an alternative notion of perfect competition to orthodox economics, critical to which is Knight’s conception of economic welfare.
Thus, in looking at welfare, Knight draws our attention to the relationship between the ‘economic’ and ‘moral’ domains of our society, arguing that self-interest cannot maximize the value of the aggregate ‘social welfare function.’ (Nash, 1998, p. 165). He refused to separate the intellectual from the moral pursuit of understanding society, nor could he accept there was a way of having widespread agreement on the goals of social policy. The idea that social and economic thinking can achieve the best ends for society is not an idea agreeable to him. The problem we face in social policy-making is one of values, not of facts, he argued, and social problems arise through conflict caused by the mere assertion of opposite claims. In a market society, a price theory amounts to a value theory because price is the means by which we arrive at agreement between individuals in exchange. Yet, we have higher wants and goals of conduct with which to test our values, rather than simply having a system that accepts and satisfies wants.
We see in his analysis how Knight used his “economics” and “social philosophy” combined to help us understand the human predicament. If we simply look at the competitive system as a wants-satisfying system, then we will see into a mirror that reflects back who we are rather than what are our highest ideals. Knight argued that the social order we have may gratify us, but it also shapes our wants, and hence our system must be judged ethically by the type of character it encourages and forges in the people within this social order, since giving the public what it wants “usually means corrupting popular tastes” (Knight, 1935, p. 49). The problem emerges, however, that price is the measure of efficiency and reflects what the people really want, through their free choice in the market, while also leading to the corruption of public taste. Yet, who is to say what is in good taste? Is this not simply liberal elitism? In the conclusion to my book Economic Parables: The Monetary Teachings of Jesus Christ (2007), I make the point that the economy is like a mirror. If we look into the mirror and think we look a little ugly then smashing the mirror is not going to make us look any prettier. The problem is not the system, it is us.
FREEDOMPut plainly, for Knight economics is about freedom. Knight’s essays in Freedom and Reform were collected and published in 1947, essentially as a sequel to the 1935 The Ethics of Competition, and again on the initiative of some of his former students. The major theme of the work, as the title implies, is freedom, but the reference to reform makes this very much a Knightian expedition, as he sought to mount an attack on any superficial grasp of freedom, and root it in some deep economic and philosophical soil. If we think of freedom in terms of laissez-faire then Knight, in his major essay Laissez-Faire: Pro and Con (1967b), explained that the relationship between laissez-faire and government control cannot arise outside of an economic and political order operating under market conditions. He argued it is absurd to draw strict battle lines between laissez-faire and “planning.” He explained that humans are social animals, and social life sets many limits to freedom, which includes social and welfare issues. He also explains that laissez-faire has been rapidly modified down the ages by political regulation, but how far this change will go he suggests is a question for prophets. The point remains: we need to recognize the necessity of a democratic political order and its inherent limitations on freedom.
Certainly, Knight is in the business of supporting the market, but this means addressing the significant challenges faced by capitalism in respect to freedom and equality, and there are many aspects of inequality to consider in the Knightian view. He accepted inequality as an inevitable outcome of freedom, even if at times it leads to unfortunate outcomes for some. The past is very much a foreign land in Knight’s view, making freedom he wrote an “historical anomaly. A few generations ago the opposite was the case; conformity and obedience were moral norms of social life” (Knight, 1960, p. 112). Complaints about inequalities, big business and monopolies are for Knight borne out of a romanticism, and he argued this is not the way to confront the real economic problems we face, though he is by no means denying the seriousness of the problems that exist. What is essential for Knight is that such romantics need to see freedom as the core sentiment, if we are fully to understand economic society.
POWERUltimately—and this is at the heart of Knight’s welfare approach—social policy must deal with power and weakness as well as freedom. He finds Hazlitt’s conception of freedom problematic and ignorant of the problems of weakness and rivalry. He argued that Hazlitt failed to address adequately the relations between freedom and power, and this is related to his treatment of equality and inequality. A proper treatment would recognize that “serious inequality of power, especially economic power, limits the effective freedom of the weaker party, and, if extreme, destroys it, making him helpless”(Knight, 1960, p. 174). Freedom thus effectively depends on power, which is power an individual possesses with meaningful content only insofar as the person has means and effective freedom to exercise their power, which for half the normal population means little, as they have no such power or means.
As noted, people will aspire to improve their position, which they will do by improving their wealth and income and by gaining distinction and power, and they will do this in any way open to them. This means using whatever power they possess to persuade and influence. To get influence they must get attention, which is what people want anyway, and he says it is at “this point that social rivalry is most acute, and free society often seems to be mostly a phenomenon of competitive “screaming” for notice in one connection or another”(Knight, 1960, p. 173). Such attention-seeking, he says, refined people find repugnant, while the Marxists would hope their dictatorship would educate this out of human nature.
Hazlitt’s individualism, in Knight’s view, ignored these problems of power, weakness, rivalry and inequality. For Knight, “the family, not the individual, is the effective unit in society, because he explained “differential inheritance—particularly of wealth—entails an unequal start in the competition of life, which violates fundamental individualistic ethics”(Knight, 1960, p. 174). Knight typifies Hazlitt’s approach as an ideal of a primitive society or small tribal groups with face-to-face interaction, and he operated under what Knight called a “cheerful assumption” that if society let men be they will cooperate rationally based on known rules. In contrast, Knight has a somewhat Augustinian view of human nature, and as such believed something akin to original sin militates against any such hope. In contrast, Knight’s understanding is that people—to be moral—must change themselves and then by mutual understanding change the world. This is what he means by discussion. This is also a very theological approach to the problem, found in conservative and Augustinian schools of theology. To paraphrase Luther, you can try and rule the world with the Gospel, but you better fill it with real Christians first. In other words, we remain in a world of conflicted values.
So, what kind of discussion of values can we have? Perhaps we can conclude that Knight fails on his own terms, because as he himself states, people are “screaming” for attention for their cause, and whatever change results is likely to be disagreeable to others. He is certainty right about the screaming, though goodness knows what he would make of today’s presidential primaries or the attempts to pull down monuments of the past because of racial politics. Knight is not against change, and he certainly does not want to see things stay as they are. Neither is he a progressive.
A WORLD OF INDULGENCE IN NEED OF COOPERATIONIn concluding this lecture, I want to set out in a Knightian way how we can come to terms with the moral question of modern capitalism. In the Knightian view, there is inevitability about inequality and the conflict between various desires. The problem of equality and inequality lies at the confluence of welfare, freedom and power. We see inequalities in developed nations and emerging nations. We see different levels of poverty. There is not sufficient time to go into the nuances of these differences. It must suffice to say when we think of extreme poverty in Africa, for instance, the causes are similar to our own—it is more a matter of scale. The problems of Africa, and the contradictions of wealth and poverty on that continent, reflect the same root cause I am about to unpack in drawing this conclusion. Just as capitalism brought many out of poverty in the west, so it can in Africa and elsewhere. The nations cry out for a legal and political system complementary to capitalism and technical assistance, but are at the mercy of corruption and skewed property rights.
All of which brings me to today and the problem I identify of indulgences, of which there are many, but I will unpack the main kinds. I suggest we live in an era of emotionalism, or emotional indulgence, where what one thinks is less important than expressing what one feels. Rationality does not trump giving offense. This emotionalism leaves many people in a spiritual search in the economy and in this search they are looking for easy ways, looking for indulgences. I borrow the term indulgences from the turning point of the medieval period that led to the Reformation, and a new age of enlightenment. As we all know, Martin Luther railed against the selling of indulgences in the Western Catholic Church as an easy morality, a forgiveness of sins without conforming to God’s will. It was merely the buying of a certificate.
Today’s indulgences come in the form of cash till receipts for free trade and organic produce, as people scream out the “gotcha” examples of extreme poverty in Africa and environmental damage caused by “big business.” It comes in the form of Occupy Wall Street and other protests, as they point the finger at the bankers and financiers. It comes in the form of celebrities campaigning for a better world and against capitalist greed, which naturally they do as CEOs of their own multinational businesses. It comes in the form of the runaway sales of the book on capital and inequality, by French economist Thomas Piketty. All these instances admirably demonstrate I suggest that the specter of inequality is never far away in the consciences of the Left, but very distant in terms of solving the actual problem of inequality.
For what is inequality? If we listen to Knight, it just is. It is unavoidable. We can do something about inequality in a limited sense, but only through discussion and cooperation. Perhaps the instances I just suggested are Knightian discussions. After all the celebrities and protesters are all discussing the problem aren’t they? Well, yes, but in a somewhat self-serving way. They are long in talking and “caring” about the problems, but well short of a realistic solution. The challenge is to solve the problem, which is why Knight argued passionately in favor of capitalism. It helps far more than it hinders, a reversal of the Leftist view, so we need a balance or nuance in our understanding of capitalism if we are to make the world a better place, and even then we are unlikely to make it a better place for everyone due to human nature.
If we take the working class of which Marx wrote so passionately, it has improved its lot greatly. Indeed, in his own terms many of the working class has become bourgeois. This change is a process of embourgeoisement, though this was reportedly dismissed for good by sociologist John Goldthorpe back in 1963. But the world has changed a great deal since Goldthorpe was writing. The “working class” today takes foreign holidays, owns property and even goes to the opera on occasion. The definition of poverty today is more related to how many cars or TVs you have, rather than subsistence. More significantly, poverty today is more defined by desire, in terms of satisfaction of wants and social aspirations, than needs. What we have to some extent is an inequality in satisfaction of desires rather than needs, though again I hasten to point out that middle classes and liberal protesters seem to have their desires satisfied by taking to what they see as the high moral ground. It is because the problem is one of desire that resentment has been breeding amongst the middle classes, especially since the 2008 recession.
The reality is that in terms of income, the poor have benefitted from the creation of wealth under capitalism; this is its great strength. We have all seen the graph of income as flatlining from the exit to the Garden Eden until the 1750s, and then moving on a steep upward curve ever since. While communists under Stalin and Mao were being executed, the poor in the western economies were buying their own homes. During the time of communism, however, intellectuals and leftists could always pretend there was an alternative. Their economic theorists could posit alternative universes. The fall of communism, and the victory of the market, appeared to show there is only one economic system—albeit flawed—but as Knight argued it is flawed because it is a system that deals with scarcity amongst flawed humanity. This system may have triumphed, and poverty may have changed, but what has not changed is the socialist bourgeois guilt over the continuing presence of the poor; hence the popularity of the Piketty book and the crowds at Occupy Wall Street gigs as they contemplate their own difficulties. Though, as I stated just now, I suspect the problem has much more to do with resentment than guilt.
Whatever it is, guilt or resentment, the fall of communist and socialist systems due to capitalist economic change, and I would add the inevitable impact of reality, has broken apart Marxism, socialism and communism. However, they have not disappeared altogether. There may be a systemic breakdown, but the same instincts remain, and these instincts are dispersed in the shattered pieces that remain in the range of causes and groups that challenge the basic assumptions of capitalism in much the same way as these grand movements tried to do. Yet, while they are dispersed, they are not freely blowing in the wind. They have become part of the capitalist system itself. To which I may add there is a significant market for these causes. Radical chic sells.
There is another indulgence, which you can find on both sides of a narrative about the ills of capitalism. On one side, we have the “social responsibility” executives, who have both the wealth and the salve for their consciences. They jostle for attention alongside the Wall Street protesters I mentioned who seem to have the time, technology and money to camp on the streets instead of working or looking for work. This is a far cry from the working classes that needed to break apart their chains; it seems they are the workers who simply prize open their wallet. Thus, the problem of inequality is a middle class problem. Of course, there has always been an air of the snob around the left, a middle class enclave that looks down at the working class as their own personal playground. This thought came to me recently, on another continent, when I heard a Corporate Social Responsibility person say how they wanted to visit poor areas, to see how “real” people live in the particular country we were visiting. It seems the Left has to travel further distances, and expand their carbon footprint, to fulfill their fantasy of how the poor live in need of their help. The so-called “anti-capitalists” and “anti-globalization” camps that periodically spring up, oddly in times of recession, are the modern day kibbutz for the spoiled to search for meaning in their own life. They still imagine a life of the greedy boss and the despoiled and alienated worker.
Such a view is out of touch with reality. Companies today are focused on employee engagement, because recognizing the engaged and interested worker is more productive. This is the antidote to alienation. Indeed, alienation is not the preserve of the factory worker or the low-paid. Many people in the workplace and in society feel this way. Managers and government bureaucrats alike can feel alienated from the workplace or the goals of the business as well. They too can be trapped by the mortgage or the sense that they lack advancement. The path to better engagement is dialogue, connecting people to each other in the workplace in a common cause, not trying to find reasons to divide them. Ultimately, in searching for our material satisfaction, we ought to be questioning what we are searching for beyond the economy not just within it. Before we get carried away with this, however, we have to recognize that whatever our search, and whatever our role in the economy, it is curbed by human nature, both ours and others’. As Jean-Paul Sartre said, hell is other people.
Of course none of this is very romantic. It is essentially a question of power. In the economy people can feel powerless, and the same may be said of our political system, both points made by Knight. It is wonderful that the market economy has moved so many out of poverty and low incomes, but it seems that we are a generation that remains in search of spiritual meaning. Our material status does not answer the spiritual problem, except perhaps in the mundane terms of retail therapy. It is simply the other side of a coin. To use again Marx’s famous image, we can see this as the switching of one set of chains for another. The historical move we have seen is the freeing of the chains of poverty for vast swaths of the population only to find themselves feeling chained by the materialism and indulgences of our age. This is what is revealed by the middle class recession we witnessed these past few years, because the working class has become middle class in relative terms and a larger middle class, overextending and indulging itself through debt and property speculation, got caught out by the inevitable force of economic gravity and resent the impact. After all, when house prices were going up I don’t recall anybody ever complaining to me how much their home is “worth,” so why complain on the way down? What suffered was their desire and expectations, and this impacted their pocket and consciences.
No matter how successful our economy, or even if humanity triumphed in the way the Left dreams, the problem will not be solved on material terms. Our economy is a reflection of our human condition. It puts numbers on what we truly care about, and this has to be the starting point of any moral understanding of the economy. Knight is correct. We do need to face the brutal reality of inequality, and we ought to recognize the inheritance deficit and help others to have a start in life, but what policies and social attitudes are necessary to tackle these is the question. There also needs to be a point where we say enough is enough, and not allow the emotionalism to dictate economic policy, which has two impacts in terms of how we might cooperate to tackle inequality and social welfare. First, we need to educate people better in fundamental economics at school so we can have better informed and more realistic discussion about economic matters, which will make cooperation more informed. We obsess about teaching God and sex, so why not money? Second, we need to turn away from the emotionalism of our times and recover the enlightenment idea that we are not simply sentient creatures; we are creatures of thought. Cooperation is a rational activity, not an emotional one, and indeed emotions tend to get in the way of cooperation. The curmudgeonly Knight may have set a high bar on this point, perhaps too high, but I fear we will make little progress politically or economically in these times if this attachment to emotionalism does not change in favor of economic realism.
REFERENCESClark, John B. 1899. The Distribution of Wealth: A Theory of Wages, Interest, and Profits. New York: Macmillan, 1908.
Cowan, David. 2007. Economic Parables: The Monetary Teachings of Jesus Christ, 2nd ed. Downers Grove, Ill.: InterVarsity Press.
——. 2016. Frank H. Knight: Prophet of Freedom. New York: Palgrave Macmillan.
Goldthorpe, John. 1963. The Affluent Worker: Political Attitudes and Behavior. Cambridge: Cambridge University Press.
Hazlitt, Henry. 1964. The Foundations of Morality. Irvington-on-Hudson, N.Y.: Foundation for Economic Education, 1998.
——. 1966. “A Reply to Frank Knight,” Ethics 77, no. 1: 57–61.
Knight, Frank. 1921. Risk, Uncertainty, and Profit. Boston: Houghton and Mifflin.
——. 1933. The Economic Organization. Chicago: University of Chicago Press.
——. 1935. The Ethics of Competition and Other Essays. New York: Harper.
——. 1947. Freedom and Reform. Indianapolis, Ind.: Liberty Fund, 1982.
——. 1956. On the History and Method of Economics: Selected Essays. Chicago: University of Chicago Press.
——. 1960. Intelligence and Democratic Action. Cambridge: Harvard University Press.
——. 1966. “Abstract Economics as Absolute Ethics,” Ethics 76, no. 3: 163–177.
——. 1967a. “A Word of Explanation,” Ethics 78, no. 1: 83–85.
——. 1967b. “Laissez-Faire: Pro and Con.” Journal of Political Economy 75: 782–795.
Knight, Frank, and Thornton W. Merriam. 1945. The Economic Order and Religion. New York: Harper.
Nash, Stephen John. 1998. Cost, Uncertainty, and Welfare: Frank Knight’s Theory of Imperfect Competition. Brookfield, Vt.: Ashgate.
Quarterly Journal of Austrian Economics 19, no. 2 (Summer 2016)
Howden (2016) dedicates a large part of his response to criticizing my way of dealing with and classifying the concept of opportunity costs in my book (Braun, 2014). I must start by saying that the main arguments in my book do not depend on my approach to the cost problem. The main reason why I considered it necessary to abandon the opportunity cost concept is that I found it impossible to apply it to the analysis of human action in the passing of time. For this purpose, the concept of costs as employed in business life, where profits are traditionally not calculated on the basis of opportunity costs but as historically incurred monetary expenses, are much more useful. It appeared to me that if “the interest rate expresses itself in the difference between income and costs at each stage” (Huerta de Soto, 2012, p. 557), the costs must not be understood as foregone opportunities but as historical outlays.
Quarterly Journal of Austrian Economics 19, no. 2 (Summer 2016)Henry Hazlitt Memorial Lecture
In this lecture, I will look at a debate in the 1960s between Frank Knight, the subject of my new book (2006) in Palgrave Macmillan's Great Thinkers in Economics series, and Henry Hazlitt, memorialized by this lecture. I will look at the dispute they had on welfare, freedom and power, which was an important debate then and now. I will take Knight’s observations and apply them to today’s debate on inequality, and what I suggest are the economic indulgences referenced in my lecture title.
The Quarterly Journal of Austrian Economics
Vol. 19 | No. 2 | 173–177Summer 2016
Reply to Dr. Howden on Opportunity Costs
Eduard BraunDr. Eduard Braun (eduard.braun@tu-clausthal.de) holds a postdoctoral position at the Clausthal University of Technology.
INTRODUCTIONHowden (2016) dedicates a large part of his response to criticizing my way of dealing with and classifying the concept of opportunity costs in my book (Braun, 2014). I must start by saying that the main arguments in my book do not depend on my approach to the cost problem. The main reason why I considered it necessary to abandon the opportunity cost concept is that I found it impossible to apply it to the analysis of human action in the passing of time. For this purpose, the concept of costs as employed in business life, where profits are traditionally not calculated on the basis of opportunity costs but as historically incurred monetary expenses,Though government intervention has partly changed this in recent years (see Huerta de Soto, 2012, pp. xxiv–xxix). are much more useful. It appeared to me that if “the interest rate expresses itself in the difference between income and costs at each stage” (Huerta de Soto, 2012, p. 557), the costs must not be understood as foregone opportunities but as historical outlays.
CRITICAL REFLECTIONS ON THE OPPORTUNITY COST DOCTRINEMost Austrians agree that costs are a praxeological phenomenon. Each action implies the incurrence of costs. In the terminology of Rothbard (1962, p. 104; see also Mises, 1949, p. 97), the objective of human action, i.e., psychic profit, can be expressed as follows:
psychic profit = psychic revenues - psychic costs
When it comes to analyzing the actions of entrepreneurs the term “psychic” is substituted by the term “monetary” as it is the purpose of business enterprises to generate monetary, not psychic income. We therefore get:
monetary profit = monetary revenues - monetary costs
These statements are uncontroversial. The disagreement between Howden and myself consists in that I do not define the costs in these formulas in the same way as do most Austrian economists or, for that matter, mainstream economists. They consider all costs to be opportunity costs. Opportunity costs are usually defined as the evaluation placed on the most highly valued alternative or opportunity that was rejected in a choice among alternatives. In the following, I will point out what I consider to be the rather questionable implications of the opportunity cost doctrine.
In his discussion of market calculation, Rothbard (1962, pp. 606ff.) provides an example of an entrepreneur who has invested 5,000 ounces of gold in his business and therefrom earns a net income of 1,000 ounces over a one-year period. According to traditional accounting principles, these 1,000 ounces are profit. Rothbard (1962, p. 607) however argues that the entrepreneur still has to deduct from this net income “his implicit expenses, i.e., his opportunities forgone by engaging in the business.” Only then has the entrepreneur arrived at a figure that denotes his profit or loss. Rothbard gives the following (hypothetical) numbers for these “opportunities foregone”: The entrepreneur could have earned 250 ounces of interest if he had not invested his 5,000 ounces in his business; he could have earned 500 ounces in wages if he had sold his labor on the market; and 400 ounces if he had rented out his land instead of using it in the business. Together, he could have made 1,150 ounces if he had not engaged in the business. Therefore, Rothbard (ibid.) argues, “the entrepreneur suffered a loss of 150 ounces over the period.”
In short, although our entrepreneur has earned 1,000 ounces, Rothbard claims that he has made a loss of 150 ounces because the entrepreneur could have earned 150 ounces more if he had invested his resources outside of his business — in other words, because his opportunity costs were higher than his revenues.
I am not the only one who considers this kind of reasoning to be questionable. Reisman (1996, p. 460) gives an analogy to Rothbard’s procedure: “One gains ten pounds, but might have gained twenty pounds. This is then taken to mean that one has lost ten pounds.” Reisman (ibid.) then goes on to state the implications of the opportunity cost doctrine as propagated not only by Rothbard, but by most economists:
It follows from the opportunity-cost doctrine that precisely to the degree that one is confronted with profitable ways to invest one’s capital, and precisely to the degree that one’s services are in great demand, one’s income must be less—in a word, that one must suffer by virtue of possessing the very qualities that create one’s success.
In my book, I drew on Reisman’s critique and formulated my reservations in the following way: According to the opportunity cost concept, “the possibility of choosing between several alternatives—a possibility that one would think to be beneficial from the point of view of the person choosing—appears to be something bad, even destructive” (Braun, 2014, p. 32). The better the alternatives among which one can choose, the smaller the resultant profits.
It is in the context of this argument that I provide the example of the two friends and their apples that Howden (2016) discusses at length. The point of this example is that according to the opportunity cost doctrine there is a great difference between the case where friend A is allowed to choose which one of the two apples of his friend B he prefers and the case where A simply gets one of B’s apples without being asked to choose. If A is allowed to choose between the two apples, the apple he does not pick constitutes the opportunity costs of his decision. If the apples should happen to be very similar, the revenues of A (the apple he chooses) would almost be matched by his costs (the apple he does not choose) and his psychic profit would be minimal. As opposed to that, if A simply received an apple without having to choose, his profit would be much greater because his revenue would not be matched by any offsetting costs.Howden (2016) objects to this example on the grounds that I have assumed (in my book) that both apples are alike, which in his point of view implies that it is impossible to choose between them. In order to show that this assumption is unnecessary, I have dropped it in the above rendition.
The purpose of the example is to show that if one takes the opportunity cost concept seriously, having options is worse and leads to less profit than having no options at all. This is the reason why both Reisman and I do not find it helpful.
Reisman’s and my criticism of the said doctrine does not imply that we question that the prices of production factors are influenced by the value of the alternative uses to which they might be put (for the following, see Reisman, 1996, p. 461). The price of the quantity of wheat that is employed in the production of bread is not only influenced by the demand for bread, but also by the demand for other products this input, wheat, could have been employed to produce. The money price of wheat emanates from the demand for all the different products which it helps or might help to produce. Alternative uses actually matter, and the choices of consumers between different consumer goods actually determine the market prices of these goods and of the producer goods that help to produce them. But to say that choices and alternative uses matter does not imply that alternative uses constitute costs. Reisman’s (1996, p. 461) summary of his argument is well worth reading:
The supporters of the opportunity-cost doctrine generally recognize the process by which money costs are determined, then confuse the alternative opportunities whose competition in bidding gives rise to the money costs with the phenomenon of cost itself, and thereafter ignore the necessity of a money outlay actually being present. In other words, they identify a cause of the determination of money costs, confuse the cause with the effect, and proceed to ignore the effect, which is nonetheless essential.
Alternative uses do matter, of course, and it is important to any decision-maker to be aware of the options he has before choosing a certain alternative and rejecting others. But it leads to confusion if these alternative uses are called costs. Particularly, as I said above, it becomes difficult to discuss the role of time in human action if costs are supposed to relate to choices. Choices are instantaneous, timeless. Only actions have a time dimension; and in action, costs must be understood as historical costs. As I show in my book, this approach to costs and action allows for a praxeological explanation of originary interest that avoids the shortcomings of the traditional Austrian analysis of this topic pointed out by Hülsmann (2002).
REFERENCESBraun, Eduard. 2014. Finance behind the Veil of Money: An Essay on the Economics of Capital, Interest, and the Financial Market. Liberty.Me.
Braun, Eduard. 2016. “A Comment on Dr. Howden’s Review of Finance behind the Veil of Money,” Quarterly Journal of Austrian Economics 19, no. 1: 121–123.
Howden, David. 2016. “Response to Dr. Braun’s Comment,” Quarterly Journal of Austrian Economics 19, no. 1: 124–128.
Huerta de Soto, Jesús. 2012. Money, Bank Credit, and Economic Cycles. 3rd edition, trans. Melinda A. Stroup. Auburn, Ala., Ludwig von Mises Institute.
Hülsmann, Jörg Guido. 2002. “A Theory of Interest,” Quarterly Journal of Austrian Economics 5, no. 4: 77–110.
Mises, Ludwig. 1949. Human Action. A Treatise on Economics. New Haven, Conn.: Yale University Press.
Reisman, George. 1996. Capitalism. A Treatise on Economics. Ottawa, Ill.: Jameson Books.
Rothbard, Murray. 1962. Man, Economy, and State with Power and Market. 2nd edition. Auburn, Ala.: Ludwig von Mises Institute, 2009.
The Austrian Economics Core Curriculum course lays out the fundamentals of Austrian Economics. Drawing on the tradition of Mises and Rothbard, the course begins with Praxeology, the study of human action, from which economic principles are deduced. An exposition of subjective value and the division of labor follow, providing the requirements for exchange and markets. From there, the concepts of money’s origin and value are explored, with the interest rate coordination of consumer preferences and the structure of production and business cycles. Finally, the crucial role of the entrepreneur in the market economy and economic calculation are explained.
Featuring lectures by David Gordon, Jörg Guido Hülsmann, Jeffrey M. Herbener, Lucas M. Engelhardt , Roger W. Garridon, Joseph T. Salerno, and Peter G. Klein.
Students that complete this course will earn a certificate of completion.
Quarterly Journal of Austrian Economics 19, no. 1 (Spring 2016): 3–28
ABSTRACT: Ludwig von Mises developed the theory of economic calculation in the context of his argument that the central planning of socialism cannot make economizing decisions concerning the use of resources in a division of labor economy. Focus on the problem of allocating resources in society led to a stress on the calculation used by entrepreneurs in making production decisions. Theory concerning other facets of economic calculation used by entrepreneurs in making investment decisions, i.e., decisions concerning the economizing combination of assets an entrepreneur should own in his enterprise, for instance, was left relatively underdeveloped. The purpose of this paper is to further explore the implications of Mises’s theory of economic calculation for asset acquisitions and disposals, especially the acquisition and disposal of entire business enterprises. In particular the paper seeks to demonstrate that the subjective approach to investment appraisal developed in the German-language, business-management literature is compatible with Austrian value theory.
KEYWORDS: value of the firm, appraisement, investment appraisal, value theory, subjectivism, Austrian school, neoclassicismJEL CLASSIFICATION: B31, B41, B53, G32
[Originally published May 2016]
Although it is sometimes imagined that a world based on gift-giving rather than market exchange would be a world without scarcity or want, we are still left with the problem of manufacturing and producing complex goods that require markets to allocate resources.
Moreover, if we remember that the act of gift-giving requires both the giver and the recipient to agree to the exchange, we quickly find that the situation is more complex than we initially thought.
Both Donor and Receiver Must Agree A gift is an unconditional transfer of an economic good from one person (the donor) to another person (the beneficiary). In the case of a service, the donor agrees to provide the service to the beneficiary, and the latter accepts to receive it as a gift.
If it is truly a gift in the real sense, the good is freely given and the decision to abandon the good comes with no strings attached. For the donor, it is not the fulfillment of an obligation, and it cannot be claimed as a right by the beneficiary. In particular, it is not a remuneration for some economic good provided by the beneficiary to the donor. To be sure, in practice, there are lots of cases of “false gifts” in which a transfer of property rights has some of the characteristics of a true gift, but not all of them.
It is necessary that both sides agree to it. If both sides agree, then the beneficiary benefits, but the donor benefits too.
This seems to be a matter of course as far as the beneficiary is concerned. After all, he receives an economic good without any payment, which is why he is called the beneficiary. However, it is important not to fall into what we might call the materialistic trap in interpreting the gift. The beneficiary benefits, not because someone else is willing to gratuitously provide an economic good to him. He benefits because he prefers to receive this good rather than to forego it. It is well known that gifts can be rejected, and that some gifts should be rejected. It is not because the Greeks offered their wooden horse on the beach to the Trojans that the latter were someone impelled or obliged to accept it. The Trojans took it because they believed to be better off owning the horse, erroneously as it turned out.
There is Value in the Act of Giving or Receiving a Gift In other words, what makes a gift a gift is not its suitability for that and that use or enjoyment (its “use value”), not the fact that other people find it desirable (its “exchange value” or market price), but the fact that the prospective beneficiary finds it desirable and therefore agrees to receive it. He gratuitously receives the object proposed to be given to him, be it a service, or be it the property rights to a commodity. But what makes him truly a beneficiary, and what makes the object a gift, is the personal value of the gift. By agreeing to accept it, he demonstrates his preference to be provided with the gift, rather than to forgo it. He demonstrates that he thinks himself to be better off, thanks to the gift, than he would otherwise have been.
The donor benefits, too. If Smith gives a five-dollar bill to a beggar, then he thereby demonstrates that he, Smith, prefers that the beggar, rather than Smith himself, own the banknote. Now, this sounds as though Smith were somehow “interested” in making this gift, which in turn would insinuate that the gift is not really gratuitous because Smith himself stands to benefit from it. Well, in a wider sense Smith is interested, but that does not per se make his gift any less gratuitous.
Smith does benefit from the gift-making. This is why he agrees to make the gift. To non-economists this assertion might sound shocking, but it should not. There is no human action that does not employ some means to attain some higher-valued end. The reason why man acts is always the desire to improve the state of affairs, that is, to bring about a state of affairs that he prefers to the state of affairs that would have existed without his action. There is no exception. But this does not imply a contradiction with the gratuitous nature of Smith’s act. He was not obliged to give the bill, and the beggar was not entitled. Therefore his act was gratuitous in the full sense of the word.
The Role of Market Prices in Gift-Giving Let us move on to a final observation on the economics of gifts. Gifts can be produced through more or less lengthy processes and involving the cooperation of many people. In other words, the decision to make a gift is not necessarily made at a moment’s notice, as when we encounter a beggar at a street corner. Gifts can also be planned in advance. They can be prepared, not only in the sense that the gift-making decision be planned, but also in the sense that the economic good that is to be donated, is especially produced to be donated.
Is it imaginable that all production processes be geared toward gift-making? Each person would no longer sell his products, but give them away; and he would in turn benefit from the gifts made by other people. Could the entire economy be a pure gift economy of this sort? As we know from the analysis of communism, this could be attempted, but it would come at a heavy price. A pure gift economy would by definition be an economy without exchange, and thus without market prices. Yet market prices provide guidance to produce one type of good (yielding higher revenue) rather than another (yielding lower revenue); and they provide guidance not to use certain goods because they cost too much to buy.
In a pure gift economy, this guidance would no longer exist. It would have to be replaced by a great sense of judgment and great discipline on the part of all members of society. Clearly, such qualities are exceedingly rare and, what is more, they would not be rewarded in a pure gift economy and would therefore not be cultivated in such a setting. It is out of the question to organize a comprehensive division of labor on the little judgment and on the little discipline that could be mounted by just a few virtuous people.
Producing Future Gifts Is Complex and Difficult Moreover, even if these people were not few but many, a pure gift economy would still suffer from a formidable impediment. As Ludwig von Mises taught us, without exchange and market prices it would be impossible to organize the division of labor within lengthy and complex roundabout-production processes. Good judgment might be sufficient to devise an overall plan for the satisfactory cooperation between a few shoe-makers and butchers without the interposition of prices and exchange. But good judgment is at a complete loss to evaluate the relative (and often changing) importance of computer programs, drilling equipment, operations research, and other goods that are removed from our immediate experience.
A static economy serving few people with very short supply chains might be organized as a gift economy, if the producers are inspired by brotherly love and mutual trust. As soon as any one of these conditions is absent, as soon as love and trust are lacking; as soon the economy involves thousands, millions, and billions of people; as soon as supply chains grow long and complex; as soon as technological and other conditions change fast and frequently, a pure gift economy is out of the question. The productivity of labor in such an economy would be exceedingly small as compared to what we know it to be in a developed market economy.
The Ludwig von Mises Memorial Lecture sponsored by James Walker. Recorded at the 2016 Austrian Economics Research Conference. Includes an introduction by Joe Salerno.
The Lou Church Memorial Lecture sponsored by the Lou Church Foundation. Recorded at the 2016 Austrian Economics Research Conference. Includes an introduction by Joe Salerno.
In the view of John Tamny — an editor at Forbes and RealClearMarkets — economics as it is usually studied and taught in universities is unnecessarily complicated. The basic truths of economics are simple and require no difficult mathematics to understand. Readers will be reminded of Hazlitt’s great Economics in One Lesson.
Entrepreneurs vs. BureaucratsThe book is animated by a controlling vision. A successful economy depends on innovative entrepreneurs who are willing to take large risks in return for the chance at great profits. It is essential to prosperity not to hamper the efforts of these entrepreneurs through governmental efforts to tax and regulate the economy. Tamny illustrates his thesis with many stories about famous persons, as the subtitle of the book suggests.
The government, Tamny emphasizes, produces nothing on its own. It operates by taking resources away from the productive. To the objection that the government may itself use money it takes in taxes for purposes beneficial to the economy, Tamny answers that people successful in business are highly likely to be better judges of what is beneficial than bureaucrats in the government. If the bureaucrats were better able to discern profit-making opportunities, they themselves would be entrepreneurs. High level bureaucrats may earn substantial salaries, but the wealth of those in business is far greater. “If you’re so smart, why are you a bureaucrat?”
To this, one can imagine someone objecting: Even if it is right that successful entrepreneurs will raise economic productivity, does this not bring with it a great danger? What about inequality? What if the successful entrepreneurs do so well that they accumulate vastly more wealth than others? Thomas Piketty has notoriously made much of this point; but Tamny has an effective and simple answer to it. Great accumulations of wealth are desirable: the rich will invest their money, and everyone will benefit. “When the rich ‘hoard’ their wealth, it is loaned to those who need money for cars, clothes, and college tuition, not to mention the next generation of Bill Gateses, full of ideas but in need of the capital that will abound if some of society’s richest keep their wealth intact so it can pass to future generations.”
If high investment is the key to prosperity, the capital gains tax is especially to be deplored. “Investors who might risk their capital in the private sector know they might lose it all, and they face a 20 percent tax on whatever return they do get on their investment. Those same investors have the option of buying government bonds, and, though the returns are small, they’re reliable and, in the case of municipal bonds, tax-free. ... Our tax code ... puts entrepreneurs at an enormous disadvantage when they compete with the government for investors.”
Taxation is of course not the only way the government hampers the free market. Attempts by government to regulate the economy face exactly the problem that Tamny finds with taxation. Antitrust laws, for example, purport to prevent companies from gaining monopoly control of important commodities; but are not those on the scene better qualified than government “experts” to assess whether market conditions make mergers desirable? Once more, it is entrepreneurs, not government officials, who are skilled at anticipating future demand. “Mergers are ultimately about survival. Companies must adjust to an uncertain future business climate, and restraining the ability of larger businesses to act in the best interests of shareholders is counter-productive. Antitrust regulation does not foster competition so much as it reduces successful companies to sitting ducks.”
“Capitalist Societies Can Rebound from Anything”We have so far omitted a key part of Tamny’s argument. Skilled entrepreneurs succeed, but many in business fail. The market operates by sorting out of the successful from the failures by the test of profitability. Given this fact, it is as essential that the failures be allowed to fail as it is that those who succeed be allowed to keep their profits. Attempts to prop up failures disable the market.
This vital point can be used to answer a common objection to free trade. Many people object to free trade because, in some cases, foreign competition drives domestic companies out of business, causing unemployment. To the response that expanded trade creates jobs elsewhere in the economy, the reply oft en given is, what about the workers who do lose their jobs? They are often unable to secure new jobs as good as those they had previously. The fact that others are better off is small solace to them.
Tamny’s account of the way the free market works makes it impossible to accept the objection just given. “In a free economy, capital migrates to talented entrepreneurs eager to pursue profitable opportunities. Innovations like the automobile, computer, and online retail services destroy jobs, but the process leads to better, higher-paying jobs ... to create jobs in abundance, we must allow the free marketplace to regularly annihilate them.” Tamny acknowledges that “the progress of job creation through job destruction does not make losing your jobless agonizing. ... Yet getting laid off is not cause for despair. Good often comes from losing your job.” Workers, like capitalists, need to be alert to new opportunities.
In a manner showing great insight, Tamny applies the point about falling businesses to the financial crisis of 2008. According to Ben Bernanke, Timothy Geithner, and many others, only the massive bailouts of financial institutions in response to the collapse of the housing market saved the economy from disaster. Tamny reverses this contention. It was essential to the proper working of the market to allow the businesses that had acted recklessly to fail. Had this been done, the economy could have quickly readjusted. “Capitalist societies can rebound from anything. In particular, they can bounce back from bank failures that do not exterminate human capital or destroy their infrastructure. An interfering government is the only barrier to any society’s revival, and that is why the global economy cratered amid all the government intervention in 2008.”
Gold, Money, and the StateSo far there has been little reason to dissent from the author’s principal arguments. In monetary theory though, he makes what seems to me an incorrect claim; but fortunately, his main policy prescription can be restated in a better way. Tamny rightly calls for sound money. He rejects as misguided inflationary efforts to reduce our “unfavorable” balance of trade. As he points out, a trade deficit is not at all to be feared. “All trade balances. Trade ‘deficits’ with producers from near and far away are the rewards for everyone’s productivity.”
So far, so good; but he errs when he compares the dollar to a measuring rod that must not change. “Just as the foot is never long or short, money should be neither strong nor weak. The foot is a standardized tool to measure actual things, and money should have the same constancy.” What is his argument for this view? As he points out, people want money, not for its own sake, but in order to purchase goods and services. (We set aside a few exceptions.) He thinks that from this fact, if the government follows the proper policy, the value of money can be kept constant. Relative prices of goods and services will change, to reflect changes in their supply and demand. Money can then serve as a measuring rod, to enable people to assess these changes in relative prices. It does not follow, though, that because money is demanded as a means to get other things, there is no independent demand for money at all. In the free market, money is a commodity whose price can change.
Even if Tamny is wrong on this point, though, his main message can be salvaged. It is entirely desirable that the monetary commodity be one unlikely to be subject to substantial fluctuations in price. The gold standard abundantly meets this requirement, and this gives Tamny all that he can reasonably want. To speak of measuring rods merely darkens counsel, as Mises long ago pointed out. “Although it is usual to speak of money as a measure of value and prices, the notion is entirely fallacious. So long as the subjective theory of value is accepted, this question of measurement cannot arise.” (Mises, Theory of Money and Credit, chapter 2.)
The book’s many insights far exceed in importance this disagreement about money as a measure of value. Popular Economics is an outstanding book that, if read widely, will greatly improve public understanding of basic economic truths.
Supporting free trade is simply a matter of taking no action when another person exchanges in non-violent exchange with another person. That person may be right down the street, or that person may be in another country somewhere. No “free trade agreements” or other paperwork of any kind is required.
To oppose free trade, on the other hand, is to engage in the imposition of fines, prison terms, and other sanctions on people for engaging in non-violent exchange.
The Moral ArgumentThat latter part is usually ignored by average people who support restrictions on free trade for whatever reason. They frame their opposition to trade as if it were a mere academic question, and as if the reality of restricting free trade were simply a matter of saying “don’t do that” and then everyone will agree to stop doing it.
But, of course, anyone who favors restrictions on free trade needs to go the next step and outline exactly what fines and jail sentences should be imposed on merchants and others who have committed the “crime” of purchasing goods from non-government-approved sources, or who have sold goods to non-government-approved recipients.
Shall fines be $1,000 or $100,000? Shall perpetrators serve 90 days in jail or 5 years in prison? These are the questions that any opponent of free trade must answer. And if the answer is “yes” to any of these questions, let’s then outline which taxpayer-funded government agencies shall be in charge of hunting down the lawbreakers, prosecuting them, and jailing or fining them. The (presumably well-paid and well-pensioned) government agents won’t work for free. What spy apparatus shall be employed to keep an eye on all the potential violators?
And, of course, ignorance of the law will be no excuse, so everyone who wishes to import a trinket or widget from a foreign country will need to know all the laws, regulations, and sanctions that come with such a business venture. To not know this all could mean one’s life will be ruined by federal prosecutors.
For example, if you don’t know the details of the US law known as the Lacey Act, you could be serving harsh prison sentences for violating foreign laws, or for importing fish peacefully acquired, or for engaging in a seemingly endless list of activities that any normal person’s common sense would suggest are peaceful and legal.
Similarly, when Gibson Guitar Corporation was raided by a SWAT team for running afoul of some arcane law about the importation of wood, that was just the natural outcome to be expected from restricting free trade. Those laws were in place to protect domestic lumber industries from imports. But hey, the law’s just there to protect American, workers, right? So, apparently, it’s fine if those Gibson guitar people have their livelihoods and families ruined by legal fees, fines, and jail sentences.
Opponents of free trade, like supporters of the anti-Cuban embargo, for example, like to talk a good game about supporting freedom and liberty, but when all is said and done, their policies amount to nothing more than the sordid jailing and prosecution of non-violent merchants and consumers.
The anti-trade crowd likes to tell themselves that these laws only punish cigar-chomping villains in skyscrapers, but that’s not how laws work. Since laws aren’t written to apply to specific companies, they punish certain behaviors instead. Such laws may indeed restrict big, evil corporations, but they also end up applying to small entrepreneurs and small business owners, most of whom lack an army of attorneys, and usually end up in a far worse position than any big company might. Like the owners of the Gibson Guitar Corporation, many small- and medium-sized business owners simply seek out the lowest-cost goods so they can offer goods to their customers at a lower price. Those goods are often located in foreign countries. But, without an immense legal team, most ordinary people will be caught up in the net of trade restrictions.
The Economic ArgumentSo far, this all ignores the economic arguments against restricting free trade. Those of us not engaged in the direct importation of goods will also suffer when goods are restricted. Trade restrictions on pharmaceuticals, auto parts, food, and whatever else only makes those goods more expensive. And not all those goods are consumption goods, of course. Entrepreneurs use those goods to create new goods and then must charge higher prices to his customers also. A janitor who must pay higher prices for a truck or a shop vac due to trade restrictions must pass on a portion of that cost to the customer. And, with higher prices, the janitors will have fewer customers and fewer profits. Shopkeepers in turn must then have dirtier shops because they can afford fewer janitorial services.
Yes, a tiny portion of the population that’s engaged in the domestic manufacture of shop vacs and trucks will benefit. But, it’s the janitors and their customers (the hair salon and sandwich-shop owners) who are paying the price of subsidizing the factory workers.
These issues aren’t part of an intellectual exercise. The downside of restricted trade is very real for real people.
But, we don’t need me to explain the economic problem with restricting trade. Adam Smith, Ludwig von Mises, and the entire line of liberal, laissez faire economists agree on this point.
The Nationalist ArgumentThe nationalist program of using protectionism to shield American workers from competition is based on the idea that trade with outsiders hurts the local economy. But many who accept this idea in the international sphere then promptly forget the idea when applied domestically.
For example, we’re told by the nationalists that it hurts California workers if Californians buy goods from neighboring Mexico, but it’s apparently A-OK for Californians to buy goods from Illinois or New York, both of which are distant economies that likely contribute far less to the economic well-being of Californians than the economy of northern Mexico.
Murray Rothbard mocked this mindset in the context of immigration when he wondered why it’s not a problem when someone moves from Massachusetts to take a job in Michigan. In that case, the response is never to complain about how people from Massachusetts are stealing the jobs of people in Michigan. No, the argument is only applied if someone crosses an international boundary to do the same.
As with trade, then, it’s bizarre to argue that goods imported from Virginia to California are perfectly tolerable — and even beneficial — while imports from neighboring Tijuana are somehow damaging.
Rothbard noted the idea becomes more absurd the more local you get. The proposed economic justification for “Buy American” is no different from the demand to “Buy North Dakotan” or “Buy 55th Street.” While there certainly are groups that promote only buying goods from one’s home states (i.e., the “ABC — Always Buy Colorado” campaign), such efforts rarely rise above being a marketing gimmick and virtually no one supports trade restrictions between states.
Thus, by their actions, the demonstrated preference of Americans is to take advantage of the benefits of buying and using goods made thousands of miles away by people they’ll never meet. That is, they clearly accept the benefits of trade with a far-away economy (as is the case of trade between San Francisco and St. Louis), but they then turn around and reject the same reality when dealing with international trade.
At the heart of this mindset is pure mysticism, of course, since it requires one to believe that a person in Brownsville, Texas, has the same economic interests as a person in Portland, Maine, but entirely different interests from a person in nearby Monterrey, Mexico. It requires a belief in some sort of metaphysical or perhaps physically objective difference between humans in Monterrey and humans in Portland.
Even the most basic powers of observation should disabuse one of such a strange notion, and yet, American discussions of trade accept the idea as a given.
Left to their own peaceful trade, of course, such ideas would evaporate quickly as people pursued mutually beneficial economic relationships across borders and barriers of every kind.
Today however, we must continue to deal with people who accept an anti-trade ideology that prefers violence to peace, and coercion to freedom. Unfortunately, governments are perfectly happy to oblige them.
The Importance of Economic Calculation In “Economic Calculation in the Socialist Commonwealth,” Ludwig von Mises challenged the socialists to explain how economic calculation could be performed in a socialist economy absent prices. Mises concluded that economic calculation in a socialist economy is impossible, therefore socialism is impossible.
Mises wasn’t saying that you couldn’t have a socialist society, he was saying that it’s not an economy, in the sense that decision makers are economizing regarding their decisions about the allocation of resources.
Socialism, at the time, was defined as a system where the state owns the means of production. The state owns the natural resources and the capital, such as the factories necessary for use in the production process. Given this state ownership, the resources are not being traded in any market and since there are no markets for the resources there are also no market prices for the resources.
In an economy where resources are privately owned, the exchange of those resources would provide us with market prices. And those prices provide us with a sound basis for assigning resources to their most productive uses.
This rational calculation is impossible in a socialist economy.
Mises concluded, “Thus in the socialist commonwealth every economic change becomes an undertaking whose success can be neither appraised in advance nor later retrospectively determined. There is only groping in the dark. Socialism is the abolition of rational economy.” (p. 23)
Land Socialism in the United States My interest in this topic was inspired by Yuri Maltsev. A few years ago, Dr. Maltsev gave a talk at Ferris State University focusing on the evils of Soviet socialism (a portion of the presentation can be seen here). Nobody disagreed with Yuri’s point that the Soviet economy was socialized, however, some took heavy issue with Yuri’s claim that the US economy was also socialized to a large degree.
This led me to consider the degree of land socialism in this country. This is a critical issue. Starting with the available land and labor, the structure of production is determined by the available technology and the capital that we derive from the available land and labor. Government control of the natural resources gives the government tremendous control of the whole economy, distorts prices, and diminishes the efficacy of our economic calculation.
Is US land ownership heavily socialized? Let’s begin answering this question by considering the states with the largest percentages of government-owned lands.
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Nevada has the largest percentage, 84.9 percent, of federally owned lands, but 30 percent of Alaska is state owned, so Alaska has the largest percentage of government-owned lands. As you can see, due to the Louisiana Purchase and other factors, much of the federal land ownership is in the Western states. I included New York on the list because New York has the highest percentage of state-owned land.
Admittedly there is some false precision in these numbers as the states and the federal government have some difficulty in accurately providing statistics on their land ownership.
Next, consider the largest federal agencies ranked by land ownership.
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Texas, with 171 million acres, is the second largest state. We see here that the BLM and the Forest Service are both larger than Texas. And the fourth largest agency, the National Park Service, is larger than all but four states, Alaska, Texas, California, and Montana, slightly larger than New Mexico’s 77.6 million acres.
Note that these numbers do not include the Bureau of Indian Affairs. The federal government claims that the 55 million acres of BIA lands are Indian lands not federal lands. I don’t know if the Indian tribes agree with this assessment. The Indian lands, if they were a state would be the 11th largest state, almost equal in size to Utah’s 54.3 million acres.
The Department of Defense administers 14.4 million acres of land, according to a 2014 Congressional report. (By the way, a 2012 Congressional report with the same title as this report claimed that the Department of Defense administers 19 million acres of land. There is no explanation for the missing 4.6 million acres in the 2014 report.)
The federal government, according to this report, “owns and manages roughly 640 million acres of land” and there is an estimated 200 million acres owned by the various state governments. Therefore, 37.1 percent of US dry land is owned by some government.
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A map of the government land ownership will help us put things in perspective.
Note that this map shows only the federal holdings and the Indian lands and omits the 200 million acres of state lands. Still, it provides us with an illustration of the degree of land socialism in this country. The federal government owns most of the land roughly from the Continental Divide west to the Pacific Ocean.
Government-owned Lands in the Oceans What about the submerged lands? The federal government also claims ownership over what they call the submerged lands of the US. These claims began with 1799 legislation regarding the “customs waters,” allowing the boarding of foreign flag vessels within 12 nautical miles of the coast. Over time, these claims have expanded and in 1945, Harry Truman declared US government jurisdiction and control over the continental shelf. During the next decades, governments of the world claimed increasingly larger amounts of the ocean beds. Problems occurred, however, if two governments disagreed over these claims. This became a United Nations issue in the 1970s, and in 1982, at the United Nations Convention of the Law of the Sea, the countries of the world came to an agreement regarding their Exclusive Economic Zones (EEZ), whereby each country owned the sea and the sea beds out to 200 nautical miles offshore.
Due to Congressional resistance of United Nations treaties, Congress did not ratify this agreement. But Ronald Reagan, in 1983 simply proclaimed sovereign rights over the US Exclusive Economic Zone. He ratified the agreement by presidential mandate.
According to a Department of the Interior report, there are 3.9 billion acres in the US EEZ. Reagan’s proclamation was the biggest land grab in US government history.
Consider this map of the US that includes the US EEZ. The various colors highlight the regions of the EEZ.
The federal government owns the sea beds out to 200 nautical miles off of the Atlantic and Pacific coasts and much of the Gulf of Mexico. Due to the Alaska Peninsula and the Aleutian Islands, there is a tremendous amount of EEZ lands off of the Alaskan coast. And the US government claims ownership over immense amounts of the Pacific Ocean, much of which is due to the military use of small islands during World War II.
For instance, the Johnston Atoll in the Pacific was used as an airstrip of about one square mile during WWII. Since this tiny island is now a federal holding it allows the government to claim ownership over 166,000 square miles of ocean sea bed, which is approximately the size of California.
We can now consider the total amount of US government lands.
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One point to make here is that there is over 70 percent more submerged lands in the US than the total amount of dry land in this country. That is, the federal government owns more submerged land than the total amount of land in the 50 states.
Thus, 76.9 percent of total land in the United States is government owned. There is no doubt that regarding this essential resource, land, our economy is heavily socialized.
Back to the Calculation Problem The government ownership of lands leads to several economic problems. Government officials can use their control of the natural resources to reward politically favored industries and punish their political enemies. Second, government restrictions on the use of resources on government lands limits economic growth. Third, and this is Mises’s point regarding socialism, land socialism will create economic calculation problems.
The first calculation issue here is the government’s decisions regarding the use of this land and the resources on and under the land. Since the government owns the land, we see no prices for these resources. The government has no way to economize on these resources in the sense that government officials, even if they wanted to, could not efficiently allocate these resources. They make these allocation decisions based on political considerations, so they end up allowing the private sector to access the wrong resources, wrong in the sense that if we were allowed to have private ownership of these resources, we would choose to use the resources much differently, and more efficiently.
The second issue is that the economic calculation of private businesses is distorted by government control of the resources, because government ownership distorts the prices of the resources. If the prices were based on the private ownership of land and resources, for instance, we would see a different array of energy prices. The prices we see for resources do not accurately reflect the underlying realities of resource availability. Even though we are engaged in calculation when we allocate these resources, we are not economizing on the resources in the sense that Mises described.
Due to the high degree of government land ownership, the US government distorts economic calculation in the exact manner that Mises explained and predicted in 1920.
The political circus of the 2016 presidential election has revived and reinvigorated popular belief in age-old protectionist fallacies. Currently both Donald Trump and Bernie Sanders, are both in favor of expanding protectionist trade policy, with both of them arguing that free trade “destroys” jobs and hurts domestic workers and producers by exposing them to foreign competition. Both candidates espouse an utterly misguided zero-sum view of economics, in which one side to an exchange wins only when the other side loses. Both men are, of course, completely wrong.
Free Trade Does Not Destroy JobsIt is true that greater competition between domestic and foreign workers can lead to a decline in wage rates and possibly unemployment in some sectors of the economy. But this is only a short-term effect. Free competition between foreign and domestic producers also naturally leads to lower prices for the goods and services which can now be freely imported from abroad. So, while nominal wage rates are pushed down in some sectors, real wage rates rise overall for everyone in the economy because of the decline in prices.
Thanks to free trade consumers spend less money on certain goods and services and this allows them to spend more money on others, which leads to rising demand and thus profits in the sectors providing the latter, and consequently leads also to more investment by entrepreneurs. This higher rate of investment naturally leads to the creation of more jobs in these sectors and thus offsets any original rise in unemployment that might have occurred.
Alternatively, the consumers may choose to save the extra disposable income that was freed up by the decline in prices. This rise in the savings rate will lead to a decline in interest rates, which makes profitable certain long-term capital-intensive projects which were not profitable beforehand. Seizing the opportunity presented by this increase in savings, entrepreneurs will start borrowing and investing in those long-term capital intensive projects, which on its own already creates more jobs, but it also leads to a rise in demand for capital goods, which raises profits in the capital goods industries and consequently leads to more investment and job openings in those sectors.
Free Trade Is Win-WinFree trade not only doesn’t “destroy” jobs, but it also promotes specialization between nations, which improves the efficiency and productivity of workers, and leads to a rise in living standards for all. Trade is not some kind of a zero-sum game in which if one side wins, the other has to lose.
When two countries such as the United States and China, for example, trade freely with one another, their citizens are incentivized to specialize in those lines of production in which they have a comparative advantage. Due to the difference in factors of production endowments it is best for different countries to specialize in producing those types of goods and services which they can produce most efficiently in comparative terms. A higher level of specialization, through the effect of economies of scale, makes production more cost-efficient.
By specializing in a certain line of production and then exchanging the goods and services produced for those that others are specialized in producing, the people of a given country can substantially raise their living standards because the gains in productivity are naturally followed by an increasing supply of goods and services and thus rising real incomes. This way free trade allows for the flourishing of what can be called an “international” division of labor. Just like a greater degree of division of labor can lead to big gains in productivity and thus real incomes on an intra-national (i.e., internal for a given country) level it can also do so on an international level.
Protectionism Makes You PoorWhen international trade is restricted, for example, by protectionist legislation which places tariffs on certain imports, this process of specialization is hindered and thus the gains in productive efficiency are diminished. By artificially raising the price of imports, tariffs allow otherwise uncompetitive and inefficient domestic businesses to remain in operation. Consumers are forced to pay higher prices for the goods the importation of which is penalized by tariffs, and this effectively constitutes a redistribution of resources from the consumers to the domestic producers.
More importantly, protectionism hinders the process of specialization described in the previous section and thus prevents living standards from rising in the long-term, or worse — it can even lead to their decline. By propping up the profits of comparatively inefficient domestic producers and keeping in business, tariffs prevent the labor shift from those inefficient sectors, to more comparatively efficient ones. Consequently, because this prevents a higher degree of specialization from taking place, or even reverses it, the benefits that specialization leads to cannot be obtained. Productivity does not increase (or at least not to the same degree as it could) and thus real incomes do not rise.
Contrary to the popular political rhetoric nowadays, free trade does not “destroy jobs.” It can only lead to a shift of resources (labor, capital, and other factors) from one comparatively inefficient sector or group of sectors in the domestic economy to another more comparatively efficient one. This process of specialization in the comparatively advantageous lines of production not only does not destroy jobs, but it also enables big gains in efficiency and productivity to take place, which leads to a rise in real incomes. This is how, far from somehow hurting the domestic workers, free trade actually does the opposite — it makes them richer. It is, in fact, protectionism which makes us all poorer, workers included, by artificially propping up inefficient businesses, leading to a misallocation of resources and a decline in standards of living for us all.
The perennial promises of free stuff from political candidates are front and center again now that we are ensnared in another US election cycle. The knee-jerk response from some economists and libertarians is “TANSTAAFL!” And of course it’s true that There Ain’t No Such Thing As A Free Lunch, because somebody must bear the costs of the supposedly “free” stuff. Nothing is free because every action has an opportunity cost.
Especially when the government is involved in doling out the gifts, all it means is that it was bought with money taken from others. Or, sometimes, the money is taken from the person receiving the gift, who thinks he’s gotten something for nothing. (This is a sleight-of-hand political trick that has fooled many for centuries.)
But what if we interpret “free” in a more colloquial sense? Is it still preferable for the government to give away free stuff? Do unhampered markets provide for free stuff?
Two Definitions of “Free”Today’s promises include free college, free healthcare, free paid time off of work, and all sorts of goodies. Although the above conclusion (no such thing as “free”) applies to all of these, I want to consider a different, more liberal definition of “free”: gifted.
For example, if Bernie gives Jonathan an apple that Bernie either grew in his orchard or bought at the store and Bernie expects nothing in return, the apple is a free gift from Bernie to Jonathan. The production, purchase, and loss of the apple is costly, but Jonathan bears none of these costs. Jonathan would technically have to expend some time and effort to hold and consume the apple, and he would lose an apple’s worth of carrying capacity on his person, but ignoring these and other technicalities, we can casually say that the apple is a free gift from Jonathan’s perspective.
So now consider this definition for the above examples: freely gifted college, freely gifted healthcare, freely gifted time off, etc. We realize that these already exist, and would exist absent government provision.
There are innumerable scholarships offered by individuals, organizations, and colleges who want certain students to attend college. Organizations like St. Jude’s, Doctors Without Borders, and Operation Smile offer freely given medical services to patients. And many businesses already allow their employees vacation days, medical leave, and family leave without them skipping paychecks, although there is an important caveat here that this would be priced into their regular salary or wage unless the employing entrepreneurs want to give from their own means.
This is all not to mention the freebies, BOGO coupons, “freemium” apps, and other marketing strategies retail stores employ.
Why Do People Give Gifts?First, we must have more than we want to keep for ourselves.
Widespread abundance like this is only possible with relatively unhampered markets and roundabout production in place, where entrepreneurs are correctly guessing consumer demands and a large capital structure made possible by saving yields plenty of consumer goods. We have to create wealth before we can exchange it, consume it, or give it away.
But once we have such an abundance of means, the reasons for giving are countless and outside the scope of economics. An altruist might give out of generosity, but even a greedy businessman could give because of increased storage costs for all of their inventory, or as a plan to attract customers.
It should be noted that self-interest motivates both the altruist and the greedy businessman. The altruist’s actions are self-interested because he is satisfying one of her own ends by relinquishing ownership of the donated means to somebody else.
Voluntary vs. Involuntary GivingWhen the giver gives voluntarily and the receiver accepts the gift, we can say it represents a mutually beneficial arrangement. The same cannot be said for forced redistribution.
When Bernie gives Jonathan the apple, Bernie is satisfying the highest ranked end he has for that apple. If, however, Bernie stole the apple from somebody else before giving it to Jonathan, then we can say with certainty that the exchange of the apple is not mutually beneficial.
The same goes for college scholarships and medical care. If the government takes the means to give somebody free college, then it does not represent a mutually beneficial arrangement, or else the individual would have voluntarily donated the money for the student to go to school.
Unlike private charities and scholarship funds, the government has no reason to dispense the gifts prudently or to minimize their own cut to maintain a donor base that is confident their donations are used efficiently and for the intended cause.
Forced redistribution also tends to spur bitterness and conflict, as opposed to gratitude and goodwill.
Proponents of Free Stuff Should Look to Capitalism, not RedistributionismThe conclusion we can draw here is that we get just the right amount of “free” stuff through the voluntary interactions of individuals in unhampered markets. And, not only that, but as capitalistic economies inevitably grow and the people become increasingly wealthy, charitable giving can increase as well. As the supply of goods that satisfy our ends gets larger, those marginal goods are more likely to be valued in terms of giving them away rather than keeping them ourselves.
Therefore, those that desire more free stuff should try to encourage more voluntary giving (maybe even leading by example), not forced redistribution. They should also be the loudest proponents of unhampered markets as any voluntary giving must come from wealth that has already been created and in such abundance as to allow for greater giving.
These days it seems that everything in our lives revolves around taxes. Taxation has always caused problems. Taxes distort the structure of production and the price system reducing the real wealth of society.
Yet not everything that people consider a “tax” is indeed a tax. A tax is something that a person is forced to pay, under threat of punishment, by the government. This does not include what has become known as the “pink tax.” The pink tax is the notion that women pay more than men for products that are female-oriented. For example, those who believe in the pink tax often claim that women pay more than men for razors, and that these women’s razors are the same product as men’s razors.
Men and Women Are Not IdenticalWhen discussing the pink tax, we can dispense with the notion that women pay more money for exactly the same products that men use. In order for goods to be identical, the two products must be viewed as homogenous units by the consumers themselves.
Clearly this is not the case, and hygiene products — even ones designed to do similar things — are viewed differently by men and women. First of all, men’s and women’s products generally smell different from one another. This fact alone is enough to distinguish them as separate products if the sexes treat the products differently.
Moreover, in terms of physical amenities, men’s and women’s razors are different in a number of ways. As indicated here, women’s razors are often larger and have more stuff around the blades to help women shave a larger area.
Women pay more for dry cleaning and haircuts. This is partially due to the fact that women’s dry cleaning and women’s haircuts takes more time, and is more labor intensive. More importantly, female consumers of dry cleaning are willing to voluntarily pay the higher prices. But these facts haven’t stopped some from calling for a federal law outlawing differences in prices.
Perhaps the largest “injustice” related to the pink tax is the fact that women often pay more for health insurance. As pointed out here, however, women are more likely to have chronic health conditions. And, as studies suggest, women use health care services differently than men.
Prices Are Not ArbitraryThe cost of producing a good will affect the price, but ultimately, how the goods are valued, relies on the subjective valuations of the consumers. This valuation manifests itself in the form of objective money prices, and it is the consumers who actually determine what products are on the market, and what the price of these consumer products will be.
In the case of hygiene products, it must be remembered that men and women have different standards of hygiene leading to very different demand curves.
Thus, prices in a functioning market will be set at the point where the aggregation of the supply and the demand schedules intersect. That is, it will be set at the level where both sellers and buyers can agree to voluntarily exchange money for the goods.
Companies must set the price as close to this equilibrium price as possible because above this price the company will have a surplus of product to sell, and if it is below this price the company will have shortages, causing a loss in revenue. This works for whole industries too; if suppliers of women’s products are actually charging a higher price for an identical product, and reaping profits, then other firms will start producing women’s products, thus increasing supply and, ceteris paribus, drive prices down.
By continuing to buy differently priced goods for men and women, the consumers have indicated that they think there is nothing wrong with there being price differentials between men’s and women’s products. On the contrary, this “price discrimination” is achieving the most efficient distribution of goods to those who value them the most. If the two different products were truly the same, then women would simply buy the male version of the products.
Moreover, nobody forces these women to pay more for the products they purchase. These products reflect what a woman deems as her most preferred product on the market with given prices. In an unhampered market there are no correct or incorrect prices. There are only the prices that people freely choose to pay. To believe that women only buy women’s products that are identical to men’s due to clever advertising campaigns would be to assume that women have no brains and can be endlessly manipulated by firms. If this where the case, why would companies not just raise their prices for all products and shift most of their funds to advertising?
This Is Not About EqualitySupporters for abolishing the nonexistent pink tax do so under a façade of “equality,” and many groups who believe in the pink tax advocate for legislative action to force companies to lower the price of women’s products so they are equal to prices charged for men’s products. This is nothing more than a form of price control, which as shown here, eventually leads to very bad things.
It is wrongly accepted by many liberals (i.e., libertarians) that most, if not all, social problems can be “solved by the market.” But clearly, the “market” cannot magically solve our problems. Let it be clear that there is no doubt that the best way to have social progress is to have a free market economy. However, free markets are not solutions to problems, per se, but are rather what gives us the opportunity to find our own solutions to our own problems by finding the most valuable way to serve one another. For example, Frédéric Bastiat famously wrote in The Law that: “At whatever point of the scientific horizon I start from, I invariably come to the same thing — the solution of the social problem is in liberty.”
By speaking about the virtues of the market, we tend to forget that markets do not have virtues, only people do. As Murray Rothbard once wrote, “it is overlooked that the ‘market’ is not some sort of living entity making good or bad decisions, but simply a label for individual persons and their voluntary interactions. … The ‘market’ is individual acting.”
The “What Should Government Do?” BiasDuring each crisis, politicians and intellectuals systematically presume that “we should do something.” Thus, when liberals emphasize the importance of not violently intervening in the free market order because of the harmful, but yet unseen, consequences of state intervention, they are often accused of favoring inaction. This is a misconception of the liberal argument.
The free market is not superior because it offers solutions. It is superior because its basis is freedom, a freedom that is used by individuals to find new ways for them that are in harmony with the interests of their fellow men. Of course, there are many problems and abuses with the market, but entrepreneurs — if not prevented from entering the marketplace by governments — seek to solve these problems in the pursuit of profits. Through these entrepreneurs, the market is a process that tends to satisfy the most urgent, not-yet-satisfied, needs of the consumers.
To be clear, liberalism — used here to denote the philosophy of laissez-faire — should not be considered as being the utopian opposite of socialism. It is not a magic recipe that guarantees perfect solutions at all times and for all things. Socialists like to imagine that liberals believe the market can cure every ill. In other words, they think liberalism is a mirror reflection of socialism. It is not. True liberalism does not promise perfection, it does not even promise a solution. There will always be problems. Our goal should be to find the best way to improve the situation, not to achieve an ideal world of fantasy.
When a social problem arises and somebody asks a liberal what must be done, he instinctively argues that “we” should free the markets, that “we” should liberalize, or that “we” should commit to deregulation.
But those proposals are not solutions to our problems at all, they are just a necessary step in the process of setting people free to solve problems. By pretending that “the market” is the solution that “we” should adopt, many liberals are victims of the top-down fallacy and deny the polycentric nature of markets. By calling “the market” a solution, we create the illusion that the free market is just another kind of government policy where the rulers offer us a solution. But the real solutions are offered by free individuals, by the free innovator, the free worker, the free capitalist, and the free entrepreneur.
Solutions to problems are not offered by the market, they are offered on the market. As development economist William Easterly brilliantly writes:
The “what should we do?” industry does not show any signs of going out of business soon. It gives us public intellectuals something to do and it gives politicians something to recommend. Much more positively, it does engage the very welcome idealism of altruists who want to make the world a better place. But the Sustainable Development Goals may be the best demonstration yet that action plans don’t necessarily lead to action, “we” are not necessarily the right ones to act, and that there are alternative routes to progress. Global progress has a lot more to do with the advocacy of the ideal of human freedom than with action plans.
Thus, free markets are a sort of meta-solution. They are the solution to the problem of finding solutions. And it is striking that liberalism might be the only political philosophy that does not have a blueprint for an ideal society.
The “Market Provides Incentives” MythAs the market is not a solution, the market does not give incentives. Leading institutional economists Acemoglu and Robinson, in their celebrated 2012 book Why Nations Fail, focused mainly on “incentives.” Whereas they — moderately — praise capitalism as an “inclusive institution,” they criticize “extractive institutions” because they “fail to protect property rights or provide incentives for economic activity.” They also write:
As institutions influence behavior and incentives in real life, they forge the success or failure of nations. … Bill Gates, like other legendary figures in the information technology industry … had immense talent and ambition. But ultimately responded to incentives.
There is no doubt that Why Nations Fails is, for the most part, a good book. However, Robinson and Acemoglu’s appraisal of incentives seems to be problematic. First of all, they assume that institutions should give “incentives.” But this is a constructivist fallacy, to use Hayek’s concept. It implicitly supposes that some external force should direct human actions.
Furthermore, it gives too much importance to top-down approaches. Acemoglu, like many other economists, seems to think something — e.g., the government — should incentivize. But what does it mean to say that government, property rights, or institutions give you an incentive? In fact, when wrongly used, the term “incentive” seems to invoke determinism. This is why Acemoglu writes that people “ultimately responded to incentives,” as if a mysterious force called incentives was influencing the choices each one of us make.
Incentives are not something that can be understood as being independent of individuals, they are purely subjective. An incentive can only be understood as the correct discovery of an individual’s own subjective preferences in order to lead him to act as you wish. Therefore incentives are not something you can “give,” it is something you have to discover.
The free market does not “provide” an incentive to work, it lets you work freely. The free market does not “provide” an incentive to invest, it lets you use your savings in order to make a profit by serving the consumer. There is no such thing as a god called “market” that will furnish you some incentive to be productive. However, the market is the best institutional framework to create harmony between the plans of a vast number of individuals — hence the title of Frédéric Bastiat’s magnus opus Economic Harmonies.
Because they are free, different individuals can understand each other’s preferences and exchange. Only in this way do people “give an incentive” to each other in order to commit to exchange and enhance their situation. Therefore, institutions do not provide incentives, people do. The sentence “the market provides incentives” contains the same problem as the sentence “the market is the solution.” It is just not so. The market is merely an institutional framework in which people can make plans freely. As Hayek says in a famous rap song “the question I wonder is who plans for who, do I plan for myself, or I leave it to you? I want plans by the many, not by the few.”
ConclusionThe modern state can be defined as the institution that pretends to have the monopoly of solutions to social problems. But since the state operates like a monopoly, it behaves like a monopoly and therefore exploits the very people it is supposed to serve. In fact, proponents of government action imply that the members of the civil society are not able to find their own solutions nor able to identify what the problems are. But the most competent men do not need the state to answer our problems, they just need freedom. When a problem arises, the right question is not “what can the government or the market do,” the right question is “what can I do.”
In their new book, Phishing for Phools, Nobel-prize winning economists George Akerlof and Robert Shiller use a behavioral economics approach to criticize the “manipulation and deception” that can exist between businesses and consumers.
According to Shiller,
[a] fundamental concept of psychology is that people often make decisions they’re not happy about. … If businesses have a chance to profit by tempting us into making decisions that are good for them but bad for us, they will take it. They have just as powerful an incentive to provide us with what we don’t want as to provide us with what we do want.
According to the Wall Street Journal, this is one of the main contributions of the book: the market is the best mechanism to offer people things they do not want to have.
We Do Not Buy What We Do Not WantNo one denies that sometimes we do things we later regret. Most of us once bought something that we later regretted spending money on.
However, the fact that these errors in judgment may occur — on the part of the consumers — is not evidence that businesses attempt to sell products that customers do not want.
It’s important to understand that individual decisions are made prospectively, looking forward in time. When an individual buys a product or service, he does so because he expects it to remove his “uneasiness.” At the time of the transaction, this person making the purchase is indeed revealing his desire to have that good. Otherwise, he would not make the purchase. This does not mean that, in retrospect, our decision may be judged to have been a success or a failure, depending on whether it really served the purpose it was meant to serve.
But it doesn’t follow from here that the market is as good at delivering what people want as it is at delivering what people do not want. If this was the case, then business would continue to sell audio cassettes, VHS videotapes, and other products to consumers who have been “manipulated” into buying them.
Obviously, this is not what happens.
Who Regulates the Regulators?Another weak point in Akerlof’s and Shiller’s argument is their implied solution: government regulation. In a recent article, Shiller writes
While we confirm the importance of free markets, we have found that market regulation has been crucial, and believe that will continue to be true in the future. [Standard economic theory] usually ignores the fact that, given normal human weaknesses, an unregulated competitive economy will inevitably spawn an immense amount of manipulation and deception.
One can’t help but notice the central contradiction in this analysis. On the one hand, it is assumed that markets fail because of “normal human weakness.” On the other hand, it is assumed that regulation, which must necessarily be implemented by human beings with equal or greater “weaknesses,” will somehow solve the problem.
Akerlof and Shiller simultaneously demonize human beings who operate in the private sector while idealizing human beings who operate in the public sector.
Lessons From South AmericaFor evidence of the problem with this approach we need look no further than South America where government agents are quite adept at giving people “what we do not want.”
For example, we can note the fact that a process of impeachment recently began against the president of Brazil because, according to the allegations, she tried to hide the true extent of increases in public spending. Meanwhile, in Argentina, former Vice President Amado Boudou cannot leave the country because he is accused of misappropriating funds from the company responsible for printing pesos bills.
These are just some recent examples in a nearly endless list of corruption cases, and if democratically elected officials such as these are capable of such large-scale deception and malfeasance, why should we think that these same people can help reduce “manuipulation and deception” in the market place?
The situation we face in South America is exactly the opposite of the free-wheeling under-regulated markets described by Shiller and Akerlof. We live in highly regulated economies which are being suffocated and corrupted by an excess of political power.
Meanwhile, according to the latest IMF estimates, Venezuela, Brazil, and Argentina have been among the slowest growing economies from 2011 to 2015. Not surprisingly, all three of these countries have been implementing highly interventionist policies, boosting public expenditure, manipulating credit markets, and controlling prices of certain goods and services.
And, of course, South America is hardly the only place on earth that experiences political corruption.
The focus, then, contra Shiller and Akerlof, must be placed on how to dismantle this system, not in providing it with more weapons and arguments to continue growing.
It seems that each new bubble brings forth claims that, although the bubble may be the result of artificially created demand, prices of this or that product will not fall and may even continue to rise. How many so-called real estate and financial planning “experts” claimed that the surest path to financial security was in buying the largest house possible with the least amount of one’s own money?
The Boom: McMansions and Luxury CarsSince home prices never go down — we were told — the gain from using OPM (other people’s money) resulted in huge multiples of gain for the little invested of one’s own money. Thus, in the first decade of the new century, Americans were buying so-called McMansions: huge homes with every imaginable feature. When the bubble burst, the leverage effect worked in reverse. Mortgage balances far exceeded the lower market price, creating the so-called “underwater mortgage.” Lower prices had wiped out not only the little equity contributed by the buyer, but created a negative equity balance. Buyers abandoned their heavy mortgages and sought smaller, lower priced homes. It turned out that home prices did not grow to the sky, as the pundits had predicted.
The same is true of automobiles, and especially those bought with auto loans. Easy credit has enticed car buyers into ever more luxurious and amenity-laden vehicles. It is nearly impossible today to buy a new car that is not loaded with luxury entertainment, navigation, and safety features that were unknown only a few years ago.
Many of these features would never have been sold in such quantities without the benefit of easy credit. As a frequent car rental customer, I have been exposed to these features and have found them difficult to use at best and completely unnecessary and distracting at the worst. On a recent business trip my modest sized four door Buick sedan’s speedometer was projected onto the windscreen and the lane proximity warnings beeped at me constantly. I never did figure out how to turn off these annoying devices, which, I admit, may be desired by a marginal few drivers. But we Austrians know that all economic choice is based on a hierarchy of preferences. The cost of each preference is measured in the alternative preferences one sacrifices. Make some preferences cheaper and they move up our personal scale. Easy auto credit meant that buyers did not have to sacrifice as many alternative uses for their money.
Last week, Tommy Behnke in Mises Daily predicted that auto prices will fall as the bubble bursts from the artificially created demand generated from excessive credit creation. Behnke pointed out that car production has increased a whopping 100 percent since 2009, but that apologists for government’s monetary stimulus programs see this fact as proof of the success of their Keynesian, aggregate demand hypothesis.
Behnke, on the other hand, took the Austrian perspective that the government has simply substituted a bubble in subprime auto loans for the bubble in subprime home loans. As defaults rise and automobile loan credit tightens, the result will be the same. Namely, a flood of used cars, and falling prices. The same happened with homes following the burst of the last bubble: a flood of “used” houses, and falling prices.
Surprisingly, the article attracted a number of reader comments predicting that used car prices would not fall, allegedly due to increases in complexity of cars or increases in the difficulty of repairing them. Another suggestion was that large dealers will dominate the used car market and simply raise prices at will.
While it’s certainly true that government interference — such as Cash for Clunkers — can raise the prices of cars, it is not true that private dealers (or any other private party) can simply raise the price. More complex and difficult-to-fix cars will not keep prices from falling in an environment in which the inventory of used cars is increasing.
Used Car Dealer or Used Car Collector?There is one thing that we can know a priori: that an increase in the supply of some good or a drop in its demand will cause its price to be lower than that which it otherwise would be. There is no other way to clear the market.
Mises explained that, eventually, even a monopolist would prefer any price to zero price. Maintaining a price above the market clearing price produces zero revenue. In a flooded used-car market, car dealers must reduce their prices in order to avoid bankruptcy. Otherwise, the used car dealer ceases to be a dealer and becomes a collector. The laws of supply and demand have not been rescinded, even in a world with very expensive-to-build and complex cars. As the automobile bubble bursts, quality used cars will flood the market, creating a buying opportunity for those with cash.
As with houses, it doesn’t matter how big or luxurious or complex you make new cars. When the credit bubble bursts, auto prices will not “always go up.”
Lego — the company that makes stackable toy bricks — has become a toy powerhouse in recent years, even surpassing Mattel in toy sales during 2014. Lego has become so popular, in fact, that the company has problems avoiding “brick shortages.”
Lego’s success as a fun and educational toy has been helped along by the fact that — finally — Lego has managed to find success with girls.
With the launch of the Lego Friends line, Lego has tapped into 50 percent of the child population:
according to research firm NPD Group, the market for girls’ construction toys in the U.S. and the main European countries tripled to $900 million in 2014 from $300 million in 2011, largely on the back of the Lego Friends sets. And Lego says the share of girls among Lego players, which stood below 10% in the U.S. before the launch of Lego Friends, has increased sharply.
The Feminist ControversyPerhaps predictably, Lego has been condemned by feminists and culture warriors for making Lego too “girly.” Those familiar with the Friends line already know how, instead of red and blue bricks for making fire stations, the new line designed for girls features purple and pink blocks (among other colors) for constructing yachts, homes, and restaurants.
The Wall Street Journal recently examined the controversy, noting:
After five years of work, [Lego] was enthusiastic about launching Lego Friends. The new sets, however, immediately unleashed a torrent of criticism from feminist groups. A U.S. activist organization, the Spark Movement, gathered 50,000 signatures with an online petition in 2012 and requested a meeting with Lego executives. Another group, Feminist Frequency, also complained.
“We were so disappointed,” said Dana Edell, executive director of the Spark Movement. “Lego was sending a message that girls get to play with hair dryers while boys get to build airplanes and skyscrapers.”
Ms. Edell, however, should probably aim her disappointment and disdain at seven-year-old girls rather than at Lego. After all, Lego’s success, or lack thereof, in marketing these products depends on the decisions of little girls.
Profit Seekers: Make Toys Girls LikeThat is, Lego can only make money from the girl demographic if it makes toys little girls decide they want to play with. Following years of focus groups and surveys, Lego has produced toys that it thinks will attract their attention and demand.
Lego has said exactly this in interviews:
Our methods are simple; meet children’s needs by testing prototypes on them and getting their opinion. We have realized that girls like building too, so LEGO gave them the chance to customise their world, until then their needs were not met. We also realised that girls wanted to be able to identify with the figures and we therefore had to develop figures closer to their expectations: more feminine, less “square” than our standard mini-figurines. Since friendship is a core value for little girls, we created a universe which centred around a story of friendship between our 5 heroines.
Anyone who has daughters — and listens to what they say — can see this is a plausible scenario.
The Lego Friends line, which is just as rigorous in terms of construction difficulty as any other line, was designed to appeal to girls in ways that Legos did not before.
Lego wanted girls to buy their products, so it designed products that appealed to them, based on market research.
How Lego Became a Boy BrandIf Lego ignored what girls really wanted, and marketed something else, they would not make as much money. Or no money at all.
This explains how Lego became a “boy’s brand” in the first place.
After marketing its toys for years in a unisex manner, Lego found by the 1980s that all its best-selling sets were “boy” sets featuring pirates and knights and spacemen.
The company then began to market more aggressively to boys, since like most companies, it ended up focusing on the most profitable sector of its customer base.
Lego Finally Figures Out What Girls WantLego still attempted to market to girls, but failed, perhaps even due to genuine sexism. Thinking that girls did not want the same level of rigor in construction as boys, Lego in the 1970s and afterward marketed a variety of “simplified” types of Legos that failed. These included Lego jewelry sets known as “Scala” and easy-to-build sets based on mimicking doll houses.
If Lego was being sexist, it was punished by the market for it. Lego simply failed to cater to the wants and needs of girls. And it endured foregone profits because of it.
With Lego Friends, Lego finally found a line that girls actually like, and the market is rewarding them accordingly. Meanwhile, feminists attack Lego for making toys that children want to buy, but which feminists think girls should not want to buy.
The real problem the anti-Lego feminists have then, is not with Lego but with the fact that girls like to play with the sort of toys found in the Friends line. The blame for this lies with the girls themselves.
After all, Lego did not raise these girls or tell them what to like. Lego simply wants to make toys that they will buy based on their existing preferences.
Indeed, any competent toy executive will be agnostic as to the question of what girls should like. They must focus instead on what girls do like. Toy companies make money by selling toys that will be popular with as little effort (for the company) as possible. And, it turns out, much to the annoyance of some activists, girls like a Lego experience that includes pink and purple bricks.
Producers Don’t Dictate to ConsumersNow, the source of the misunderstanding here is apparent. The activists think that Lego is responsible for deciding what girls should want because — like many people who don’t understand how markets work — they think that producers dictate to consumers what to buy.
The idea at work here is that girls will buy and like whatever it is that Lego Corp. wants to market to them. Thus, by extension, it is Lego’s job to fight culture wars and tell girls what the “correct” play experience is.
But it doesn’t work that way. Companies make money by selling what people want. At the same time, companies that make products few people like will ultimately fail, no matter how many commercials they put on the television.
Consumers Decide What Is ProducedAfter all, if people will buy whatever they’re told to buy, then why not just spend nearly 100 percent of the toy company’s budget on marketing and advertising? The rest can go to making a low-quality product. If it breaks easily or turns out to be no fun, then that’s all the better because then they’ll just buy another one because an ad told them to.
If a slick ad campaign is all that is necessary to make someone like a product, just make a slick ad showing the sub-par product in a good light. People will just keep on buying it because the advertisements say so.
Everyone instinctively knows this is not true, though. McDonald’s can run TV commercials all day long, but that, apparently, isn’t enough to keep people buying Mickey D’s food at the price the company prefers. Subway can repeat the “eat fresh” mantra, but that won’t keep sales from slipping, as they have been doing for several years.
And if we’ll buy whatever toy makers tell us to buy, why aren’t children playing with the same toys they were playing with thirty years ago? It costs money to develop new toy lines and design new sets. Why go through the trouble of creating new toys, when it’s possible to make customers like your products by just running ads for existing ones?
The reason for this, as Murray Rothbard observed long ago, is that every consumer has the ability to simply refuse to purchase what she’s asked to buy for whatever reason or whim she deems important. Ludwig von Mises called this “consumer sovereignty.”
Even more frustrating to producers is the fact that consumer preferences change constantly due to a variety of — often inscrutable — factors far beyond the control of marketers and producers. Producers thus have a choice: adapt to changing customer preferences, or die.
The literature on market imperfection and market failure is voluminous, ever-growing, and filled with Nobel laureates. Identify a new source or instance of market “failure,” and you’re likely to win a Nobel Prize, or so it seems.
Phishing for Phools: The Economics of Manipulation and Deception, by Nobel Laureates George A. Akerlof and Robert J. Shiller, presents the thesis that we are overly confident in unregulated markets and that entrepreneurs accrue profit by preying on hapless consumers, exploiting “our weakness in knowing what we really want” through the market’s tendency “to spawn manipulation and deception.” Mavens of manipulation themselves, Akerlof and Shiller claim many, if not most people — especially the poor — are irrationally exuberant and are induced into buying things they really do not want. How do they know what the consumer really wants, one might ask? The answer is that anything the authors would not do themselves is ipso facto not in the best interest of the consumer. In fact, it is something that “no one could possibly want.”
We’ll Decide What’s Best For YouTheir opening chapter is an exercise in convoluted methodology. In it, Akerlof and Shiller obliterate any distinction between adroit entrepreneurship/marketing and deception/fraud. The most fundamental problem, however, is that Akerlof and Shiller think that what people really want is what is (objectively) good for them. They refuse to recognize that even if consumers were aware of the costs of eating Cinnabon — their bête noire in the opening chapter — and consuming a high calorie meal devoid of nutrients, they still might choose to eat Cinnabon. In their paternalist fervor, they cannot fathom that some people, in some places, at some times, might be willing to make such a trade off.
Rejecting Mises’s economic tautology that business owners stay afloat by satisfying consumer preferences through voluntary exchange, they believe that, instead, business owners compete for who can best deceive their customers. They call Cinnabon’s efforts to attract customers by making their product more desirable and available in convenient locations “phishing.”
Is the alternative, then, to mandate that businesses instead locate their stores in inconvenient locations, where they are less likely to sell their products to increase market efficiency? No answer is forthcoming. Also never answered by the duo is, if advertising is so effective at deceiving consumers, why do firms not spend nearly all of their budgets on advertising? Wildly exaggerating the problem they present, Akerlof and Shiller even think that the cumulative effect of “phishing” that companies like Cinnabon do through luring people in with the aroma of their cinnamon rolls may be as significant as the financial crash of 2008.
“Information Asymmetry” or Just Division of Labor?They also maintain that the incompetence of the average person prevents them from wisely investing their funds. What they do not show is that a disinterested bureaucrat spending someone else’s money has an incentive to invest carefully, which they simply assume. No matter that an individual has knowledge of his time, place, and preferences that a bureaucrat cannot have, regardless of whether or not consumers make systematic cognitive errors. What they call informational asymmetries, i.e., the different levels of knowledge among consumers and producers, should properly be called the division of labor and knowledge in society, which underpins all markets and gives us a basis to make exchanges in the first place. It is for the very reason, namely that producers of goods know more about the goods they produce, that we purchase from them. Hence, in criticizing information asymmetry in markets, they are criticizing all exchange. Akerlof and Shiller habitually succumb to this Nirvana fallacy, holding up the utopian ideal of perfect information as their (unreachable) model, and then when markets fail to reach this ideal, assume that this justifies government intervention, never giving us a reason why these systemic cognitive biases and information asymmetries can be avoided by bureaucrats more than they can by the average consumer.
Variety and Convenience Are Bad Things?Fundamentally, they mistake the beauty of the market and its convenience with manipulation. When they see a wide variety of products to choose from within arm’s reach, such as in a supermarket, they view it as a scheme to induce consumerist depravity and indulgence, rather than as a wonder to behold. They critique overpaying for health plans at the same time they critique obesity. We also see them succumbing to extraordinarily misleading explanations of history. For instance, in chapter six, they repeated the canard that Upton Sinclair’s The Jungle exposed the meatpacking industry’s unsanitary practices, when in fact his book was a complete fabrication, making no mention of this.
In general, Akerlof and Shiller appear oblivious to the roles consumer reporting institutions, competition, reputation, repeated dealings, and quality assurance play in doing just what they claim markets fail to do. If they desired to write a complete, and balanced look at the phenomenon they studied, rather than forward their agenda — what is in reality a jobs program for economists — they had ample material with which to work. The “heroes” of the story, instead, are primarily government regulators, and others who “step back from the profit incentive.” The profit incentive, for them, is essentially a one-way trip down Deceit Drive toward Manipulation Station. This single chapter focuses on the ways these problems are overcome, but they present nothing but impotency regarding the ability of businesses to do anything other than manipulate and deceive. The market, apparently, cannot provide solutions to or protect against this predatory behavior they attribute to these businesses, evidence to the contrary notwithstanding. We are left with the impression that these phishing problems are real, devastating, pervasive, and unresolved, as well as the impression that the solution is government regulation and bureaucratic administration. Nothing could be further from the truth.
In every instance, Akerlof and Shiller showcase their own “irrational exuberance” and monomania for decrying consumer choices, rather than market failures arising from information asymmetries. What else can we conclude from the foregoing but that there are informational asymmetries abounding about the true value of the information in Phishing for Phools — and that it is, objectively, something that “No One Could Possibly Want” to buy? If there is anything that could shake one’s faith in unregulated markets, it’s that anyone could be duped by Phishing for Phools.
In its most basic application, the TANSTAAFL principle is a simple statement of reality: everything of value has a cost. The TANSTAAFL principle can also be interpreted as a mandate for a policy of full-cost pricing. In a world where resources are scarce, everything has a cost. Scarce resources are used most efficiently when the price paid by the final user reflects all costs, including waste disposal, harm from pollution, and depletion of non-renewable resources.
Author Edwin G. Dolan is a leading environmental economist and academic. This 40th anniversary edition includes the full original text along with a new introduction and extensive commentaries on each chapter by the author. The commentaries explore aspects of environmental issues that have changed over time, for example, the arrival on centre stage of climate change, something that merited only a few words in the 1971 edition. They also discuss things that have not changed: for example, the tendency of government to play the role of villain at least as often as that of hero when it comes to protecting environmental values. As the author repeatedly emphasizes, it is as important today as in the past to apply the TANSTAAFL principle: the polluter must pay.
The modern age of economic intervention began under the pretense of helping workers. Professor Sennholz demolishes the entire edifice that gave rise to this movement.
We were told that workers must be organized into unions. They must have job protection. Their safety must be guaranteed by legislation. There must be a minimum wage. People under the age of 15 must never engage in remunerative work, for that would be exploitation. And workers need retirement income. If unemployment rises, nothing short of full scale central planning is required!
So on it goes, except for one inconvenient fact: the age of intervention accomplished precisely the opposite of its stated goals for workers. The unemployment of the 20th century was government created. And today, workers are taxed, regulated, and regimented to their own detriment.
Here is the uncompromising case against the entire interventionist regime erected on behalf of workers. No one does a better job in showing how the state has harmed the very group that it claimed to be backing.
Sennholz refutes dozens of theoretical fallacies and exposes the bad policies that flow from them. His focus on current trends like "mandated benefits" explains how they have so drastically increased labor costs. He also deals with the feminist arguments against the free market, and makes a strong case for the benefits of the underground economy. A principled and readable work that unfies theoretical rigor and a passion for liberty.
In The Real Crash, New York Times bestselling author Peter D. Schiff argues that America is enjoying a government-inflated bubble, one that reality will explode . . . with disastrous consequences for the economy and for each of us. Schiff demonstrates how the infusion of billions of dollars of stimulus money has only dug a deeper hole: the United States government simply spends too much and does not collect enough money to pay its debts, and in the end, Americans from all walks of life will face a crushing consequence.
We’re in hock to China, we can’t afford the homes we own, and the entire premise of our currency---backed by the full faith and credit of the United States---is false. Our system is broken, Schiff says, and there are only two paths forward. The one we’re on now leads to a currency and sovereign debt crisis that will utterly destroy our economy and impoverish the vast majority of our citizens.
However, if we change course, the road ahead will be a bit rockier at first, but the final destination will be far more appealing. If we want to avoid complete collapse, we must drastically reduce government spending---eliminate entire agencies, end costly foreign military escapades and focus only on national defense---and stop student loan or mortgage interest deductions, as well as drug wars and bank-and-business bailouts. We must also do what no politician or pundit has proposed: America should declare bankruptcy, restructure its debts, and reform our system from the ground up.
Persuasively argued and provocative, The Real Crash explains how we got into this mess, how we might get out of it, and what happens if we don’t. And, with wisdom born from having predicted the Crash of 2008, Peter Schiff explains how to protect yourself, your family, your money, and your country against what he predicts.
Here Eugen von Böhm-Bawerk--Mises's teacher and a huge figure in the history of thought--explains and argues for the subjective theory of value, the theory of marginal utility, and their relationship to price.
This book was originally published in German in 1886 as an elaboration on Menger--driving home points concerning value as against every non-Austrian point of view.
He completely demolishes not only the labor theory but also the value theory that rests on claims of aggregate economic value or social worth. In so doing, he clarifies points that Menger himself hadn't entirely spelled out. He also outlines for the first time in this article the modern marginal productivity theory of factor pricing.
The author covers the nature and origin of value, the measurement of value, the value of complementary goods, the scientific significance of subjective value, and the theory of objective exchange value.
Written the year of Mises's death, this is the book that brought new prominence to the Austrian theory of the entrepreneur. Kirzner views him as the discoverer of opportunities in the competitive process, and contrasts this view with the general equilibrium view-which defines away the entrepreneur-and the Schumpeterian view that discovery is always disequilibrating. For its lucidity and focus, this remains an Austrian classic.
Sweden might be heading toward reform of its very rigid labor laws, which include labor union control of wages and “last in — first out” hiring and firing rules. This means the previously most-untouchable tenet of the Swedish welfare state is finally being discussed as a problem, not a value. And the reason for this change of tone is the immigration crisis.
The Swedish State Prevents IntegrationThat Sweden struggles with immigration has become common knowledge. What is little known, however, is that the problem is not the immigration volume per se. There is plenty of room in Sweden but the country, given the welfare state, is in desperate need of young people to enter the labor force as the baby boomers en masse enter retirement.
The main problem is integration of those who immigrate: they are prohibited to work until their asylum or petition for residency has been approved. In other words, they are a cost in the state’s budget and a burden for taxpayers — often for many years — while bureaucrats process their application. Another effect of this is that immigrants aren’t integrated into Swedish society, since they’re effectively kept out of interacting with “ethnic Swedes” through the normal meeting places: school, the workplace, the commute, and so on.
A major force against allowing immigrants to get integrated into Swedish society is the powerful labor unions. Not only do they control the level of what is not formally — but is effectively — a minimum wage in most occupations, but they also have veto power in approving permanent residency status. Recent examples of the absurdity of this system include the long-time owner of a small business who (on paper) made the equivalent of 50 cents per day below the average salary of union members in this industry. This was deemed to be “too little,” and therefore doesn't meet the formal requirements to make a living. Consequently, and on the labor union’s recommendation, he was deported along with his family after many years living in Sweden.
The Role of Labor UnionsThe labor unions are routinely invited to comment on the salaries earned by immigrants who have already made it through most of the hoops (that is, who have been permitted to work). Unless they earn a sufficiently high salary, which is based on what others make in the same line of business, they are deemed unable to care for themselves and therefore deported. The labor unions, when asked, respond not with their required “minimum” wage but with the “average” wage earned by their members. In other words, unless immigrants in a certain line of work make at least as much as the average of those already employed, they might face deportation.
This type of protection measure is part of the very rigid Swedish labor laws, which also mandate employers to fire in the opposite order they hire: “last in — first out.” Needless to say, this means employers refrain from hiring unless absolutely necessary. It also means they will need to fire (without the possibility of rehiring) productive workers hired after a “bad apple” employee. This type of “protection” of course only leads to a static labor market, where very few workers change jobs as they will then face greater odds of unemployment regardless of their qualities or value to the employer.
Salaries are also set by the labor unions who in centralized negotiations with employers’ alliances decide on changes in wages for the whole country. While this is referred to as “negotiation,” the labor unions have always been negotiating with the threat of legal action: the social democrats, who ruled the country for most of the twentieth century, would legally mandate wage increases unless the parties to the labor market could agree “voluntarily.”
The Consensus Is FailingThis centralized model has always been a core part of the Swedish welfare state, and it has been beyond any type of scrutiny. Indeed, the “Swedish model” is based on this rule by the social democratic labor unions through “negotiation” with employers’ alliances under the threat of legal action by the other wing of the social democratic movement: the party.
But due to the recent increase in migration and millions of refugees seeking shelter, the failing integration of migrants was soon in the public eye — and with it the realization among the public of a major downside to the rigid labor market. This has led to a situation where there is an emergent discussion on the inability of the Swedish model to include new workers — whether they are ethnic Swedes graduating college or migrants from other countries — and possible solutions.
Who knows? Maybe this core of the Swedish welfare state will soon crumble. And as a result, both Swedes and immigrants will be better off.
Philip Mirowski, known for his book More Heat than Light: Economics as Social Physics, Physics as Nature’s Economics in which he criticizes neoclassical economics for adopting methods from the natural sciences, recently published a book on neoliberalism and the economics profession during the financial crisis. In Never Let a Serious Crisis Go to Waste: How Neoliberalism Survived the Financial Meltdown, his main thesis is that the economics profession utterly failed in predicting and explaining the financial crisis. Nevertheless mainstream economists did not suffer any negative consequences but continue with business as usual.
In Mirowski’s view, neoclassical economics, neoliberalism, and the political right came out of the crisis stronger thanks to a complicated propaganda effort and an intricate lobbying machine headed by the Mont Pelerin Society (MPS). According to Mirowski, the Mont Pelerin Society functions at the heart of a complex web of conservative and free-market think tanks and the neoliberal academics that controls politics.
Mirowski’s analysis is interesting even though it comes from a far left and egalitarian perspective. Especially pertinent is his analysis and critique of neoclassical economics.
The Lamentable State of the Mainstream Economics ProfessionThe neoclassical mainstream profession was unable to predict the Great Recession. As neoclassical economists believed in a new age of macroeconomic stability, dubbed the Great Moderation, in which central banks had basically abolished harsh recessions, they were taken by surprise by the immense problems the financial system and the world economy started to experience in 2008.
Mirowski explains this failure as the result of a methodological dead end. The neoclassical profession was unable to predict the Great Recession with their methodological instruments such as the infamous dynamic stochastic equilibrium models (DSGE). Since in the DSGE there is basically no room for crises, neoclassical economists were not only unable to predict the financial crisis, they are also unable to explain it in retrospect.
Mirowski diagnoses a cognitive dissonance in the neoclassical camp. As neoclassical theories are unable to explain the financial crisis, there is a gap between the accepted theory and reality. To bridge this gap neoclassicals have, according to Mirowski, reacted in accommodating (or distorting) the empirical evidence to fit their theories somewhat. Instead of recognizing that a paradigmatic change is necessary in mainstream economics, the economics profession stubbornly sticks to their mathematical models.
Mirowski describes accurately the inertia of mainstream orthodoxy. Sunk costs of intellectual capital investments for neoclassical economists are enormous. The profession remains without orientation and vision, stumbles, and stagnates in mediocrity. Indoctrination propagates the orthodoxy. Students are socialized with economics textbooks using an incoherent potpourri of theories. They are made to read short-lived articles published in highly ranked journals using mainstream methodology. In this context, Mirowski points to the fact that journals in general have stopped publishing articles on methodology and economic history in favor of mathematical and statistical articles. Mirowski correctly connects the mathematization with the incorporation of natural scientists into economics and regards this development as one reason for the financial crisis.
The Methodology ProblemMirowski criticizes neoclassical methodology arguing that economists envy the physical sciences. Due to this envy, economists started to imitate the method and models of physics. It was the mathematical approach used in physics that made neoclassical economists unable to foresee the crisis. Mirowski’s critique does not shy away from leftist neoclassical economists. Consistent in his approach he not only chides Greenspan and Bernanke, but also Stiglitz and Krugman. While there may be ideological differences between them, they all employ DSGE models in which a representative agent maximizes utility functions.
According to Mirowski it was the DSGE model that allowed for the unification of economics again after microeconomics had been separated from macroeconomics due to the Keynesian revolution. DSGE models allowed employing the mathematical approach of microeconomics in the macrosphere by introducing utility maximizing agents and high aggregation. Mirowski goes so far as to say that without DSGE, neoclassical economics disappears.
While Mirowski calls for a reset of economics and the end of the neoclassical paradigm, he fails to provide an alternative, and he does not seem to be aware of the praxeological approach of the Austrian school. The realistic alternative Mirowski calls for already exists. He is also unaware that due to their realistic approach, Austrian economists were not surprised at all by the financial crisis, which was predicted by some of them. Unfortunately, the ignorance of Mirowski concerning the Austrian school is immense as we will see in his interpretation of Hayek and his complete neglect of the works of Ludwig von Mises and Murray Rothbard; not to speak of his neglect of contemporary Austrians.
Mirowski’s Confusion About Schools of ThoughtThe main problem of Mirowski is his confusion when it comes to the Austrian school and libertarianism. Mirowski regards most neoclassical economists as neoliberals (with some exceptions on the left such as Stiglitz or Krugman). Implicitly he also incorporates the Austrian school in the neoliberal camp. He even writes about “Hayekian neoliberals.” Yet, Austrians are neither neoclassical nor can many be considered to be neoliberal.
It is true that in some parts of his book Mirowski distinguishes between neoliberal versus libertarian, and neoclassical versus Austrian, but he does not apply this distinction consistently. This lack of consistency produces curious results.
For instance, he argues that Chicago’s efficient market hypothesis (EMH) formalizes Hayek’s theory of knowledge. This seems to imply that Hayek, or other Austrians, share the method of neoclassical economists, and belong to one and the same neoliberal camp.
Nothing could be further from the truth. Hayek’s theory of subjective knowledge treats knowledge as being tacit, private, subjective, and decentralized. Hayek’s treatment of subjective knowledge is fundamentally opposed to any mathematical or formalized treatment of information. More specifically, the creative nature of entrepreneurial knowledge in the Austrian tradition contrasts with the objective and given type of information of the EMH.
The EMH states that market prices are efficient as they incorporate all relevant information and assumes an objective kind of information that can be bought and sold on the market place. Yet, what is important is not the objective and given information, but rather the subjective interpretation thereof and the creation of new entrepreneurial knowledge in a dynamic process. Past prices are just historical exchange relationships that serve market participants to create new information. Mirowski distorts Hayek by stating that according to Hayek the market transmits the knowledge of what we need to know. Instead Hayek pointed out that market prices allow us to use the subjective knowledge of other market participants. The market does not automatically transmit the knowledge that we need to know, rather market participants need to discover and create what they need to achieve their ends.
There are additional problems with Mirowski’s mixing of subjectivism and Hayek’s theory of knowledge with EMH, CAPM, and the Black-Scholes model. There is nothing subjectivist in an equilibrium construct such as the EMH, the CAPM; or Black-Scholes. In all these mathematical models all relevant information is already given. They are static. Mirowski simply misses Hayek’s main point that entrepreneurs in a competitive market process discover new information. As the market is a process, the market is never perfect. Market participants may err or fall prey to illusion; Mirowski’s whole book is a prime example for that.
Another curious result from Mirowski’s failure to distinguish clearly between the Austrian school and neoliberals comes when he deals with constructivism. Mirowski regards neoliberals as constructivist. At the same time Mirowski includes Hayek in the group of neoliberals (and one might wonder the whole Austrian school) and tries to reconcile Hayek’s criticism of constructivism with neoliberalism. But how can Hayek, who has fought most vigorously against scientism and constructivism in the twentieth century, be a constructivist?
Austrians vs. ChicagoansThe implicit mixing of the Austrian and Chicago schools is especially problematic. Mirowski claims that neoliberals subscribe to the concept of the spontaneous order. Yet, the spontaneous order is a concept employed mainly by Hayek and other Austrians. In contrast, neoliberals of the Chicago school use the equilibrium construct as an analytical tool. Yet, equilibrium analysis is fundamentally opposed to the Austrian school’s analysis of the dynamic market process. In short, neoliberals of the Chicago school do not employ the concept of spontaneous order consistently.
Writers such as Mark Skousen (2006) have tried to bridge the gap between the Chicago school and the Austrian school. Yet, this endeavor is an impossible undertaking. The main and fundamental difference between the two schools of thought is their methodological approach. Austrians in the Misesian tradition logically derive a priori economic laws from the axiom of human action with the help of some general presuppositions. Instead of making experiments and looking into the outside world, they look inside using introspection to find truth.
In contrast, Chicago school economists following Milton Friedman (1953) employ a positivist methodology. While Austrians maintain that one needs a theory first in order to understand history, followers of the Chicago school try to derive economic laws from history; sometimes applying econometric analysis. While scholars in the tradition of the Austrian school view reality as a dynamic process of human interaction, Chicago scholars employ equilibrium models, in which entrepreneurship and creativity are absent by definition and the dynamic market process is frozen. While Austrian economists regard the aim of an economist to understand and to explain the laws that govern the dynamic market process, Friedman’s aim is to make correct predictions. While Austrian economists aim at a realistic explanation of the market process, for Friedman realism of the assumptions is irrelevant. Only the predictive power of a theory counts.
In his book, Mirowski criticizes Friedman’s approach stating that model building for predictions has been a disastrous failure, an assessment many Austrians would share. Unfortunately, Mirowski fails to mention Austrian methodology in his book and seems to be unaware of this alternative defended by many members of the “neoliberal” MPS.
Directly related to these methodological differences between Vienna and Chicago is the opposed view on competition. While Chicago scholars tend to support and devise antitrust laws in order to bring reality closer to their model of perfect competition, Austrian scholars oppose the intervention of the government into the dynamic market process in the form of antitrust laws.
The high aggregation required by model building and mathematization has also lead to directly opposed views on capital by both schools. Capital, which is presented by the letter “K” in Chicagoite models, is viewed as a homogenous, permanent fund that synchronously and automatically produces income. The view of capital as a homogenous fund and production as instantaneous is a direct consequence of the mathematization and formalization of the Chicago school.
The Austrian view on capital is fundamentally opposed to the neoclassical one. Indeed, there was an intense debate between Chicago and Vienna on the concept of capital. Friedrich Hayek (1936) and Fritz Machlup (1935) criticized Frank Knight for the meaningless concept of capital as a homogenous, automatically self-maintaining fund. Austrian capital theory and the view of production as a time consuming process allowed Austrian economists to develop a theory of intertemporal distortions in the structure of production induced by credit expansion unbacked by real savings. Austrian business cycle theory is commonly not understood by the Chicago school as neoclassical economists lack the necessary theoretical instruments; instruments they are unable to develop with their methodological approach.
Explaining Booms and BustsConsequently, the interpretations of the Great Depression (and the Great Recession) by Austrians and Chicagoites differ widely. The Chicago school, following Milton Friedman and Ana J. Schwartz, maintains that the severity of the Great Depression was due to errors committed by the Federal Reserve. More precisely, the Federal Reserve according to Friedman and Schwartz did not expand the monetary base fast enough during the early 1930s. Following the Chicago interpretation, Ben Bernanke (2002) promised Milton Friedman not to commit the same mistake again, which explains the Federal Reserve’s reaction to the Great Recession in the form of Quantitative Easing.
In contrast, Austrian business cycle theory explains the Great Depression by the extraordinary credit expansion of the 1920s. Reinflating the money supply, in the Austrian view, disturbs the necessary readjustment as it stabilizes artificially old malinvestments and stimulates additional ones. Austrians explain the severity of the Great Depression by the size of the credit expansion in the 1920s and the concomitant malinvestments as well as the government interventions introduced in the 1930s such as the Smoot-Hawley Tariff Act or the New Deal in general.
Austrian economists were not blinded by the apparent price stability in the early 2000s. In fact, Mises and Hayek warned against policies of general price level stabilization hailed by Fisher and other monetarists. In times of economic growth such policies require the continuous injection of new money which is the source of intertemporal distortions. Due to their business cycle theory, Austrians were not taken by surprise by the financial crisis in contrast to Chicago economists. The same is true for the years leading to the Great Recession. Thus, Mirowski is just plain wrong with his sweeping statement that the (whole) economics profession did not foresee the financial crisis. It is true that neoclassical economists due to their methodological approach could not develop the theoretical tools necessary to understand the problems of the ongoing credit expansion of the early 2000s. In contrast, Austrian economists had those tools.
Unsurprisingly, another main area of disagreement between Chicago and Vienna, which Mirowski does not explain, is on monetary policy. Most Austrians favor the abolition of central banks and the introduction of a free market money, such as a 100 percent gold standard. Chicago school economists generally do not want to entrust the money supply to the market but are in favor of a central bank issuing fiat money. Central planning in money is not seen as a problem, but as a solution to crisis in the banking sector by defenders of the Chicago school.
Mirowski does not touch upon all these fundamental differences. He is correct, when he points to the central bank correctly as a neoliberal institution. Yet, he also claims that the Tea Party in the US is basically a neoliberal group. Later in the book he states that Ron Paul wants to abolish the Federal Reserve. Mirowski also mentions that Ron Paul is in the tradition of Hayek who is in favor of free banking. However, Ron Paul is regarded to be close to the Tea Party. The reader remains confused. Why would a hero (Ron Paul) of a neoliberal group (Tea Party) want to abolish a neoliberal institution (Federal Reserve)?
We are faced with another apparent contradiction caused by not distinguishing clearly between Austrians and Chicagoites or neoliberals and libertarians. If Mirowski had explained that Ron Paul is a follower of the Austrian school, it would have been no surprise to the reader that he opposed the Federal Reserve. But Mirowski just states that Bernanke sides with the neoliberal position of Milton Friedman. He simply fails to understand that Chicagoites and Austrians are diametrically opposed on fundamental questions and that it is a fallacy to consider them as ideologically and methodologically close.
The Origins of Mirowski’s ConfusionWhere does Mirowski’s confusion stem from? Why does he not clearly differentiate between the Chicago and the Austrian school?
There are basically three reasons that may have contributed to this confusion. First, the Austrian school and the Chicago school share many free market ideas. Members of both schools generally oppose price controls, product regulation, and the public provision of education services. Yet, as we have pointed out above, differences abound. The Chicago school supports central banking and antitrust, while the Austrian school does not. If Mirowski had looked into the libertarian positions many Austrians hold, he would have recognized that most Austrians are wide apart from the neoliberal positions of Chicago.
Second, Hayek became a professor at the Univeristy of Chicago in 1950. Yet, the location of Hayek at Chicago does not imply that he was close to Chicago school ideas. In fact, Hayek became professor at the Committee of Social Thought in Chicago, because Chicago economists had opposed his appointment at the economics department. This is understandable as Hayek was very critical of the positivistic approach that Chicago economists followed.
Third, the most likely cause of confusion stems from Mirowski’s treatment of the Mont Pelerin Society where Austrians and Chicagoites often meet together. From the very beginning, starting with the 1947 founding meeting of the Mont Pelerin Society, there were three main schools of thought that were represented: the Austrian school, the Ordoliberalism, and the Chicago school. Mises and Hayek from the Austrian school, Walter Eucken and Wilhelm Röpke were Ordoliberals, and George Stigler, Frank Knight, and Milton Friedman from the Chicago school.
Both the Chicago school and the Ordoliberal school can be classified as neoliberal. They oppose socialism, but also Manchesterism, i.e., they oppose the laissez-faire approach of classical liberalism. Both Ordoliberals, mainly located in German speaking countries, and the Chicago school favor a strong state to set the framework for the market and direct economic life in certain directions. They also want the state to provide some social security.
There has been tension from almost the very beginning between Austrians and neoliberals within the Mont Pelerin Society. As Mises wrote in the 1950s: “I have more and more doubts whether it is possible to cooperate with Ordo-interventionism in the Mont Pelerin Society.”
In retrospect and from the point of view of the Austrian school, it may be regarded indeed as a strategic error to found an alliance with the Chicago school and other neoliberals within the Mont Pelerin Society. As Austrians and neoliberals are united in the Mont Pelerin Society, authors like Mirowski tend to conflate neoliberalism with libertarianism and Chicago positions with Austrian ones. Instead of treating neoliberals as friends with a common cause, Austrians could have fared better by regarding neoliberals as enemies of their enemies; namely of full-blown socialism. Austrians could have made their ideological and methodological differences much clearer in a Mont Pelerin Society dominated by themselves and excluding Chicagoites and other neoliberals. Most of the attacks from Mirowski against the economics profession per se or against liberalism would have lost credibility. Then Mirowski would have had to direct his criticism only against the Chicago school and neoliberals.
This article was adapted from Philipp Bagus’s article “Why Mirowski Is Wrong About Neoliberlaism and the Austrian School.”
The world waits to see if next week is finally the week that the groundhogs at the Fed announce their long-anticipated interest rate hike. Can the economy survive whatever small bump the Fed deals out? Perhaps, but any temporary stability doesn’t change the inherent instability of our current monetary regime. Even with today’s technology, central planners can’t predict the future or know the “optimal quantity of money.” Only by returning to true sound money, and a proper appreciation for the market, will true, sustainable prosperity emerge.
In honor of the twenty-fourth anniversary of the collapse of the Soviet Union, we have a special guest on the latest episode of Mises Weekends, Dr. Yuri Maltsev. A Mises Senior Fellow and a Soviet economist during the Gorbachev era, Maltsev shares his thoughts on the West’s enduring love affair with socialism. He and Jeff also discuss its political consequences in regard to Obama, Trump, and the Bernie Sanders phenomenon. This is an interview you won’t want to miss.
And in case you missed any of them, here are this week’s featured Mises Daily articles and some of our most popular articles at Mises Wire:
Piketty Is Wrong: Markets Don’t Concentrate Wealth by Louis RouanetWhy Gold-Backed Money Doesn’t Bring Booms and Busts by Frank ShostakEnd the Sugar Tax Now by Gary GallesGovernment Debt Is Not Like Private Debt by Simon WilsonNo, "Big Data" Can’t Predict the Future by Per Bylund"Capitalism" Destroyed Itself? by Matt McCaffreyBlowing Up the Death Star Didn’t Destroy Economy, Building It Did by Tho BishopMan, Economy, and Beer: Rothbard-Themed Gastropub Opens in ConnecticutArticle Submission Guidelines for Mises DailyIndia’s Failing Gold Monetization Scheme: Seizure Imminent? by Paul-Martin FossViva Venezuela ... But Not Yet by Carmen Elena DorobățGun Control Fails: What Happened in England, Ireland, and Canada by Ryan McMakenTranscript: Ask David Gordon AnythingTop Ten Most-Read mises.org Articles in NovemberGerman translation of "PC is Control, Not Etiquette"Thanks, Janet Yellen: Homeownership in US Falls to 25-Year Low by Ryan McMakenWhy the No-Fly-List Gun Ban Is a Terrible Idea by Tho BishopBubble Watch: No-Down-Payment Jumbo Mortgage Makes a Comeback by Paul-Martin Foss
“Sugar Vs. Corn Syrup” reads the headline about legal wrangling between enablers of America’s sweet tooth. Big sugar accused big corn syrup of misleading the public with an ad campaign that it is “nutritionally the same as sugar,” asking for $1.5 billion in damages. Corn syrup producers had already sued for $530 million in damages, alleging that sugar producers falsely depicted corn syrup as less healthy than sugar.
No jury will determine a winner, however. The battling “Rock ‘em Sock ‘em” robots ended the trial by reaching a confidential settlement. Given that agreement was reached between the parties, the false-advertising sparring may be over. But that will not leave them as intense competitors in every other dimension.
Why Special Interests Help Other Special InterestsThe sweetener competitors will continue to support one another’s pet special interest policies. Corn syrup producers will continue to back import quotas on sugar; sugar producers will remain on board with methanol mandates.
A single reason explains the false-advertising rumble and its settlement, as well as their ongoing political alliance — sugar and corn syrup are substitutes.
Advertising that tarnishes just one benefits its nearest substitute. However, mutually tarnishing each other can hurt both. Putting an end to that process can explain a confidential settlement. But because they are substitutes for one another, anything that artificially boosts the price of one also benefits the other.
Consider ice cream and frozen yogurt. If the products were produced by different firms, ice cream makers would like to tarnish frozen yogurt’s reputation and frozen yogurt makers would like to tarnish ice cream’s reputation, as long as the stain didn’t extend to their competing products. But when both are harmed as a result, they have an incentive to mutually restrict the defamation. At the same time, if some protectionist policy raised the price of ice cream, producers of frozen yogurt will also benefit, because a higher price of ice cream will increase demand for frozen yogurt. And if some government mandate forced up the price of frozen yogurt, producers of ice cream will also benefit, because a higher price of frozen yogurt will increase demand for ice cream. Replace ice cream protectionism with import quotas that sharply inflate US sugar prices and frozen yogurt mandates with ethanol mandates, and you have the sweetener marketplace.
Those government intrusions have increased US prices of both sugar and corn syrup, raising profits artificially for both groups. But those hikes have driven many candy makers and the jobs they entail out of the US, harming those workers and their communities, with parallel effects for the other major sweetener users. The resulting higher prices have also harmed food consumers.
Rather than focusing on their tit-for-tat advertising contretemps, if we were interested in consumer well-being, we should learn from economist John McGee’s admonition that “what businessmen do to one another is much less significant than what they find it useful to do together to serve their common interests,” and focus on policies that benefit both sugar and corn syrup producers at the expense of consumers.
Such an approach would also make good use of Adam Smith’s far-earlier insight:
The interest of the producer ought to be attended to only so far as it may be necessary for promoting that of the consumer. … But … the interest of the consumer is almost constantly sacrificed to that of the producer … to enable the dealers, by raising their profits above what they naturally would be, to levy, for their own benefit, an absurd tax upon the rest of their fellow-citizens.
Quarterly Journal of Austrian Economics 18, no. 3 (Fall 2015)In the introduction to this collection, Guinevere Nell applauds Austrian scholars for their noteworthy contributions to economics. However, in her view, contemporary Austrians are too often motivated—and constrained—by the search for free-market conclusions, leading them to neglect both the problems of unregulated markets and the promise of alternative forms of organization. To remedy this myopia, Nell’s book attempts to apply Austrian theory outside “free market boundaries.”
The other day I was having coffee with a new friend, a retired businessman who had customized luxury cars in California. I mentioned I had recently retired from owning an investment firm and had studied economics for many years, especially Austrian economics.
Like so many people, he said, “I really don't understand economics and always have been confused by it.”
To which I surprised him with, “Of course you understand economics; it is the thought process you use every day to deal with three things: scarcity, property, and relationships.”
His eyes got big and he said, “Whoa! Say that again.”
“OK,” I said, “Everything in human life is organized around how we make decisions about three things: scarcity, property, and relationships.
“First let’s talk about scarcity which you’ve known about all of your life — you notice when something is missing or about to be missing; it is how you decide when it’s time go to the grocery store, do your laundry or whether you should drive your car faster so not to be late for an appointment.
“Every human being is an expert in the decision process of scarcity. It is something we all naturally do whenever we act and choose — which, by the way, we are doing all the time, every day, all day long.”
I smiled, “I could go on and on. You want more?”
“Sure,” he smiled back.
“All humans make action and choice decisions that automatically weigh the following factors. Knowledge: what do we know? Risk and uncertainty: what is our estimate of the risk we can foresee? What do we not know? Time and priority: when do I want or need this? And, how important is this to me right now in relation to other options? Value: what am I willing to give up to have this thing right now?
“This is the personal way you understand economics; it’s the decision process that every human being goes through every time they act and choose, even if it is only for me, alone.
“But there is another important way you already understand economics, which is how we interact with others. That is why I mentioned property and relationships because here is where the decision process I outlined above takes into account other people.
“Economics is also about how we decide how we will think about — and therefore organize — our property and our relationships.”
After a long pause my new friend then said, “Wait a minute. You haven’t talked about money. Even I know that economics is the study of money.”
To which I said, “The study of money and monetary exchange is the most applied use of economic theory. And this is to be expected.
“Why? Because of property.
“You probably already know that money is a medium of exchange. But what are we exchanging? We are exchanging property, your property for my property.
“It is most valuable to think that there are two conversations happening during every monetary — or property — exchange.
“The first conversation is the one I am having with myself; when I give $3 for this fancy cup of coffee I am saying, “I value that coffee more than the $3 in my pocket.”
“The second conversation is the one the café owner is having with himself. He is saying, “I value your $3 more than the coffee I have for sale.”
“Money is the handiest form of property so I don’t have to try to exchange a fish or a chicken for a cup of coffee, for example.”
I continued, “the real use of economics is in the conversation of how we organize ourselves in groups. Do we peacefully respect each other’s property? Do we peacefully cooperate with a shared sense of peaceful-values or is it that fearful-values are forced on us by some Single Dictator, as in a single person, or a Group Dictator, which is otherwise called democracy, by the way.”
At this point my new friend was squirming and said, “So, really economics is based on politics.”
I said, “Actually, it’s the other way around. If you like, I can send to you a great little essay written in 1850 that clarifies this. The writer’s name is Bastiat and he explains that economic architectures precede political architectures.
“In other words, if you look at politics as simply an argument of how we should organize ourselves, then it becomes obvious that it really boils down to how we know, or don’t know, what property is and how we should deal with it as we relate to each other in life and living.
“This is what I was referring to when I said that economics is also about relationships. The connection between economics and politics is how we organize our relationships and whether our ‘shared values’ assume we can have (and want to have) a society based more on peaceful cooperation — or not.”
As all conversations go, it became apparent that it was time to wrap this up, so I said, “Well, there you go. I have been studying this for a long time. If you would like to learn more I can direct you to learn about these things in a step-by-step way.”
To my surprise, he said, “No, let’s continue. This is very interesting. But one thing bothers me. Are you also saying that humans don’t need rules and laws and that our so-called ‘self interests’ are enough to keep us humans interacting in a more peaceful way? The news is too full of the horrors of humanity to swallow that one.”
I replied, “Well, it is true that the media is mostly reporting bad news. And there are definitely places and times throughout the world where the balance was and is greater violence of man against man.
“But it is also true that this exists against a backdrop of a pretty darn peaceful world overall. On any average day, you are more likely to end the day peacefully in bed than being the victim of some violent or unfortunate occurrence.
“There are many, many examples of shared peaceful values that we — the world over — rely on in our daily life, that show this to be true. My favorite is the freeway. Here we move along at speeds that easily can kill us and yet we all — mostly and most of the time — peacefully cooperate.
“But let’s talk next time about whether we need to organize ourselves around an assumption that the only way people will peacefully cooperate is via some agency being given the exclusive use of force or whether there are other ways that we can both have rules, laws, and remedies and — at the same time — a higher order of peace, prosperity, and freedom.
“Because there is a way.”
From everyone at the Mises Institute, we’d like to wish you a Happy Thanksgiving weekend!
Even our readers outside of the US can agree, the Thanksgiving lessons of free enterprise and the beauty of abundance are of universal importance (as is knowing how to best communicate with family during the holidays!) This weekend is also a good time for us to reflect on all the many things we have to be thankful for: from the incredible supporters we’ve met during this year’s sold-out Mises Circles, to our phenomenal group of Mises Fellows, Rothbard Graduate Seminar attendants, and 2015 Mises University class, to the continued spread of Misesian ideas around the world — the Austrian school is thriving today and it is because of people like you.
Thank you for your time, your support, and your passion for the cause of Austrian economics, freedom, and peace.
Mises Weekends this week focuses on libertarian strategy and how we can continue to make gains in the name of liberty. During our Phoenix Mises Circle, Jeff Deist gave his thoughts on the question, “What Must Be Done?”
And in case you missed any of them, here are this week’s featured Mises Daily articles and some of our most popular articles at Mises Wire:
Should People be Allowed to Work for $1 an Hour? by Jonathan Newman
The Good Ol' Days: When Tax Rates Were 90 Percent by Andrew Syrios
With Mass Shootings, the State Makes Us Less Safe by Justin Murray
Thanksgiving Is a Celebration of Free Enterprise by Judy Thommesen
Economics Is About Scarcity, Property, and Relationships by Michael J. McKay
Peronists Lose in Argentina after 12 Years of Populist Rule by Ryan McMaken
Swiss Banks Expand Use of Negative Interest Rates by Ryan McMaken
Letter to the Philadelphia Inquirer by Patrick Barron
OMG: Do a Million Americans Really Have no Toilet? by Ryan McMaken
Austrian Student Scholars Conference by Jeffrey Herbener
Rothbard on North by David Gordon
Eliminating Cash Makes it Easier to Silence Critics by Ryan McMaken
Ralph Nader Is Right: The Fed's Stimulus Hurts Ordinary People by Ryan McMaken
What is the least you would be willing to be paid to verify business addresses or phone numbers for a database? If you had a large online inventory and wanted simple word tags to describe each one of your products for search engine optimization, how much would you be willing to pay somebody to trudge through your product images and generate tags?
Tasks like these still require human labor, but a voluntary wage for such tasks is usually very low, especially relative to legislated minimum wages.
Despite exponential growth in computing power and capabilities over the past few decades, computers still struggle with simple tasks like identifying objects in a picture, making qualitative judgments, and confirming the accuracy of language translations. Amazon embraced this fact and connected those that need these Human Intelligence Tasks (HITs) performed with the humans willing to do them.
The service is called Amazon Mechanical Turk, after the fake chess-playing machine constructed in 1770. It was just a real, human chess master playing from inside a box. Back then, no such artificial computing capabilities existed, mechanical or otherwise. Like the “machine,” Amazon Mechanical Turk involves humans doing the work, even if the task seems suited for computers.
A company with a large catalog might want to find and eliminate duplicate listings, but the items’ pictures and descriptions might be a little different, making computers unqualified for the job. “Turkers” may also fill out surveys for marketing information, social science research, or really anything the task creator wants to ask a large number of people. Audio and video transcriptions are common, too.
Submissions are judged by having multiple people perform the same task. If their submissions are the same or very similar, the task requester can assume that they are really working on the task and not just filling in random text to complete tasks.
Below is an example of a HIT that asks people to pull information from pictures of receipts. If three people perform this HIT and two of the responses for the business address city are “Lincoln Park,” but one of the responses is “a;sldkfj,” the first two would be paid and not the third. Having more than one submission per HIT is more costly, but the task requesters get more accurate responses this way.
Today, there are more than 500,000 workers and around 200,000 HITs listed. Most tasks will earn the worker just a few cents, but some workers have been able to make a living from the service. As a member satisfactorily completes the simpler but lower-paying HITs, they are granted access to the higher-paying ones. A dedicated few make thousands of dollars a month by working full time. Others make a few extra hundred dollars a month by doing HITs after their regular job.
A recent study found that almost half of the MTurk workers performed tasks while at their primary job: “For example, a cab driver at the airport may answer survey questions while waiting for a fare. A teacher or office worker could MTurk during lunch break.”
Many enjoy doing the tasks as a form of relaxation and social engagement. Although the tasks seem incredibly boring to me, some find it an escape from boredom. Through turker-only forums, they have built a large, thriving community. They direct their fellow turkers to fun and high-paying HITs and help them steer clear of tasks posted by those who might fraudulently withhold payment for a completed task. Hayek would be impressed.
Minimum-Wage Activists Strike AgainThe most common hourly rate for working on HITs is about $1. As such, minimum wage proponents have railed against Amazon Mechanical Turk, calling it modern day slavery. They see people having fun and voluntarily exchanging pennies for simple tasks and want it abolished. Bored people should just stay bored.
What would they say is an appropriate price for asking somebody to select what color a shirt is in a picture? How much should they charge for filling out their age, sex, and favorite ice cream flavor in a survey?
The correct answer, of course, is whatever the two parties agree on. Workers can scroll through hundreds of thousands of HITs and decide for themselves which ones are worth the payment, which is listed with each HIT. If something looks too long and complicated for the advertised payment, they can simply pass on it. The workers have complete control over which tasks they perform, what hours they work, and, of course, whether they are signed up to be an Amazon Mechanical Turk worker at all!
In the early days of Amazon Mechanical Turk, Salon ran an article on it that read like an exposé of a cult or a crime ring. They found a man who does HITs for fun and made him out to be an unknowing slave to evil corporate interests:
Curtis Taylor, 50, a corporate trainer in Clarksville, Ind., who has earned more than $345 on Mturk.com, doesn’t even think of turking as work. To him, it’s a way to kill time. “I’m not in it to make money, I’m in it to goof off,” he says. Taylor travels a lot for business and finds himself sitting around in hotel rooms at night. He doesn’t like to watch TV much, and says that turking beats playing free online poker. To him, it’s “mad money,” which he blows buying gifts on Amazon, like Bill Bennett’s “America, the Last Best Hope,” for his son, a junior in high school. “If I ever stop being entertained, I’ll stop doing it,” he says. “I’ll just quit.”
Yet what’s a happy diversion for Taylor is serious business for the companies on Amazon Mechanical Turk.
It turns out that there is a market for bored people. Prices emerge to pull them out of their boredom by working on simple tasks.
There are other ways people with extra time on their hands can provide labor services for low or even no pay. Certainly minimum wage proponents wouldn’t condemn volunteering for charities like homeless shelters, soup kitchens, Habitat for Humanity, disease awareness/cure campaigns, etc. Yet, what non-arbitrary feature distinguishes this sort of work from other lines of work that might offer a wage lower than any proposed minimum wage?
Not All Value Is Expressed in DollarsIn all voluntary arrangements, both the worker and the employer agree to a mutually beneficial wage, which sometimes means $0/hour. Even if nothing tangible is trading hands, it doesn’t mean that volunteers get nothing out of their work. Their “payment” is knowing they did something nice for free. It’s not really a wage or a payment in the economic sense, though, because the employer doesn’t lose this good feeling, like they would forgo money wages for paid work. In fact, volunteering labor like this is more appropriately considered a gift, not an exchange of labor for a wage.
When individuals make a choice, they aren’t just exchanging goods for goods or services for money, but they are making choices over alternative states of the world.
A potential volunteer isn’t weighing $0 against time working for some charity, they are weighing all the consequences of helping a charity versus not helping, including the subjective feelings they have for the cause and the knowledge that they had a hand in its well-meaning goals.
Likewise, a turker only agrees to a $0.01 HIT if the task looks easy or fun enough. They weigh the prospect of doing the task and receiving one penny versus missing out on the fun and not receiving the penny. Again, “fun” is also subjective. Most of the tasks look downright boring to me.
Whether a job requires intense effort and a specialized skill or just having a human brain, market prices are the only way to match people that want to do the job with the people that want the job done. Even $0/hour is sometimes voluntarily chosen by a worker who simply wants to help a certain cause. Mandated minimum wages eliminate these kinds of peaceful and productive arrangements, leaving both parties unsatisfied and society worse off.
Elections took place across the country this past Tuesday with some interesting results. Voters in Ohio decided they hated monopolies more than they liked marijuana, while residents in Houston voted down the left’s latest egalitarian menace. While there is never a reason to trust the empty promises of pandering politicians, elections can occasionally offer insight into who is winning the battle for ideas. So there may be reason for optimism when you see Hawaiians’ discussing secession or the fact that there is global momentum in the fight against prohibition. While central planners struggle — both in the US and abroad — to maintain the status quo, bad government will never be able to repeal good economics.
The question then turns to how to we advance the cause of Austrian economics, peace, and freedom? That is the topic of this weekends’ Mises Circle in Phoenix, Arizona. One of our speakers, Dr. William Boyes, joined Jeff Deist this week to offer a preview of his talk. The founder of Arizona State University’s Center for Economic Liberty and a successful author of economics textbooks, Dr. Boyes discusses how to advance liberty and capitalism in the face of a statist educational system. One option — our new Online Mises Boot Camp!
In case you missed any of them, here are this week’s featured Mises Daily articles and some of our most popular articles at Mises Wire:
Activists Seek to Impoverish Thai Villagers to Save Monkeys from "Slavery" by David AdamsFor WHO, Red Meat Is a Red Herring by Yuri N. MaltsevThe Fed Desperately Tries to Maintain the Status Quo by Ronald-Peter StöferleHow Beijing and the West Work Together to Manipulate the Global Currency War by Brendan BrownWhy We Need Private Property to Deal with Scarce Resources by Patrick Barron"Social Expenditures" In the US Are Higher Than All Other OECD Countries, Except France by Ryan McMakenZwolinski and Woods on the Basic Income Guarantee by David GordonPot Battle in Ohio by Mark ThorntonPoverty Does Not Cause Obesity by Ryan McMakenWill Regulation Destroy a Revolution in Physics? by Matt McCaffreyMy Irish Eyes Are Smiling by Mark ThorntonA Practical Guide to Hawaiian Secession by Ryan McMakenMexico, Canada, and Ten American States Look Toward Marijuana Legalization by Ryan McMakenYellen on Negative Interest Rates by Jonathan Newman
On Wednesday, the Federal Reserve once again reaffirmed its zero-interest rate policy. Amusingly, this commitment to the monetary status quo is being seen by some as “hawkish” which, as Ryan McMaken points out, “shows just how much the goal posts have been moved in recent years.” Unfortunately all the spin and promises of future rate hikes doesn’t change the fact that we are nearing the seven year anniversary of ZIRP with an economy Janet Yellen doesn’t think is strong enough to survive the reversal of the Fed’s monetary morphine. Hopefully our central bankers will one day realize their war on deflation is leaving us poorer, but in the meantime — at least we can laugh about it.
In this edition of the Mises Weekends, we have the third in our series on the current state of healthcare. Our first episode featured Charles Hugh Smith who discussed the consequences of a healthcare market taken over by government regulators and insurance lobbyists. Our second featured Dr. Michel Accad giving his perspective as a practicing doctor in a post-Obamacare world. This week, Robert Murphy discusses his new book, The Primal Prescription, which he co-wrote with Dr. Doug McGuff. Murphy not only applies his understanding of Austrian economics to highlight the problems plaguing us today, but offers advice on how to navigate through the current state of American healthcare.
In case you missed any of them, here are this week’s featured Mises Daily articles and some of our most popular posts at Mises Wire:
The Fed Can’t Raise Rates, But Must Pretend It Will by Thorsten PolleitRobert Shiller Imagines What Consumers Should Want, While Ignoring What They Do Want by G.P. ManishThe War on Cars Is a War on Workers and the Poor by Gary GallesToday's War Against Deflation Will Make Us Poorer by Frank ShostakThe World Bank Threatens Free Markets in Peru by Simon WilsonIf Sweden and Germany Became US States, They Would be Among the Poorest States by Ryan McMakenThere’s More to Money than Hyperinflation by Matt McCaffreyPew: Homicide Rates Cut in Half Over Past 20 Years (While New Gun Ownership Soared) by Ryan McMakenSpectre by Matt McCaffreySunday of the Blind, or the Failed Revolution by Carmen Elena DorobățUS Soldiers Are Paid Significantly More than Civilians with Similar Skills and Education by Ryan McMakenWith Interest Rates, "There Are Two, Opposite Causal Chains at Work" Murray RothbardFOMC: We'll Raise Rates Some Day; We're "Hawkish" Now by Ryan McMakenUnderwear Prices to Remain Near Zero by Peter KleinTextbook Definitions of Economics: An Informal Survey by Jonathan NewmanPoliticians Pander to an Anti-Fed Public by Tho BishopIn Sweden Cash Is Becoming Radioactive by Joseph SalernoFirst they came for the cash, then they came for the microwaves by David Howden
Scarcity of resources exists in many forms and is the problem in economics. If resources were not scarce, there would be no need to economize. The existence of scarcity is true of all resources (such as time, human energy, and natural resources). However, it is not necessarily intuitive that allowing scarce resources to be owned privately is the solution to this problem.
Consequently, socialism appears attractive to many and they turn to having all resources owned collectively for the “common good.” Unfortunately, a society which spurns private property — and hands resources over to government planners instead — often learns the terrible lessons of central planning and the tragedy of the commons (i.e., commonly held resources will be plundered to extinction).
If society spurns allowing private ownership of resources, it must find some other means to prevent the tragedy of the commons and to allocate goods. Historically, the means chosen is the use of force and central planning. Throughout history, most of mankind has been divided into a hierarchical system of masters and slaves with some gradations between the two extremes. The masters (pharaohs, emperors, kings, sultans, warlords, etc.) devised complex rules-based systems for resource distribution that were decided by a small number of people and not by markets. And ultimately, these plans depended upon pure terror for enforcement. But this so-called solution to the problem of scarcity — restricting the people’s liberty through the use of force — does not work.
Problem 1: We Can’t Economize Without Effectively Ordering Our Preferences FirstThe gradual growth in the understanding of what we now regard as basic economics eventually ended thousands of years of subsistence existence for the masses in the West. Modern economics explained that without private ownership of resources, there was no mechanism for observing or acting on ordinal preferences in which persons prioritize desires from highest to lowest. Without a way to allocate goods according to ordinal preferences, there is no rational means to economize for the betterment of society.
In other words, without markets and prices, there is no way to know what people really want or need, so the masters never really knew what to order the slaves to produce, what technical means to use, what alternative materials to use, the quality desired, or how much to produce. Thus, the commissars of the Soviet Union ordered the production of inefficiently produced, shoddy goods. The Soviet empire collapsed, despite the fact that Russia is blessed with vast natural resources and an industrious population.
Problem 2: Few Raw Materials Are Ready to ConsumeA second fatal problem with common/government ownership of resources is that few readily available, consumable resources actually exist. There are no resources on the planet that do not require at least a minimum of effort to transform into a consumable product. Even edible berries growing in the wild must be harvested, meaning that someone must transport himself to the berries’ location and pull them from the bush at just the proper time. The cost of doing so is the value one places on forfeiting his leisure. Of course, other natural resources require much more effort to convert to consumable products, passing through many stages of production.
For example, timber and minerals must be extracted, harvested, etc. and then molded into something that can be consumed. Consider a hiker lost in the wild. It matters not at all to him that great stands of timber lie within easy reach or that valuable minerals lie under foot. These natural resources require great effort over very long time periods to be converted into something consumable, as is the case with converting timber into a shelter or crude oil into gasoline. A lost hiker does not have the knowledge, time, or previously produced means to convert these basic resources into consumable products to ensure his survival. All this is far beyond anyone's autarkic abilities.
Now let us assume that someone did harvest trees by felling them, transporting them to a lumber mill, milling them, storing them in a ventilated and dry place for many months before kiln-drying them (all processes that are required to turn trees into useable lumber), advertising their availability to contractors, keeping sales records, sending out bills, and collecting the bills, only to have a socialist call him a plunderer and confiscate his lumber for free distribution to whomever the masters deemed to be politically advantageous to their continued privileged position. No one other than the favored cronies of government would ever harvest another tree. In other words, production of usable lumber would be monopolized, and as with all cases of monopolies, prices would increase and quality would decline. Moreover, with no voluntary market at work in timber and forest land, there would be no means of knowing if these resources were being used in a way valued by those who valued them most.
At the same time, the central planners could not let just anyone harvest the trees or access the land. If the trees had no owners, great forests would be denuded in short order because there would be no social mechanism to prevent what would amount to a tragedy of the commons by order of the state.
Problem 3: We Need Private Property to Build CapitalWithout the ability to profit from privately owned property, there would be no incentive to provide or withhold capital for any endeavor. Also, a system of private ownership is necessary to determine if that capital is being used in a way the consumers value. The consequences of ignoring this fact of economic science is most evident today in China's ghost cities, where resources, both natural and human, have been expended for no observable benefit except to advance the careers of politicians who can claim to have met the requirements of the latest Five Year Plan. Timber and other resources were provided to build ghost cities, not because the owners of the resources sought to be economical with their resources, but because government edicts required that timber, concrete, gasoline, and more be used to produce what are now empty cities.
The opposite case of resource waste comes from special interest groups who capture the political apparatus of the state and prohibit exploitation of resources by private individuals. In the name of protecting Mother Gaia from being plundered, modern environmentalists have convinced the political class that most progress is unsustainable, dangerous to our health, or any number of other specious claims. Society is prevented from benefiting from their conversion to consumable products. The poor suffer the most from these policies as the prices of raw materials — and thus finished consumer goods — are driven up.
Private ownership insures that valuable resources will never be plundered to extinction, because their value will have been capitalized. Instead, private owners will seek to make resources as widely available as possible without endangering the long-term prospects for future harvesting of resources. The process of determining a resource’s capitalized value is impossible absent free-market capitalism with strict defenses of property rights.
Despite both the theoretical and empirical evidence to the contrary, socialists tell us the opposite; i.e., that state ownership of all resources will prevent their plunder and ensure prosperity for all. As Ludwig von Mises explained, though, socialism is not an alternative economic system of production. It is a system of consumption only, and a system of economic ignorance and economic plunder.
A just-released poll of Los Angeles residents found that 55 percent of respondents indicated their greatest concern was “traffic and congestion,” far ahead of “personal safety” — the next highest area of concern — at 35 percent. So if their city government was working in their best interests, it would be doing something about automobile congestion.
It is. Unfortunately, it will make things worse.
Los Angeles’s recently adopted Mobility Plan 2035 would replace auto lanes in America’s congestion capital with bus and protected bike lanes, as well as pedestrian enhancements, despite heightening congestion for the vast majority who will continue to drive. Even the City’s Environmental Impact Report admitted “unavoidable significant adverse impacts” on congestion, doubling the number of heavily congested (graded F) intersections to 36 percent during evening rush hours.
Driving Saves Time and Offers More OpportunitySuch an effort to ration driving by worsening gridlock purgatory begs asking a central, but largely ignored, question. Why do planners’ attempts to force residents into walking, cycling, and mass transit — supposedly improving their quality of life — attract so few away from driving?
The reason it takes a coercive crowbar to get most people out of their cars is that automobile users have concluded cars are vastly superior to the alternatives.
Why is automobile use so desirable:
Automobiles have far greater and more flexible passenger — and cargo-carrying capacities.They allow direct, point-to-point service.They allow self-scheduling rather than requiring advance planning.They save time.They have far better multi-stop trip capability (this is why restrictions on auto use punish working mothers most).They offer a safer, more comfortable, more controllable environment, from the seats to the temperature to the music to the company.Those massive advantages explain why even substantial new restrictions on automobiles or improvements in alternatives leave driving the dominant choice. However, they also reveal that a policy that will punish the vast majority who will continue to drive cannot serve residents effectively.
How Restrictions on Automobiles Punish the Working Poor the MostThe superiority of automobiles doesn’t stop at the obvious, either. They expand workers’ access to jobs, increasing productivity and incomes, improve purchasing choices, lower consumer prices and widen social options. Reducing roads’ car-carrying capacity undermines those major benefits.
Cars offer a decrease in commuting times (if not hamstrung by government planning), providing workers access to many more potential employers and job markets. This improves worker-employer matches, with expanded productivity both benefiting employers and raising workers’ incomes.
One study found that a 10-percent improvement in travel time raised worker productivity 3 percent. And increasing from a 3 mph walking speed to 30 mph driving speed is a 900-percent increase. In a similar vein, a Harvard analysis found that for those lacking high-school diplomas, owning a car increased monthly earnings by $1,100.
Cars are also the only means of assembling enough customers to sustain large stores with highly diverse offerings. Similarly, “automobility” dramatically expands the menu of social opportunities that are accessible.
Supporters like Los Angeles Mayor Eric Garcetti may dismiss the serious adverse effects of the “road diets” they propose (a term whose negative implications were too obvious, getting it benched in favor of the better-sounding “complete streets”). But by demeaning cars as “the old model” and insisting “we have to have neighborhoods that are more self-contained,” the opponents of auto use do nothing to lessen the huge costs or increase the very limited benefits they plan to impose on those they supposedly represent.
Further, the “new model” of curtailing road capacity to force people out of cars is really a recycled old far-inferior model. As urban policy expert Randal O’Toole noted in The Best-Laid Plans:
Anyone who prefers not to drive can find neighborhood … where they can walk to stores that offer a limited selection of high-priced goods, enjoy limited recreation and social opportunities, and take slow public transit vehicles to some but not all regional employment centers, the same as many Americans did in 1920. But the automobile provides people with far more benefits and opportunities than they could ever have without it.
In a recent New York Times article, Robert Shiller takes aim at the idea that “an unregulated competitive economy is optimal for everyone.” While a defender of certain aspects of the free market, he has misgivings about the amount of manipulation and deceit that permeates it. A competitive economy, in his eyes, features numerous entrepreneurs preying on consumers making decisions that run counter to their best interests.
Too Many AssumptionsThis view of the free market is the result of a particular theoretical perspective that unfortunately pervades mainstream economics. In this view, which draws its inspiration primarily from Vilfredo Pareto and John Hicks, markets are optimal because they bring about a state of near-perfect rationality. Each consumer’s preferences are assumed to be error-free, reflecting the latest scientific knowledge. Thus, a consumer, when making decisions about what to eat, follows the advice of dietary experts. He never makes a “mistake” by consuming products that are deemed to be unhealthy. He never indulges himself in a candy bar or a box of chocolates.
Similarly, when making decisions which affect his health the consumer never runs afoul of his doctor’s instructions. Smoking cigarettes, excessive alcohol consumption or inadequate exercise are options that are off the table. Each consumer, moreover, has perfect knowledge regarding the state of the market and the prevailing prices. Therefore he never purchases a good and then finds out that it was available cheaper elsewhere. Such errors are ruled out by assumption.
The process of competition ensures that resources are allocated to best satisfy these rational consumer preferences, thereby bringing about a state of equilibrium that is optimal for everyone. In such a state each market participant is maximizing his or her welfare, allocating the scarce money income at his disposal to satisfy the most highly ranked wants that will truly contribute to it.
It should come as no surprise that the neoclassical economist, when turning his attention from such a defense of the free market, should gasp with horror at the irrationality pervading the real world. The consumers he meets in the supermarket are very different from those that pervade his theoretical model. They purchase candy, often in abundance, eat junk food, consume excessive alcohol, and make a host of other choices which experts in various fields would disapprove of. Why, they even happen to have a proclivity for gossip magazines, something that any rational being would surely see as nothing but a complete waste of time!
It is then a short jump to the conclusion that the entrepreneurs providing the consumers with the means to satisfy these irrational wants are mere manipulators and deceivers. Their desire to make profits in the face of competition forces them to exploit the human frailties of their customers, often finding ways to make them choose in a manner that is contrary to their true welfare. They take advantage of a consumer’s weak moments, when he fails to reason like a scientist or an expert and is inclined to give in to mere whims and fancies. In the process the entrepreneurs, far from ensuring the maximization of welfare, push consumers to make choices that leave them worse off.
Observing the Economy as it Is, Not as it Should BeEconomists working in the Austrian tradition provide a completely different defense of the benefits of the market that are immune to the criticisms advanced by Shiller. The heart of this defense lies in the concept of consumer sovereignty. The characteristic feature of a free, competitive economy is that the decisions of the entrepreneurs and the allocation of resources are always aligned to anticipated consumer preferences, however irrational they may be.
These preferences don’t have to stand up to rational scrutiny. They don’t have to be guided by the most up to date scientific knowledge. Instead, they reflect the momentary valuations of men as they are: erroneous, imperfect, and whimsical. As Mises notes, “Not what a man should do, but what he does, counts for praxeology and economics. Hygiene may be right or wrong in calling alcohol and nicotine poisons. But economics must explain the prices of tobacco and liquor as they are, not as they would be under different conditions.”
Consumers, Not Producers, Direct the MarketThe prices that entrepreneurs bid for the factors of production merely reflect their expectations of these preferences. And those who are correct in their anticipations are rewarded with profits whereas those who are not are punished with losses. Thus, the real boss in the realm of the market, the true captain of the ship, is the consumer, irrational and ignorant as he is, and it is he who decides what should and should not be produced.
Any notion of welfare is inseparable from the satisfaction of these imperfect and irrational preferences. The market maximizes consumer welfare because it caters to the whims and fancies of consumers, not because it satisfies the wants of men guided by knowledge deemed to be perfectly rational by the economist.
Thus, when an Austrian economist walks into a supermarket he does not see irrationality, manipulation, and deceit. Instead he sees the miracle of the market at work; he sees the manifestation of the price system and its ability to ensure the satisfaction of the whims and fancies of consumers. When he notices candy bars and gossip magazines being sold in the checkout aisles he does not conclude that entrepreneurs are trying to manipulate consumers. Instead, he realizes that this allocation of resources merely mirrors the preferences of the vast majority of his fellow men. The ability of entrepreneurs to correctly anticipate these preferences and to cater to them enhances rather than diminishes consumer welfare.
Defending the free market is important but how one goes about doing it is equally important. Austrian economists defend the market not because it is perfect but because it allows us to prosper and thrive while letting us embrace our innate human frailties and limitations.
On Friday, a desperate China announced another round of interest rate cuts — its sixth such announcement in the past year. Cheered on by Nobel Prize winning economists, and pundits who dream of socialists utopias, governments continue to cling to the follies of central planning, easy money and growing debt.
Of course, not even science fiction can change the hard realities of economics.
Luckily, the resulting chaos that inevitably leads from these disastrous policies creates opportunities for the truth to prevail. Examples can be seen when panicked regulators taking a second look at the benefits of 100 percent reserve banking or the emergence of healthcare providers have broken the shackles of the government-distorted insurance model.
One doctor that has taken that stand is Dr. Michel Accad. A frequent Mises Daily contributor, Dr. Accad joined Jeff Deist this week on Mises Weekends to discuss his experiences as a practicing cardiologist in the Age of Obamacare. If you feel like just a number at the doctor’s office, you’re right: the entire visit culminates in a particular code being entered into the insurer’s database. That code determines how much your doctor gets paid, and it’s all part of a system of bureaucratic overhead and perverse incentives.
If you’re interested in learning about the true state of medicine in a post-Obamacare world, this interview is a must listen.
In case you missed any of them, here are this week’s featured Mises Daily articles and some of our most popular articles at Mises Wire:
Reflections on Venezuela’s "Economic Miracle" by Andrew SyriosBeavis and Butt-Head Take Over Silicon Valley by Paul CantorStar Trek Is Wrong: There Will Always Be Scarcity by Jonathan NewmanRobert Shiller Is Shilling for Socialism by Peter St. OngeNew Berlin-Based Master's Degree Program in Austrian Economics by Ryan McMakenHappy Birthday, Ralph! by David GordonThe Fed Says No to Pot Money, Unless it's the Government's Pot Money by Jonathan NewmanHow Currency Exchange Rates Are Determined by Frank ShostakDesperate Financial Regulators Turn to ... 100% Reserves by Joseph SalernoThe Complexity of Violent Crime and the Role of State-Sanctioned Killing by Ryan McMakenCanadians (Sort of) Vote for Less Interventionism and More Freedom by Ryan McMakenA Tax I Can Support by Per BylundMy Day at the Fed by Mark ThorntonFantasy Sports and the State of Nevada Go Head-to-Head by Jonathan Newman
What is necessary to take away a man’s freedom? For many progressives, nothing more then a bad workplace. Amazon takes ongoing heat for its work environment, with opponents like Business Insider calling it a “slave camp.”
But this comparison mistakes the fundamental nature of coercion.
Many leftists, such as left-libertarian Susan Webber at Naked Capitalism, argue that we must work in order to live, and that therefore work is coercive. If you must do X to live, then surely whoever controls your ability to do X is coercing you.
The problem with this argument is that the state of nature is not a Rousseauian paradise, but a brutal place where most die. The state of nature involves poverty and endless drudgery to catch, kill, and cook whatever food one can to stay alive. The workday is every waking moment, and the pay is little more than an occasional meal.
There’s nothing stopping people from living this way in the modern world — say, off the grid — but the beauty of capitalism is that it offers us a way out of this wretched existence. When a company offers a man a job, they are not saying, “work or die!” the way a slaver does; they are promising him that, if he helps them to succeed, they will give him money to improve his life.
Professors Bertram, Gourevitch, and Robin at Crooked Timber make another argument: that the workplace is coercive by virtue of an unequal power balance. Employers can, after all, fire employees if they don’t do X. But this mistakes the nature of work and ignores the power of employees.
Coercion, according to the Oxford English Dictionary, is, “The practice of persuading someone to do something by using force or threats.” It involves a threat to harm someone if they don’t do X. In a prison or slave camp, prisoners can be beaten or killed for not complying with orders.
This is fundamentally different from the promise of an employer like Amazon, which is to engage in a relationship with workers so long as that relationship is mutually beneficial. As long as the employee performs good work, Amazon will continue to help him improve his life. If the employee no longer provides value to Amazon, then Amazon is under no obligation to continue to help him.
Refusing to continue helping someone is fundamentally different from the use of “force or threats” inherent in coercion. A slaver’s whip makes a person’s status quo worse if he doesn’t do as he’s told. An employer’s continued payments make one’s status quo better if he does as he’s asked.
Admittedly, being fired can leave former employees in a tough spot, and that’s more true if they’re fired without warning. Amazon’s harsh work conditions, combined with the specter of being suddenly let go if we don’t perform every day, don’t constitute a job most of us would choose. But equating this with a slave camp does employees a disservice by denying their agency.
The comparison ignores the power of employees. They can leave a company whenever they want, and wielding that power can leave their former employers in a bind. In a small company or a busy firm, an employee who quits can leave the company without the manpower to meet its obligations. If an accountant suddenly quits H&R Block during tax season, he'll leave their franchise struggling to make up lost ground.
Even in a big firm like Amazon, employees who leave suddenly cost their bosses money. According to the liberal-leaning Center for American Progress, the turnover costs for employees earning under $50,000 per year averages 20 percent of that employee's annual salary. These costs incentivize employers to retain staff, and grants bargaining power to employees.
Such language also ignores the fact that people tend to find jobs that represent their best option.
This is true of Amazon’s “fulfillment centers,” which took a lot of heat in 2013. But as The Guardian notes, Amazon builds these centers in, “places of high unemployment and low economic opportunities.” Workers who otherwise wouldn’t find a job flock to Amazon, knowing that it may not be perfect but that it beats their baseline — unemployment. It’s also true of Amazon’s white-collar workers who just happen to be the subject of the latest controversy.
Amazon has, “one of the most rigorous hiring processes in America,” according to Business to Community, and those hired could find jobs at most other tech companies. But they choose to work at Amazon. Rather than considering that these men and women may choose to work at Amazon for a reason, progressives deride their choices and their agency with talk of coercion.
The issue of coercion is important to understand because it’s the central difference between government and the private sector. If you don’t do X, government can punish you: it can take away your savings, throw you in jail, even shoot you. That’s true coercion. By contrast, if an employer asks you to do X, she can’t threaten you; all she can do if you say no is refuse to keep giving you money.
This difference highlights the essential freedom of the market. In any market-based relationship, one party can leave and the other party can do them no harm. This is a freedom that is noticeably lacking in our interactions with government.
With the recent successes and announcements of sci-fi movies and TV shows like The Martian, Interstellar, and new incarnations of Star Trek and Star Wars, no one can deny that we crave futurism and stretching our imagination on what advanced technology can accomplish. Many look to the example of these fictional worlds as an indication of what life might be like when technology can provide for all of our basic needs, a condition some call “post-scarcity.”
The same people call on dramatic government interventions to make sure everybody can earn a “living wage” when robots and automation do all of the producing. They say that “post-scarcity” conditions will completely overturn economies and even economics itself.
But, scarcity can never be eliminated because our infinite human wants will always outnumber the means available in this finite universe. Scarcity is found even in the shows and movies that supposedly represent worlds without scarcity.
A prime example of what is meant by “post-scarcity” and its contrast to present-day is presented in the Star Trek: The Next Generation series.
In the final episode of the first season, the Enterprise happens upon an “ancient” vessel floating through space. Lt. Commander Data and Security Officer Worf find three humans from Earth, frozen in cryonic chambers for 400 years, which gives the twenty-fourth century crew a chance to interact with people from the viewers’ time period.
One of these late twentieth-century humans, Ralph Offenhouse, was preoccupied with regaining control over what he expected to be a gigantic fortune from a 400-year-old stock portfolio. Indeed, one of the first things he asked for after being thawed and resuscitated was a copy of the Wall Street Journal.
Captain Picard informed him that “A lot has changed in the past three hundred years. People are no longer obsessed with the accumulation of things. We’ve eliminated hunger, want, the need for possessions. We’ve grown out of our infancy.”
The show paints a Marxist picture of how humans arrived at being able to warp across space with food replicators and beaming devices and all sorts of technology that renders even our early twenty-first-century scramble for scarce resources a mere curiosity.
During centuries that stretch between the crew of the Enterprise and their time capsule visitors, technology changed in such a way to abundantly provide for people’s material needs. Therefore human society phased out of capitalism and trade and into socialism, which Karl Marx predicted in his theory of history.
The economics of the Star Trek universe is the subject of a forthcoming book by Manu Saadia, called Trekonomics. Saadia proposes that we should take sci-fi seriously and prepare ourselves for “post-scarcity” conditions:
Good science fiction like Star Trek can be great fun. Yet, at the same time, it is deadly serious. Its central purpose is to explore the changes that lie ahead of us. What are the economic, social and even psychological consequences of technological change? What will happen to us humans in a world that runs on automata?
Noah Smith gives a similar prognostication:
the rise of new technology means that all the economic questions will change. Instead of a world defined by scarcity, we will live in a world defined by self-expression. We will be able to decide the kind of people that we want to be, and the kind of lives we want to live, instead of having the world decide for us. The Star Trek utopia will free us from the fetters of the dismal science.
Both argue that markets and trade will become unnecessary once we arrive at so-called “post-scarcity” conditions. The study of economics itself will be a thing of the past, like VCRs and 8-tracks.
Scarcity Is Fundamental to the Physical UniverseUnfortunately for all of us, however, scarcity isn’t going anywhere. And the only way to maximize human want satisfaction with a limited pool of resources is with unhampered markets: private property and prices. Scarcity is a fundamental fact of our universe — we are bound to it by physical laws and logic.
Scarcity is even present in the fictional Star Trek universe, as well as self-ownership and private property. In the very same episode, Captain Picard and the crew have a tense confrontation with the Romulans, who have invaded Federation space. Both parties were investigating the destruction of some of their outposts in the “Neutral Zone.” Space is not only the final frontier, but apparently ownable. The Romulan and Federation outposts are also scarce and owned.
When Ralph Offenhouse wandered onto the main bridge during this confrontation, Captain Picard ordered security officers to “Get him off my bridge!”
We can’t even conceive of a fictional universe with no scarcity. There can be no time, space, or anything that has any limited capabilities in satisfying our desires. Such a universe would be timeless, incorporeal, and all satisfying. It’s hard to imagine a TV show based in such a universe because there could be no conflict for the characters to overcome.
What Manu Saadia and Noah Smith mean by “post-scarcity,” then, is just that some things are more abundant than before. But this prospect does not mean the end of economics, because even today many goods are more abundant than they have been in the past.
No matter what, individuals will still be making choices about how to use the resources that are scarce. We may make things relatively less scarce, but we can never repeal scarcity as a fundamental condition of our universe.
Suppose every household in the world has all of their biological needs abundantly satisfied. Food is provided by replicators like those on the Enterprise. Everybody has as at least as much shelter as they need. Super-medicines and all health services are easily provided with the touch of a button in your own home.
Moving Beyond “Subsistence” Is Not the Same as Moving Beyond “Scarcity”All this means is that people can pursue other ends besides survival, like art, entertainment, learning, or simple relaxation. Our demand for goods and services does not stop once we are at subsistence levels of consumption. This is obviously true for anybody with the means to read this article.
Also, there may be demand for food and other goods specifically made by human hands even when robots or replicators could have made something identical or more precisely machined at a lower cost. We see this today, and we are far from Star Trek.
Sometimes we like knowing something was made in a certain way, and this translates into demand for goods with a specific, usually labor-intensive, production process. Craft and hand-made trade fairs are common, even when many of the items offered are mass-produced elsewhere.
Toward the end of the episode, when Ralph Offenhouse is reeling in an existential crisis, he asks Captain Picard about the purpose of twenty-fourth-century life if it’s not “accumulating wealth”:
Captain Jean-Luc Picard: Material needs no longer exist.Ralph Offenhouse: Then what's the challenge?Captain Jean-Luc Picard: The challenge, Mr. Offenhouse, is to improve yourself. To enrich yourself. Enjoy it.
What Picard doesn’t realize is that improving and enriching yourself, even with the Enterprise’s mission: “to explore strange new worlds, to seek out new life and new civilizations, to boldly go where no one has gone before” involves the use of scarce, material resources, like starships, starship crews, planets to explore, communicators, teleportation machines, phasers, and warp drives.
Picard also doesn’t realize how wealthy he is. Wealth is the ability to satisfy ends, and his spot on the Enterprise makes him enormously wealthy, with all the replicators and the holodeck (environment simulator) and the instant access to top-notch medical care. For someone who rejects accumulating wealth, he has accumulated a lot of it.
Although biological needs may be abundantly satisfied, human desires outnumber the stars. As such, scarcity is unavoidable in the same way gravity is unavoidable, or the forward “continual flux” of time, to use the words of Mises. Our goal is the optimal allocation of those scarce resources, and only unhampered markets can “make it so.”
The Nobel Prize just gets cheaper and cheaper. Recent laureate Bob Shiller graces the New York Times with his latest rant that free-markets stink, bolstering his argument by making stuff up.
For starters, Shiller writes that America’s wealth “can be attributed” to regulation. Well, sure, it “can be attributed” to Zeus. Or sunspots. In the real world, America became the richest country long before the regulation age, and that position has been eroding ever since. Maddison (2007) estimates that by 1913 — before the New Deal regulatory explosion — the US was at $5,300 per person PPP (purchasing power parity), against $3,500 in Western Europe, $1,500 in Latin America, and $700 in the rest of Asia and Africa.
A similar pattern occurred in Europe, where the richest countries of the pre-modern age, Britain and Holland, used relatively free markets regulated by tort, while the rest of Europe mired hobbling markets with regulation and diktat. So, the story isn’t that regulation made the West. It’s that low-regulation economies soared ahead of the rest of humanity until socialists clipped their wings.
Indeed, Shiller doesn’t even seem to believe his own fantasy, writing, “The Thatcher-Reagan revolution a third of a century ago was a turning point away from market regulation, with mixed results.“
Here, the phrase “mixed results” is a red flag that the data doesn’t support his argument. Because Shiller would be kind enough to share the data if it did; it’s not very hard to look up GDP figures. And what do GDP figures tell us? That in Reagan’s eight years per capita GDP adjusted for inflation rose 3.5 percent per year. Compared to 0.7 percent in the previous eight years and 1.5 percent in the following eight years.
So, no, this is not a “mixed result.” This is a clear contradiction of Shiller’s claim that socialism makes America rich. Not to be too hard on Shiller, but he is the one who brought up Reagan.
By the way, if the US economy had kept up that Reagan 3.5 percent growth today, we’d have a per-capita GDP of $70,000. Twenty percent higher than Switzerland, and 50 percent above where we are today. Take your salary, top up by 50 percent, and that’s how rich you’d be if characters like Shiller would get out of the way.
Shiller’s next section is even heavier on the wishful thinking. He writes, “In fact, the real success of economies that embody free markets has much to do with the heroic efforts of campaigners for better values, both among private organizations and advocates of government regulation.”
I’m sure many economists are impressed that Shiller managed to mathematically quantify “real success” or “better values” to arrive at this particular “fact” of his. He is writing in The New York Times, not an academic journal, so we can forgive some looseness. Still, an economist writing about economics should take care in labeling opinions as facts, lest they be thought of abusing public trust in our field.
It helps to know where Shiller’s coming from. For a few years now, Bob Shiller’s been hawking institutionalized bail-outs. He wants to extend bail-outs into brave new corners of our lives. Career insurance for those who major in gender studies, housing insurance for house-flippers, even GDP insurance so countries that wreck their economies can get bailed-out by the prudent. The idea of making you pay for others’ screw-ups is one hustle socialists are always selling, simply because people vote for politicians who bail them out.
And this brings us to why Shiller’s telling tales about capitalism. Shiller thinks people are stupid so companies manipulate them, so Bob Shiller and his friends in government should run peoples’ lives. His vehicle here is Irving Fisher’s line that people don’t maximize utility — happiness — rather, in Fisher’s phrasing, “something that could better be described as ‘wantability’ rather than utility, for they are subject to temptation and mistakes.”
Shiller is dredging a strawman here; no economist thinks humans are perfect and error-free. What economists do debate is whether people should have overlords. Because the problem here is that somebody must decide whether you buy an iPhone, eat salad or bacon, or drive an SUV or a compact. If individuals don’t get to choose, who does? Alas, we know who: Bob Shiller and his buddies in government.
While overlords are antithetical to any lover of freedom, let’s humor Shiller and ask whether overlords can make “better” decisions than people. Here the key is what Hayek called the local knowledge problem: preferences aren’t automatically known by the overlords. Indeed, as Shiller complains, people often don’t even know their own preferences. Why would we think bureaucrats would know our preferences better than we ourselves do?
Does Bob Shiller really know you better than you do? Do his bureaucrats in the Department of What to Have for Lunch, or the Department of Choosing Vacation Destinations? Worse, to use real-world socialist examples, the Department of Dating and Marriage, or the Department of Choosing a Career? Unless Shiller has stumbled across a secret stash of all-knowing Angels, his overlords are only human. And their mistakes are magnified by their power.
Worse, putting overlords in charge brings a dark new problem — overlords want things, too. Maybe they love power, maybe they want to purify the earth and usher in a thousand-year Reich. Or maybe they just accept campaign donations. This means Shiller’s big-brained overlords may not even be trying to estimate what you want. They may not care. Because they want things, too.
You might think this problem — in Roman poet Juvenal’s phrase, “who watches the watchers” — would merit some thought after a century of blood and poverty from socialism’s failures. Alas, we’re subjected to a non-stop stream of Nobel laureates oblivious to what Mises’s Human Action told us a generation ago: “Socialism is not an alternative to capitalism; it is an alternative to any system under which men can live as human beings.”
International trade grabbed headlines this week with Monday’s announcement that twelve governments have reached agreement on the Trans-Pacific Partnership. While it should be of no surprise to see the news celebrated in the editorial pages of the Wall Street Journal or the Council of Foreign Relations blog, it is unfortunate even libertarian organizations are praising the agreement.
Of course, this is not the first time alleged defenders of lassiez-faire have endorsed intergovernmental agreements that enhance the power of the state. Ferghane Azihari and Louis Rouanet put TPP in historical context in Wednesday’s Mises Daily:
Murray Rothbard opposed NAFTA and showed that what the Orwellians were calling a “free trade” agreement was in reality a means to cartelize and increase government control over the economy. Several clues lead us to the conclusion that protectionist policies often hide behind free trade agreements, for as Rothbard said, “genuine free trade doesn’t require a treaty.”
Dr. Ed Stringham takes on the notion that government is necessary at all for markets and trade to thrive in his new book Private Governance. He joined Jeff Deist to discuss his work on the latest episode of Mises Weekends. Listen as Jeff and Ed destroy the argument that markets rely on government to protect property rights, mediate contracts, and numerous other excuses interventionists make in defense of the state.
In case you missed any of them, here are articles from this past week’s Mises Daily and Mises Wire:
The TPP and the Trade Rhetoric by Carmen Elena DorobățTPP: The Latest Assault on Free Trade by Ryan McMakenRothbard: Gun Regulation Explained by Murray RothbardIn Policy Debates, Can Economics Trump Ethics? by Matt McCaffreyThe Future Is Decentralized by Patrick ByrneNo More "Free Trade" Treaties: It's Time for Genuine Free Trade by Ferghane Azihari and Louis RouanetThe Menace of Egalitarianism by Lew RockwellFashionable Prohibition for Modern Lawmakers by Ryan McMakenIn Brazil, Free-Market Ideas Rise as the Economy Falls by Antony P. MuellerMissed last Saturday’s Mises Circle? Watch Jeff Deist, Tom DiLorenzo, Tom Woods and Lew Rockwell tackle the threat of political correctness.
With the latest school shooting, all humane people are expected to jump up and do something to stop the next shooting. The most popular response among media pundits and national policymakers right now is an expansion of the various prohibitions now in place against guns.
For anyone familiar with the history of prohibitions on inanimate objects, however, these appeals to prohibition as a “common sense” solution are rather less convincing.
Americans and others have tried a wide variety of similar prohibitions before, and with mixed results at best. Nowadays, prohibitions on drugs are in decline as states continue to unravel prohibitions of the past and make the nature of prohibition less drastic and less punitive. And, of course, the prohibition of alcohol has been dead for decades.
The prohibitions of old have been deemed failures. But fortunately for prohibitionists, there’s a fashionable form of modern prohibition that won’t go away.
Why Not Ban Alcohol?Now, I know what some of you are saying: “Hey, McMaken, you can’t compare alcohol prohibition to gun prohibition because alcohol mostly only hurts the drinker, while guns have many harmful side effects for the public at large.”
But the fact that anyone could think this shows just how well the anti-alcohol-prohibition rhetoric has worked. Since the repeal of prohibition in the 1930s, alcohol has taken on an image of fun and relaxation. Sure, some people use it irresponsibly, we are told, but for the most part, people should be allowed the freedom to use it. For those high risk behaviors linked to alcohol, such as drunk driving, we’ll regulate that, but the ownership of alcohol itself, of course, should be open to all adults.
And yet, in the face of this laissez-faire attitude toward drinking, we could offer a host of illustrations of how alcohol is in fact a public safety menace.
Indeed, prior to the 1920s, during the heyday of the temperance movement, alcohol’s image was as anything but a mere benign luxury among a sizable portion of the population.
While many people today assume that the prohibitionists argued along puritanical lines, and emphasized the dangers of moral ruin, the arguments against alcohol were really far more complex than that.
The prohibitionists argued — quite plausibly, mind you — that any number of social ills could be addressed through alcohol prohibition. Chief among these was the fact that many families, including children, were often rendered destitute by the drinking of the male head of the household who was unable to hold down a job due to his addiction. Moreover, cases of child abuse and spousal abuse were clearly connected to alcohol consumption, as were household accidents and accidents on the job.
When breadwinners were killed or injured on the job, or if a drunk spent half his income at a bar on payday, families often ended up on the local dole. Or worse.
And there was a connection to non-domestic violence too. Public drunkenness, bar fights, and the deadly and irresponsible use of guns were connected to drinking as well.
Ironically, back then though, it wasn’t the guns that were seen as the problem (although gun control advocates did exist). For many, the problem was that drunks were irresponsibly using guns and that the common-sense solution was to prevent them from getting drunk.
Guns are Less Deadly than AlcoholNowadays, 88,000 deaths per year are attributed to alcohol abuse, and thirty people per day in the United States die in alcohol-related auto accidents. Heavy drinkers are more prone to violence, suicide, and risky sexual behavior.
In fact, if we compare these statistics, we find that alcohol abuse is significantly more deadly and problematic than misuse of guns. There were 36,000 gun-related deaths (including suicides and accidents) in the US in 2013, and as a percentage of all causes of death, alcohol-related deaths are more than twice as common as gun deaths.
What’s more, one-third of gun deaths are alcohol related. Thus, according to prohibitionist logic, we could eliminate one-third of gun-related deaths overnight by prohibiting alcohol consumption. So why aren’t we doing it? If it could save one life, wouldn’t it be worth it?
Most have concluded that saving one life is not, in fact, worth it. In practice, alcohol-related deaths (including those inflicted against third-party victims) are treated very differently than gun-related deaths.
For example, it is clear that alcohol is a central component in the more than 10,000 drunk-driving deaths that occur each year. So, is the response to restrict certain types of alcohol or populations that can buy it? Are background checks instituted to prevent sales to incorrigible drunk drivers? No, the response is to ban how alcohol is used in certain cases.
On the other hand, in response to the 11,000 gun-related murders per year, the prescribed response is to restrict the guns themselves. But, if we were to apply the same logic behind drunk driving bans to gun violence, the only legislation we would be considering would be something along the lines of special penalties for carrying firearms when mentally impaired, on psychotropic drugs, when sight impaired, or in crowded areas where accidents are more likely to affect bystanders. The mere purchase or ownership of guns would not be restricted, just as the purchase or ownership of alcohol is not restricted in response to drunk driving.
Indeed, if we add to drunk driving all the cases of spousal abuse and child abuse and public cases of assault, bar fights, and more, it becomes clear that alcohol is in fact far more damaging to the social fabric than guns have ever been. Once we factor in the harm that alcohol does to the user himself, in terms of health problems, riskier sex, and suicides, the numbers look even worse for alcohol.
Does Prohibition Work?Now, you might be thinking, “yes, but if gun prohibition works, shouldn’t we try it?” Unfortunately, there are few reasons to believe that it would work, or that the cure would not be worse than the disease.
Mark Thornton illustrated years ago that alcohol prohibition led to more alcohol consumption, and more consumption of harder distilled drinks versus more mild beer and wine beverages. In addition to the complete failure to end the behavior it targeted, Americans also became acquainted with numerous unpleasant side effects of prohibition including more organized crime and more government harassment of peaceful citizens.
Comparing the StatesAs far as gun prohibition goes, thanks to a diversity of gun laws among the American states, we can compare between gun ownership levels in the states and homicide rates.
And what we find is that there is no correlation between the level of restrictiveness in gun laws and the murder rate. Most recently, Eugene Volokh ran the numbers looking at homicide rates and the so-called Brady Score assigned to states by gun-control advocates. Volokh even provides the data so you can analyze it yourself. (Volokh explains why homicides and not “gun deaths” is the important metric here.)
We can also see that this is quite plausible by simply eyeballing the data if we look at gun restrictions by state and homicide rates. Gun-control advocates like to point to southern states that have both permissive gun laws and high murder rates, such as Alabama and Mississippi. But, even a cursory analysis beyond this cherry-picking shows that there are numerous states with permissive gun laws (such as Utah, Wyoming, Kansas, and others) where the murder rate is very low. And states with more restrictive laws, such as Illinois, New York, and California have higher murder rates than numerous states where it is easy to buy a gun.
So, while gun-control advocates press for “common-sense” restrictions, real common sense suggests that gun restrictions cannot explain the prevalence of murder in a state. This means that gun-control advocates are looking at the wrong social statistics to explain the violence.
Reasons Why They Want to Ban Guns and Not AlcoholBut none of this matters when gun violence is being exploited to drive for more state power and more regulation of private citizens. Many gun-control advocates really do believe that government regulation and management can solve every social ill. They ignore the realities behind failed experiments such as alcohol prohibition or the war on drugs, and instead move on to the latest sexy prohibitionist drive because they sense an opportunity to control one more aspect of daily life.
Most everyone accepts that prohibition creates unintended consequences that can be negative, and with alcohol prohibition, these consequences included organized crime and the criminalization of peaceful citizens. Gun-control advocates assert, however, that whatever the downsides of gun control may be, they are minimal compared to the many advantages.
As Murray Rothbard pointed out in For a New Liberty, whether or not you come face to face with those down sides can depend a lot on your wealth and influence within society. For example, white, middle class people who live in safe suburbs, have influence over local police forces, and can even resort to private security (including alarm systems) see little down side to gun control. After all, they have little reason to fear police or common criminals when they can exercise their well-established political influence at the local level or purchase a home security system with the expectation that police will arrive quickly in case of emergency.
Powerless minorities, on the other hand, face much larger downsides to gun control. For them, police are an unreliable deterrent to local crime, and are little use in cases of social unrest. Many may remember how police in Ferguson, Missouri protected government buildings, but left the rest of the town on its own during the riots there. Local citizens paid for police protection, but got none. And then, of course, there are countless cases of the “proper” authorities using their legal guns against powerless populations, with no resource left to them other than private firearms. Just one example would be the Texas Ranger rampages that followed the so-called Plan de San Diego when the Rangers swept through southern Texas lynching Mexican-Americans who were deemed traitors.
Consequently, some principled leftists, most of whom are radicals, do not subscribe to the dominant gun-control position of the left. But certainly the mainline left, dominated by university intellectuals, government employees, and politicos with nice houses in safe neighborhoods, see few problems associated with centralizing coercive power in the hands of “official” law enforcement.
The downsides of restricting alcohol, however, are plentiful for those who spend many hours at cocktail parties and send their children to booze-soaked elite universities to be paired up with a future spouse from the appropriate social class.
So, until this changes, we ought not expect much of a change in the double standard applied to alcohol and guns in terms of violence, health, and safety. The people who make the laws are quite happy having plenty of booze around. But they can afford to pay someone else to handle the guns for them.
This talk was delivered at the Dallas-Ft. Worth Mises Circle, “Against PC,” on October 3, 2015.
A sharp Martian visiting Earth would make two observations about the United States — one true, the other only superficially so. On the basis of its ceaseless exercises in self-congratulation, the US appears to him to be a place where free thought is encouraged, and in which man makes war against all the fetters on his mind that reactionary forces had once placed there. That is the superficial truth.
The real truth, which our Martian would discover after watching how Americans actually behave, is that the range of opinions that citizens may entertain is rather more narrow than it at first appears. There are, he will soon discover, certain ideas and positions all Americans are supposed to believe in and salute. Near the top of the list is equality, an idea for which we are never given a precise definition, but to which everyone is expected to genuflect.
A libertarian is perfectly at peace with the universal phenomenon of human difference. He does not wish it away, he does not shake his fist at it, he does not pretend not to notice it. It affords him another opportunity to marvel at a miracle of the market: its ability to incorporate just about anyone into the division of labor.
Indeed the division of labor is based on human difference. Each of us finds that niche that suits our natural talents best, and by specializing in that particular thing we can most effectively serve our fellow man. Our fellow man, likewise, specializes in what he is best suited for, and we in turn benefit from the fruits of his specialized knowledge and skill.
And according to Ricardo’s law of comparative advantage, which Mises generalized into his law of association, even if one person is better than another at absolutely everything, the less able person can still flourish in a free market. For instance, even if the greatest, most successful entrepreneur you can think of is a better office cleaner than anyone else in town, and is likewise a better secretary than all the other secretaries in town, it would make no sense for him to clean his own office or type all of his own correspondence. His time is so much better spent in the market niche in which he excels that it would be preposterous for him to waste his time on these things. In fact, anyone looking to hire him as an office cleaner would have to pay him millions of dollars to compensate for drawing him away from the extremely remunerative work he would otherwise be doing. So even an average office cleaner is vastly more competitive in the office cleaning market than our fictional entrepreneur, since the average office cleaner can charge, say, $15 per hour instead of the $15,000 our entrepreneur, mindful of opportunity cost, would have to charge.
So there is a place for everyone in the market economy. And what’s more, since the market economy rewards those who are able to produce goods at affordable prices for a mass market, it is precisely the average person to whom captains of industry are all but forced to cater. This is an arrangement to celebrate, not deplore.
This is not how the egalitarians see it, of course, and here I turn to the work of that great anti-egalitarian, Murray N. Rothbard. Murray dealt with the subject of equality in part in his great essay “Freedom, Inequality, Primitivism, and the Division of Labor,” but really took it head on in “Egalitarianism as a Revolt Against Nature,” which serves as the title chapter of his wonderful book. It is from Murray that my own comments today take their inspiration.
The current devotion to equality is not of ancient provenance, as Murray pointed out:
The current veneration of equality is, indeed, a very recent notion in the history of human thought. Among philosophers or prominent thinkers the idea scarcely existed before the mid-eighteenth century; if mentioned, it was only as the object of horror or ridicule. The profoundly anti-human and violently coercive nature of egalitarianism was made clear in the influential classical myth of Procrustes, who “forced passing travellers to lie down on a bed, and if they were too long for the bed he lopped off those parts of their bodies which protruded, while racking out the legs of the ones who were too short.”
What are we to understand by the word equality? The answer is, we don’t really know. Its proponents make precious little effort to disclose to us precisely what they have in mind. All we know is that we’d better believe it.
It is precisely this lack of clarity that makes the idea of equality so advantageous for the state. No one is entirely sure what the principle of equality commits him to. And keeping up with its ever-changing demands is more difficult still. What were two obviously different things yesterday can become precisely equal today, and you’d better believe they are equal if you don’t want your reputation destroyed and your career ruined.
This was the heart of the celebrated dispute between the neoconservative Harry Jaffa and the paleoconservative M.E. Bradford, carried out in the pages of Modern Age in the 1970s. Equality is a concept that cannot and will not be kept restrained or nailed down. Bradford tried in vain to make Jaffa understand that Equality with a capital E was a recipe for permanent revolution.
Now, do egalitarians mean we are committed to the proposition that anyone is potentially an astrophysicist, as long as he is raised in the proper environment? Maybe, maybe not. Some of them certainly do believe such a thing, though. In 1930, the Encyclopaedia of the Social Sciences claimed that “at birth human infants, regardless of their heredity, are as equal as Fords.” Ludwig von Mises, by contrast, held that “the fact that men are born unequal in regard to physical and mental capabilities cannot be argued away. Some surpass their fellow men in health and vigor, in brain and aptitudes, in energy and resolution and are therefore better fitted for the pursuit of earthly affairs than the rest of mankind.” Did Mises commit a hate crime there, by the standards of the egalitarians? Again, we don’t really know.
Then there’s “equality of opportunity,” but even this common conservative slogan is fraught with problems. The obvious retort is that in order to have true equality of opportunity, sweeping government intervention is necessary. For how can someone in a poor household with indifferent parents seriously be said to have “equality of opportunity” with the children of wealthy parents who are deeply engaged in their lives?
Then there is equality in a cultural sense, whereby everyone is expected to ratify everyone else’s personal choices. The cultural egalitarians don’t really mean that, of course: none of them demand that people who dislike Christians sit down and learn Scholastic theology in order to understand them better. And here we discover something important about the whole egalitarian program: it’s not really about equality. It’s about some people exercising power over others.
At the University of Tennessee this fall, the Office for Diversity and Inclusion explained that traditional English pronouns, being oppressive to people who do not identify with the gender they were “assigned at birth,” ought to be replaced with something new. The diversity office recommends, as replacements for she, her, hers, and he, him, his, the following: ze [pronounced zhee], hir [here], hirs [heres]; ze [zhee], zir [zhere], zirs [zheres]; and xe [zhee], xem [zhem], xyr [zhere]. When approaching people for the first time, students were told, we should say something like, “Nice to meet you. What pronouns should I use?”
When the whole world burst out laughing at this proposal, the university was at pains to assure everyone that these were just suggestions. Of course, what are not suggestions are the thoughts all right-thinking people are expected to have about moral questions that have been decided for us by our media and political classes.
Another aspect of equality that’s been in the news in recent years is, of course, income inequality. We are told how terrible it is that some people should have so much more than others, but rarely if ever are we told how much (if any) extra wealth the egalitarian society would allow the better-off to have, or the non-arbitrary basis on which such a judgment could be rendered.
John Rawls was possibly the most influential political philosopher of the twentieth century, and he advanced a famous defense of egalitarianism in his book A Theory of Justice that attempted to answer this question (among others). If I may summarize his argument in brief, he claimed that we would choose an egalitarian society if, as we contemplated the rules of society we’d want to live under, we had no idea what our own position in that society would be. If we didn’t know if we would be male or female, rich or poor, or talented or untalented, we would hedge our bets by advocating a society in which everyone was as equal as possible. That way, should we be unlucky and enter the world without talents, or a member of a despised minority, or saddled with any other disability, we could still be assured that of a comfortable if not luxurious existence.
Rawls was willing to allow some degree of inequality, but only if its effect was to help the poor. In other words, doctors could be allowed to earn more money than other people if that financial incentive made them more likely to become doctors in the first place. If incomes were equalized, people would be less likely to go to the trouble of becoming doctors, and the poor would be deprived of medical care. So inequality could be allowed, but only on egalitarian grounds, not because people have the right to acquire and enjoy property without fear of expropriation.
Since no one in his right mind accepts full-blown egalitarianism, Rawls was bound to run into trouble. That trouble came in the form of his attempts to deal with equality between countries. Even the most dedicated egalitarian living in the First World doesn’t seriously favor an equalization of wealth between countries. College professors who teach the moral superiority of egalitarianism during the day want their wine and cheese parties at night.
So Rawls came up with a strained and unpersuasive argument that although inequality between persons was outrageous and could be justified only on the basis of whether it helped the poorest, inequality between countries was quite all right. He then proceeded to give reasons that inequality between countries was quite all right, even though these were the exact reasons he had said inequality between individuals was unacceptable.
Even if egalitarianism could be defended philosophically, there is the small matter of implementing it in the real world. Just one reason the egalitarian dream cannot be realized involves what Robert Nozick called the Wilt Chamberlain problem; James Otteson has called something like it the “day two problem.” In Chamberlain’s heyday, everyone enjoyed watching him play basketball. People gladly paid to watch him play. But suppose we begin with an equal distribution of wealth, and then everyone rushes out to watch Chamberlain play basketball. Many thousands of people willingly hand over a portion of their money to Chamberlain, who now becomes much wealthier than everyone else.
In other words, the pattern of wealth distribution is disturbed as soon as anyone engages in any exchange at all. Are we to cancel the results of all these exchanges and return everyone’s money to the original owners? Is Chamberlain to be deprived of the money people freely chose to gave him in exchange for the entertainment he provided?
But the reason the state holds up equality as a moral ideal is precisely that it is unattainable. We may forever strive for it, but we can never reach it. What ideology could be better, from the state’s point of view? The state can portray itself as the indispensable agent of justice, while at the same time drawing ever more power and resources to itself — over education, employment, wealth redistribution, and practically any area of social life or the economy you can name — in the course of pursuing the unattainable egalitarian program. “Equality cannot be imagined outside of tyranny,” said Montalembert. It was, he said, “nothing but the canonization of envy, [and it] was never anything but a mask which could not become reality without the abolition of all merit and virtue.”
In the course of working toward equality, the state expands its power at the expense of other forms of human association, including the family itself. The family has always been the primary obstacle to the egalitarian program. The very fact that parents differ in their knowledge, skill levels, and devotion to their offspring means that children in no two households can ever be raised “equally.”
Robert Nisbet, the Columbia University sociologist, openly wondered if Rawls would be honest enough to admit that his system, if followed to its logical conclusion, had to lead to the abolition of the family. “I have always found treatment of the family to be an excellent indicator of the degree of zeal and authoritarianism, overt or latent, in a moral philosopher or political theorist,” Nisbet said. He identified two traditions of thought in Western history. One he traced from Plato to Rousseau, that identified the family as a wicked barrier to the realization of true virtue and justice. The other, which viewed the family as a central ingredient in both liberty and order, he followed from Aristotle through Burke and Tocqueville.
Rawls himself appeared to admit that the logic of his argument tended in the direction of the Plato/Rousseau strain of thought, though he ultimately — and unpersuasively — drew back. Here are Rawls’s own words:
It seems that when fair opportunity (as it has been defined) is satisfied, the family will lead to unequal chances between individuals. Is the family to be abolished then? Taken by itself and given a certain primacy, the idea of equal opportunity inclines in this direction. But within the context of the theory of justice as a whole there is much less urgency to take this course.
Nisbet took little comfort in Rawls’s pathetic assurances. Can Rawls, he wondered,
long neglect the family, given its demonstrable relation to inequality? Rousseau was bold and consistent where Rawls is diffident. If the young are to be brought up in the bosom of equality, “early accustomed to regard their own individuality only in its relation to the body of the State, to be aware, so to speak, of their own existence merely as part of that of the State,” then they must be saved from what Rousseau refers to as “the intelligence and prejudices of fathers.”
The obsession with equality, in short, undermines every indicator of health we might look for in a civilization. It involves a madness so complete that although it flirts with the destruction of the family, it never stops to consider whether this conclusion might mean the whole line of thought may have been deranged to begin with. It leads to the destruction of standards — scholarly, cultural, and behavioral. It is based on assertion rather than evidence, and it attempts to gain ground not through rational argument but by intimidating opponents into silence. There is nothing honorable or admirable about any aspect of the egalitarian program.
Murray noted that pointing out the lunacy of egalitarianism was a good start, but not nearly enough. We need to show that the so-called struggle for equality is in fact all about state power, not helping the downtrodden. He wrote:
To mount an effective response to the reigning egalitarianism of our age, therefore, it is necessary but scarcely sufficient to demonstrate the absurdity, the anti-scientific nature, the self-contradictory nature, of the egalitarian doctrine, as well as the disastrous consequences of the egalitarian program. All this is well and good. But it misses the essential nature of, as well as the most effective rebuttal to, the egalitarian program: to expose it as a mask for the drive to power of the now ruling left-liberal intellectual and media elites. Since these elites are also the hitherto unchallenged opinion-molding class in society, their rule cannot be dislodged until the oppressed public, instinctively but inchoately opposed to these elites, are shown the true nature of the increasingly hated forces who are ruling over them. To use the phrases of the New Left of the late 1960s, the ruling elite must be “demystified,” “delegitimated,” and “desanctified.” Nothing can advance their desanctification more than the public realization of the true nature of their egalitarian slogans.
The only Rothbardian word missing from that stirring conclusion is one of Murray’s favorites: “de-bamboozle.” It is that, above all, that needs to be done. The Mises Institute has accomplished many things over the years: advancing scholarship through our academic conferences and scholarly journals, educating students in the economics of the Austrian school, and reaching out to the public to give them a free education worth vastly more than what many people spend six figures for. But put it all together, and it amounts to perhaps the greatest de-bamboozling effort of all time. Once you understand the economics of the Austrian school and the philosophy of liberty in the tradition of Rothbard, you never look at anything — not the state, the media, the central bank, the political class, nothing — the same way again.
Help us carry on our great de-bamboozling mission, as we devise more and more programs and outreach to the public, and provide a new generation of brilliant young scholars with the tools they need to resist and defy a regime that would intimidate us into silence. Their way is violence, envy, and destruction. Ours is peace, liberty, and creation. With your help, we can tear down the state’s benign facade, which has bamboozled so many, and reveal for all to see that the only winner in the state’s crusades is the state itself.
Pope Francis made history this week when he became the first pontiff to speak before Congress. While his speech made headlines in calling for global action against the dubious problem of global warming, it became clear that Francis had not listened to the advice of Lew Rockwell or familiarized himself with the works of Tom Woods. In fact, Dr. Woods found himself attacked by Fortune magazine for his principled defense of free markets as a devout Catholic. The real question will be whether Tom’s arrival in Texas next weekend for the Dallas-Ft. Worth Mises Circle will cause fewer traffic problems than this week’s Papal visit.
Speaking of religious figures, the actions of Janet Yellen’s Federal Reserve were once again put under the microscope on a new episode of Mises Weekends. Bill Bonner of Agora Financial joined Jeff Deist to discuss what he previously called “the most anticipated move in central bank history.”
And in case you missed any of them, here are this week’s featured Mises Daily articles and some of our most popular articles at Mises Wire:
100 Years of Government's "Managed" Health Care by Dr. Michel AccadThe Economics of Hillary Clinton by William L. AndersonCollege Athletes Embrace the Division of Labor by Matthew DoarnbergerCentral Banks Don't Dictate Interest Rates by Frank ShostakYour Ideology Depends on if "Your Guy" Is in Power by Ryan McMakenDemocracy, De-Civilization, and Counterculture by Hans-Hermann HoppeVideo: Is Fed Credibility on the Line? by Ron Paul and Paul-Martin Foss
After months of assuring the world that the Federal Reserve would soon be ending its zero rate interest policy, the FOMC blinked on Thursday. Citing “[r]ecent global economic and financial developments,” the Federal Reserve decided to further postpone the inevitable pain that will come from taking away the financial punch bowl.
While the decision may have shocked few Fed followers, Jeff Deist, President of the Mises Institute, reminds us to not lose perspective of what the Fed’s decision really means for the world’s economy:
After so many years of the “new normal,” we have to be reminded just how extraordinary — and unprecedented — the Fed’s actions since 2008 have been. But does it not occur to bankers, much less the media breathlessly covering stock and bond markets, that these actions have set America on a hopelessly dangerous and unsustainable path? Or that placing so much economic power in the hands of a select few might not end well?
Appearing on Bloomberg TV shortly after the Fed’s announcement, Ron Paul also skewered the very notion of a world so dependent upon a central bank:
The whole idea that one person or twelve people might know what the interest rate should be is preposterous. ... There is never going to be a “right thing” to do because it is absolutely impossible for individuals to calculate the right answer. You can’t plan an entire economy by manipulating interest rates.
Our guest this week on Mises Weekends is Patrick Barron, a professor of economics and a student of global currency markets. Patrick and I dissect the Fed’s big announcement this past week not to raise interest rates, and consider whether Janet Yellen and other central bankers really believe in what they’re doing. Is it all just to save themselves from the judgment of history, by kicking the can down the road? Have they read, or even considered, Austrian arguments on money and banking? Or are they simply so wedded to Keynesian orthodoxy that they literally don’t know what else to do? And what type of precipitating events might spell the end of US dollar imperialism?
And in case you missed any of them, here are this week’s featured Mises Daily articles and some of our most popular articles at Mises Wire:
In Thrall to the Federal Reserve by Jeff DeistGovernments Give Migrants a Disastrous Mix of Social Welfare and Bureaucracy by Justin MurrayProgressive-Era Economics and the Legacy of Jim Crow by William L. AndersonThe Fallacy of "Buy Land — They’re Not Making Any More" by Peter St. OngeVote with Your Feet: Free States Are Happier and Richer by Gabriel OpenshawTime to Raise Interest Rates by Randall G. HolcombeQuo Vadis, Federal Reserve? by Paul-Martin Foss
It has recently come to the attention of the media that Auburn University reversed an initial decision to eliminate the public administration major from the school’s curriculum in 2013. This reversal came as the result of resistance from Auburn’s athletic department. Apparently, the public administration major is looked down upon by much of the school’s faculty. But its popularity among athletes, specifically Auburn’s football team, is what looks to have kept it afloat.
So just how popular is being a public administration major at Auburn? Well, if you’re an athlete, quite popular indeed. Although public administration accounts for less than 1 percent of the school’s undergraduate student body, 51 percent of students pursuing this major were Auburn athletes according to 2013 statistics. Among this group were the university’s starting quarterback, running back, leading wide receiver, and several starting defensive players. In 2014, 32 percent of the football team was majoring in public administration.
The reason for having a major like public administration at an elite Division One athletic program like Auburn is pretty transparent. The unchallenging nature of the course material usually makes it easier for student athletes who are looking to focus more energy on their sport. According to an internal athletic department memo from 2012, “If the public administration program is eliminated, the [graduation success rate] numbers for our student-athletes will likely decline.”
Some will predictably criticize Auburn (and other similar big conference schools) for continuing to have these kinds of majors. But let’s stop and think about what harm is really being done by this. Are there any real victims in this whole ordeal?
Someone able to play football at Auburn, undoubtedly a great college football program, is clearly among the elite young football players in the country. Odds are, someone good enough to compete on this level is probably better at football than they are at anything else. So if this is the case, shouldn’t someone gifted in this way be able to focus as much energy as possible on the thing that they are best at? If choosing to major in public administration enables these elite football players to spend more time and effort improving their football abilities, then having this major as an option should be seen as a positive rather than a blemish on Auburn’s academics.
Without the public administration option, some of the school’s football players would be forced to choose more challenging majors. This would lead to less available time for training, practice, weightlifting and all of the other things that can improve the skills of a football player. Thus, the talent of the players and the overall football program at Auburn could suffer. Considering the amount of money Auburn brings in through the success of their football team, this kind of potential decline would indeed be problematic.
Individual players on Auburn’s football team no longer able to major in something like public administration would face more significant roadblocks en route to becoming highly paid professionals. College is supposed to be an institution which prepares someone for a professional career where they can make a living. Taking elite college football players away from improving their talents so that they might become professional football players runs counter to what college is supposed to be about. Especially since the salary of a rookie professional athlete far exceeds virtually any other salary someone could obtain immediately after college.
While it’s certainly true that not all of Auburn’s players will reach the NFL, going to college in general is no guarantee of employment in a field requiring a college degree. According to a careerbuilder.com survey, half of recent college graduates are working in jobs not requiring those degrees. And since less than 1 percent of Auburn’s students major in public administration (as previously mentioned), it’s not as if a significant portion of undergraduates are being duped into choosing an easy major that teaches them very few skills. Students at the school more or less know what public administration is there for and know enough to avoid majoring in it.
In an ideal world, amateur athletics for all sports would take place independently from colleges and universities. Young aspiring pros would advance through levels just below the professional level which would most likely be controlled by professional teams. This would look very similar to what the minor leagues are to Major League Baseball.
But of course, we don’t live in an ideal world. The NCAA would never let something encroach on its control over athletes prior to becoming professionals. So if easy classes and sham majors are the price we pay for the ability of elite athletes to specialize in what they do best, then so be it. Not only do the athletes benefit, but the university gets to make more money and the students get to watch a more talented football team. Sounds like a win all around.
“Buy land — they’re not making any more!” is an old investing chestnut, and a common sense one to boot. Economically, it’s also completely false.
As counterintuitive as it may seem, we make land all the time. It just doesn’t look like land.
Why? Because land’s value doesn’t come from its ability to cover up the naked earth. Land’s value comes from its economic usefulness. From the value of things that can be done using that land (Rothbard’s “marginal revenue product” of the land). And that value is, indeed, changing all the time. Economically, from a price perspective, then, we make land all the time.
Step back a moment and ask why land has value anyway. Why do people want land? Well, obviously, because you can put stuff there — including yourself — plus buildings, swimming pools, and factories.
Now, anybody who’s visited West Texas knows there is plenty of building space in the world. You could drive for hours and meet nobody. There’s lots of space for that factory of yours. But it’s not really space itself that makes land valuable. It’s location. As in, there’s only so much room in Manhattan. Or Central London.
Once again, though, it’s not the actual space that matters. It’s the access. Put a strip mall on Manhattan surrounded by crocodile-filled moats and snipers and it will have low value. The value is in access. So Manhattan is valuable because it’s easy to get to other parts of Manhattan. And it’s easy for other people to get to you. Customers, partners, and friends can all easily visit you if your apartment or office is in Manhattan, moatless and sniperless.
So if it’s the access that matters, are they making new access? Of course. They’re doing it all the time.
New highways, new exits, new streets, mass transit, pedestrian malls are being regularly constructed. These all effectively “make new land” because they offer access to existing space. They turn relatively “dead zones” into "useful zones," or new land.
What are some of the meta-trends on land as investment, then?
First: roads. This was a bigger value-driver a generation ago in the US, as new roads made the suburbs more accessible, helping to drain many cities even as US population grew. Outside the US (Mexico, Thailand, Russia), new roads are still a big deal, and even in the US, new highways can reshape values — draining old neighborhoods and building value in new ones. The decline of cities like Baltimore or Detroit are partly thanks to those beautiful roads that redistribute access to the suburbs.
Second: population. In the US “rust belt” of declining manufacturing, many regions have dropped in price simply because people are leaving. Detroit homes for $100 is emblematic, although of course there are also political reasons some cities are so cheap — in particular, taxes and crime.
And that brings us to politics. Real estate can be cheapened shockingly quickly by taxes and crime, and those traditional drivers have been joined in recent decades by environmental politics.
Environmentalists, by taking land off the market, effectively squeeze the remaining accessible locations. Driving up the price. Regions like Seattle or San Francisco are poster children of this environmental squeeze, with modest homes even in remote suburbs costing upward of a million dollars. On the other extreme, cities like Dallas or Houston have kept prices down despite exploding populations by allowing farmland to be converted to residential, commercial, or industrial use.
Beyond the access and political angles, land is also vulnerable to “network effects.” In other words, the neighbors matter. Gentrification or urban decay can be hard to predict. Even in a compact city with rising population like Washington, DC, it can be hard to predict where the middle class or rich want to colonize, and where they want to flee.
There are clues, of course — in large US cities, gays moving into a neighborhood, new coffee shops or art galleries are some leading indicators that property prices might swing up. But gentrification has it’s own mind; even in a booming city it might go into some other neighborhood. New York’s Harlem or Silicon Valley’s East Palo Alto are two very accessible locations with low prices because of perceptions of the neighbors.
So, while they’re not “making” land, they are constantly making things that affect land price. Access, regulations, changing neighbors. These are the kinds of factors that make land valuable, not it’s ability to cover the earth.
And so land comes back to earth, joining boring old commodities like wheat or copper. Just as vulnerable to changing supply and demand factors.
And if you are looking for something they’re not “making more of?” Well, gold does come close. Hence its appeal. They do mine new gold all the time, but the costs are high enough that gold is a very “inelastic” commodity. It comes close to “they’re not making more.”
Beyond that? Develop your ultimate resource: yourself.
With Labor Day upon us, newspapers across the US will be printing op-eds calling for a mandated “living wage” and higher wages in general. In many cases, advocates for a living wage argue for outright mandates on wages; that is, a minimum wage set as an arbitrary level determined by policymakers to be at a level that makes housing, food, and health care “affordable.”
Behind this effort is a philosophical claim that employers are morally obligated to pay “a living wage” to employees, so they can afford necessities (however ambiguously defined) on a single wage, working forty hours per week. This moral argument singles out employers as the morally responsible party in the living wage equation, even though the variables that determine a living wage go far beyond the wage earned.
For example, as I discussed here, the living wage is a function not simply of the wage, but of the cost of housing, food, health care, transportation, and a myriad of other factors. Where housing costs are low, for example, the living wage will be lower than it would be in a place where housing costs are high.
So, what matters is not the nominal wage paid by the employer, but the real wage as determined by the cost of everything that a wage is used to purchase.
Why Is Only the Employer Responsible?So, if it’s the real wage that matters, why is there a fixation on the nominal wage itself? After all, wages, in real terms, could be increased greatly by forcing down food costs and rents. So, why is there not a constant drum beat for grocers to lower their prices to make necessities affordable? Why are activists not picketing outside grocery stores for their high prices? Why are they not outside KB Homes headquarters for KB’s apparently inhumane efforts at selling homes at the highest prices that the market will bear? Why are people not picketing used car dealers for not lowering their prices to make transportation affordable for working families? And why are gas stations strangely exempted from protests over the high cost of gasoline? Certainly, all of these merchants are just as instrumental in determining real wages as any employer. Grocers, landlords, home sellers, and the owner of the corner gas station can put a huge dent in the family budget when they allow their “greed” to impel them to charge the highest prices they can get away with in the market place.
And yes, it’s true that plenty of activists regularly denounce landlords as “slumlords” or greedy capitalists for charging the highest rents the market will bear. And there are still plenty of activists who argue for price controls on rents and food. But they’re in a small minority nowadays. The vast majority of voters and policymakers recognize that government-dictated prices on food and housing lead to shortages. Setting a price ceiling on rents or home prices simply means that fewer housing units will be built, while setting a price ceiling on eggs, or milk or bread will simply mean that fewer of those staples will be brought to market.
Such assertions are barely even debated anymore, as can be seen in the near-extinction of new rent-control efforts in the political sphere. You won’t see many op-eds this Labor Day arguing for price controls on fruit, gasoline, and apartments. You won’t see any articles denouncing homeowners for selling their homes at the highest price they can get, when they really should be slashing prices to make homeownership more affordable for first-time homebuyers.
So, for whatever reason, homeowners, grocers, and others are exempt from the wrath of the activists for not keeping real wages low. The employers, on the other hand — those who pay the nominal wage — remain well within the sights of the activists since, for some arbitrary reason, the full moral obligation of providing a living wage falls on the employer.
Were food prices to go up by 10 percent in the neighborhood of Employer X, who is responsible? “Why, the employer, of course,” the living-wage activists will contend. After all, in their minds, it is only the employer who is morally obligated to bring up real wages to match or exceed an increase in the cost of living.
So while price controls on food, housing, and gasoline are generally recognized as a dead end, price controls on wages remain popular. The problem, of course, as explained here, here, here, and here, is that by setting the wage above the value offered by a low-skill worker, employers will simply elect to not hire low-skill workers.
A Low Wage Is Unacceptable, but a Zero Wage Is FineAnd this leads to the fact that when faced with high wages, employers will seek to replace employers with non-human replacements — such as these automated cashiers at McDonalds — or other labor-saving devices.
But this phenomenon is simply ignored by the living-wage advocates. Thus, the argument that employers are morally obligated to not pay low wages becomes strangely silent in the face of workers earning no wage at all.
Indeed, we see few attempts at passing laws mandating that employers hire human beings instead of machines. While it’s no doubt true that some neo-Luddites would love to see this happen, virtually no one argues that employers not be allowed to employ labor-saving devices. Certainly, anyone making such an argument is likely to be laughed out of the room since most everyone immediately recognizes that it would be absurd to pass laws mandating that a road builder, for example, hire people with shovels instead of using bulldozers and paving machines.
Meanwhile, successes by living-wage advocates in other industries — where automation is not as immediately practical — have only been driving up prices for consumer goods. Yes, living wages in food, energy, and housing sectors will squeeze profits and bring higher wages for those who luckily keep their jobs, but the mandates will also tend to raise prices for consumers. This in turn means that real wages in the overall economy have actually gone down, thanks to a rising cost of living.
All in all, it’s quite a bizarre strategy the living-wage advocates have settled on. It consists of raising the prices of consumer goods via increasing labor costs. Real wages then go down, and, at the same time, many workers lose their jobs to automation as capital is made relatively less expensive by a rising cost of labor. While the goal of raising the standard of living for workers and their families is laudable, it’s apparent that living wage advocates haven’t exactly thought things through.
Quarterly Journal of Austrian Economics 18, no. 2 (Summer 2015)Symposium: Is There A Missing Element in Economics?
ABSTRACT: John Mueller claims that Austrian economics does not have the tools to explain the economy. His major criticism against Neoclassical economics and its Austrian variant is that Austrian economics does not have an economic theory of the gift and does not treat persons as ends. Institutions like nonprofits, charities, churches, and especially families cannot be explained with the concepts that Austrians and Neoclassicals use: utility, production, and exchange. There is a missing element, which he calls the “final distribution.” I concede that Austrian literature neglects the gift and distributive economy, but argue that Ludwig von Mises gave us a concept—autistic exchange—from which a theory of the gift can be developed. I also discuss how that relates to the Austrian discussion of the catallactic and non-catallactic economy.
KEYWORDS: normative economics, positive economics, Austrian economics, history of thought, Ludwig von Mises, John D. Mueller, heterodox economics, autistic exchange, catallacticsJEL CLASSIFICATION: A13, B25, B53, D64
In this article by economist Jeffrey Sachs, pharmaceutical company Gilead is taken to task for selling its hepatitis C cure, Sofosbuvir (sold as Sovaldi), at a price of $84,000 per course of treatment. Sachs says that the actual production cost of Sofosbuvir is about $100.
Sachs says that Gilead is "bilking the taxpayer" by charging the government prices far above production costs — and government is probably paying for most of the Sofosbuvir drugs. Sachs further complains that people will die because of Gilead's refusal to cut the price to something more affordable.
Gilead, Sachs says, bought the patent rights to Sofosbuvir for $11 billion in 2011, and took the drug through the last stages of FDA approval, which came at the end of 2013. Gilead made $12.4 billion in 2014 from Sofosbuvir, and Sachs says that first quarter 2015 sales of the drug brought in revenues of $4.6 billion.
Sachs quite rightly points out that patents are relevant to the issue. But he says that patents are "an important tool to incentivize R&D" which have been "abused" by Gilead, and argues that "life and death" patent holders should be subject to price controls by the federal government. He goes on to say that patients who are "denied access" (i.e., can't afford the drug) should sue Gilead for reckless endangerment. And finally, Sachs suggests "public outrage and activism."
In an August 6 tweet replying to me and to a physician who had briefly engaged him on this issue, Sachs said, "No way to regard the current arrangements even crudely efficient or equitable. Killing people senselessly."
Sachs is being somewhat disingenuous in representing the production cost of Sofosbuvir as $100, and the markup as 800 times costs (as he did in an August 7 tweet). There are substantial fixed costs involved in R&D, trials and FDA approval, and the like. Any company incurring those costs expects to recover them by charging an above-marginal cost, and if trade secrets or other features of the market allow them to do so, they will. Sachs’s markup complaint applied elsewhere doesn't make sense — authors of mass market paperback novels (and maybe Sachs himself, the author of several popular books) would also have to be regarded as terrible price gougers because the marginal cost of printing a paperback book is a few cents, while the retail price is $6 to $10. Of course, writing the manuscript is an extremely costly part of the production process. Once that is done, reproduction can be relatively cheap. This is true of a great number of goods and services for which there is a high up-front cost.
Problems with PatentsThere are clearly some problems stemming from the intellectual property rules here. The government will prosecute any firm that competes with Gilead in the production of the particular chemical formula Gilead has acquired. Sachs is right, then, that IP is relevant here. But rather than see IP as part of the problem, he defends patents as basically beneficial and proposes using them as a way for a government to beat a company's prices down. In contrast to the widespread notion of most of the public and most policy commentators, it is not at all clear that patents are essential to drug innovation. Even where new drugs could be reverse-engineered and copied, innovation could still be rewarded in a world without patent laws. See, for example, this article by Nathan Nicolaisen. First-mover advantages may be important, as could the inevitable delays in ramping up generic drug production. Nicolaisen mentions a survey of R&D labs and company managers that indicated that they believed trade secrets to be more effective than patents in getting a return on an investment. For a more extensive treatment of a free-market view of IP, see Jacob Huebert's article here, and for an application to a similar issue involving a life-saving drug, see this article by Stephan Kinsella.
The FDA’s Role in Denying Access to Health CareSachs — at least in this article — ignores the role of the FDA in causing death and suffering by keeping drugs off the market. When Gilead bought the patent to Sofosbuvir, it was running the risk that the drug would not be approved, or that approval would be delayed so long that the opportunity cost of its initial $11 billion investment would become quite large. Uncertain but potentially large profits after approval may be quite reasonable, given the risk Gilead took on. The FDA itself injects a politicized uncertainty into the drug research, production, and marketing process, and therefore drives up costs.
These costs can appear as death and suffering as well as dollars. The American public tends to think of the FDA as a protector against dangerous side effects, as we saw with Thalidomide decades ago. But how many Americans have died because of lags in approval? A five-year delay in bringing the antibiotic Septra to the US market may have cost 80,000 lives. A lag in the approval of beta blockers may have cost 250,000 lives.Miller, Benjamin, and North, The Economics of Public Issues, 18th ed. (2014), pp. 6, 7. The FDA's ban on advertising aspirin as an effective preventer of first heart attacks may have caused the deaths of tens of thousands of Americans every year. But because it's easy to identify those harmed by side effects, and difficult to identify who might have been saved by earlier introduction of Septra to the marketplace, the FDA tends to be over-conservative in its regulatory process.
Some Regulation Begets More RegulationBut one of the most interesting features of Sachs's diatribe against Gilead is how well it tracks with Ludwig von Mises's explanation of the natural progression of socialism. In "Middle of the Road Policy Leads to Socialism," Mises points out that a government facing milk shortages from its price controls on milk may add to its initial intervention a second intervention controlling the prices of the factors of production used in milk production, and then — if the government still refuses to acknowledge the fundamental problems of intervention —a third intervention controlling the prices of still other resources. The price system shrinks and is gradually replaced with central planning.
Sachs sees problems with the prices of Gilead's new drug. And I do too — I don't think for a minute that the free-market price of Sofosbuvir would be $84,000 per course. But rather than attack the State's patent laws directly, as well as the costly FDA regulatory process and other interventions, Sachs wants price controls on life-saving drugs. This is a well-traveled path toward socialism, and it does not end well.
Dan Price, the CEO of Gravity Payments, took a $930,000 pay cut to raise the minimum salary of his employees to $70,000. The plan was announced in April 2015, and set to be completed over the course of three years. Both his employees (especially the ones with a larger pay increase) and proponents of income equality celebrated the move. It garnered considerable publicity and rippled through social media, with mostly positive but some negative reactions.
In the New York Times piece that reported on people’s initial reactions in April, they quoted Rush Limbaugh calling it “pure, unadulterated socialism,” and an economist from the American Enterprise Institute saying “A lot of people have the sense that this may work for this one firm, but it is nothing we should take general lessons from.” Another economist from the Stanford University Hoover Institution took a different stance and predicted, “This is going to be great for his business.”
As usual, most of the praise and uproar from the respective proponents and critics are either wrong or right for the wrong reasons (if there’s not already a name for this phenomenon, there should be). But we can say this even without the benefit of hindsight, which has shown that the CEO’s actions have had some negative consequences he did not anticipate.
The Strategy BackfiresThe New York Times published another piece about three and half months later, reporting turmoil and struggles for the Seattle-based firm, directly and indirectly related to the new pay structure.
Some clients of Gravity Payments left because they viewed the action as a political move or because they expected fee increases as a result. But the number of new clients has more than offset those that sought payment processing services elsewhere, meaning Gravity Payments had to hire more employees, which now come in at a minimum of $70,000 a head.
The firm’s real problems are internal, though. According to the New York Times article, “Two of Mr. Price’s most valued employees quit, spurred in part by their view that it was unfair to double the pay of some new hires while the longest-serving staff members got small or no raises.”
Also, Dan Price’s brother, Lucas Price, has sued over violations of his rights and benefits as minority shareholder of Gravity Payments. Lucas also accused Dan of having excessive CEO pay (beyond the stipulations of their contract), which was $1 million before Dan’s voluntary pay decrease. So one major reason for the charitable restructuring of pay may have been to get public opinion on Dan’s side — quite the ignoble scheme for a seemingly noble move.
How Does Economic Theory Tie In?It’s tempting to pull in arguments against minimum wage legislation for this case, but the ostensibly applicable claims from economic theory actually don’t apply here. Dan Price voluntarily increased his employees’ pay. All of his employees are still earning no more than their expected discounted marginal revenue product. It’s just that some of their “product” may be non-monetary or “psychic” for the CEO, in the form of a good feeling Mr. Price gets from charitable donations, or the reputation Mr. Price wants as a CEO. The benefit he would get by having public opinion on his side and against his brother in their dispute would also qualify as psychic profit.
Entrepreneurs hire laborers on the margin, meaning they make decisions about hiring an additional laborer based on what that additional laborer would be paid and how much that additional laborer would help produce output and therefore generate revenue from the sale of output. Because of this, a laborer’s discounted marginal revenue product is the maximum any entrepreneur is willing to pay for a given laborer (“discounted” because there is a time difference between the laborer’s pay and the sale of output).
The situation with Gravity Payments requires that we distinguish between factor payments and charitable gifts. Suppose Dan Price hires a laborer at $70,000/year, but the laborer only brings in $50,000/year of increased revenue for the firm. This means that, for Mr. Price, it’s worth $20,000 for that worker to have $20,000 more per year, whether it’s in the name of income equality, or a happy-workers-are-productive-workers philosophy, or just plain charity.
The situation is the same with any sort of charitable gift. If A donates $100 to B, it means A prefers that B have the $100 (and not A) to A having the $100 (and not B). Charity isn’t “socialism” (per Rush Limbaugh), it’s people doing what they want to do with their own money, i.e., capitalism.
This, then, is the extent of the economics of the situation. It starts and ends with the coordinated preferences and expectations of the entrepreneur and the workers. On the other hand, there’s much to be said about Mr. Price’s business strategy and the social, psychological, and organizational implications.
Fairness and Equal PayWorkers prefer to be treated fairly, which doesn’t necessarily mean they all want the same pay. Maisey McMaster, former financial planner for Gravity Payments argued against the move and ended up leaving her job because of it. In her words, “He gave raises to people who have the least skills and are the least equipped to do the job, and the ones who were taking on the most didn’t get much of a bump.”
Mr. Price also lost Grant Moran, a talented web developer, who felt like the new pay structure wasn’t fair: “Now the people who were just clocking in and out were making the same as me.” He also said, “It shackles high performers to less motivated team members.”
Many of the employees didn’t like their pay information being open to the public eye, especially with all of the politically motivated attention. Other employees stated they didn’t feel like they deserved their new higher pay. One even admitted, “I didn’t earn it.”
So it seems that even the workers of a progressive and trendy (it is Seattle-based, and many of its clients are a part of the ultra-hip Pike Place Market) firm don’t equate “fairness” with “equal pay” — in fact, it has spawned envy, guilt, and ill feelings for their boss and coworkers. But this isn’t some inexorable law of human behavior. We could easily imagine a situation where workers do demand equal pay and collectively bargain for such a result. The economics of this type of situation would be different than the one at Gravity Payments, though (see Man, Economy, and State, chap. 10).
Economic theory pertaining to minimum wage legislation, unions, or socialism can’t be applied here directly. We can, however, branch outside the scope of economics and take the social, psychological, and organizational implications of an entrepreneur’s voluntarily chosen minimum salary (like with Gravity Payments) and reasonably apply them to government-mandated minimum wage and equal pay schemes. Imagine millions of people thinking the same things as Maisey McMaster and Grant Moran, who felt unfairly treated with the new pay structure. Or even more people saying, “I don’t earn my wage.”
If these sorts of negative consequences arise from a voluntary equal pay scheme, I don’t think we could expect anything better from an involuntary one on a national level.
Hillary Clinton’s latest campaign salvo attacked “quarterly capitalism,” the supposedly irresponsible corporate focus on short-term results at the expense of long-term growth. She promised government fixes.
Short-Termism, Share Prices, and IncentivesIs there too much short-termism in business firms? To answer this, let’s look at participants’ incentives.
Shareholders own the present value of their pro-rata share of net earnings, not just present earnings. They do not want to hurt themselves by sacrificing good investments today which raise that expected present value. Owners often tarred as too selfish do not ignore those consequences. Critics also confuse short-term corporate results as the goal, when they are actually valuable indicators of the likely future course of net earnings. Just because good short-term results raise stock prices does not imply excessive short-termism.
Since share prices are both a primary metric for managerial success and basis for their rewards, and they reflect the present value of expected future net earnings, managers’ time horizons reflect shareholders’ time horizons, stretching far beyond immediate measures.
Bondholders, who want to be paid back, incorporate the future, where repayment risks lie, in their choices. Workers and suppliers are also sensitive to firms’ future prospects, and the prospect of those relationships being terminated if things start turning south forces consideration of the future in present choices.
Beyond misinterpreting share price responses to good short-term results as short-term bias, Clinton’s main proof of short-termism was that firms have increased stock buybacks, supposedly sacrificing worthwhile investments by returning funds to shareholders. She ignores that those funds will largely be invested elsewhere with better prospects. But she also ignores that the buyback binge reflects the Fed’s long-term artificial cheapening of borrowed money. When debt financing gets cheaper relative to equity financing, firms substitute toward debt. But a firm substituting debt financing for an equal amount of equity controls no fewer funds for future-oriented investments.
The Role of the Fed and Government InterventionConfusing business responses to artificial Fed interventions as business-caused only begins the list of government created biases toward short-termism. Constant proposals to raise corporate tax rates and worsen capital gains treatment in the future reduce the after-tax profitability of good investments. Regulatory mandates and impositions pile up, with far more put in the pipeline for the future, doing the same. Energy policy threatens huge increases in costs, reducing likely investment returns. And the list goes on.
That government regulators will put more emphasis on the future than the private sector is also contradicted by political incentives. Owners bear predictable future consequences in current share prices, but politicians’ incentives are far more short-sighted.
Government Is More Short-Term Oriented Than the Private SectorAn election loser will be out of office, and capture no appreciable benefit from efforts invested. So when an upcoming election is in doubt, everything goes on the auction block to buy short-term political advantage. And politicians’ incentives drive those facing the DC patronage machine. That is why so much “reform” meets Ambrose Bierce’s definition of “A thing that mostly satisfies reformers opposed to reformation.” The mere passage of bills in the political nick of time, even largely unread ones, can be declared victorious legacies, with harmful consequences never effectively brought to bear on decision-makers.
Not only is politics inherently more short-sighted than private ownership and voluntary contractual arrangements, there is a cornucopia of examples of government short-termism at the expense of the future, whose magnitude dwarfs anything they promise to reform.
Unwinding Social Security and Medicare’s 14-digit unfunded liabilities will punish future generations, caused by massive government overpromising to buy earlier elections. Other underfunded trust and pension funds threaten similar future atonement for earlier short-term “sins.” Expanding government debt similarly represents future punishment for short-term political payoffs. Foreign and military policy have similarly turned away from dealing with long-term issues. But serious long-run issues like immigration escape serious attention because “public servants” are afraid of short-run interest group punishment.
Political attacks on short-termism, and reforms to fix it, are beyond confused. They ignore financial market participants’ clear incentives to take future effects into account. They are clueless about what provides evidence of short-termism. They treat private sector responses to government impositions as private sector failures. They ignore far worse political incentives facing “reformers.” And they act as if the most egregious examples of short-termism in America, all government progeny, don’t exist.
There is little to Clinton’s criticism and alleged solutions beyond misunderstanding and misrepresentation. We should recognize, with Henry Hazlitt, that “today is already the tomorrow which the bad economist yesterday urged us to ignore,” and that expanding government’s power to do more of the same is not in Americans’ interests.
Taught by Professor Peter G. Klein, this course provides a systematic overview of Austrian microeconomics, starting with the basics of scarcity, choice, and value; then moving to exchange and demand; the determination of prices; factor markets and factor pricing (including labor); profit, loss, and the entrepreneur; the structure of production; and competition and monopoly.
Last week, former Secretary of Education and US Senator Lamar Alexander wrote in the Wall Street Journal that a college degree is both affordable and an excellent investment. He repeated the usual talking point about how a college degree increases lifetime earnings by a million dollars, “on average.” That part about averages is perhaps the most important part, since all college degrees are certainly not created equal. In fact, once we start to look at the details, we find that a degree may not be the great deal many higher-education boosters seem to think it is.
In my home state of Minnesota, for example, the cost of obtaining a four-year degree at the University of Minnesota for a resident of Minnesota, North Dakota, South Dakota, Manitoba, or Wisconsin is $100,720 (including room and board and miscellaneous fees). For private schools in Minnesota such as St. Olaf, however, the situation is even worse. A four-year degree at this institution will cost $210,920.
This cost compares to an average starting salary for 2014 college graduates of $48,707. However, like GDP numbers this number is misleading because it is an average of all individuals who obtained a four-year degree in any academic field. Regarding the average student loan debt of an individual who graduated in 2013, about 70 percent of these graduates left college with an average student loan debt of $28,400. This entails the average student starting to pay back these loans six months after graduation or upon leaving school without a degree. The reality of this situation is that assuming a student loan interest rate of 6.8 percent and a ten-year repayment period, the average student will be paying $326.83 every month for 120 months or a cumulative total re-payment of $39,219.28. Depending upon a student’s job, this amount can be a substantial monthly financial burden for the average graduate.
All Degrees Are Not of Equal ValueUnfortunately, there is no price incentive for students to choose degrees that are most likely to enable them to pay back loans quickly or easily. In other words, these federal student loans are subsidizing a lack of discrimination in students’ major choice. A person majoring in communications can access the same loans as a student majoring in engineering. Both of these students would also pay the same interest rate, which would not occur in a free market.
In an unhampered market, majors that have a higher probability of default should be required to pay a higher interest rate on money borrowed than majors with a lower probability of default. In summary, it is not just the federal government’s subsidization of student loans that is increasing the cost of college, but the fact that demand for low-paying and high-default majors is increasing, because loans for these majors are supplied at the same price as a major providing high salaries to its possessor with a low probability of default.
And which programs are the most likely to pay off for the student? The top five highest paying bachelor’s degrees include: petroleum engineering, actuarial mathematics, nuclear engineering, chemical engineering and electronics and communications engineering, while the top five lowest paying bachelor’s degrees are: animal science, social work, child development and psychology, theological and ministerial studies, and human development, family studies, and related services. Petroleum engineering has an average starting salary of $93,500 while animal science has an average starting salary of $32,700. This breaks down for a monthly salary for the petroleum engineer of $7,761.67 versus a person working in animal science with a monthly salary of $2,725. Based on the average monthly payment mentioned above, this would equate to a burden of 4.2 percent of monthly income (petroleum engineer) versus a burden of 12 percent of monthly income (animal science). This debt burden is exacerbated by the fact that it is now nearly impossible to have student loan debts wiped away even if one declares bankruptcy.
Ignoring Careers That Don’t Require a DegreeMeanwhile, there are few government loan programs geared toward funding an education in the trades. And yet, for many prospective college students, the trades might be a much more lucrative option. Using the example of plumbing, the average plumber earns $53,820 per year with the employer paying the apprentice a wage and training.
Acknowledging the fact that this average salary is for master plumbers, it still equates to a $20,000 salary difference between it and someone with a four-year degree in animal science while having no student loans as a bonus. Outside of earning a four-year degree in science, technology, engineering, math or, accounting with an average starting salary of $53,300, nursing with an average starting salary of $53,624, or as a family practice doctor on the lower end of physician pay of $161,000, society might be better served if parents and educators would stop using the canard that a four-year degree is always worth the cost outside of a few majors mentioned above. Encouraging students to consider the trades and parents to give their children the money they would spend on a four-year college degree to put a down payment on a house might be a better use of finite economic resources. The alternative of forcing the proverbial square peg into a round hole will condemn another generation to student debt slavery forcing them to put off buying a home or getting married.
Loans Drive Overall DemandThe root of the problem is intervention by the federal government in providing student loans. Since 1965 when President Johnson signed the Higher Education Act tuition, room, and board has increased from $1,105 per year to $18,943 in 2014–2015. This is an increase of 1,714 percent in 50 years. In addition, the Higher Education Act of 1965 created loans which are made by private institutions yet guaranteed by the federal government and capped at 6.8 percent. In case of default on the loans, the federal government — that is, the taxpayers — pick up the tab in order for these lenders to recover 95 cents on every dollar lent. Loaning these funds at below market interest rates and with the federal government backing up these risky loans has led to massive malinvestment as the percentage of high-school graduates enrolled in some form of higher education has increased from 10 percent before World War II to 70 percent by the 1990s. Getting a four-year degree in nearly any academic field seemed to be the way in which to enter or remain in the middle class.
But just as with the housing bubble, keeping interest below market levels while increasing the money supply in terms of loans — while having the taxpayer on the hook for a majority of these same loans — leads to an avalanche of defaults and is a recipe for disaster.
In contrast to the expected shortage of tens of thousands of physicians, there appears to be an abundance of health care administrators. Economists and physician-activists at Physicians for a National Health Program (PNHP) have invoked the below graph and the administrative bloat it shows as reason to promote a single-payer system. With a single payer, they argue, complexity will be greatly reduced, the administrative burden wiped out, and costs brought under control:
For those who contend that administrative positions consist chiefly of make-work jobs soaking up a glut of workers otherwise destined to swell the ranks of the unemployed, this outcome could indeed be welcome. Unfortunately, if PNHP gets its wish, we may all discover that gluts and shortages are enhanced, not avoided, by the central planning process that would necessarily accompany the establishment of this program.
A Hayekian Perspective on Centralizing Health-Care KnowledgeReflecting on the way by which scarce resources are allocated, Friedrich Hayek argued that coordination of economic activity ultimately depends on localized and dispersed knowledge, knowledge that no single person or authority can ever claim to possess.
In his brief essay on “The use of knowledge in society,” Hayek wrote:
the shipper who earns his living from using otherwise empty or half-filled journeys of tramp-steamers, or the estate agent whose whole knowledge is one of temporary opportunities, or the arbitrageur who gains from local differences in commodity prices, are all performing eminently useful functions based on special knowledge of circumstances of the fleeting moment not known to others.
Only in a decentralized system of decision-making, where price fluctuations can adjust to the reality of needs and provisions, are major gluts and shortages avoided. In contrast, a centrally planned economy typically relies on quantitative models to forecast supply and demand and set prices, and such models either overlook the importance of local knowledge or cannot adequately take it into account:
If it is today so widely assumed that [experts] will be in a better position [to use knowledge], it is because one kind of knowledge, scientific knowledge, now occupies so prominent a place in public imagination that we tend to forget that it is not the only kind that is relevant.
... a little reflection will show that there is beyond question a body of very important but unorganized knowledge which cannot be called scientific in the sense of knowledge of general rules: the knowledge of the particular circumstances of time and place. (emphasis mine)
Of all economic sectors, health care should clearly rank among those most dependent on local knowledge. After all, how to best treat a patient is decidedly circumscribed in the here and now. Yet, lured by the idea that medicine is a scientific enterprise, we persevere in our attempt to manage health care with the same methods that would fail to optimize the construction and distribution of even a simple pencil.
Codes and Data are Not KnowledgeIt is particularly noteworthy that the PNHP graph depicts the administrative workforce as shooting up in the early 1990s, for it is around that time that payment for medical services would become highly dependent on a byzantine scheme of codification, invented precisely to convey to central authorities in charge of health insurance crucial information about what is taking place in the privacy of medical offices, within the confines of operating rooms, or at hospital bedsides.
In 1992, with the passage of the Medicare Fee Schedule, use of this coding system became mandatory. From then on, clinical care would be spoken in the lingua franca of CPT, ICD, and E/M codes, and the term “documentation” would take on a bitter significance for doctors.
But translating the what, how, and why of local medicine into cryptic ciphers for remote bureaucrats does not make the business of health care any more intelligible to the central planner, regardless of whether the codes are transmitted by an archaic fax machine or digitized and made immediately accessible by means of mandatory electronic health records systems.
Codes and data, of course, are not knowledge. Hayek’s shipper engaging in tramp trade can make a judgment about the significance of empty spots on a boat because the context associated with that information elicits meaning based on which he acts.
In contrast, a CPT code 99204-21 (new patient visit, E/M coding level 4, prolonged service) associated with ICD-9 code 786.50 (chest pain, unspecified) hardly conveys any real knowledge and cannot possibly be a basis on which relevant decisions can be made or value established. These codes cannot help determine the needed supply of doctors, nor that of drugs and other material necessities. The only tangible effect of the coding scheme, then, is simply to require a massive influx of administrators charged with “interpreting” and acting upon its obscure data signals.
And when price is divorced from value, shortages and gluts necessarily ensue. Although a single payer could conceivably reduce administrative burden and cut costs, its doing so will never be on the basis of “knowledge of the particular circumstances of time and place” that is at the heart of genuine medical care.
In the fourth and latest installment of the Jurassic Park franchise, a theme park containing cloned dinosaurs plays host to horrifying scenes as visitors are preyed upon by reptilian attractions that have eluded the confines of their cages.
The chaos begins after the introduction of a new, ahistorical dinosaur, the Indominus Rex, a chimera cooked up by the park’s scientists. This monster, the film makes clear, is the product of capitalism run amok: simple de-extinction no longer impresses the park’s guests; to keep drawing in paying visitors the dinosaurs must keep getting bigger and meaner — a trend which quickly proves unsustainable.
If we in the real world ever become capable of reincarnating dinosaurs, should we leave the technology in government hands for fear that the profit-driven would, just as in Jurassic World, create overly hazardous attractions?
How Private Dinosaur Parks Would Work: Balancing Conflicting ValuesPrivate owners assess an operation’s profitability by subtracting their opportunity cost (e.g., what they could earn by selling up and putting the money at interest) from its capital value. Importantly, the capital value is based on the sum of expected future profits. So no private dinosaur park could afford to be shortsighted in its strategizing: to maximize profits, it must strike a sustainable balance between conflicting elements (risk, “wow-factor,” cost). Far from resembling the inexorable outcome of a profit-and-loss system, then, Jurassic World is an exemplary illustration of what not to do if you are concerned by your bottom line.
Instead, private dinosaur parks would aim at two society-pleasing equilibria. The first equilibrium is the profit-maximizing balance between safety and wow-factor. Imagine a placid leaf eater behind an eight foot fence. If we were to substitute this herbivore for a more impressive carnivore, say, a T.Rex, we would quite obviously be doing so at the expense of some safety. Wow-factor and safety move in opposite directions, but consumers value both. Therefore the two must be balanced, an endeavor in which private dinosaur parks would be guided by profit-and-loss signals. They would increase wow-factor and drive down safety only so far as this increased the number of tickets sold, in the process achieving the “optimal” balance between wow-factor and safety (viz., that one which persuades the maximum number of people to voluntarily part with the entry fee).
The second equilibrium relates to balance between cost and safety. Factors of production (fencing, girders, armed guards) would be employed by the park until the marginal value of their contribution fell equal to the price at which they could be bought. The first unit of fencing would provide enormous value: it would allow a basic partition to be erected, without which the park could not hope to attract any visitors. Girders would reinforce the fence, and make escape very unlikely; the park could then foster a favorable reputation in the long term, thereby increasing its capital value/profitability. Additionally, the presence of armed guards would provide further assurance, and encourage still more paying customers to attend. However, beyond a point, additional security resources would provide such little value as to make them unprofitable to buy. They would of course still provide some value, but the price mechanism forces private actors to take heed of the bigger picture; other causes in the economy require these finite resources more urgently. The private dinosaur park, then, would strive to buy only as much security as could be justified by market data.
Get Government Off Our Brachiosaurs!Governments, on the other hand, don’t worry about profit — they get their revenue not by providing goods and services, but via taxation. And this is why, the argument goes, they should provide dinosaur-amusement-park services: they would not ratchet up risk for profit’s sake; they could run a thoroughly stolid park and never go out of business.
But, as we have already seen, the balance between wow-factor and safety struck by private dinosaur parks would be the one that pleases the maximum number of people. Therefore, if the government were to outlaw the private ones in favor of its own, less-impressive parks, it would override the peoples’ demonstrated preference in the process.
To be sure, no one wants to be eaten by a dinosaur, but that does not mean that no one wants to run the risk thereof. Many parallels exist in our daily lives, but to choose just one: nobody wishes to die in an airplane crash; and yet, people constantly get on airplanes — they accept the risk as a cost worth bearing. So, too, would some people accept the risk of being eaten if it came part and parcel with especially cool dinosaur parks. Unless we also accept bans on flying, driving, skydiving, swimming, eating fast food, etc., we should not in principle accept interference with individual choices regarding dinosaur-viewing.
On the issue of security: should no expense be spared? Impervious to profit and loss, the government dinosaur park could continue hoovering up security resources even after the marginal value no longer justified the price; the result would, of course, be a slightly safer park. However, only someone with a very myopic view could conclude this to be unambiguously good, for in the process of armoring their reptile attraction the government would unwittingly deprive other, more urgent causes in the economy of those same resources. As we have seen a private dinosaur park would instead equate marginal value with price, thereby unconsciously factoring conditions of supply and demand into its decision; it would take a more appropriate quantity of resources, given the relative importance of its end within the context of the wider economy.
Mistakes HappenWe have argued that the incentive to make profit would impel private dinosaur parks to balance safety, wow-factor, and cost in the optimal manner described above. So how, then, do we account for the Indominus Rex of Jurassic World? After all, this monstrosity was concocted by a profit-motivated, private dinosaur park; does this mean that it was in some way optimal?
It should be clear to anyone who watched the film that the Indominus Rex was a dinosaur too well endowed genetically: it presented a risk that was far greater than the majority of visitors would have tolerated ex ante. Therefore, Jurassic World’s operators made an “entrepreneurial error,” an attempt at profit-making gone awry. The balance between safety and wow-factor was ill-struck, and by no means profit-maximizing — Jurassic World will lose many, many prospective guests as a result of the Indominus Rex debacle.
Importantly, the Indominus Rex must not be held against the market per se; we should assess the market not on the basis of individual case studies but rather by the equilibria it inspires. Non-optimal outcomes do occur on the market’s watch, but in spite of (and not because of) its carrot-and-stick regime. The market institutionalizes optimal outcomes; without profit and loss, optimal outcomes could come about only by a fluke.
Business is often portrayed as being crude and cruel. According to the popular narrative — the Charles Dickens view of the world — businesses are filled with cold-hearted scrooges who value profits more than people. This is then contrasted with the kindness and altruism of charities, non-profits, and governments, which are all supposedly created to help people. Charity, in particular, is seen as ethically superior to business. After all, what could make a greater impact on the world than giving to the needy?
This view of the world is shortsighted. While it’s true that charity helps people, business makes a far greater contribution to humanity. Virtually all of the increases in society’s standard of living are because of simple commerce, and it’s the poor, in particular, who benefit the most. To understand why, we need to examine the different formulas that charities and businesses operate under.
Charities deal with distributing wealth — coordinating the transfer of some people’s “surplus” to other people’s “shortage.” Businesses, on the other hand, deal with creating wealth by selling goods and services people value.
Wealth Creation Comes FirstWithout this initial creation of wealth, charities would have nothing to distribute. In the developed world, it’s easy to forget that poverty is the default state of human existence. Wealth is not found in nature; it must be created, and this is precisely the role of businesses and entrepreneurs. They are the force which takes us out of the state of nature. All cases of poverty have the same solution — not wealth distribution, but wealth creation. This is not merely a theoretical argument. It’s witnessed everywhere around the globe.
The deeper we examine, the clearer it becomes. Consider the humble washing machine. We take it for granted in the developed world, but the washing machine has changed the lives of hundreds of millions of people. It’s no exaggeration to say its inventor has changed the course of history. How so? By dramatically reducing the amount of manual labor required to do laundry. Millions of people around the globe — women, in particular — are freed from spending countless hours washing clothing every week; their time can be spent elsewhere.
Let’s take a conservative estimate and say the washing machine saves five hours of labor per week. If a hundred million people own a machine, that’s five hundred million hours of work saved per week — a number so large it’s hard to wrap your mind around. That’s five hundred million hours which can be spent doing other things — getting educated, spending more time with family, earning larger incomes, volunteering at the local food bank, etc.
The impact of wealth creation and entrepreneurship is enormous, even though the engineer who designed the washing machine might have been selfish. His only motivation might have been to make money. Or, perhaps he kindly thought to himself, “I wish women didn’t have to spend so much time laboring over laundry.” Either way, the result was the same. The world has changed because of his invention. The businesses which sell washing machines, the engineers who design better ones, the steel workers who find cheaper ways to create the necessary raw materials — they all contribute to an exponential rise in people’s standard of living.
The Ripple Effects of EntrepreneurshipThe benefits of entrepreneurship are not only immediate; they create a butterfly effect. Consider the plight of children who are born into families with washing machines. They, too, benefit from their mother’s free time. They might now be able to get an education and become engineers and producers themselves. Who knows? Perhaps the invention of the washing machine was an essential step to curing cancer. After all, the children who will grow up to become doctors must have a high enough standard of living in order to attend school.
But the ripple effects don’t stop there. Consider the individuals who are saved by the doctor who cures cancer! They, and their families, will also benefit from the washing machine’s existence, and will be able to produce even more for the rest of society. In other words, wealth creation is exponential, and it literally changes the course of history. A greedy businessman might only care about himself, but his inventions and efficiencies end up benefitting society in an extraordinary way.
Contrast this with charity. Giving a washing machine to somebody will change his or her life, there’s no question. And it certainly creates a ripple effect of its own. But creating a washing machine — or selling, designing, or improving one — changes the world. Even supplying the raw materials to the factory changes the world. The workers in the ore mill, or the waitress supplying their afternoon lunches, are directly involved in the process which brings people out of poverty.
This does not diminish the role of charities; they serve a valuable function too. If you are like me — if you aren’t an entrepreneur or engineer — then charity is an essential way to help your fellow man. Not everybody has the skills necessary to create a new invention or become a successful businessman. But that doesn’t preclude them from making a positive difference in the world. However, we should be realistic: a donation of furniture to Goodwill does not create the same ripple effect as selling affordable food or power tools to everyone.
Many economic truths work this way. We’re quick to praise what’s easily seen — giving a hamburger to someone truly in need — but we overlook or even condemn what happens behind the scenes and all of the labor and cooperation necessary to make and distribute cheap hamburgers. The farmer, the butcher, the truck driver, the cook, the engineer, and the businessman should also be praised for their work. Without them, there would be no surplus food for the charity worker to give away.
The job-threatening rise of the machines is an economically illiterate meme that refuses to die. We’re actually probably in the early stages of it, a bull-market in neo-luddism, if you will. Bastiat’s “Candlemakers Petititon” answered this one long ago, but today I’ll run a little thought experiment that owes it all to good old Bastiat.
Let’s say Weird Al Yankovic invents a machine capable of making everything with a single push of a button. The first thing he does is print up a bunch of machines and sell them for a ton. Weird Al is now a billionaire, and there are thousands of make-everything machines.
This diffusion of Weird Al’s new technology replicates the market process, where new tech spreads in proportion to its usefulness. If you doubt this, because of patents, for example, check out Brazil’s experience with AIDS drugs, where they tore up the patents on humanitarian grounds.
Weird Al’s machines will, at a minimum, be mass produced in Brazil. Or China. Or Mozambique.
So, one way or another, we get a bunch of make-everything machines.
What happens to the jobs? We’re getting everything for near-free now. So all the production jobs disappear. There are still lots of jobs, of course — child-care, gardeners, musicians. But all the production jobs have vanished — something like 20 percent of jobs, maybe up to 50 percent when you include knock-on replacement of people by capital (truck drivers, robot bartenders). Heck, let’s go crazy and say 90 percent of the jobs vanished. Nobody’s got a job outside of preschool or performing on a stage. It’s the end of the world, right?
Well, the key here is that, now that everything is made with the push of a button, everything’s extremely cheap. For example, a sixteen-bedroom house or a Lamborghini costs almost nothing. Let’s say they now cost ten cents.
The main expense in such a world is probably surface space. To park all those dime-a-dozen cars. It’d take a while to “run out” of space, though — divide the world by the people and you get about twenty acres (eight hectares) for a family of four — about 100 large surburban yards. Add in the oceans — floating islands cost nothing, remember — and triple that. We end up with about 300 homes-worth of space per family.
What about those unemployed people? Well, when a house or a year’s food costs a dime, they’ll be willing to work really cheap. We’ll work for a penny a day. After all, that’s a new house or a years’ food every two weeks.
Who would hire these workers for a penny? Plenty of people. Heck, if workers cost a penny a day I’d hire several for each of my children. Just to keep the kids from getting bored. I’d hire another to cook, one to clean, one to run errands. One to keep track of my mail. One to check Facebook for me. At a penny a day I’d personally hire 100 people, easy. You would too — a buck a day’s nothing.
So the remaining 10 percent of workers who didn’t lose their jobs — babysitters, baristas, musicians — would want 100 workers each. Even at a penny, they’d take them all, and they’d be paying an outrageous rate — a tenth-house per day! That’s a daily rate of $15,000 in today’s terms.
Now, those who kept their jobs would, of course, see dropping wages. A barista who made $12 an hour in the old days would have to compete with the hordes of unemployed workers. Maybe her wage would drop to a penny, too. But, remember, a penny now buys $15,000 worth of stuff.
When the smoke clears, most people would make some extremely low wages — a penny a day. And that extremely low wage would be worth an awful lot — $15,000 a day. Implying an annual income north of several million dollars in today’s values. Some lucky few would make a dollar a day — probably the people who are good at things machines cannot do: entertainment, child-care, being a good listener, strumming the guitar at the old-folks’ home, and laughing at jokes. At a dollar a day, this super-rich elite that excels at human skills — such as making us laugh — would be billionaires in today’s values.
Either way, there would be nothing we think of even remotely as “poverty.” Sure, there’ll be inequality, but it’ll be of the sort “Sarah’s got 200 Lamborghinis and I’ve only got 40.”
The upshot is that wages plunge, but production costs plunge even more. Of course, this is based on the ridiculous Weird Al machine. Why do this? To illustrate the absolute worst-case scenario, when machines make everything for near-nothing.
What about going one step further, that the machine destroys all jobs in the whole world — it makes every single thing for us free, and it even keeps the folks entertained and the warm fuzzies flowing at the old folks’ home.
Well, we’ve already got a case study there — the sun. It gives us warmth and mangos for free. And how do we respond? We sit around and lazily enjoy it. So a machine that truly replaced all jobs would simply mean nobody works anymore — life’s somewhere between a non-stop party and a non-stop pleasant walk in the woods followed by a nice bonfire with friends and chardonnay.
We should all be so lucky that the machines do actually take every last job there is.
A comparison between CEOs and the average worker seems like a perfect manifestation of the old cliché, “the rich get richer and the poor get poorer.” During the recent financial crisis, stories were commonplace of CEOs paying themselves millions as they drove their firms into the ground. Not only that, we constantly read that CEOs are out-earning the average worker by a sickening amount — and that this gap is on the rise. And of course those reporting on these alleged trends do so to further a specific agenda: shameless greed and salary disparity.
One of the most common charges leveled against CEOs is that they out-earn the average worker 300:1. I’ve even seen a variation of this claiming a ratio of 500:1, but the more common figure cited is from the AFL-CIO, which claims a ratio of 331:1. Nowhere in the AFL-CIOs report is the disclosure that the CEOs in question are CEOs “of an S&P 500 Index company.” So, in fact, the sample is only of 500 CEOs, and those at some of the nation’s largest companies, while there are nearly 250,000 CEOs in the United States representing firms of varying size.
But read any news outlet and you get the same story. Look at Al Jazeera’s reporting, “In 2013 the average American CEO was paid 331 times what the average worker in the United States earned and 774 times what full-time minimum wage workers made, according to a new analysis released Tuesday by the AFL-CIO, the nation’s largest labor union.” The fact that this only reflects the pay of 500 CEOs not millions of Americans is clearly glossed over, as they even claim that this is representative of the “average CEO.”
Even the “experts” aren’t much better. Paul Krugman cites the same misleading statistic in his book The Conscience of a Liberal without clarification. Robert Reich, being at least half honest, uses the same stat for potentially millions to see in his documentary Inequality for All, but only clarifying who the stat represents — “big companies” — in his blog at UC Berkeley.
So we now know the greatest problem with the AFL-CIO statistic is that it is not representative of all CEOs, just those at the nation’s largest companies. The report does reveal an actual fact: there is a CEO to worker pay gap. The average CEO in the United States earned a salary of $178,400 in 2013, compared to $46,440 for the average worker (both figures exclude benefits). This is a radically different picture from the misrepresentation of the AFL-CIOs data report, which enthusiastically takes a group of outliers to draw conclusions from. The pay gap between the CEOs the AFL-CIO sampled and the average worker is a multiple of the gap between the actual average CEO and average worker.
In addition to pointing out the outrageous CEO salaries, many claim that CEO pay is on the rise. This maybe characterized as a “half-truth,” depending on how the claim is spun. When looking at CEO salaries at the nation’s largest companies, the gap in pay between CEOs and workers has increased. In the early 1980s, a gap of only 42:1 existed, compared to the gap of 300+:1 we see today.
For many, the rise in CEO pay relative to the average worker’s pay is a perfect illustration of the rise in inequality that Occupy brought to the nation’s conscience. And, we are told it should worry us if this disparity comes at the expense of the worker, as the CEO takes more and more for himself, leaving scraps for everyone else.
Luckily, this is not what happened. Something changed: the average size of a company on the S&P500. The companies comprising the S&P are ever changing, with larger companies replacing smaller ones. It would thus make sense that as the average market capitalization of companies comprising the S&P increases, the average CEO pay of those firms will increase. According to economists Xavier Gabaix and Augustin Landier in a study published by the National Bureau of Economic Research, “the six-fold increase in CEO pay between 1980 and 2003 can be fully attributed to the six-fold increase in market capitalization of large U.S. companies during that period.”
There are obvious exceptions to the rule, such as bailed-out firms paying their CEOs exorbitant salaries, or the seemingly oft-reported media stories on CEOs paying themselves handsomely as they run their firms into the ground, but they’re just that: exceptions.
Contrary to whatever narrative is implied by the “CEO pay is out of control” charge, this increase in pay has not been at the expense of the typical worker. Worker compensation (salary + benefits) as a percent of corporate income has been relatively stable since the 1940s.
In an almost daily debate over economic and monetary policy politicians complain if prices — such as home prices — do not rise, and some complain if they think other prices — such as health care prices — are going up too much. This situation begs the question: do we want rising prices or falling prices?
The truth is that prices are neutral, at least as far as social welfare is concerned. Constant changes in prices indicate that an economy is working to coordinate the wants and needs of consumers and entrepreneurs. They are the mechanism by which buyers communicate with sellers, and vice versa.
For this reason, before we can understand the role of prices, it is important to distinguish between “prices” and “offers,” even if in our daily dealings we tend to conflate both terms. A price is the ratio at which two commodities have been interchanged by two individuals in a concrete transaction. However, the “prices” we see in a supermarket for each of the available goods are not actually prices, but offers, and will only become prices if the good is actually bought. If the “price” for an apple is set at, say, 100 euros per apple, and consequently no one buys any apples, it would be wrong to say that the price of an apple is 100 euros, just because the supermarket tried to sell apples at such a price.
With this in mind, let’s try to answer the question: does social welfare improve, when prices increase or when prices decrease? If the price of a concrete good rises, it is clear that people who already own the good will be better off. Those people which have the means to produce it, be it labor or assets, will likely profit from the increase too. Conversely, people who do not own the good will be worse off, especially if they are planning to buy it in the short term. The contrary will of course happen if the price goes down.
So, what is the balance for society? There is no answer. In fact, from the point of view of “society,” the rise and fall of various prices are simply the marketplace at work. For concrete individuals in specific concrete transactions, there are costs and benefits, but in relation to “social welfare” or “the economy,” we can conclude nothing.
The Role of Prices in SocietyHowever, this is not the end of the story: prices have also a fundamental role to play in the market. They are the signals by which entrepreneurs guide their decisions on investment. As such, prices are an indicator of the relative scarcity of a good with respect to its uses.
If a price rises, this means that a good is more valued by society, and conveys the signal to entrepreneurs that more resources should be deployed to the production of that good, because this is what society is currently demanding. Conversely, if a price decreases, the good is losing value for society, and resources should be moved from its production to other more productive uses. This process, as explained, is not automatic, but driven by entrepreneurs using prices as signals.
When We Mess With PricesWhat happens if prices are tampered with through price controls or other coercive government controls? Of course, the first effect will be that some individuals will lose and others will win. For example, if prices are not allowed to increase, people owning the product — or the means of production — will lose wealth, while people intending to buy it will increase their own wealth. Politicians normally think that this is good for “the people,” because — in the minds of many populists — firms are “rich” and this action re-distributes wealth from “the rich” to other people.
This may be good for the individual consumer for a particular transaction; but individuals are much more than consumers: they may be shareholders of firms, or they may have a pension plan which is invested in the firm, or they may work for the affected enterprise or for any of their providers upstream in the value chain. So, in the end, it is not even easy to clarify if a concrete individual, much less society, is better or worse off as a result of the price control.
However, this is not the gravest effect of price tampering. The biggest problem is that disrupting the price system jams the price signal system, and thus entrepreneurs are hindered from calculating how they should devote resources to a particular enterprise. The entrepreneurial process will go on, but the resources will be taken to the wrong places, impoverishing the society with each investment.
One other thing should be considered: entrepreneurs, being human, may make mistakes. An entrepreneur may offer a good at too a high “price” and then find he is not able to sell enough units to make the investment worthwhile, being forced to bring the price down in order to increase the sales. This does not make the initial price wrong and the new price right: it just means that the entrepreneur is reacting to the new information acquired after the first attempt. If further information comes along, the price may be revised again, be it upward or downward. This is the essence of the entrepreneurial process, to react to changes in the environment trying always to adapt to the new preferences shown or anticipated by individuals.
To maximize this essential interplay between consumers and producers — through which consumers exercise their control over the marketplace and even society at large — the goal needs to be freedom in prices, and not “high” prices or “low” prices. Tampering with prices prevents them from doing what they’re supposed to do, making the process of resource allocation harder and more ineffective. And this would definitely harm all of us.
Image source: https://www.flickr.com/photos/civisi/2611679744
Some myths die hard. The myth of the gender wage gap is one that’s had particularly long legs. Right after winning an Academy Award, Patricia Arquette proclaimed that “It’s our time to have wage equality once and for all and equal rights for women in the United States of America” to thunderous applause. In her “11 Commandments of Progressivism,” Elizabeth Warren is so beside herself she writes “… I can’t believe I have to say this in 2014 — we believe in equal pay for equal work.” President Obama established an Equal Pay Task Force and one of his first acts was to pass the Lilly Ledbetter Fair Pay Act.
It’s all but taken for granted. Women make 77 cents on the dollar compared to what a man makes for the same work. I’ve been taught this since grade school. Indeed, it would seem to be that the only people who disagree with this are actual economists who study the issue.
As many have noted, a question quickly comes up when discussing wage discrepancies between two groups; if employers care so much about money (which progressives seem to be convinced of), why would they ever hire a man when they can hire a women to do the same thing for three quarters the cost?
Jobs Are Not Homogeneous But a second problem comes up after just briefly scratching the data; why isn’t this wage gap even remotely close to being consistent across industries? It’s not just models (who make 10 times as much as their male colleagues), but also a variety — albeit minority — of different fields. Forbes recently ran an article based on the Bureau of Labor Statistics titled “15 Jobs Where Women Earn More Than Men.” These jobs include bakers (104 percent), teacher assistants (105 percent), nutritionists (101 percent), and occupational therapists (102 percent). Do those hiring bakers just happen to be some of the few people in this country who aren’t sexist?
What about location? The Huffington Post ran a similar article based on census data titled “The 11 Cities Where Women Out-Earn Men By the Biggest Margin.” They include Atlanta (121 percent), New York (117 percent), and San Diego (115 percent).
And as Warren Farrell notes, the 2003 Census Bureau Current Population Survey showed that “When women and men work less than 40 hours a week, the women earn more than the men.”Warren Farrell, Why Men Earn More, Amacom. Copyright 2005, p. 79. 134 percent for between 25 to 34 hours and 107 percent for between 35 and 39 hours.
Add to this another interesting fact. A study by the American Association of University Women — a group that strongly believes in the wage gap — found that,
[o]verall, the regression analysis of earnings one year after graduation suggests that a 5 percent pay gap between women and men remains after accounting for all variables known to affect earnings.
Leave aside the fact that regression analyses cannot be taken as gospel. There’s simply no way to control for every variable (see here for a great discussion on this topic). Even so, 5 percent is a lot less than the supposed 23 percent wage gap. Why would employers discriminate more as women got older? So, the wage gap is not only inconsistent with employer’s best interests, it’s also inconsistent across industries, locations, hours worked, and ages. Yes, this doesn’t sound suspicious at all.
As I’ve discussed before, differences do not automatically equal discrimination. After all, Asian-Americans are paid more than Whites. And Japanese-Americans are paid more than Korean Americans. For crying out loud, lesbian women make more than straight women! One must dig a deeper before settling on discrimination as the end-all explanation.
Men and Women Often Have Different Career Goals And once you dig a little deeper, it becomes abundantly clear that men and women do not treat work or life in the same way. By either culture, biology or a mix of the two, men place a higher value on income. For example, a survey of men’s and women’s reasons for obtaining an MBA found that,
Men acquiring an MBA aspire to become President or CEO of both public and private companies. … Women MBAs, however, ranked management consulting, executive level vice-President positions and non-profit executive management high among their career goals. … Men expect to hold the top leadership positions and for women, it is still the exception.
This would also explain why men are more likely to seek after dangerous jobs with hazard pay. Thus, men make up 93 percent of workplace fatalities. Professor James Bennett found 20 differences between what men and women do in the workplace that influence income that aren’t found in the raw numbers — which is all the “77 cents on the dollar” takes into account. These reasons include,
Men go into technology and hard sciences more than women.Men tend to take more stressful jobs that are not "nine-to-five."Men are more likely to work longer hours, and the pay gap widens for every hour past 40 per week.Women are more likely to have "gaps" in their careers, primarily because of child rearing and child care. Less experience means lower pay. The reason women are more likely to have a gap in their career is what economist Walter Block coined as Marriage Asymmetry Hypothesis in a study criticizing the wage gap back in 1981. Namely, when a man and woman get married, what typically happens is the man will take on the lion’s share of making money and the woman will take on the lion’s share of raising the children (a fact that has been demonstrated time and time again).
Whether this is right or wrong is irrelevant to the discussion at hand. The only thing that matters here is if the wage gap is due to discrimination. And the major differences between men and women in workplace behavior — primarily as a result of marriage — cast a lot of doubt on the discrimination hypothesis.
As Denise Venable points out in her analysis of the wage gap, “in general, married women would prefer part-time work at a rate of 5 to 1 over married men.” (This is probably why part-time women earn more than part-time men.) Furthermore, women over twenty-five years of age have held their current job for an average of 4.4 years vs. five years for men and pay raises come with seniority.
In addition, expectations and future plans play a big role in these decisions. As economist Thomas Sowell observes,
Women tend not to go into occupations in which there’s a very high rate of obsolescence. If you’re a computer engineer and you take five years out to have a child and [raise him] until the age you can put him in daycare, well my gosh, the world has changed. You’d have to start way, way back. On the other hand, if you become a librarian, a teacher or other occupations like that, you can take your five years off and then come back pretty much where you left off.
Computer engineers generally make more money than librarians.
Never-Married Women Make More than Men Indeed, when comparing never-married women with never married-men, the wage gap doesn’t just disappear, it flips. As far back as 1971, never-married women in their thirties have earned slightly more than similar men.“The Economic Role of Women,” The Economic Report of the President, 1973. Washington D.C.: U.S. Government Printing Office, 1973, p. 103. In 1982, never-married women on the whole earned 91 percent of what men do.“Current Population Reports,” Series P-60, No. 132, Bureau of Labor Statistics, Washington D.C.: U.S. Government Printing Office, 1982, p. 161. Today, among men and women living along from the age twenty-one to thirty-five, there is no wage gap.Anita U. Hattiangadi and Amy M. Kahn, “Gender Differences in Pay,” Journal of Economic Perspective (Autumn 2000): 58. And among unmarried college-educated men and women between forty and sixty-four, men earn an average of $40,000 a year and women earn an average of $47,000 a year!Farrell, Why Men Earn More, pp. 16–17.
And when all of this is taken into account, the wage gap all but disappears, as many studies have found:
A study by the CONSAD Research Corp. for the US Department of Labor found that once they controlled for the variables, there was “an adjusted gender wage gap that is between 4.8 percent and 7.1 percent.”“An Analysis of Reasons for the Disparity in Wages Between Men and Women,” CONSAD Research Corp, January 12, 2009, p. 1.A study by June and Dave O’Neill for the National Bureau of Economic Research found that “… the gender gap largely stems from choices made by women and men concerning the amount of time and energy devoted to a career.”Warren Farrell conducted a thorough study reported in his book Why Men Earn More and found no evidence of a wage gap.A 1983 study by Walter E. Williams and the aforementioned 1981 study by Walter Block discredit the idea that the wage gap is caused by discrimination.Carrie Lukas notes that “In a 2010 study of single, childless urban workers between the ages of 22 and 30, the research firm Reach Advisors found that women earned an average of 8% more than their male counterparts.” Even PolitFact rated the claim that “women are paid 77 cents on the dollar for doing the same work as men” as “Mostly False.”
It’s certainly possible that the small remaining gap in the CONSAD report is because of discrimination, although it’s just as likely to be other variables that weren’t accounted for since no study can have perfect controls. For example, how does one control for motivation and personal work/life goals? Regardless, most of the gap has to do with choices. There’s nothing wrong with women’s choices; indeed, there may be something wrong with men’s as seeking a work-life balance is probably a wiser decision. Still, it is these decisions that are the primary reason for the wage gap, not discrimination. This stubborn fact might explain why, despite all of their protests, the White House paid women only 88 cents on the dollar compared to men and even Hillary Clinton herself only paid women on her staff 72 cents compared to men. Reality just doesn’t seem to care much about rhetoric.
Image source: iStockphoto
For the head of the Federal Reserve Board Janet Yellen — and most economists — the key to economic growth is a strengthening in the labor market. The strength of the labor market is the key behind the strength of the economy. Or so it is held. If this is the case then it is valid to conclude that changes in unemployment are an important causative factor of real economic growth.
This way of thinking is based on the view that a reduction in the number of unemployed persons means that more people can now afford to boost their expenditures. As a result, economic growth follows suit.
We Need More Wealth, Not Necessarily More EmploymentThe main driver of economic growth is an expanding pool of real wealth, gained through deferred consumption and increases in worker productivity. Fixing unemployment without addressing the issue of wealth is not going to lift economic growth as such.
It is the pool of real wealth that funds the enhancement and the expansion of the infrastructure, i.e., an expansion in capital goods per individual. An enhanced and expanded infrastructure permits an expansion in the production of the final goods and services required to maintain and promote individuals’ lives and well-being.
If unemployment were the key driving force of economic growth then it would have made a lot of sense to eradicate unemployment as soon as possible by generating all sorts of employment.
It is not important to have people employed as such, but to have them employed in wealth-generating activities. For instance, policy makers could follow the advice of Keynes and his followers and employ people in digging ditches, or various other government-sponsored activities. Note that the aim here is just to employ as many people as possible.
A simple commonsense analysis however quickly establishes that such a policy would amount to depletion in the pool of real wealth. Remember that every activity, whether productive or non-productive, must be funded. When the Fed or the federal government attempt to increase employment through various types of stimulus, this can result in the expansion of capital goods for non-wealth generating projects which leads to capital consumption instead of growth.
Hence employing individuals in various useless non-wealth generating activities simply leads to a transfer of real wealth from wealth generating activities and this undermines the real wealth-generating process.
Unemployment as such can be relatively easily fixed if the labor market were to be free of tampering by the government. In an unhampered labor market, any individual that wants to work will be able to find a job at a going wage for his particular skills.
Obviously if an individual demands a non-market related salary and is not prepared to move to other locations there is no guarantee that he will find a job.
For instance, if a market wage for John the baker is $80,000 per year, yet he insists on a salary of $500,000, obviously he is likely to be unemployed.
Over time, a free labor market makes sure that every individual earns in accordance to his contribution to the so-called overall “real pie.” Any deviation from the value of his true contribution sets in motion corrective competitive forces.
Purchasing Power Is KeyUltimately, what matters for the well-being of individuals is not that they are employed as such, but their purchasing power in terms of the goods and services that they earn.
It is not going to be of much help to individuals if what they are earning will not allow them to support their life and well-being.
Individuals’ purchasing power is conditional upon the economic infrastructure within which they operate. The better the infrastructure the more output an individual can generate.
A higher output means that a worker can now command higher wages in terms of purchasing power.
Image source: iStockphoto.
In public policy discussions, the words independence and dependence make frequent appearances. Given that American political ideology has in many ways been defined by the Declaration of Independence, Americans naturally think of independence as good and dependence as bad. As a consequence, arguments to implement government policies to reduce our dependence on others — dependence on “foreign oil” being the most common current manifestation — often find a receptive audience.
Unfortunately, our understanding of dependence and independence in political and economic contexts is confused.
Economic Dependence Is Limited by the Availability of Other ChoicesEconomic dependence is not the same as political dependence. Say that you wanted to buy widgets and sell them in your store. Assume that the best offer you received to supply the widgets was $3, and the next best offer was $5. The freedom to choose the lower-cost option is economic independence. Which ever supplier you choose, you become economically dependent on that supplier, in this case, the lower-cost supplier. Let's say the supplier of the $5 widget has a sterling reputation for delivering quality widgets, and on time. But you choose the supplier with the $3 widget, taking the risk that the supply of widgets won't be interrupted, the cost won't change, or he stops selling to you altogether. You become dependent on that seller’s choices (concerning his own business operations), and his continued willingness to sell to you at the original price. The potential harm or risk to you is the $2 difference between the best offer and the next best offer.
In other words, economic independence — the power to choose among offers — will typically coincide with you becoming dependent, to some degree, on the exchange partner you choose. In this case, you accept the risk that you could be harmed by changes to the original agreement (a willing offer).
It is important, however, to understand the limits on potential harm. When arrangements are voluntary, the availability of other willing offers places an upper limit on damages from dependence on a particular trading partner. In our example, if $3 widgets disappear, you can turn to the seller of $5 widgets. Thanks to economic independence, an alternative is available, and the harm has been limited to that $2 difference between the two types of widgets. To that extent, the potential “damage” is the extent to which the current gains you are getting from a partnership — relative to your alternatives — may be reduced or eliminated in the future. If one remains free to choose among competitors, however, the availability of voluntary arrangements with others (i.e., competitors) guarantees that there will be no “harm” beyond that.
Political Dependence Is Not About Choice, But CoercionDependence on government stands in sharp contrast to economic dependence. Since governments have the power to coerce you, they can take away options that others would willingly offer you. And not only can they take away the best options you have, they can also take away the alternatives that would protect you from harm in voluntary arrangements. That is, they can take away everything. As Barry Goldwater memorably put it, “A government big enough to give you everything you want is big enough to take everything you have.”
Dependence Is Fine, If VoluntarySo given that economic independence is perfectly consistent with voluntary dependence on trading partners who benefit us the most, the important choice is not between independence and dependence. The real choice we face is between the dependence that results from voluntary arrangement and the dependence that results from government control.
“Oil Independence” and Other FallaciesIt is also important to note that dependence arguments, such as “reducing our dependence on foreign oil,” are generally misleading excuses for imposing political restrictions that harm citizens. For example, protectionism that is sold as a choice between “good” American producers and “evil” foreigners ignores the fact that we deal with those foreigners because they make us better off than our domestic alternatives. And taking those superior options away can seriously harm Americans. A better way to view the results of this argument is as a conspiracy between American producers and the American government to harm American consumers and the foreign suppliers that most benefit them.
Finally, we must question the way dependence arguments are usually framed — as if it is never a problem to depend on other Americans, but always at least a potential problem to depend on foreigners. Do we really trust other Americans that much? If so, why do we have so many laws and prisons to deter our neighbors from harming us? The fact is, the best thing we can do to facilitate trust in our domestic neighbors is denying them the ability to coerce us. But that same defense of our self-ownership would equally allow us to trust non-American trading partners, as well. In contrast, the damaging power of government coercion that is repeatedly employed in the service of some, while necessarily harming others, puts us almost totally at our rulers’ mercy, while giving us very little reason to trust them.
Image source: iStockphoto.
Volume 17, No. 4 (Winter 2014)Eswar S. PrasadPrinceton: Princeton University Press, 2014, 432 pagesThe great mystery of international finance is how the U.S. dollar has managed to retain its dominance. This is a currency, after all, that has lost about 83 percent of its purchasing power since President Richard Nixon cut the dollar’s remaining link to gold in August 1971. More recently, in the wake of the 2008 financial crisis, the Federal Reserve has sought to resuscitate the American economy by directly endeavoring to generate an abundance of dollars through the policy of quantitative easing. All the while, the level of the country’s public debt has escalated above 100 percent of GDP, thus portending a continued outpouring of dollars from America’s central bank to pay what is owed, with all that entails in cheapening the currency.
Yet for all this, the greenback is still used in an overwhelming majority of transactions in the foreign exchange market. As of April 2013, its share of all trades stood at 87 percent, far greater than its closest counterpart, the Euro (Bank of International Settlements, 2014). When it comes to global trade in goods and services, the U.S. dollar was used to settle 81 percent of all transactions as of October 2013 (SWIFT, 2013). The latest figures for the first quarter of 2014 show the world’s central banks retaining their confidence in the greenback as a store of value, holding 61 percent of their foreign exchange reserves in U.S. dollars, not much different from where that proportion was back in 1996, and still well ahead of its peers (International Monetary Fund, 2014). Topping it all off is the fact that investors the world over remain eager to purchase securities denominated in American dollars, with Treasury bonds a particular favorite despite these carrying historically low yields.
So what is going on? Are we witnessing the financial equivalent of a seemingly well-structured and prosperous city moments before a massive earthquake exposes the rickety foundations of its buildings? Or is the resiliency of the greenback reflective of forces assuring its paramountcy going forward? These are the questions taken up by Eswar S. Prasad, the Tolani Senior Professor of Trade Policy at Cornell University, in his book The Dollar Trap. Prasad argues the thesis that a confluence of politico-economic trends and seminal events over the past several decades, including the 2008 financial crisis originating out of the U.S. housing sector, have cemented the American dollar’s reign over the global financial system. Though he acknowledges various threats to the greenback, Prasad does not think it will fall from its perch anytime soon. This will not be ideal, he concedes, but he does maintain that the continued supremacy of the U.S. dollar is the best we can expect under the present circumstances. It will be “suboptimal”, as he puts it, but at least it will be “stable and reinforcing” (p. 307). Prasad tells a fairly convincing story about the recent strengthening of the greenback’s position in global finance, but he is too accepting of the status quo.
First, some basic facts about the political economy of foreign exchange. Just as money exists to facilitate the trade of goods and services amongst individuals and firms, so foreign exchange exists to smooth that trade when it takes place between parties across national borders. For as each nation often has its own currency, and sellers typically desire to be ultimately paid in their national unit, a market will emerge to exchange the different monies of the world. Inevitably, purchases and sales between various countries will not balance; on aggregate, individuals and firms in certain nations will buy a greater value of goods with money than they sell, while those in other nations will sell a greater value of goods for money than they buy. From the economic point of view, this is not a problem, inasmuch as the imbalances merely reflect an accounting by which people have been artificially sorted into national groups. One could just as easily carve up the population within national frontiers, by say tallying the transactions of those who reside in Long Island against those in southern California, and find an array of surpluses and deficits. What matters is how each of us fares irrespective of where we happen to live. Clearly, everyone benefits from cross-border trade, for they would not have otherwise engaged in it.
Politically, however, the imbalances have posed a dilemma because of the adjustment in the currency that is required. Prior to World War I, when the major currencies were backed by gold, the adjustment was supposed to be made through a change in the quantity of money. Countries that imported more than they exported were supposed to enable outflows of gold, whereas those that exported more than they imported were enjoined to tolerate inflows. After World War I, the world progressively moved away from this regime, eventually reaching the point with the breakdown of Bretton Woods in the early 1970's in which the advanced nations have opted to rely on price as the adjustment mechanism. This has spawned a gargantuan mart of floating fiat monies, where currency values can fall for countries with deficits and rise for those running surpluses, following the script laid out by Milton Friedman (1962, pp. 56–74) for a flexible exchange rate regime.
That the architecture of global finance has evolved in this direction is a sign that it better suits the needs of politicians. Rather than stand by as the money supply fluctuates with the international activities of their citizens, policymakers would much prefer to have a free hand in influencing its quantity in order to swing the economy in their political favor—which is precisely what the current system gives them. But as the exertion of this control over quantity also impacts the prices of currencies, the present framework has had the baleful consequence of turning the movements of the US dollar, Euro, Japanese yen, Chinese renminbi and all the rest into a political battleground. Instead of furthering economic co-operation between the peoples of the world as it ought to do, the foreign exchange market has become a source of national discord.
Prasad nicely details this conflict. The chief protagonists are the U.S., the Euro zone, along with the developing world, principally the so-called BRICS nations, which include Brazil, Russia, India, China, and South Africa. Echoing all the discussion of late concerning the renminbi’s ascent in currency markets, China looms large in Prasad’s account, due to that country’s size, rapid economic growth, and geopolitical ambitions. As the leading player, the U.S. dollar attained its status in the 20th century, assuming it from the British pound that dominated in the 19th century, and consolidating it after World War II with the establishment of Bretton Woods. When this exchange rate system fell apart with Nixon’s 1971 decision to abandon gold, one might have expected the US dollar to lose its preeminence. That it instead gained influence Prasad explains by observing that everything is relative in international finance. Though the U.S. government effectively devalued its currency with respect to gold, what mattered for the dollar henceforth was how it stood compared to other fiat currencies in the eyes of investors, businesses, central banks, and governments.
On this score, the greenback has consistently trounced the rest of the field. According to Prasad, this is owing to the extent and depth of America’s financial markets, which offer a multitude of highly liquid alternatives to deploy any funds set aside for future uses. Prasad also believes it reflects the superiority of America’s political and legal institutions. For all the hue and cry about partisanship and gridlock in Washington, the U.S. democratic system, with its various checks and balances, gives assurance to holders of the country’s debt that a default is unlikely, whether done explicitly through non-payment or implicitly through higher inflation. Likewise, property rights and the sanctity of contracts are protected by America’s courts.
Reinforcing the dominance of the greenback are the policies of developing nations. As Prasad well observes, there are both insurance and neo-mercantilist motives at work here. Mindful of the balance of payment crises that befell Mexico, Thailand, Indonesia among others during the 1990s, developing nations have taken to bulking up their foreign exchange reserves. The greater these are, the more wherewithal governments have to defend their currencies, as well pay for imports and any maturing external debt, should foreigners suddenly decide to take flight with their capital. To perform this insurance function, however, foreign exchange reserves have to be invested into something safe and no instrument in the financial markets is thought to have a better guarantee of repayment than U.S. Treasury bonds. Bolstering this demand for American dollars is the penchant among developing nations of pursuing growth through export promotion, a neo-mercantilist strategy best executed with a low currency. However, any country that succeeds in exporting more than it imports will invariably come head on against the economic reality that surpluses push the currency upwards, everything else remaining equal. How governments deal with this is to intervene in the foreign exchange market by purchasing another currency using their own and then adding it to reserves. Again, the dollar is preferred for this purpose on the belief that it can be parked safely in U.S. Treasury bonds. China is exhibit A of this practice, as Prasad duly notes. By 2013, its central bank had amassed an eye-popping $3.8 trillion of foreign exchange reserves.
Prasad points out, too, that there exists a wider demand for safe assets. From pension funds, insurance companies, commercial banks to private investors with a low risk tolerance, the desire for securities bearing a guaranteed return of principal is always present in financial markets, making itself felt especially in periods of uncertainty and turbulence. As such, the demand for safe havens has risen since the recent financial crisis. At the same time, the economic carnage that ensued in the aftermath of that crisis has diminished the supply of safe assets. Over the past five years, bonds issued by numerous governments around the globe once thought to be secure have come to be seen as risky bets. U.S. Treasury bonds now compete with fewer debt securities for the title of sure thing, further strengthening the greenback’s position. Prasad recognizes the irony of the country that started the financial crisis being the one whose currency has gained the most prestige from it.
Any system that produces this kind of outcome is bound to be subject to grumbling. A long standing sore point, going back to the French government led by Charles de Gaulle in the 1960's, is that the dollar has an “exorbitant privilege” by which the Fed can simply issue currency to finance U.S. trade deficits instead of having to pay for imports with real goods. Both American consumers and governments can spend lavishly and rack up big debts because foreigners are willing to hold the country’s dollar denominated bonds. Developing nations, in turn, protest feeling the brunt of the Fed’s easy money ways. The added liquidity finds its way into their economies, boosting their currency to a level that renders their exports uncompetitive, while fomenting a transient boom that abruptly turns into a bust as soon as the Fed is compelled to tighten and the foreign money departs to safer locales. Understandably, developing countries have reacted by attempting to displace the dollar, with the BRICS nations going so far recently as to agree to pool their reserves. Even as the hegemon, the U.S. finds much to complain about, whether it involves shifting blame from the Fed’s monetary policy by admonishing developing nations to reform their economies or the regular allegations against countries (Japan twenty to thirty years ago and China nowadays) of harm to American companies from too low a currency.
This is a lot of tension for an international financial system to shoulder. What makes it all the more damaging is that capital ends up flowing in the wrong direction from the developing to the developed world. It is the Chinas and Indias of the world that have a greater need for capital in order to make their workers more productive; and it is there that holders of capital from places like the U.S. can obtain the highest return on their investments. Prasad’s only suggested fix is a global insurance scheme that would create a reserve fund which countries could tap into whenever they ran into balance of payments difficulties. Premiums would depend both on the size of the country’s economy and the quality of its economic policies. Prasad figures that such insurance would convince developing countries to stop bulking up their reserves. But lack of agreement among countries on what constitutes good policy is enough to make this proposal a non-starter. Will developing nations suddenly see the light and agree that the pursuit of neo-mercantilism deserves a higher premium?
Since even he concedes that the insurance scheme is unworkable, Prasad ends up defaulting to the current U.S. dollar standard. In part, he does so because he fears that its end would generate chaos in the financial markets and wreak havoc on the economy. A decisive consideration for him, though, is how the quest for safe assets plays a stabilizing role in global finance. Whenever a crisis affects any part of the system, the demand that arises for a safe haven in the U.S. dollar serves to buttress that system at its most critical structural point precisely when that is needed the most. Still, the greenback can only serve this function so long as it is perceived as a gateway to the safety of U.S. treasury bonds. How long will that perception last as the U.S. public debt continues its relentless climb amid an aging population driving entitlement spending inexorably higher? Prasad acknowledges this threat without ever adequately explaining why it does not vitiate his model of a self-equilibrating financial order. Aside from arguing that China would only harm itself were it to dump its large US Treasury bond portfolio, he just clings to the idea that all is relative in finance and that, therefore, investors have no safer option than the U.S. dollar.
What about gold? The most disappointing part of this book is that Prasad never seriously considers a return to the yellow metal as the basis of the international financial system. He does consider the possibility, but dismisses it with a nod to Barry Eichengreen’s (1995) contention that the gold standard worsened the Great Depression, as if a mere citation can resolve such a highly contested topic in economic history. Prasad’s main objection, however, is that there is not enough gold in existence for it to function as a reserve asset. Yet scarcity is hardly an obstacle, since that can be dealt with by allowing the price of gold to appreciate. As this review is being written, half of the entire American money supply, as defined by M2, could be backed up by U.S. current official holdings of gold at a price of $21,863 per ounce. The issue with reviving the gold standard is not so much about quantity as it is about political will. Prasad worries also about gold’s price volatility, even though Britain somehow managed to keep it at 4.25 pounds per ounce for 93 years up to 1914. We are not trapped into the U.S. dollar.
Our daily lives are determined by our choices as individual economic actors. When governments intervene in our personal economics, they intervene in our personal preferences and choices, writes Hunter Hastings.
This audio Mises Daily is narrated by Dianna Keiler.
Ludwig von Mises was careful to establish the individual actor as the basis for all economic analysis. An individual acts to improve his circumstances. To do so, he chooses among various available means in order to achieve his ends. Those ends are based on his individual values, which are subjectively established. Methodological individualism and dynamic subjectivism are distinctive features of Misesian Austrian economics.
The Importance of Economics Based on the IndividualInterventionists and Keynesians, on the other hand, use economic aggregates such as GDP and aggregate demand as their basis for analysis. By reducing economic activity to a matter of measuring aggregates, interventionists seek to justify the manipulation of those aggregates in order to establish policy goals, and to design interventionist policies that purportedly are intended to achieve those goals.
In order to manipulate such immense aggregates, Keynesians turn to powerful government institutions that, the Keynesian rationale goes, are necessary to manage such a huge economy. These institutions include not only government agencies and regulations, but also their favored partners including big banks (protected financial franchises benefiting from central bank policies and bailouts), big pharma (government-protected pharmaceutical monopolies), and big food (government-protected purveyors of government-approved diets).
This regulation and manipulation is supposedly done for the good of “the economy,” but in the face of so much government favoritism and management for the benefit of certain special interests, it is easy for individual economic actors to feel disempowered. And it’s not just a feeling. The more government intervenes to control markets, the less sovereignty the consumers have.
How Governments Destroy CompetitionAn example is the increasing domination of the major Wall Street banks in the US. Consumers and small businesses report in surveys that two-thirds of respondents consistently report dissatisfaction with big banks, and three-quarters say it is important to bank locally. Yet, the number of community banks has declined by 24 percent over 2000–2013, while big banks grew their share of deposits — the five biggest banks now hold 47 percent of deposits, and in some counties, as much as 75 percent of deposits. Their low consumer satisfaction scores are a result, at least in part, of higher prices. For example, Consumer Reports found that the ten largest banks charged a monthly fee of $10.27 for a non-interest checking account, compared to $7.45 at small banks and $6.00 at the ten biggest credit unions.
Professor Amat R. Admati of Stanford University stated in testimony to the Senate Banking Committee in July 2014 that Too-Big-To-Fail legislation provides an explicit subsidy to large banks in the form of a lower cost of capital, and bemoaned the “extreme opacity of large banking institutions” that grow “to inefficiently large sizes.”
Yet customers do not switch. Some of this can be explained by the convenience found in banking with a very large enterprise, but consumers also find it costly to switch to smaller banks in the face of market dominance facilitated by government protection.
Things would be different if big banks had to truly compete. In Liberty and Property Mises explained that the real power in the market lies with individual consumers who are making the choices that ultimately determine output and prices; he termed it “consumer sovereignty.” Murray Rothbard in Man, Economy, and State elevated the idea of individual economic power, emphasizing not only the right to choose, but also (and perhaps more tellingly) the right to refuse: “Economic power, then, is simply the right under freedom to refuse to make an exchange. Every man has this power. Every man has the same right to refuse to make a proffered exchange.”
To choose and refuse to make an exchange, i.e., to do business with any other economic entity, is the essence of individual economic power.
True Diversity in the MarketplaceTrue freedom in the marketplace can greatly shape a consumer’s entire lifestyle.
In their financial lives — if true market competition is allowed — individual economic actors can refuse to do business even with big Wall Street or global banks, and choose, instead, community banks or credit unions.
In their home lives, consumers can install solar panels or a home generator and disconnect from the regulated energy utility. This releases them from guaranteed price increases, often caused by the need for the utilities to support their excessive pension commitments, and the charges imposed by the forced redistribution of energy subsidies to low-income households.
Consumers can refuse to buy from the food companies that hide behind government food regulations and agricultural subsidies, and instead choose smaller, more local and healthier options. They can choose online education in the form of free MOOC’s (Massive Open Online Courses offered by top professors at many universities) or pay per course from online providers like Udemy, and refuse the offerings of pro-government biased content and tenured Keynesian professors. They can choose Uber and refuse the highly regulated local taxi monopoly, which is often typified by old, uncomfortable, and poorly maintained vehicles caused by the high cost of taxi regulations and lack of competition.
On the other hand, every government subsidy, every regulation, and every tax-code change that favors one group of businesses over another reduces consumer sovereignty. This interference results in monopolies and oligopolies which are typically the product of government intervention in markets.
Nevertheless, short of a total monopoly — such as those often enjoyed by the government itself in law and other areas — the individual economic actor does have freedom to refuse to do business with these government-favored industries.
A Partnership of Entrepreneurs and ConsumersFreedom of choice is best secured by allowing true freedom for both entrepreneurs and consumers.
Entrepreneurs “are at the helm and steer the ship,” Mises noted in Human Action. “But they are not free to shape its course. They are not supreme, they are steersmen only, bound to obey unconditionally the captain’s orders. The captain is the consumer.”
Not only is the exercise of individual economic power a choice, it is a powerful tool for directing change, one that we can wield with purpose. As Frank Fetter wrote in The Principles of Economics: “Every individual may organize a consumer's league, leaguing himself with the powers of righteousness. Every purchase has far-reaching consequences. You may spend your monthly allowance as an agent of iniquity or of truth.”
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True welfare and value can only be achieved through exchange when it is fully voluntary. When the state intervenes to "improve" trade, it destroys value, all the government stats notwithstanding, writes Patrick Barron.
This audio Mises Daily is narrated by Dianna Keiler.
Opponents of free markets sometimes describe market competition of dog-eat-dog, but that metaphor has nothing to do with markets and everything to do with politics and war, writes Gary Galles.
This audio Mises Daily is narrated by Dianna Keiler.
Cantillon defines wealth as the consumption goods produced by land and labor. This contrasted with the Mercantilists who thought money was wealth.
From Part 1: "Production, Distribution, and Consumption". Narrated by Millian Quinteros.
Derek Thompson of The Atlantic recently wrote about how the evolving music industry is now utilizing modern, mostly online technology to predict which bands and artists will emerge as the next breakthrough acts.
HitPredictor, a subsidiary of iHeartMedia, that Thompson notes is the largest owner of FM stations in the US, predicted forty-eight of the top fifty radio hits in 2013 by playing key sections of songs for online listeners and rating their responses. Other companies, including Shazam and The Next Big Sound, offer similar tools for industry forecasting.
Some are suggesting, however, that these new services are “discouraging good music” by leading investors toward what listeners are already known to like, and less toward new or obscure artists and styles. Music fans typically agree that the best artists have been those that were “ahead-of-their-time” original, such as Elvis, The Beatles, or Bob Dylan. The hesitation is that contemporary musicians of this caliber will be tragically overlooked. Admittedly, such artists before they explode do present greater risks for record companies and investors — but there’s the potential for greater rewards also.
The Consumers Are in ControlIn the end, the listeners are in control, so rather than view these innovations as detrimental to the state of music, it should be recognized that this is what people want, after all, as evidenced by their purchasing and streaming trends. People don’t want to waste their time scouring through music trying to find artists they enjoy; they want their favorite music brought straight to them, which is exactly what is being done.
In general, the market economy has done fascinating things for the industry over the decades — from the perspective of fans, artists, producers, and publishers alike — with the advent of amplification, recording, and mass distribution, as well as computer generated sound. Popular music has become less of a luxury for the rich and more than ever accessible to the common person. These new techniques should be seen as continuing the trend of giving listeners what they want, rather than as a negative happening.
Just this past year, YouTube-popularity launched the careers of the German band Milky Chance and also the Irish musician Hozier, both of whom are now booking major venues. Of course the most popular artist to gain massive exposure from YouTube — which then propelled him to the top of the charts — is Justin Beiber. Love him or hate him, evidently he’s giving millions of young people music they like.
Purevolume.com, which sparked the careers of the bands Gym Class Heroes and Panic! at the Disco — and some say even sparked a new musical genre altogether — is a further example of this phenomenon. Such platforms and opportunities as these were non-existent until the digital revolution when these cutting edge internet-markets emerged.
Another major advancement has been the dramatic increase in the availability of inexpensive, quality instruments. Of course the majority of people who play a musical instrument will never become famous from it, but they still enjoy playing and creating music independently as self-patrons, i.e., people who do music in their free time and pursue a different occupation to make a living. There are certainly more composers living right now than at any other time in human history — some of whom do make the leap from obscurity to a successful music career, who wouldn’t have even had the means to purchase an instrument centuries ago, let alone be able to get their music heard around the world within minutes of recording, if not writing it!
Peaceful Cooperation and Collaboration Are KeyCertainly these developments aren’t to be dismissed as harmful to music. As in all areas of human action, cooperation and collaboration are central to progress. No individual knows everything, and so the more feedback mechanisms they have to bounce ideas off, the better. The most famous example of this is The Beatles, who have twenty number-one singles on the Billboard Hot 100 chart, the most ever. For reference, The Fab 4 were around for a mere ten years, but still have more number-one singles than do all of their solo careers combined, over a much larger time span.
This principle is the same as it relates to the role of fans in the process of musical creation. Blues hits, and singles of other genres too, have been covered and redone time and again — not due to artistic genius or even design — but simply because fans like the originals and new interpretations. And the more direct control fans have to purchase music they prefer, the more artists and producers gain insight into the types of styles and melodies that people like, based on what is bought (or streamed). The market in this way promotes the composition of more and more popular — well-liked — better music.
Furthermore, there’s an organization called Bandcamp, a free microsite which allows artists to distribute their music online and gives fans the ability to make donations. The option is also there for the artists to charge, in which case Bandcamp takes 15 percent from sales. Kickstarter is similar, providing a platform for crowdfunding campaigns, where musicians can present their ideas to the public and people are free to donate money to assist with funding. Kickstarter only takes 5 percent and has received $1 billion in pledges from 5.7 million donors since 2009.
The Market Provides Resources for All Types of MusicYet for all the influence that markets have on the music industry, progress is not confined to what’s popular either: plenty of room is left over for the avant-garde. Sure, for most coffee shop folk singers and experimental indie groups, the money isn’t there; but if the mentality common to underground punk music is any indication, some artists don’t seek monetary profits for music and others even despise them.
The market is the “marketplace of ideas,” the setting in which culture is realized by different people voluntarily coming together and exchanging music, or anything else really. The market is responsible for creating abundant opportunities, resources, platforms of distribution for composers, and for giving fans music they like — thus the market ought to be seen as a boon to the development of musical culture generally. Not as a destructive force promoting “bad music.”
Benjamin M. Wiegold is a staunch libertarian and has been educating himself through The Mises Institute since 2011. He is also a self-taught musician and founding member of the Chicago band Pariah Folk. Check them outon facebook.
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The basic unit of all economic activity is the uncoerced, free exchange of one economic good for another. Moreover, the decision to engage in exchange is based upon the ordinally ranked subjective preferences of each party to the exchange. To achieve maximum satisfaction from the exchange, each party must have full ownership and control of the good that he wishes to exchange and may dispose of his property without interference from a third party, such as government.
The exchange will take place when each party values the good to be received more than the good that he gives up. The expected — but by no means guaranteed — result is a total higher satisfaction for both parties. Any subsequent satisfaction or dissatisfaction with the exchange must accrue completely to the parties involved. The expected higher satisfaction that one or each expects may not be dependent upon harming a third party in the process.
Third Parties Cannot Create Value by Forcing ExchangeSeveral observations can be deduced from the above explanation. It is not possible for a third party to direct this exchange in order to create a more satisfactory outcome. No third party has ownership of the goods to be exchanged; therefore, no third party can hold a legitimate subjective preference upon which to base an evaluation as to the higher satisfaction to be gained. Furthermore, the higher satisfaction of any exchange cannot be quantified in any cardinal way, for each party's subjective preference is ordinal only.
This rules out all utilitarian measurements of satisfaction upon which interventions may be based. Each exchange is an economic world unto itself. Compiling statistics of the number and dollar amounts of many exchanges is meaningless for other than historical purposes, both because the dollars involved are not representative of the preferences and satisfactions of others not involved in the exchange, and because the volume and dollar amounts of future exchanges are independent of past exchanges.
One Example: The Case of EthanolLet us examine a recent, typical exchange that violates our definition of a true exchange yet is justified by government interventionists today: subsidized, protected, and mandated use of ethanol.
The use of ethanol is coerced; i.e., the government requires its mixture into gasoline. Government does not own the ethanol, so it cannot possibly hold a valid subjective preference. The parties forced to buy ethanol actually receive some dissatisfaction. Had they desired to purchase ethanol, no mandate would have been required.
Because those engaging in the forced exchange did not desire the ethanol in the first place, including the dollar value of ethanol sales in statistics purporting to measure the societal value of goods exchanged in our economy is meaningless. Yet the government includes all mandated exchanges as a source of “value” in its own calculations.
This is just one egregious example of many such measurements that are included in our GDP statistics purporting to convince us that we have "never had it so good."
Another Example: The Soviet EconomyOur flawed view that governments can improve satisfaction caused us to misjudge the military threat of the Soviet Union for decades. Our CIA placed western dollar values on Soviet production data to arrive at the conclusion that its economy was growing faster than that of the US and would surpass US GDP at some point in the not too distant future. Except for very small exceptions, all economic production resources in the Soviet Union were owned by the state. This does not necessarily mean that it was possible for the state to hold valid subjective preferences, for those who occupied important offices in the state held them at the sufferance of what can only be described as gang lords, who themselves held office very tentatively.
State ownership is not real ownership. Those in positions of power with responsibility over resources hold their offices for a given period of time and have little or no ability to pass their office on to their heirs. Thus, the resources eventually succumb to the law of the tragedy of the commons and are plundered to extinction. Nevertheless the squandering of the Soviet Union's commonly held resources was tallied by our CIA as meeting legitimate demand.
Professor Yuri Maltsev saw first-hand the total destruction of the Soviet economy. In Requiem for Marx he gives a heartbreaking portrayal of the suffering of the Russian populace through state directed, irrational central planning that did not come close to meeting the people's legitimate needs, while our CIA continued to crank out bogus statistics of the supposed strength of the Soviet economy upon which the Reagan administration based its unprecedented peacetime military expansion.
Peaceful Exchange Allowed, Violent Exchange RedressedWith the proviso that no exchange may harm another, as explained so well in Dr. Thomas Patrick Burke's book No Harm: Ethical Principles for a Free Market, we are led to the conclusion that no outside agency can create greater economic satisfaction than can a free and uncoerced exchange. The statistics that support such interventions are meaningless, because they cannot reflect the satisfaction obtained from true ordinally held subjective preferences. Once this understanding is acknowledged and embraced, the consequences for the improvement of our total satisfaction are tremendous. Our economy can be unshackled from government directed economic exchanges and regulations.
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When people want to add extra “oomph” to negative depictions of self-owners acting without coercion — that is, market competition under capitalism — they turn to name-calling. One of the most effective forms is describing such competition as dog-eat-dog. When that characterization is accepted, the mountain of evidence in favor of voluntary social coordination can be dismissed on the grounds that it involves a vicious and ugly process so harmful to people that it outweighs any benefits.
Unfortunately, dog-eat-dog imagery for market competition is entirely misleading. It not only misrepresents market competition as having properties that are absent in truly free arrangements, but those properties are essential characteristics of government, the usual “solution” offered to the evils of dog-eat-dog competition. Further, it frames the issue in a way that precludes most people from recognizing why the analogy fails.
To begin with, dog-eat-dog is an odd way to characterize anything. I have never seen a dog eat another dog. I don’t know anyone who has. In fact, some trace the phrase’s origin back to the Latin, canis caninam not est, or “dog does not eat dog,” which says the opposite (and makes more sense, as an animal may try to protect its feeding grounds against competing predators, but it does not eat those competitors). It is nonsensical to rely on an analogy to something that doesn’t actually happen in animal behavior as a central premise toward condemning market systems as ruthless and hard-hearted.
Market Exchange Is Purely VoluntaryThe dog-eat-dog characterization of capitalist systems is the polar opposite of reality. The private property on which capitalism is based mandates solely voluntary arrangements. Since the weak do not voluntarily consent to aggression that violates their rights, it protects them against coercion based on superior ability to harm others. In Herbert Spencer’s words, it is “an insistence that the weak shall be guarded against the strong,” which stops dog-eat-dog predation, the default setting in the absence of respect for individual rights.
Further, when one sees coercion in the private sector, it represents the failure of government to deliver on the only conceivable means by which it could advance everyone’s welfare — uniting citizens in mutual defense of their property to provide all a more secure basis on which to build mutually beneficial arrangements. As John Locke put it, “the end of government” is “the preservation of property,” protecting all citizens’ rights against predation, including that imposed by government. When force or fraud is enabled, government has rented or sold out this end to the highest political bidder. However, the problem is not in mutually acceptable arrangements, but in government that enables piracy whose prevention is its sole defensible rationale.
“Dog-Eat-Dog” Describes the Non-Market Events Known as War and PoliticsDog-eat-dog can be descriptive of behavior during war, which can cause desperation-induced atrocities. But war is not a market failure. It is aggression by a government or governments against others. In the process, it also involves government aggression against its own citizens through higher taxes, implicit inflation “taxes” and government expropriation of resources and citizens, as with military drafts.
Dog-eat-dog language is also increasingly descriptive of politics. As Bruno Leoni noted, politics has increasingly become used “merely as a means of subjecting minorities in order to treat them as losers in the field,” as in war. In such a world, as Friedrich Hayek noted in The Road to Serfdom, the massive payoffs to political hegemony lead the worst rise to the top. Along the way, we observe continued escalation of what former President Clinton called “the politics of personal destruction,” in scorched-earth electoral marches to Washington.
All of the above abuses can be seen as dog-eat-dog in nature — humans predating on other humans. But they are that way because government made them so, not because they are in any way inherent in freely chosen arrangements.
Despite the dog-eat-dog analogy’s usefulness in describing government behavior, how has it bait-and-switched people into blaming freedom and free markets? By directing attention away from two essential ways that market competition differs from predators in the animal world. The animal kingdom’s competition is a zero-sum fight for fixed resources provided by nature. But that zero-sum fight occurs only because animals do not trade, and therefore do not produce for other animals. But people do produce for others, and all parties can then benefit via trade. That makes market competition an incredibly positive-sum “game” in which each benefits him- or herself by finding ways to benefit others, made necessary by the need to get mutual agreement. As George Reisman noted, the result is very different — “one man’s gain is positively other men’s gain.”
People Exchange Goods Because It Benefits ThemThese core insights are of fundamental importance. And without the distraction of dog-eat-dog and other similarly mischaracterizing language, people paying the slightest attention to economics would not miss them. After all, they are the focus of the second chapter in Adam Smith’s The Wealth of Nations, “On the Principle which gives occasion to the Division of Labor.”
Adam Smith there highlighted individuals’ “propensity to truck, barter and exchange,” as “common to all men, and to be found in no other race of animals.” And what was his illustration? “Nobody ever saw a dog make a fair and deliberate exchange … with another dog.” Other species do not make contracts, nor do they have a means of persuading others by offering or negotiating mutually beneficial voluntary arrangements. But for man, “the greater part of his occasional wants are supplied by … treaty, by barter, and by purchase,” which, in turn, “gives occasion to the division of labor,” and the massive expansion of output that makes massive expansions of consumption possible.
What Smith saw was that the fixed, nature-given resources that inform “dog-eat-dog” imagery are completely overridden by the human ability to create and exchange with others, and the consequent gains from specialization to produce more effectively for others than they can for themselves. And Smith is hardly the only economist to call attention to this. For instance, the textbook I used as an economics principles student — Alchian and Allen’s Exchange and Production — put those issues at the very core of economic analysis.
Dog-eat-dog imagery does offer some insight into understanding war, politics, and the failures of government, all because of their subversion of freedom. But it makes no sense to portray economic freedom, constrained to respect participants’ rights, as creating a desperate battle for survival, where “anything goes.” Such “I win, you lose” behavior traces back to given, limited resources, which is the constraint faced only in the absence of production and voluntary exchange. But that is not at all the case with capitalism, which has done more than any other social “discovery” to replace such behavior with win-win possibilities. As long as people’s ownership of themselves and their production is respected, that is, as long as arrangements are voluntary, production and exchange is the process by which all gain. And humans benefiting one another is a far cry from a dog-eat-dog world.
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A recent article in the left-leaning Independent argued that student volunteers are useless. In one project putting UK college students to work building a local school, the work was so awful that local Ugandan masons "dismantled the structurally unsound work [the students] had done — relaying bricks and resetting timbers whilst the students slept."
"Giving back" is big these days, but how can we know if we’re really making a contribution, or if we, like those students, are just tourists who need cleaning up after.
Economics, fortunately, gives us a very elegant answer: The best way to "give back" is to earn honest money and lots of it.
I teach in a business school. As horrifying as this might seem, one of the biggest debates among business academics is social responsibility. The terms of the debate are familiar: the lefties, who dominate even business-schools, want business to do charity as penance for their wicked money-making. Meanwhile, the "pro-business" view comes from Adam Smith: greed, for lack of a better word, is good. Because the Invisible Hand turns self-interest into social good.
Of course, we can go further: the money you earn isn’t just morally neutralized by the Invisible Hand. Rather, the money you earn actually indicates that you’ve contributed to the world. More money means more contribution. In Man, Economy and State, Rothbard points out that a voluntary price puts a floor on the value created. Higher price received means more value created for others.
If somebody is willing to pay Kobe Bryant $300,000 per game, that means Bryant creates at least $300k of value per game. Kobe may well be an excellent computer programmer or veterinarian, but $100k per hour is probably his highest contribution. He can sleep easy knowing that he "gives back" plenty simply by playing basketball on TV.
The logic is the same for us mortals: so long as your salary is honestly earned, chasing the highest pay is precisely how you make your highest contribution to society. By "honestly" here I mean obtained without coercion. So no force, no fraud. This means the mafia and government are, of course, out -— salaries paid for hijacking trucks, witness intimidation, or public schooling may simply reflect the ability of your employer to extort money from others.
Among “honest” livings, then, the data is clear on the best way to “give back” to society: learn math. Starting with petroleum engineering, paying $103,000 per year for a bachelor's degree, fourteen of the highest twenty starting salaries are engineering. After petroleum, top are chemical, nuclear, computer, and electrical. The rest are still math-heavy: actuarial mathematics, computer science, information systems, statistics, and everybody's favorite dismal science, economics.
Of course, not all of us are good at math. Perhaps your education was heavy on recycling milk cartons or learning union songs. So many cartons, so many songs just doesn’t leave time to develop the skills that actually help others.
Well, there's still hope: Khan Academy, Udacity, and Udemy have cheap or free math courses, nicely done and easy on the brain. Some parents have their kids on calculus at age 8 at Khan Academy, which is forbidden in public schools. And, of course, Mises Academy has economics; the Austrian flavor, which is much recommended over the store-brand.
Still, not everybody wants to learn math. And we all deserve the opportunity to give back. So the highest-paid non-math jobs are: nursing ($55k starting), construction management ($52k), finance (less math than it seems), and business (almost no math). Then, of course, there’s the biggie: entrepreneurship. Here you write the rules, so you earn as much as you’re willing to put in.
So that's the heroes. Let's take a moment for the selfish reactionaries. Those who are unwilling to give back. Who just want to sponge off the petroleum engineers and actuarial mathematicians of the world, contributing little to the world's problems.
No surprise here. The least-valued courses of study include: journalism, drama, music, anthropology, psychology, English. All pay so little that you're really not contributing much of anything. Now, it's not a crime to be selfish: a free society means you're free to read French deconstructionists or to make pretty collages. Instead of giving back to society by learning calculus or making pretty Gantt diagrams for R&D.
Still, it's sad that so many just don't have the social awareness to go out and learn to differentiate a function. Instead they sit around writing thesaurus-busting jeremiads about the world's unsolvable problems that they, themselves, won’t get off the couch to solve.
Of course, then there's the coercive professions: bureaucrats, prison guards, public teachers. Since their salaries are seized at gunpoint and distributed by government unions, we can’t actually know if they contribute anything at all. Perhaps they do, perhaps they don’t, putting us back at the Ugandan stonemason problem.
Bottom line for the student of any age: if you want to make a difference to society, first learn to differentiate a function. If you can't do that, at least look for something honest that earns a lot of money. Only then can you be sure you're really helping others.
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The unhampered market creates economic inequality. Free marketeers tend to concede this fact as an unfortunate defect in an otherwise laudable system. F.A. Hayek, however, in a chapter from The Constitution of Liberty, argued that inequality is fundamental to a society's progress. Hayek explained how, by purchasing luxuries unimaginable to the average man, the rich unwittingly perform a vital public service. Indeed so fundamental is inequality to economic progress that egalitarian societies, Hayek concluded, would be faced with no choice but to deliberately re-inflict upon themselves the very class systems they had sought to escape, should they wish to achieve well-directed economic advancement.
Leaders and FollowersThere never exists sufficient material resources to institute all technically feasible innovations at once: fantastic ideas are always in a surplus relative to our physical means. Hence, there is a need for choice between paths — not every new idea can be successful at revolutionizing the lives of consumers. But who decides which innovations are to be successful? The rich.
Those new goods that prove sufficiently popular in the marketplace will spread through the upper echelons of society; they will come in time to be strongly associated with the finer things in life. Though of course desirable on their own terms, it cannot be denied that their appeal is enhanced by this association. The rich are mannequins over which these new ways of life are seductively draped. And in observing this display of "better things," the poor come to see something concrete to which they might personally aspire; they envisage those same goods in their own homes.
The rich's consumption decisions have the effect of giving the future a specific and achievable form. The future is no longer an abstract concept: it is a tangible item that one expects for himself or his children to someday enjoy.
To be sure, the rich intend only to buy luxuries for themselves — they do not intend, when browsing new technologies, to inform the very direction of societal progress. Regardless, they find the poor attentive to their tracks, tracing their steps forth.
Hopefully, the role played by the rich is clear: it is they who provide the market on which new and expensive technologies might find success; it is their spending which is the lifeblood pioneers seek. Their choices are scrutinized by those behind and, like a contagion, the desire for their lifestyle spreads, prompting a frenzy of further, cost-cutting developments and innovations which eventually climaxes in provision for all. Ultimately, the consumption decisions of the rich set the path for those behind; they sculpt the horizon for which society is bound.
Why Is this Good?This piece began with the claim that, when the rich spend lavishly, they perform (albeit inadvertently) a vital public service. Admittedly, it remains unclear how exactly anyone could defend this claim. Why should we favor the state of affairs outlined above, whereby the consumption decisions of the rich guide our progress? One is required to imagine a counterfactual, characterized by perfect egalitarianism, before he may come to appreciate the important function served by inequality (i.e., by the rich) in society.
The Department of Research and DevelopmentClearly an egalitarian society, existing by definition without wealth disparities, could provide no market for expensive, nascent technologies. Hence, in such a society no consumers would nurture technological saplings. Without a high-end market on which to sell, innovators would find less incentive to innovate: they wouldn't earn a dime until the economy had advanced to a stage at which general provision of their new product was feasible. This wait might in some cases exceed the innovators' life spans. But could not the State plug this hole?
We will posit a Dept. of R&D, created to overcome this problem. They provide a State-funded forum for innovation. It is this Dept. of R&D, in the absence of a rich class, which is tasked with providing rewards to innovators. Innovators need wait no longer to be compensated for their brilliance. In this way, a role for the rich has been entirely omitted; goods need never be the preserve of any privileged few. The State keeps in its employment a host of innovators, whose products will be released from the labs only once general provision is feasible.
Here is the problem: who will decide which innovations are to be instituted first, second, and third, i.e., which ideas and designs should receive the bulk of the innovators' time? In unequal societies, this is determined by the rich. The rich's consumption decisions provide information as to the relative importance of new, expensive luxuries. And on reflection, it is clear that they are best equipped to make such judgments. The rich live in an advanced state: their present lifestyle anticipates that of the future. It is, therefore, the rich who are best able to predict what average men of the future will want, and hence it is also the rich who may best direct modern-day innovators, who, because of the long timeframe of their work, are engaged in anticipating today the preference scales of tomorrow.
As an extreme (and possibly tasteless) illustration of the foregoing, imagine an impoverished Zambian boy being asked to choose Christmas presents for his middle-class, American counterpart from a 2014 catalog. The Zambian might well understand that a copy of The Crew on PS4 would grant the American a fantastical virtual adventure; that Water Dancing Speakers would illuminate his room as he listened to music; and that a Remote Control Robot would entertain him as it "danced, spoke and fired disks." He would not, however, be well-placed to judge the ranking of the goods in the catalog on the American boy's preference scale. The Zambian lives in a far less-advanced material state, and hence finds it hard to think beyond those more basic things to which he presently aspires.
The people of an egalitarian society would similarly struggle in thinking beyond their current, more meager aspirations. In an unequal society a rich class exists ahead of the rest, with a view of the way forth; the desires that spring from their lives of luxury are a map for those at the helm of material progress. Without such a class of people, innovators would be without much indication as to the likely ordering of future preference scales, and as a result they would provide less effectively for future generations.
As mentioned in the introduction, the egalitarian society could overcome its problem only by destroying itself. It would be forced to create sectors of society that lived in more advanced states, so that innovators in the employment of the Dept. of R&D would have the ability to compile focus groups with which they could consult and by whose preference scales they could be guided. Hayek remarked that this "situation would then differ from that in a free society merely in the fact that the inequalities would be the result of design and that the selection of particular individuals or groups would be done by authority rather than by the impersonal process of the market and the accidents of birth and opportunity."
ConclusionIn an unequal society, even when innovative new products are still in their infancy and costly to manufacture, it is possible to subject them to a market test. The results of these tests may be used to direct innovators and entrepreneurs: they will abandon their efforts to further develop those goods that proved unpopular among the rich, focusing their resources instead in the refinement of those goods that proved popular. The rich's lavish spending, then, is a signal for innovators, providing direction as to how they might best focus their efforts — the rich's preferences, remember, act as a proxy for those of future average men. When there is no class of rich people, as in egalitarian societies, there is no longer anybody to channel the preferences of tomorrow. Innovators are left in this case to stumble without guidance. They will find no indication as to the popularity of their products with future men, and hence will be far more likely to find themselves engaged in worthless endeavors, to the detriment of themselves and society.
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As Charles Dickens himself admits, Ebenezer Scrooge is a thoroughly peaceful man, guilty of no true crime, who has robbed no one. Therefore, we must conclude that his wealth is a sign of his ability to please at least some people, and as Michael Levin notes: “Dickens doesn't mention Scrooge's satisfied customers, but there must have been plenty of them for Scrooge to have gotten so rich.”
But as he is a person with bad manners and a disagreeable personality, many have conflated Scrooge’s personality traits with his business practices, although the two are unrelated phenomena. As a miser and businessman, Scrooge provides numerous valuable services to the community including, as Walter Block has shown, driving down prices and making liquidity available to those who, unlike the wrongly maligned misers, have been either unwilling or unable to save in comparable amounts.
His business prowess notwithstanding, however, a closer look at Scrooge’s economics suggests some significant blind spots in several areas. Scrooge, as displayed in many of his comments and observations, misunderstands some key economics concepts. Indeed, Scrooge’s ignorance in these areas may contribute to his bad habit of assuming that others are taking advantage of him, or are too foolish or lazy to attain what Scrooge has.
Value is Subjective As Carl Menger demonstrated long ago, value is subjective and different persons value goods differently depending on the person’s goals in life. Does the person want to raise a family? Perhaps he wishes to be an independent scholar who devotes all his time to reading and research. Perhaps he wishes to be a hermit who prays most of the day. Money prices reflect these goals, and a hermit will value a video game console differently from a gamer. But of course not everything can be calculated in terms of money prices. A like or dislike of Christmas, for example, cannot be calculated this way.
Scrooge, who is apparently not a Christmas enthusiast, greatly values money, and likes to have plenty of it handy. But why? If we accept the analysis of Scrooge’s former fiancée, (a fairly reliable source on that period in his life) she suggests that Scrooge “fear[s] the world too much” and that all his other hopes “have merged into the hope of being beyond the chance of its sordid reproach.”
So here we see the real root of Scrooge’s fondness of money. In Human Action, Ludwig von Mises explained that human action stems from a desire to “remove unease” about one’s present situation. With Scrooge we see (if his fiancée is to be believed) that the thought of being destitute is a source of constant unease for him. Thus, he desires to build as much wealth as possible in the hope of being beyond the possibility of poverty.
As Scrooge’s primary goals is poverty avoidance, this colors how he views all economic action. His peers tend to not recognize this in him, either dismissing his as simply “odious,” as Mrs. Cratchit does, or as unhappy.
In fact, as Levin demonstrates, Scrooge appears rather content with his situation at this point, although, unfortunately — just as Scrooge’s colleagues and family members do not appreciate his ranking of values — Scrooge does not seem to appreciate that others might value money for different reasons.
This is demonstrated in an early exchange with Scrooge’s nephew. When wished a merry Christmas by his nephew Fred, Scrooge retorts "What right have you to be merry? What reason have you to be merry? You're poor enough."
To this Fred replies, "What right have you to be dismal? What reason have you to be morose? You're rich enough."
Fred is probably wrong about Scrooge being morose, and he also appears to not understand why Scrooge values money.
But at the same time, Scrooge also displays an ignorance of value subjectivity by suggesting that Fred’s ability to be merry is rendered impossible by his poverty.
(Now, in this case, “poverty” as used by Scrooge is a highly relative term. We know from the text that Fred enjoys a comfortable middle-class lifestyle in which he can afford a servant girl, plenty of lamplight, and a Christmas feast for his many friends. Moreover, Fred’s wife is, according to Scrooge’s own assessment, “exceedingly pretty.”)
In this same exchange, although Fred doesn’t understand how Scrooge could be happy, it is Fred who displays a better understanding of economic value when, in response to Scrooge’s declaration of Fred’s poverty, Fred declares “There are many things from which I might have derived good by which I have not profited.” By this, Fred means that he profits from many things which bring him no money profits.
Is Scrooge More Prudent? It is often supposed by both critics and defenders of Scrooge (and by Scrooge himself) that he is a more skilled businessman than most, and that he is more savvy, more intelligent, and more prudent in his management of his own affairs. Other people, Scrooge supposes, are more likely to be incautious and trust to fate for good fortune.
But there is ample evidence that the lack of material wealth enjoyed by others is not due to any lack of intelligence or prudence, but simply that they value things differently from Scrooge.
Scrooge’s ex-fiancée, for example, is no fool when it comes to money. In her final conversation with Scrooge, she notes that when she and Scrooge had agreed to marry, it was assumed that they would be poor in the beginning, but that “we could improve our worldly fortune by our patient industry.” In this, she is expressing what most young heads of household know — that in most circumstances, households build wealth slowly, since raising a family is costly. Her words hardly suggest a woman who plans to throw caution to the wind.
There is no denying that Scrooge is highly skilled at attaining what he values, (i.e., large amounts of material wealth in the form of cash and revenue-producing capital) but it does not follow that others do not possess these things because they are less intelligent or less industrious. Others simply value other things in life such as child rearing, Christmas celebrations, and consumption as well as the things that can be obtained by “patient industry.”
Scrooge is quick to assume that others are imprudent for marrying (he is dismayed by his nephew’s decision to marry for love) or doing other activities they find to be pleasurable when those same energies could be devoted to making money. But Scrooge is simply imposing his value systems on others, although in this, he is no more guilty than Dickens, Fred, and all the others who insist that Scrooge absolutely must celebrate Christmas.
Bob Cratchit: Victim or Wily Negotiator? In addition to lacking insight on the subjective nature of value, Scrooge also fails to understand the intricacies of voluntary exchange.
Much is made by Dickens of how Cratchit is the hapless victim of Scrooge’s miserliness, and in response, the contrarians note that if Cratchit were indeed underpaid, as Dickens implies, then Cratchit is free to find employment elsewhere.
This is no doubt true, all things being equal, but we also find that Scrooge himself, well before his change of heart at the end of the story, is open to re-negotiating the terms of Cratchit’s employment. Scrooge denies his openness to renegotiation in words, but shows it with his actions.
When Cratchit asks for a vacation day on Christmas day, Scrooge claims that this is akin to “picking a man’s pocket,” but ultimately, Cratchit negotiates for himself the day off, with nothing more than a tepid “be here all the earlier next morning,” from Scrooge. Scrooge was not compelled to give Cratchit the day off, so given Scrooge’s clearly demonstrated immunity to social pressures, it stands to reason that Scrooge concluded it was more profitable to give Cratchit the day off than face the possibility of losing Cratchit as his clerk. But even if he were susceptible to being shamed into giving the day off, he is nonetheless voluntarily doing so.
At this point, Scrooge shows that his claim of having his pocket picked is sheer nonsense since we plainly see that his demonstrated preference was to grant the day off. Scrooge cannot now claim that he was somehow robbed. If he felt he was being robbed, he could have denied Cratchit the day off. It turns out, however, that Cratchit, while not “underpaid,” is at least seen as a bargain employee by Scrooge, and so much so that Scrooge felt he could afford to voluntarily pay Cratchit a small raise in the form of a day off.
Poor Scrooge Ebenezer Scrooge asks very little of his fellow human beings. He only asks that they keep up their ends of the bargains in the business agreements they make. It was just his misfortune, then, that he is surrounded by a bevy of control freaks who are hell bent on making sure Scrooge enjoys Christmas in just the way they want him to.
Scrooge returns the favor by maintaining a ferociously low opinion of most others around him, concluding quite often that others are simply fools for choosing to enjoy the company of friends and family when there’s money to be made.
Ultimately, though, it’s all just an unfortunate misunderstanding, and one that might be improved by a reading of Man, Economy, and State.
Image credit.
This week's internet-fueled Outrage of the Week is the case of Harvard attorney Ben Edelman who has insisted on "notifying the authorities" to punish a small restaurant for "overcharging" the professor to the tune of four dollars.
Boston.com reported on the case, posting the full email exchange. Now, the professor has received the sort of social-media drubbing you might expect from an internet world that's more likely to sympathize with an immigrant small businessman than they are to side with a man who obviously has a lot of free time on his hands, and likes to report people to "the authorities."
Nevertheless, Peter Jacobs at Business Insider has taken Edelman's side noting that the lawyer did indeed have a point. The restaurant should have correct prices posted:
It's not likely that someone else would have called out the restaurant on having out-of-date prices on its website, which many of the customers use as a reference for ordering food. Additionally, as Edelman emphasized, Duan even said the website had been "out of date for quite some time." Many customers likely ended up paying more money than they expected to due to advertised prices that were no longer applicable.
Rothbard's Welfare Economics in Action
Yes, it's true that other people were likely paying more for their Chinese food than they initially thought they might when they perused the menu. But, in economics we can only observe the actions of people, and we cannot measure their thoughts. Thus, what Jacobs ignores is the fact that the actions of the customers shows they consented to the final bill regardless of any discrepancy between the menu price and the final bill price. We know that Edelman claims that he thought the prices were different on the menu than on the bill. But his actions tell us his true preference was to simply pay the bill. Indeed, for all we know, Edelman knew the discrepancy beforehand and was hoping to use this to his advantage after the fact. Is this just speculation? Certainly. But the assertion that Edelman was tricked is also pure speculation. On the other hand, we have the actions of Edelman which show he was willing to pay the bill. His thoughts in his head are immeasurable and unobservable, and are irrelevant from the point of view of economics.
There's No Such Things as "Overcharging"
I don't know the exact take-out business practices of Sichuan Garden, the restaurant in question, but I assume — given the practices of most such restaurants — that a customer has not morally or legally committed to purchase the food the moment the order has been said out loud or typed into a web site. No, the only commitment comes at the time of payment, when the customer agrees to pay for the service rendered. Up until that moment, the customer can refuse payment if anything is not to his liking.
So, if the customer orders an egg roll that is priced at $4, but is delivered an egg roll that costs $5, the customer has not been given the product he ordered. In this case — if he cares enough to check each item — he may refuse to pay after the order has been placed but before payment. If he does consent to paying the final bill, then his demonstrated preference was to buy the food regardless of any other factor.
In such cases, the customer is never "overcharged" because he consented to the charge in exchange for the food. Or he refused, and was not charged. Meanwhile, Edelman and Jacobs assert that customer is somehow "tricked" by the restaurant. But, if the customer was told the total amount of the bill prior to payment (who pays a bill without being told the amount first?), then the customer was not in any way tricked. He consented to pay a certain amount and then was given food in exchange.
The only way trickery or fraud or "overcharging" is involved is if the customer was told his credit card would be charged one amount, but was then surreptitiously charged another. If the customer consented to a $50 charge, and the card was charged $50, then there’s no fraud.
But if the customer is unwilling to itemize the order before payment, that’s his decision. He has been told the total amount, has deemed it acceptable, and has concluded it’s not worth his time to check the menu price of every item and compare it to the invoice price.
In the Edelman case, it appears that he saw after the fact that he was charged $5 for what he thought was a $4 egg roll (or whatever the specifics were). And then, after having already agreed to a price — and eaten the food — went back and insisted that the government take action against the firm.
Edelman then goes on to suggest that the restaurant should be sued or punished for all the "overcharging" that has gone on with other customers, all of whom consented to pay the stipulated price by the act of paying their bills. The fact of the matter is that all these other customers, like Edelman, were also uninterested in itemizing their bill — whether over the phone or in person with the delivery person — before paying the bill.
And why were all these customers unwilling to itemize their orders and check every price of every egg roll before finalizing the order? Well, because the customers concluded it was not worth their time to do so. For the customers, their preference — as demonstrated by their actions — was to "take their chances" with the final bill more or less reflecting the prices on the menu, or whatever figure the customer has in his head as being the price.
Edelman obviously understands none of this. For him, there is some mystical "correct" price that the consumer should pay out there, and any deviation from that price should be punished by government authorities.
Contrary to Edelman, however, the correct price is whatever price the customer is willing to pay to get his Chinese food. The stated prices on the menu become irrelevant the second the customer consents to pay a certain price for the total order.
The "Cure" Is Worse Than the Disease
Customers could of course make this menu-invoice comparison whenever they wish before handing over the money, but for Edelman and Jacobs, it is an unendurable hardship for the customer to have to check his bill using third-grade arithmetic before purchase, and it is therefore more reasonable that government employees be hired, trained, and deployed to punish firms that don't update their online menus in a "proper" manner. What is proper is of course to be determined by government agents.
This is a classic case of the cure being worse than the disease. There is no doubt that some consumers have paid a few more nickels and dimes to firms than they initially thought they would. But, once all those nickels and dimes are added up, is the sum greater than the cost to the customer in taxes for creating and staffing a government bureaucracy to make sure your egg roll has the “correct price”? This seems unlikely. And of course, ultimately, such a government agency would be punishing firms for prices and services that the customers had already consented to.
As I write this, Twitter is telling me that Edelman has apologized to Sichuan Garden for his disagreeable and threatening behavior. If Edelman had merely informed Sichuan Garden that their business practices were objectionable and that they should stop, he would have been well within the realm of good taste. (This assumes the restaurant did not charge a different amount than was stated on the bill.) But, as far as we can tell, Edelman chose to report a peaceful, private firm that had not cheated him “to the authorities” and made additional threats of legal action. Edelman consented to a peaceful transaction with the restaurant, but upon reflection decided to demand violence and coercion to make up for his lack of due diligence. This immediate call for violence against the restaurant is what those who condemn Edelman noticed. A great many Americans live in fear of reprisals, fines, and worse from the state. Edelman, on the other hand, thinks such things should be employed against peaceful citizens over a matter of four dollars.
Image source: wikimedia public domain http://commons.wikimedia.org/wiki/File:CookbookEggrollTongs.jpg
The debate whether or not cryptocurrencies are “money” has put a spotlight on the Menger-Mises Regression Theorem. As stated, the theorem posits that a non-fiat money must have had value before it became a money. Some have used currencies’ lack of antecedent value as knocking it off the money pedestal or as forcing cryptocurrencies to ignominiously piggyback on fiat currencies’ own regressions.
In a 2013 post Konrad Graf makes the excellent point that such critiques misread the Regression Theorem. In reality, Graf argues, the theorem is not a hypothesis to be tested, rather the theorem tells us that cryptocurrencies such as Bitcoin indeed had some antecedent value. At which point our task is to discover what that antecedent value was. Graf suggests several alternatives, including utility of Bitcoin as a geek toy, as art, or as social marker. Because of these non-monetary uses, Graf writes, bitcoin and the theorem do not threaten each other, but “merely gaze across the intellectual landscape at one another with knowing smiles.”
While I agree with Graf on his main point that the theorem implies cryptocurrencies did have antecedent value, I believe that both the original critique and Grafs’ response fall into a trap of misreading the theorem as requiring non-monetary and previously realized ("bought and sold") benefits.
Money Is a Useful GoodAmong Menger’s greatest contributions in his Principles is the realization that money is fundamentally a good like any other — demanded for its usefulness in enabling transactions and store of value — with an actual price dictated by its scarcity.
If money, like any other good, derives its value from the benefits it offers, it’s hard to see why the money, even those benefits, require an antecedent. Just as the internet can be valuable without a “pre-internet,” a cryptocurrency enabling anonymous, irreversible, low-regulation transactions and savings can be valuable without a precursor.Cryptocurrencies benefit from a perception of anonymity, although whether or not there is actual anonymity in practice is another matter. If there is no regression requirement for value in any other good, why does money alone bear this burden?
Must Money Have a Non-Monetary Use?Instead, I would argue for a reading of the Regression Theorem with two important liberalizations. First, benefits provided by a money needn’t be non-monetary. That is, the benefits can reside in the good’s use as money itself — no need for geek-chic art. Second, antecedent demand needn’t have been realized — the use needn’t have actually occurred. It’s the antecedent demand, even latent, not the previous buying and selling, which counts in importing value via the Regression Theorem.
To give an example that satisfies both liberalizations, a benefit such as anonymous wire transfers is both a money-related benefit and is also a service that didn’t previously exist. In a liberalized Regression Theorem, this benefit would count as the antecedent demand giving the spark of life to a scarce cryptocurrency.
A concrete historical example of a currency offering both mainly monetary value and offering it only at moment of birth is Tang China’s paper money. Called “flying cash,” paper offered the key benefit of portability, set against its other risks compared with bullion coins (flammability, uncertain redemption). We could surely seek out non-monetary antecedent value for Tang cash — toilet paper comes to mind. But it seems a stretch to reach for artistic or hygiene uses, compared to the natural conclusion that flying cash was demanded because of its monetary benefits. The fact that demand for portable money was unrealized would simply increase paper money’s value to the unfortunate customer who lacked alternative light-weight money.
This mistaken focus on non-money-related and realized antecedent value is understandable, since even Mises seems to be mixing historical and praxeological discussion in Human Action (chapter 17, sec. 4) where Mises writes, “No good can be employed for the function of a medium of exchange which at the very beginning of its use for this purpose did not have exchange value on account of other employments.”
Here Mises seems to clearly state that Menger’s Regression Theorem requires a currency to have historically represented a commodity having non-money use. This is a natural interpretation, especially in context of Mises’s subsequent discussion of precious metals, clearly useful commodities that you can flash at parties.
But we must take care here to separate Mises’s historical generalization from the praxeological core of his statement. Because Mises has metal on his mind, he suggests the “other employments” must have been antecedent (“did not have”) and, in his subsequent discussion of metals, seems to imply the commodities should be both concrete and previously in use (realized) for non-money purposes.
Money Benefits Are as Useful as Non-Money BenefitsAgain, praxeologically, none of these requirements are essential. Money benefits are as useful as non-money benefits, and a useful commodity could conceivably be created and become a medium of exchange at the same moment. So long as the commodity offers “employments” in the form of benefits to users. Cryptocurrencies’ anonymity, regulatory treatment, algorithmically fixed rate of growth, fee structure, and irreversibility of transfer are all money-related benefits, many unrealized before cryptocurrencies came along.
On this reading, and in agreement with Graf, cryptocurrencies are not at all a challenge to the Regression Theorem. They are a confirmation. At birth, cryptocurrencies offered useful features. These benefits function as “employments,” giving cryptocurrencies demand via transaction and store of-value benefits, which in turn import durable purchasing power.
Perceptions Are ImportantThat “seed” of demand can then be amplified by marketing — by framing the subjective benefits of the currency. Again like any other good, if individuals exert effort to communicate and frame the benefits of a cryptocurrency, then we might expect demand to increase. These individuals may be the owners of businesses that benefit from the currency, or they simply may be enthusiasts.
Now we can simply match these subjective benefits to scarcity to yield a price of a cryptocurrency. Below zero and the currency isn’t “good enough” — it’s not perceived to offer enough benefits. It’s not cool and it’s not art. Above zero and a currency is born: now Satoshi Nakamoto t-shirts are all the rage.
As technology lowers the costs of producing cryptocurrencies, broadening the Regression Theorem’s value requirement to accept novel money-related benefits opens up enormously the range of currencies that are possible in the future. It should be an exciting few decades in the world of currency innovation.
Image source: iStockphoto.
The wealth of a nation depends on putting the labor force to work. Those who are unnecessary for farming can be employed in making higher quality products and manufactured goods, particularly durable goods made from metal. Saving is the key determinant of wealth and gold is a particularly useful form of savings because it can purchase all things, even in time of war. The prince and property owners determine how people will be employed by their consumption choices, while the Catholic Church reduces the resources available to materially sustain the people.
From Part 1: Production, Distribution, and Consumption. Narrated by Millian Quinteros.
Here Cantillon uses his price-specie flow mechanism to analyze some of the effects of inflation. Increasing the supply of money by mining hurtssome people and benefits others because certain prices and incomes rise faster than others. However, if the new money is accumulated and saved by those who successfully export goods, either because of superior quality or more efficient transportation, it will lead to higher standards of living.
From Part 2: Money and Interest. Narrated by Millian Quinteros.
Because the opportunity cost of a good cannot be fixed, it is impossible to know the proper exchange ratios for barter. This problem is overcome in the market by using commodities that have marketable characteristics, such as transportability, durability, and a recognized economic value, to serve as a medium of exchange. Prices of goods do not strictly follow the quantity theory of money.
From Part 2: Money and Interest. Narrated by Millian Quinteros.
Fractional-reserve banking is a system where the banks lend some of their deposits and earn interest. This increases the amount of money in circulation compared to warehouse or 100% reserve banking. This utility of banking comes at the risk of being unable to withdraw your deposits. The amount that can be lent into circulation depends on the type of bank and the needs of the depositors. There are goldsmith-bankers, the typical banker who issues banknotes, and the national bank.
From Part 3: International Trade and Business Cycles. Narrated by Millian Quinteros.
Cantillon develops a circular-flow model of the economy that shows the distribution of farm production between property owners, farmers, and workers. Farm production is exchanged for the goods and services produced in the cities by entrepreneurs and artisans. While the property owners are “independent,” the model demonstrates the mutual interdependence between all the classes of people that Adam Smith dubbed the “invisible hand” in The Theory of Moral Sentiments (1759).
From Part 1: Production, Distribution, and Consumption. Narrated by Millian Quinteros.
Farm production produces three rents, one of which sustains the farm workers, while the other two can be sold at wholesale to entrepreneurs who in turn provide property owners and farmers with goods and merchandise. This is the circular flow model of the economy. Money facilitates the flow and timing of rent payments (i.e., “velocity”) and the rate of the monetary flow determines the ratio between the quantity of money and the value of annual production. This model is then used to explain the implications of international trade.
From Part 2: Money and Interest. Narrated by Millian Quinteros.
Cities form at sites where large property owners have decided to live. Specialization of labor expands to meet the demands of the wealthy. Cities grow even larger when manufacturing industries produce for export, and whose workers are essentially supported by the production of foreign lands. Cantillon placed a great deal of emphasis on transportation costs. He found that property owners who lived far from their lands would experience a reduction in income proportional to the cost of transporting their production to market.
From Part 1: Production, Distribution, and Consumption. Narrated by Millian Quinteros.
All human societies are based on a system of property rights. The distribution of rights will necessarily be unequal, and the use to which property is put will be dependent on the tastes of the owners.
From Part 1: Production, Distribution, and Consumption. Narrated by Millian Quinteros.
There is an expense associated with transporting money based on the distance, risks, and other transaction costs. Bills of Exchange are a type of contract that can reduce this cost by avoiding shipments that are offsetting between two locations. When money must be sent, bankers charge a fee for arranging the shipment and providing their customers with a bill of exchange, or check, that can be drawn or cashed at a correspondent bank where the money is sent. When the exchange rate is above par, it indicates a balance of payments deficit, and when the exchange rate is below par, it indicates a balance of payments surplus.
From Part 3: International Trade and Business Cycles. Narrated by Millian Quinteros.
Here the circular-flow economy is extended to international trade. Instead of barter or exchange with money, Cantillon explains how international trade takes place on the basis of bills of exchange. He showsthat a state which accumulates money will enjoy a temporary gain in international trade, but that states where manufacturing industries develop will enjoy a higher standard of living. The only clear exception Cantillon makes to free trade is his famous endorsement of the English Navigation Acts, where domestic shipping is protected, not in its own right, but to provide ships and sailors during wartime.
From Part 3: International Trade and Business Cycles. Narrated by Millian Quinteros.
The opportunity cost of becoming a skilled worker includes both the direct expenses as well as the foregone labor during the training period or apprenticeship. As a result, skilled workers must be paid higher wages than unskilled workers.
From Part 1: Production, Distribution, and Consumption. Narrated by Millian Quinteros.
Entrepreneurs establish markets in centrally located villages which provide the necessary conditions under which prices are established between supply and demand. The size of the market town depends on the size of the economy it serves.
From Part 1: Production, Distribution, and Consumption. Narrated by Millian Quinteros.
Wherever a government establishes its capital, the city will grow in size because the additional spending attracts labor and businesses to service the government and its employees and thus, it becomes a commercial center for the nation as well.
From Part 1: Production, Distribution, and Consumption. Narrated by Millian Quinteros.
When the government’s national bank inflates the money supply by increasing the supply of banknotes, it reduces the rate of interest and can increase the price of stocks. This is a corrupt process and when the notes are redeemed, the price of stocks falls and can result in bank runs and economic chaos. This is now known as the business cycle.
From Part 3: International Trade and Business Cycles. Narrated by Millian Quinteros.
Increases in the supply of money from a balance of trade eventually causes prices to rise. This in turn puts pressure on domestic producers and increases imports. The result is that the balance of trade is reduced and eventually is negative. This is Cantillon’s price specie-flow mechanism which demonstrates the reasons for the tendency for equilibrium in international monetary flows. The balance of trade can result in economic power, but this also causes the economy to lapse into luxury and decline.
From Part 2: Money and Interest. Narrated by Millian Quinteros.
In addition to training and the forces of supply and demand, workers with higher quality skills, risky jobs, or jobs which require trustworthy employees will receive higher wages. This is now known as the theory of compensating differentials that is often attributed to Adam Smith.
From Part 1: Production, Distribution, and Consumption. Narrated by Millian Quinteros.
Interest is established in the market by lenders and borrowers and the interest rate on a particular loan is determined by the risk of default. A loan is repaid from the income generated from capital investments and the interest paid is equivalent to the profits of fully capitalized enterprises. Small entrepreneurs pay high rates whether they borrow cash or purchase goods to be paid at a later date, based on risk and their propensity to spend beyond their means.Thereby, interest rates on loans are connected with an individual’s time preference.
From Part 2: Money and Interest. Narrated by Millian Quinteros.
Gold and silver were highly valued before they were used as money. They hold many advantages over other goods such as durability, divisibility, transportability, and homogeneity. These are the reasons which led gold, silver, and copper to be chosen as money, not “fancy” or common consent. When princes debase money or issue imaginary money, they hurt the economy.
From Part 1: Production, Distribution, and Consumption. Narrated by Millian Quinteros.
In this first of four chapters on economic geography and location theory, Cantillon explains that settlements are based on the requirements of production, especially the quantity of labor, and the extent of the specialization and division of labor.
From Part 1: Production, Distribution, and Consumption. Narrated by Millian Quinteros.
Rural France was impoverished because commodities had to be sent to the capital and major cities to pay taxes to the state and rents to the property owners living there. It is argued here that if factories were permitted in rural areas, basic commodities could be turned into goods, which could then be sent to the cities at a much lower transport cost. This would save resources in transportation and benefit both rural populations and property owners.
From Part 2: Money and Interest. Narrated by Millian Quinteros.
Large transactions can be accomplished with the use of bills of exchange or barter, which reduces the demand for money. Ordinary transactions by people require actual coin money in circulation. A variety of factors, therefore, affect the flow of money in circulation and this in turn affects the amount of money in circulation.
From Part 2: Money and Interest. Narrated by Millian Quinteros.
Raising and lowering the nominal value of money is shown not to undermine the theory of the value of money. In contrast, such measures are shown to be methods by which the prince acquires resources by deceiving individuals about the value of money. The process causes chaos in the market.
From Part 3: International Trade and Business Cycles. Narrated by Millian Quinteros.
Intrinsic value can be measured by the quantity of land and laborers, taking into account the quality of land and labor. Some goods are produced almost entirely with land, others solely from labor. In the garden example, intrinsic value is both the direct expenses of the garden and the foregone value of land. Intrinsic value of a choice never changes, but market prices vary according to demand. Cantillon’s construction of “intrinsic value” should therefore be understood as the concept of opportunity cost, not the essential nature of a thing.
From Part 1: Production, Distribution, and Consumption. Narrated by Millian Quinteros.
National Banks are of little utility and can be the source of economic chaos. The increase in the supply of money that they provide is relatively small and offers the same disadvantages as increases in real money. They are therefore unnecessary and potentially very harmful, as in the cases of the Bank of Venice and the Bank of London. The roles of legal tender laws, fractional reserve banking, and regional trade fairs are described.
From Part 3: International Trade and Business Cycles. Narrated by Millian Quinteros.
The interest rate is determined by the supply and demand for loanable funds, not the supply of money. Savings and frugality decrease the interest rate while lavish spending increases it. War increases the interest rate, peace decreases it. Paying off the national debt decreases the interest rate. A positive balance of trade decreases the interest rate, but the government cannot effectively lower the interest by a usury law. The interest rate is a critical factor in the valuation of assets such as land.
From Part 2: Money and Interest. Narrated by Millian Quinteros.
When there is an increase in the quantity of money, prices will increase depending on how the new money holders decide to spend their money. The price changes will also be affected by such things as regulations on trade and the perishability of the products that are traded. In other words the simple quantity theory of money is naïve in proposing that a doubling of the quantity of money would double all prices equally. Changes in the quantity of money will change relative prices and have real effects on the economy, a phenomenon now known as the Cantillon Effects.
From Part 2: Money and Interest. Narrated by Millian Quinteros.
Exchange rates are explained as a function of the balance of trade and other factors. A trade deficit can cause your money to exchange below par, while a trade surplus will cause it to exchange above par. In fact, the exchange rate, above and below par, is an indicator of the general balance of trade in a country. An attempt to prohibit the export of gold necessary to pay for deficits only hurts the economy.
From Part 3: International Trade and Business Cycles. Narrated by Millian Quinteros.
Market prices are determined by the bargaining between suppliers and demanders. Price determination by supply and demand is illustrated with a thought experiment that uses a fixed quantity of a perishable product (i.e., green peas) and known maximum valuations of consumers.
From Part 2: Money and Interest. Narrated by Millian Quinteros.
The supply of workers adjusts itself to the demand for labor, across all professions, via wage rates, migration, and changes in population. Prosperity cannot be created by subsidizing job training.
From Part 1: Production, Distribution, and Consumption. Narrated by Millian Quinteros.
William Petty set off the search for a par value between land and labor. Cantillon provides a theoretical answer (referenced in Adam Smith’s Wealth of Nations) that property owners must provide their labor with the production of at least twice the land necessary to sustain the worker in order that enough children are raised to maintain the workforce over time. The amount of land will actually vary from job to job, person to person, and among different countries and societies. Therefore, the practical circumstances of the world dictate that there is no such “par” value between land and labor, only money— a “most certain measure”—can be used for income measurements and comparisons.
From Part 1: Production, Distribution, and Consumption. Narrated by Millian Quinteros.
Cantillon constructs a model of the isolated estate or closed economy where the choices of property owners determine outputs and prices, regardless if they manage the isolated estate or lease it to farmers. Mistakes of the farmers or changes in demand by the property owners cause changes in prices, profits and losses, which drive the economy back to equilibrium. The result is that the price system directs resources to the same outcome as that provided by the direct management of the estate owner, ala Adam Smith’s use of the “invisible hand” in the Wealth of Nations.
From Part 1: Production, Distribution, and Consumption. Narrated by Millian Quinteros.
Population is based on the tastes and choices of property owners. Early versions of the Malthusian approach to population growth—that it follows some mathematical formula—are criticized. This chapter also shows that the opulence and lavish spending of the prince and absentee landlords living far from their lands was responsible for the poverty and declining population of France, which ultimately led to the French Revolution.
From Part 1: Production, Distribution, and Consumption. Narrated by Millian Quinteros.
The price of gold and silver and the ratio between them is determined by markets and is also based on their usefulness, cost of production, and transportation costs. When government mints establish a fixed ratio between gold and silver money that is not based on market prices, the overvalued metal will be driven from circulation. This is commonly referred to as “Gresham’s Law” where bad money drives out good money.
From Part 3: International Trade and Business Cycles. Narrated by Millian Quinteros.
Every person has different goals for himself, which means everyone will value differently the means to attain those ends. No central planner can know these goals and values, writes Frank Shostak.
This audio Mises Daily is narrated by Dianna Keiler.
A major problem with the mainstream framework of thinking is that people are presented as if a scale of preferences were hard-wired in their heads. Regardless of anything else this scale remains the same all the time. Valuations however, do not exist by themselves regardless of the things to be valued. On this Rothbard wrote,
There can be no valuation without things to be valued. Murray N. Rothbard, Toward a Reconstruction of Utility and Welfare Economics.
Valuation is the outcome of the mind valuing things. It is a relation between the mind and things.
Purposeful action implies that people assess or evaluate various means at their disposal against their ends. An individual’s ends set the standard for human valuations and thus choices. By choosing a particular end an individual also sets a standard of evaluating various means.
For instance, if my end is to provide a good education for my child, then I will explore various educational institutions and will grade them in accordance with my information regarding the quality of education that these institutions are providing. Observe that the standard of grading these institutions is my end, which, in this case, is to provide my child with a good education. Or, for instance, if my intention is to buy a car, and there are all sorts of cars available in the market, then I have to specify to myself the specific ends that the car will help me achieve. I need to establish whether I plan to drive long distances or just a short distance from my home to the train station and then catch the train. My final end will dictate how I will evaluate various cars. Perhaps I will conclude that for a short distance, a second-hand car will do the trick.
Since an individual's ends determine the valuations of means and thus his choices, it follows that the same good will be valued differently by an individual as a result of changes in his ends. At any point in time, people have an abundance of ends that they would like to achieve. What limits the attainment of various ends is the scarcity of means. Hence, once a larger variety of means become available, a greater number of ends — or goals — can be accommodated (i.e., people's living standards will increase).
Another limitation on attaining various goals is the availability of suitable means. Thus to quell my thirst in the desert, I require water. If no one willing to sell water is nearby, any diamonds in my possession will be of no help in this regard.
The flowering of the tiny house movement is due in large part to the most recent boom-bust cycle, which left many homeowners wondering if mountain-sized homes are worth equally sized debt or a risky gamble on future housing prices. For some, this meant moving into a house that could be smaller than their previous house’s bathroom.
Although definitions vary for what “tiny” means — from the hardcore enthusiasts to the more inclusive tiny-housers — most agree that any residence smaller than 1,000 square feet fits the bill (but most are less than 500 square feet). And speaking of the bill, such dwellings can range anywhere from $10k to $50k, depending on the size and amenities, and they can enjoy total monthly utilities in the double digits.
Thoreau would be proud, too, as many of the tiny-housers build on their own and/or go “off the grid” (the r/homestead and r/tinyhouses subreddits have notable membership overlap, for example). They eschew public provision of various utilities by collecting rainwater, using solar panels, and installing composting toilets. Another way the tiny-housers thumb their nose at the government is by building on trailers to skirt building codes that dictate minimum square footage or other regulations. Randy England, in an August 2014 Mises Daily article, noted how such laws hurt the poor, who would benefit greatly by accessible cheap housing.
Debt Looking Less AttractiveThe tiny house movement is a natural consequence of the most recent macroeconomic swing. After a boom-bust cycle, capitalist-entrepreneurs attempt to reallocate capital into profitable lines of production. This can be a painful process for many, as workers get laid off and prices adjust. Decision-making is difficult when vital information like interest rates and other prices haven’t accurately reflected consumer demands or time preferences in the past. These necessary market corrections are made even more difficult when central banks and governments get in the way, either by revving another cycle or disrupting prices and market processes even further. In spite of the gargantuan and manifold stimulus programs and expansionary monetary policy since 2008, firms like Tumbleweed Tiny Houses and SmallWorks have grown and thrived, attracting workers, capital, and customers when the powers that be would have them fueling and refueling bubbles.
The average house size has climbed steadily over the past few decades, even though the average number of people per household has fallen over the same time period — an unorthodox sign of a growing housing bubble, albeit in hindsight. At the peak of the crisis in 2007–2008, the average household member had about 985 square feet to himself. The members of the tiny house movement suggest that much space is more than enough for an entire household of 2, 3, or even 4 people.
Volatile home prices, increased underemployment and unemployment, and a growing fear of debt seem like the perfect mix for a popular tiny house movement.
I asked a few tiny house owners about their experience and motivation, and found that avoiding debt was a major factor in their decision to go small. “I could afford this house without a mortgage” one owner observed, while another remarked “We are debt-free, and we didn't want a huge mortgage. Seeing the housing bubble definitely reinforced that view (we are now 29, and it was kind of happening when we were getting married and deciding how our lifestyle should be).”
When asked about the future of the tiny house movement, owners replied with several economic reasons for why they believe there will continue to be a demand.
“Pragmatism will be a driving force. Primarily due to financial constraints,” an owner replied. “These constraints could be external (people can't get a job that pays enough to afford ‘the American dream’) or internal (people choose this option to avoid the economic hardships imposed by buying a McMansion.)”
“I believe [there will continue to be a demand], yes,” another owner said. “Not only has the housing bubble added to the tiny house movement, I think millennials and other young folks who will have crushing student loan debt will find [traditional] home ownership to often be an unattainable dream ...”
Perhaps we can chalk up the tiny house movement as another unintended consequence of the Federal Reserve’s low interest rate setting starting around 2002, and the federal government’s similarly timed initiatives to increase homeownership. Or maybe we are witnessing the start of a major cultural change, and our conceptions of the typical family or community are readjusting in the wake of macroeconomic upheaval. Either way, the movement has urged me to reconsider installing that second bowling alley next to my two-million volume library. Rothbard was very prolific.
From The Review of Austrian Economics Vol. 1, No. 4, 1987.
From the first, the Austrians entertained a wish ... to apply their marginal utility theory to the case of money—which both the enemies of this theory and some of its foremost sponsors . . . declared to be impossible.
—Joseph A. SchumpeterSchumpeter, 1954, 1089.
The current epoch of inflation over much of the world has emphasized yet again the acute relationship between the quantity of national moneys and domestic price levels. Inflation has also underscored the inadequacy of the Keynesian model in dealing with money-price level relationships. Keynes for the most part disposed of price level movements by assuming prices constant. His focus was on employment and interest rates (Keynes, 1936). Keynesianism swept the economics profession at a time when inflation was not a problem. Therefore, economists who embraced Keynesian doctrine as a general theory have had a less-than-satisfactory framework for treating price level changes.
The current epoch of inflation over much of the world has emphasized yet again the acute relationship between the quantity of national moneys and domestic price levels. Inflation has also underscored the inadequacy of the Keynesian model in dealing with money-price level relationships. Keynes for the most part disposed of price level movements by assuming prices constant. His focus was on employment and interest rates (Keynes, 1936). Keynesianism swept the economics profession at a time when inflation was not a problem. Therefore, economists who embraced Keynesian doctrine as a general theory have had a less-than-satisfactory framework for treating price level changes.
Keynes’s great intellectual victory in the middle half of the twentieth century has obscured at least two major doctrines that dealt specifically and directly with the quantity of money and prices. One was early monetarist theory, then known as the quantity theory of money. This doctrine was developed by Irving Fisher, E.W. Kemmerer, and others in the United States. In Britain, similar analysis resulted from the works of Edwin Cannan, A.C. Pigou, and economists of the Cambridge school, who were beneficiaries of the earlier classical works of John Stuart Mill, Henry Thornton, and David Ricardo. The other development was the Austrian theory of money initiated by Carl Menger, and continued and enlarged upon by Ludwig von Mises, Friedrich Hayek, Murray Rothbard, and other economists in the Austro-German tradition. These two doctrines shared important similarities and registered some differences, but both were fundamentally distinct from the Keynesian theory that has eclipsed them. Neglect of these doctrines has left economics less rich than it otherwise would be, and the doctrines themselves have had less impact on current theory and policy than they would have had if they had focused their attention on points of agreement and come to terms with their differences.
This article explores the fundamental operational concepts in monetarist and Austrian theories that bear on the utility and value of money, in order to determine where they are compatible and to assess the logic and significance of their differences.
Money evolved from commodities that were not money. Self-sufficient households, when they began to specialize, first bartered goods and services directly. They then learned to barter indirectly for items they did not want, but which they knew they could use subsequently in other exchanges for things they did want. These indirect bartering devices became media of exchange.
Primitive commodity moneys were varied and innovative (Jevons, 1898, 20-28). The more widely a given commodity money circulated, the more utility it had as a money and the more valuable it tended to become in terms of other goods. Carl Menger observed that, “Money commodities came to have utility as money beyond their utilities as commodities because they brought people closer to their ultimate goals of getting the goods and services they wanted” (1981, 262). This evolution is so inferentially logical that it hardly needs empirical substantiation. If it had not occurred, any historian could have invented it.
In the course of time, however, even the most refined commodity moneys gave way to token representations in order to economize their costs as media of exchange; and finally—if “finally” is now—the commodity itself has faded from the scene. Economic systems have been left with only paper and bookkeeping representations that are initiated and accepted under the coercive authority of the state.
The concept of subjective utility in economic analysis was introduced by Carl Menger, and, contemporaneously, by the English economist William Stanley Jevons and the French economist Leon Walras in the great triple coincidence of economic thought (Schumpeter, 1954, 825-29, 1055, passim). Menger developed a table showing assumed cardinal values for the declining marginal utilities often economic goods as envisioned by some economic man. However, he did not defend the simplifying assumption of cardinality for the utility schedule, nor did he include either an income constraint or a utility schedule for money (Menger, 1981, 125-28).
The inability to discriminate conceptually between commodity utility and monetary utility is evident in all the works on money in this period. Jevons, for example, wrote correctly:
Since money has to be exchanged for valuable goods, it should itself possess value, and it must therefore have utility as the basis of value. Money ... is only received to be passed on. The utility of the substance for other purposes must have been the prior condition for its employment as money. ... It is doubtful whether the most powerful government could oblige its subjects to accept and circulate as money a worthless substance which they had no other motive for receiving (1898, 31).
Jevons’s statement shows how difficult it was to penetrate the veil of the commodity in order to perceive the special utility of money. This analytic difficulty often led to the observation: “Money itself has no marginal utility, since it is not intended for consumption” (Wicksell, 1935, 20).
Ludwig von Mises came closer than any other economist of the time to a valid interpretation of the utility of money. He first wrote: “The subjective value [utility] of money is conditioned by its objective exchange value (emphasis added).” So far so good. However, he then restated the conventional error:
Money has no utility other than that arising from the possibility of obtaining other economic goods for it. . . . This peculiarity of the value of money can also be expressed by saying that, as far as the individual is concerned, money has no use-value [utility] at all, but only subjective exchange value (1980, 118, 130).
Von Mises’s statement acknowledged the necessity for money to have utility—that it is an economic item to be brought into the panorama of market evaluation. But since its perceived utility was locked into its purchasing power for buying other things, the contradiction followed that money has no utility of its own.
Three factors probably contributed to this widely accepted view. First, at the time this issue came into economists’ thinking, almost all money was commodity money, or pretended to be. Since some commodity first gave monetary life to any commodity money, the supposition followed that money without its redemptive commodity could not have value of its own and certainly could not have utility. Second, the awareness that the nominal quantity of money units could change without changing the real value of the total stock of money seemed to discourage the notion that the total stock is real capital, regardless of the fact that the size of the nominal stock is irrelevant to the value of the real stock. Third, since money “only” existed to be exchanged for something else, its utility had to be something akin to an imaginary number. It was derived from the utilities of the things it could buy. To their everlasting credit, the Austrians insisted on bringing money into the general theory of value by emphasizing a demand function for money, but they lacked a utility theory of money qua money with which to complete the analysis.
Schumpeter correctly interpreted the Austrian view to mean that the exchange value of money—what it will buy—must be known before the individual can assign any utility to a unit of money: “It is therefore impossible to do in the case of money what can be done in every other case, namely, to deduce its exchange value from . . . schedules of marginal utility: to attempt to do so seems to spell circular reasoning” (1954, 1090). Indeed, this “problem” came to be known as the “Austrian circle” (Rothbard, 1976, 167).
Von Mises recognized and accepted the sequence of thought that led into the Austrian circle, and he tried to break out of it with his “regression theorem.” He argued that money’s value and utility today could be traced back incrementally day-by-day, year-by-year, decade-by-decade “in temporal regression” to the time when the money was a commodity money; then, as summarized by Murray Rothbard, “to the last day of barter, at which point the temporal element in the demand for the money commodity disappears, and the causal forces in the current demand and purchasing power of money are fully and completely explained.”Cf. Jevons’s statement earlier in this article Rothbard claims that this theorem “fully explains the current demand for money and integrates the theory of money with the theory of marginal utility” (Rothbard, 1976, 167-69, emphasis added; von Mises, 1980, 131-36).
Don Patinkin rejected the circularity argument by noting that it does not distinguish between “demand” as a schedule of alternative quantities, and “demand” as an amount demanded:
It is true that the amount demanded of money [by an individual or by all individuals}—as well as of any other good—depends upon prices. Nevertheless, it is also true that the equilibrium prices depend upon the demand functions. The “circularity charge” is simply a denial of this elementary distinction (1965, 116).While Patinkin rejects the Austrian circle and, therefore, von Mises’s regression theorem, he nonetheless gives full credit to von Mises’s contribution
Patinkin’s observation does not quite hit the mark. Von Mises did not confuse “demand” and “quantity demanded.” Nonetheless, this paradox is an illusion and the regression theorem is an awkward and useless contrivance which does nothing more than reargue the origin of commodity money. All these “problems” result from not recognizing money’s utility as money, and from a confusion of utility and value. Money does not have utility “only” to buy other things. It has the utility of being the exclusive vehicle for allocating expenditures of income over time. This role should be analyzed as one factor contributing to the terms on which money is exchanged for goods and services (that is, its value). If fiat paper money were dumped into a primitive barter economy and forced into acceptance by the impress of legal tender, its price would be established in terms of other things because of the monetary function it fulfilled and because its quantity was limited. Note that the coercive authority that would force acceptance of the money by means of the legal tender power cannot fix the terms on which the money is exchanged. The price level and the corresponding “price” of money—expressed by the inversion of the price level—are determined by the number of money units imposed on the economy, the efficacy of the payments system as a means of metering payments over time (that is, on the monetary utility of money), the stability of the economic environment, the productivity of enterprise, et hoc genus omne.
A memorable article that dealt definitively with this issue was written by W.H. Hutt in 1954. Hutt first reviewed the state of utility theory with respect to money and found it wanting, even though he, too, thought von Mises had come the closest to a correct interpretation. Money has utility, Hutt explained, because it is a “wealth-unit ready to be activated.” It also has the property of being the most easily adjusted asset in case an excess quantity accumulates. It yields service, and therefore an implicit rate of return to its owners. Adam Smith, Hutt observed, had written that money was unproductive because it was like a highway (Hutt, 1954, 217). “But Mises,” Hutt declared, “would insist that a highway is productive” (von Mises, 1980, 170). He cited a passage from von Mises that is notable both for its insight and also because it contradicts von Mises’s previous assertion that “money has no use-value at all (Hutt, 1954, 218).” Wrote von Mises:
It must be recognized that from the economic point of view there is no such thing as money being idle. All money, whether in reserves or literally in circulation, ... is devoted in exactly the same way to the performance of a monetary function. ... All money . . . lies in some individual’s stock ready for eventual use. . . . What is called storing money is a way of using wealth (von Mises, 1980, 170).
Hutt contributed important details to the utility argument. Money does not do its work by circulating, he stated.
If the work of money is circulation, then money is always “idle” because transactions are quasi-instantaneous. . . . The transfer [of money] itself occupies a mere moment whilst the services which flow from the possession of money are continuous over time. The essence of all these services is availability.
Real money units are thus like a real piano, which has utility because it is ready to be played even when it is silent. Money assets, Hutt emphasized, are “subject to the same laws of value as other scarce things [and] are equally productive in all intelligible senses (1954, 218-20).
Irving Fisher was as ambivalent as von Mises with respect to the utility of money. In The Purchasing Power of Money, published just the year before von Mises’s Theory of Money and Credit, Fisher wrote that marginal utilities, unlike prices, are “not only impossible to measure, but are unequal and vary unequally among individuals.” He recognized that money has marginal utility, which would vary directly with the purchasing power of money “if all prices and all money incomes change in the same ratio” (1911, 220).
Fisher, similar to von Mises, fell into the error of not allowing money to have its own utility because he (of all people) neglected money’s real value when analyzing its utility. “The quantity theory of money . . . rests,” he wrote, “. . . upon the fundamental peculiarity which money alone of all goods possesses—the fact that it has no power to satisfy human wants except a power to purchase things which do have such power” (1911, 32).
What Fisher, von Mises, and others did not recognize explicitly was that this “exception” to money’s “uselessness” was all important. It can be brought into focus most meaningfully by changing the statement, “Money can only be used to buy other things,” to, “Money is the exclusive means for buying other things.” These statements are similar; but one describes money’s function with the bemeaning adverb “only,” while the other uses the elite adjective “exclusive.”
In his Rate of Interest written in 1907, Fisher offered a view of money’s utility very similar to von Mises’s more profound expression:
The most salable of all properties is, of course, money and as Carl Menger pointed out, it is precisely this salability which makes it money. The convenience of surely being able, without any previous preparation, to dispose of it for any exchange ... is itself a sufficient return upon the capital which a man seems to keep idle in money form. This liquidity of our cash balance takes the place of any rate of interest in the ordinary sense of the word (1907, 212; also cited in Patinkin, 1965, 580; emphasis added).
Fisher’s notion of an implicit return on money held is identical to Hutt’s “yield.” Patinkin noted the ambiguity in the two passages from Fisher and the fact that Fisher wrote the meaningful interpretation of monetary utility in 1907, and the conventionally incorrect view four years later in 1911.
All this emphasis on the utility of money in the late nineteenth and early twentieth centuries should have culminated in an epic work on the subject. However, if the “culmination” of monetary economics was Keynes’s General Theory, the marginal utility of money is conspicuous by its absence. It appeared in only one paragraph in which Keynes treated the general properties of money. Besides the fact that the supply of money is completely inelastic under a fiat paper money system, Keynes wrote, the demand for money has an elasticity of substitution of zero,
which means that as the exchange value of money rises [the price level falls] there is no tendency to substitute some other factor for it. . . . This [inelasticity] follows from the peculiarity of money that its utility is solely derived from its exchange-value, so that the two rise and fall pari passu, with the result that as the exchange-value of money rises there is no motive or tendency ... to substitute some other factor for it (1936, 231).
This treatment has money held in a portfolio of interest-earning assets, and not as an exchange medium appreciating to the point where it would be too valuable to be held any longer and would be “sold.”
The fallacy in Keynes’s argument lies in the clause, “its utility is solely derived from its purchasing power” (emphasis added). The utility schedule of money is indeed proportional to money’s purchasing power. However, money does not “derive” its utility from its purchasing power. Its utility is derived from its effectiveness as a rationing device for household and business income over time—as Keynes himself recognized at one point. “One reason for holding cash,” he observed without any particular emphasis, “is to bridge the interval between the receipt of income and its disbursement” (1936, 195).
Keynes did not redeem himself with another passage in which he explicitly recognized the utility of money held, as did Fisher and von Mises. While he saw that the marginal utility schedule of money was geared to the exchange-value of the money unit, he did not notice that this linkage would permit money to be entered into a marginal utility calculus for establishing spending equilibrium between money and other economic wealth. (See appendix.) In Keynes’s world, a falling price level that increased the exchange-value of the money unit generated no behavioral reaction that would stabilize general disequilibrium conditions, but only further acquisitions of the wealth-item that was appreciating. This oversight is consistent with his inability to derive a real balance effect that would get the economy into “full employment” equilibrium.
A resolution of the value-utility argument over money requires some reassessment of money. Much of the confusion and error in characterizing money has resulted from concentrating on the nominal quantity rather than on the real quantity. In the absence of expectations, the real quantity is largely independent of the nominal quantity. A nominal unit of money loses utility during an inflation in proportion to the rise in prices. But a real unit of money— the nominal unit adjusted for changes in the value of the money unit—loses no utility until it no longer performs in its usual way as a disburser of income between payment periods. As in all other determinations of real value, money’s utility is a feature that contributes to its demand, and the real income of money users is a second conventional determinant. However, the quantity of nominal money units is as irrelevant to the real value of the money stock as is the calibration of apples in bushels or pounds to the real value of apples.
Utility and value are not on the same plane. Utility precedes value and is parallel to scarcity. To label the utility of money “subjective value” as von Mises did is to foster a contradiction in terms. Money has subjective utility and objective value, regardless of whether a price index (inverted) measures its value accurately or not.
This correction does not deny the principle that consumption guides production. Nonetheless, the scarcity of resources used in getting the supply of anything to market is essential for setting the terms on which the demand is satisfied.
Both Fisher and von Mises emphasized the impossibility of measuring subjective utilities. Both saw utility as a force operating in markets, and also as a force whose magnitude marginally declines. To Fisher, its unmeasurability was a reason to use an objective measure—a price index—as a guide to “corrections in a monetary standard” (Fisher, 1911, 22). He did not mean to throw out the gold standard. He simply recommended periodic modifications to the fixed official price of gold because the production of gold was so great at the time that he feared a gold inflation (!) (Fisher, 1911, 248-50).
His prescription in practice called for only an occasional change in the mint price of gold to adjust for severe changes in its real price that were associated with a chronically rising or falling level of money prices. “Our ideal, he wrote “is not primarily constancy of the dollar but rather dependability. Fluctuations which can be foreseen and allowed for are not evils. ... [No one] should expect the monetary unit to insure him against every wind that blows” (1911, 223; emphasis added).
Fisher’s mathematical and statistical training undoubtedly led to his confidence in the use of a price index as a vehicle to measure the value of the money unit. Without such a construction, the common general confusion between relative prices and the price level could never be resolved, so changes in money prices were not likely to be distinguished from changes in real prices. “Individual prices,” he wrote, “cannot be fully determined by supply and demand, money cost of production, etc., without surreptitiously introducing the price level itself” (1911, 175). He recognized that the price level when inverted is the only conceptual means for expressing the price of money, and that a price index is the only practical means for estimating the price level.
Von Mises argued that since money prices (“objective exchange values”) were the result of subjective utilities, their general level was not explicitly measurable. Money prices he saw as indispensable means for valuing economic goods and services, but, paradoxically, the value of money itself was unquantifiable (von Mises, 1980, 62).
Von Mises here derived what can be labeled the Austrian principle of money: “Every variation in the quantity of money introduces a dynamic factor into the static economic system” (von Mises, 1980, 168). When the stock of money—even if money is gold—changes, the circumstances of the change (where and how the money comes into the system, and who first gets it) inevitably result in relative price changes. In addition, the distribution of wealth and income also change (von Mises, 1978, 81). Thus far, von Mises’s analysis and Fisher’s had much in common: Money in practice is not neutral in the short run.
Statistically speaking, von Mises noted, these changes in relative prices and real incomes change the “scaling factors” that weight the prices computed in any index. Statistical doctrine cannot provide an accurate means for weight changes. Therefore, “the idea that change in the purchasing power of money may be measured is scientifically untenable” (von Mises, 1978, 99). On the other hand, “any index method is good enough to make a rough statement about the extremely severe depreciation of the value of a monetary unit, [but it] is not necessarily either scientifically correct or applicable in practice” (von Mises, 1978, 89; also 1980, 216-22). Since monetary changes alter relative prices, von Mises argued, a policy to stabilize the price level would have to fix all relative prices and would result in severe distortions to the economic allocation of resources.
The difference between the two schools over this issue is both conceptual and practical. Both recognized that the purchasing power of money is a reflection of money prices inverted. Von Mises even stated that the ‘’fictitious” concept of a “price level” enables the observer “to distinguish and determine whether changes in exchange relationship between money and other commodities arise on the money side or the commodity side. . . . This distinction is urgently needed” (1978, 85). Fisher developed much the same argument (Fisher, 1911, 174-79). However, Fisher also believed that the price index, with all of its imperfections, was statistically valid and operationally useful. Since money prices are measurable data, a price index is “an ascertainable magnitude with a meaning common to all men” (Fisher, 1911, 220).
The conceptual validity of a price index seems logical. Imagine an economy in which the purchase and sale of one commodity dominates all exchanges. The market price of that commodity in terms of the money unit when inverted would also be the market price of the money unit in terms of that commodity. If the number of commodities exchanged for money were to increase, the conceptual means of evaluating the money unit would not change. It would still be the value of the money unit in terms of some aggregate of goods. Indeed, the value of the money unit cannot be measured in any other way. The validity of the concept cannot be denied because of the imperfection of the method used to measure it.
The propriety of using index numbers to measure prices, and hence the value of the money unit, is another story. It depends ultimately on the statistical reliability of the method for deriving the index, and is essentially an empirical issue. For example, given two periods, one of reasonably stable prices and one of pronounced inflation, do relative prices change significantly more in the inflationary period than they do in the stable period? If so, von Mises’s rejection of indexes would have some practical weight.
The Austrian view of the value of money, as set out by von Mises, argued correctly that money must be analyzed in a general theory of value. The value of money is determined in all markets where money is exchanged, he wrote. “To explain its determination is the task of the theory of the value of money” (von Mises, 1980, 141). Very properly, he applied an implicit real balance effect to show how an adjustment of prices resulted from a change in the quantity of money:
An increase in a community’s stock of money [alters] the ratio between the demand for money and the stock of it . . .; [people] have a relative superfluity of money and a relative shortage of other economic goods. The immediate consequence of both circumstances is that the marginal utility to them of the monetary unit diminishes. This necessarily influences their behavior in the market. They are in a stronger position as buyers. . . . They are able to offer more money for the commodities that they wish to acquire. It will be the obvious result of the [circumstances] that the prices of the goods concerned will rise. . . . Thus the increase of prices continues, having a diminishing effect until all commodities . . . are reached by it (von Mises, 1980, 160-61).
No quantity theorist or monetarist could describe the adjustment to an excess supply of money more effectively. Following this passage, however, von Mises made a substantive criticism of the “mechanical version” of the quantity theory of money: “A thorough comprehension of the means by which money changes prices makes [the quantity theorists’] point of view untenable” (1980, 161). Consequently, “no fixed relationship can be established between the changes in the quantity of money and those of the [money] unit’s purchasing power” (von Mises, 1978, 91).
To von Mises, Fisher’s manipulations with “neutral” money seemed impossibly mechanistic. The quantity theory assumes an exogenous quantity of money and employs a velocity of circulation and a total output of goods and services—variables outside the decision-making volition of human beings. In his view, therefore, it could not reflect subjective valuations of individuals, (von Mises, 1980, 153-54).
This charge is understandable and has long been a criticism of the quantity theory. Another criticism of some moment is that the quantity theory sublimates the real balance effect implicit in its workings, and hides the utility of money. Von Mises’s use of the real balance effect, and his simultaneous criticism of the quantity theory, imply that he, too, saw the quantity theory in this light. He recognized Fisher as one who “takes his stand upon the subjective theory of value,” but who is “unable to show the way subjective valuations are affected by variations in the ratio between the stock of money and the demand for money” (von Mises, 1980, 158).By the “demand for money,” von Mises indicated that he meant “volume of transactions [divided by] velocity of circulation.” Using the algebra of the equation of exchange,
T/V =M/P, and M/M
in contemporary parlance is the real value of the total stock of money (von Mises, 1980, 158).
If Fisher oversold his price index thesis because of his faith in statistical measurement, von Mises’s arguments were often whimsical. He had the habit of acknowledging that economic concepts have magnitudes, and he would use these devices analytically; but then he would argue that assigning any precise values to these variables by statistical measurement was improper.
All index-number systems are based upon the idea of measuring the utility of a certain quantity of moneyNot “utility,” but value. And not “subjective significance” in the next sentence but objective value as registered by markets. . . . . Their purpose is the determination of the subjective significance of the quantity of money in question. For this, recourse must be had to the quite nebulous and illegitimate fiction of an eternal human with invariable valuations (von Mises, 1980, 221).
Recognition of the quantity theory’s defects as an engine of analysis was expressed by A.C. Pigou when he wrote that he favored the form of the cash balance (or “Cambridge”) equation to the quantity theory because the cash balance approach
focuses attention on the proportion of their resources that people choose to keep in the form of [money] instead of focusing it on “velocity of circulation.” . . . [The cash balance method] brings us at once into relation with volition—an ultimate cause of demand—instead of something that seems at first sight accidental and arbitrary (1951, 174).
D.H. Robertson made a similar distinction. The cash balance equation, he wrote, “is the more useful for enabling us to understand the underlying forces determining the value of money; while the [quantity theory] is the more useful for equipping us to watch with understanding the actual processes by which in real life the prices of goods and services change” (1948, 38-39). The cash balance equation thus lent itself to the construction of a demand for money that answered von Mises’s criticisms of the quantity theory and, as well, provided a vehicle for understanding the true utility of money.
In most important respects, Austrian and monetarist monetary doctrines employ similar constructions and similar methods to analyze money’s impact on the economy. Both imply an awareness of the utility of money as money. Both develop demands for money that are methodologically consistent with demand constructions for all other goods and services. Both emphasize the necessity and importance of markets for specifying prices as guides to economic decision making. Both see the value of money in its classical garb as an inversion of money prices. Both make use of the real balance effect. Both deny the short-run neutrality of money; and both deplore the misbehavior of “managed” monetary systems. Wherein then lie their differences?
Most of the disagreements are either methodological misunderstandings or questions of empirical fact. One lingering difference between the two, in contrast to their many common principles, is in the validity each assigns to the statistical measurement of prices. Austrians incongruously deny validity of indexes yet continuously make use of the concept. In this day and age of statistical refinement—never mind the many misuses of statistics—this intellectual position is untenable. Just because a device is not perfect does not mean that it is useless. It should be used, however, with caution and with an understanding of its frailties. The Austrian criticism is a well-considered caveat if it limits itself to this point.
Fisher seems to have leaned too far in the other direction by assigning too deterministic a role to index numbers and by emphasizing too literally the influence of money on prices. Schumpeter hazards the guess that Fisher’s vested interest in a “piece of social engineering—the compensated-dollar plan—pushed aside all other considerations” (Schumpeter, 1954, 1103).
Another methodological issue is the Austrian contentiousness for insisting that utility can only be measured ordinally and not cardinally. Utility is a force that has magnitude and direction, as the Austrians know better than anyone else. Therefore, it can be treated as if its values are specific (as, indeed, Menger did). In fact, the only necessary condition for determining market equilibrium between money and goods is that all marginal utility schedules decline (Patinkin, 1965, 95). When people then give up money to get other wealth, they run themselves up the utility schedules of money and down the utility schedules of other wealth, until they reach a new equilibrium. (See appendix.)
Austrian doctrine also objects to the assumption of fixed utility schedules for other wealth when only a change in money disturbs some previous equilibrium. This issue is also methodological rather than substantive. Since the nonneutrality of money and the heterogeneity of individuals’ utility schedules do not violate in any way the conclusion that changes in the quantity of money significantly affect prices, the assumption of monetary neutrality and the specification of cardinal utilities are simplifications that clarify the analysis by showing it unadorned. The argument, in short, is not over a question of fact but over the efficacy of method.
Austrian doctrine on price indexes and utilities has some substantive basis, and is very useful in limiting enthusiasm for authoritarian tampering with the monetary system. However, the concept of circularity in the utility, value, and demand for money is an illusion, and the regression theorem therefore is a pointless contrivance. If a paradox is imaginary, the “solution” to it is worthless.
All professional specialists tend to culture their intellectual rent factors or vested interests, and economists are not exceptions. When this practice is carried on so intensively over minor details that it produces what appear to be ideological differences, it becomes counterproductive to the momentum of valid first principles. All of which is to say that, as allies, monetarists and Austrians both would better serve their common interests.
Appendix:The Equilibrium Value for the Marginal Utility of MoneyAssume declining marginal utility schedules for money, M, and all other goods and services, R. Money exchanges for these goods and services at market prices until a typical individual maximizes his utilities for money and goods relative to their prices. That is, in equilibrium (ephemeral as it might be) the marginal utility of money relative to the price of money equals the marginal utility of goods relative to the price of goods.
MUm = mur
Pm Pr
(1)
The price of goods, PR, is some construction of the general price level, and the price of money, pM, is 1/PR. Therefore, equation 1 can be reduced to three terms:
MUm _ MUr
(2)
and
MUm _ MUr Pr2
(3)
This last equation states that the marginal utility of the nth money unit in equilibrium is equal to the marginal utility of goods divided by the price level squared.
To visualize this explanation, let the original equilibrium in equation 1 occur when PR and pM are both 1. In this case, MUm would also equal MUR Now let a monetary inflation, say, triple the price level by a threefold increase in the stock of money. The new equilibrium, assuming no expectations of further price change, occurs when
MUm = MUr, and
(1/3) 3
(4)
the new equilibrium marginal utility of money is
mum = mur /9
(5)
When the money stock and the price level triple, the marginal utility of the nth dollar in equilibrium is one-ninth what it was originally. This value is explained by noting that the whole schedule of monetary utility for nominal money units must be scaled down to one-third of its former value, and in addition everyone must hold three times the former number of money units. Equilibrium, therefore, occurs on a utility schedule that has been reduced by a factor of 3 at a point three times as far out on the money axis.
My dinner companion sounded indignant. “It’s a shame we have to tip the waitress,” she said. “The restaurant owner ought to pay the staff enough to live on.”
I imagine that is a common attitude among those steeped in our current cultural climate of envy and dislike of economic success — the anti-capitalist mentality, as Mises put it. It’s easy to fall into the trap of thinking that we tip waiters out of sympathy, due to their misfortune of having to work in an industry full of greedy restaurant owners who won’t pay a “living wage.” In fact, tipping is an elegant market solution to a particular set of circumstances, often present in service jobs, that makes determining an appropriate wage extremely problematic. The practice of tipping used to be more common, applying to many more service positions than at present, when it is largely restricted to waitstaff and skycaps. Part of the reason for its partial demise is just the wandering course of economic change, but many jobs that used to be paid primarily by tips came to be covered by minimum wage legislation and simply disappeared.
So why do we tip? At first glance it seems rather odd that a waiter should be paid by two different people — employer and customer — for the same job. But in fact we, as tipping customers, are paying for a very different aspect of the waiter’s job than is the employer. The restaurant owner needs a way to get the customer’s order to the kitchen and the food out to the customer. Most anyone who can walk a straight line and operate a pencil can perform that task. But the restaurant owner also wants happy customers, and customers are happy when they have a waiter who can solve problems, handle special requests, and generally make their meal a pleasant experience, and that is a special skill set indeed. Coordinating these two different, and not closely connected, aspects of the job is what tipping is all about.
Information AsymmetryThe employer wants happy customers, but he has a twofold information problem. As a practical matter it is difficult for him to observe interactions between waitstaff and customers. In addition, the customers’ expectations regarding the quality of service are impossible to observe. This is further complicated by the fact that staff members are heterogeneous; they are different in terms of skill levels, personalities, and other characteristics that affect the customer’s experience of quality service. Thus the employer doesn’t have the information he needs to arrive at an appropriate wage for each member of his staff. The customer, however, is a participant in these interactions and as such has as complete information as is humanly possible. If the customer pays the server directly for that aspect of the job, the decision of the appropriate pay is made by the person with the most information about job performance.
Incentive AlignmentEmployers generally want their employees to give their best, and presumably are willing to pay for that. However, the aforementioned information problem inhibits his ability to do so. Ideally, tips make the server’s compensation directly proportional and immediately responsive to the quality of service provided. This aligns the employee’s incentives with the employer’s; both now want to provide high-quality service to the customer, each for their own benefit.
Risk SharingHiring a new employee entails risk. For the new employee, there is the risk that the job may not turn out as he had hoped. It could turn out to be a dead end with no future, or unsatisfactory in innumerable other ways. The employer, however, has a financial risk. The new employee’s skill set is unknown to the employer to at least some degree, regardless of how thorough the interview process might be. There is even more uncertainty with an inexperienced new hire; there is no history for the employer to work from. The employer has to pay the agreed upon wage, and if the new employee doesn’t perform as hoped he is losing money. If the new employee accepts a lower guaranteed wage and makes part of his compensation contingent on performance — the tip — this relieves risk in two ways. First, the employer is more willing to take a chance on a young, inexperienced worker. If the wage is lower, the minimum performance level needed to make the employee worth the wage is also lower. Second, since the employee can increase his earnings directly and immediately by improving his performance the job is not so much of a dead end. The low paying job becomes a valuable stepping stone, allowing the young, inexperienced employee to learn job skills, establish a performance record, and move on to something better. (It should be obvious that minimum wage legislation short-circuits this entire arrangement, making the employer much less willing to hire someone unless he is certain they are worth the higher wage. This is how lower-skilled individuals get shut out of the job market. But that’s the subject of another essay.)
That is the magic of the market. Even mundane habits like leaving a tip for a waiter play an important role in social cooperation and coordination. It is an elegant solution to a knowledge problem, developed spontaneously through the actions of a myriad of market participants. When left alone, people are pretty darn resourceful.
Image source: iStockphoto.
Many people think that tipping is a results from stingy employers not paying a "living wage." But tipping solves multiple economic problems while making employers more likely to hire untried workers, writes Kenneth Zahringer.
This audio Mises Daily is narrated by Robert Hale.
The term “quid pro quo” has been twisted to now include government handouts and state-mandated exchanges, writes Gary Galles.
This audio Mises Daily is narrated by Robert Hale.
Like other spontaneously evolving systems, language tends to move in the direction of more effective cooperation. But sometimes usage distorts once-clear words into sources of confusion.
C.S. Lewis cited “gentleman” as an example. Its usage moved from stating a fact — a man who was landed and had a coat of arms — to a way of praising someone’s behavior, something we already had plenty of words for. But in the process, the word lost its ability to clearly communicate what it once meant.
Quid pro quo is a phrase that has similarly evolved from offering clarity to producing confusion. It originally meant “something for something.” That offered a useful distinction between voluntary market arrangements, in which people were induced to cooperate by being offered adequate compensation, and government arrangements (or robbery), in which such inducements need not be offered.
However, the usage of quid pro quo has evolved to typically mean an exchange of equally valuable goods or services. In the process, it has muddied the distinction between voluntary and involuntary arrangements.
Traded Goods Not Valued EquallyMarket exchanges are not quid pro quo arrangements in its newer sense. Individuals’ self-interest would require that if you voluntarily traded me a baseball bat in exchange for a glove, it would have to be true that I valued the bat more than the glove and you valued the glove more than the bat. Every such exchange is better than equal for all parties.
As Clarence Carson recognized, “The equity consists in the advantage which each party receives, not in some sort of equality supposed to be in the goods traded.” Because both gain, improving their well-being in their own eyes, it is equitable. Inquiring into whether equal values were exchanged, when the exchange itself demonstrates that the parties involved placed different values on the goods or services in question, can only undermine understanding.
Wealth Gained from Every Free ExchangeConsidering market exchanges as involving equal values also leaves people blind to the fact that artificial government restrictions which reduce the volume of willing exchanges destroys wealth that would have been created in the absence of those restrictions. These include taxes, tariffs, and onerous regulatory burdens that act like taxes; price ceilings and floors; entry barriers and other limitations on competition, etc.
The distortion of thinking in terms of supposedly equal, quid pro quo arrangements also extends to government redistribution. Such actions involve conferring additional rights on certain individuals. But since government has no resources but those taken from members of society, that requires the extraction of rights from others. Such actions may be portrayed by some as a quid pro quo between society and those “helped,” but that characterization is inherently inaccurate, because it leaves out what William Graham Sumner called “the forgotten man,” who is forcibly made a loser in those arrangements.
Government Wealth Redistribution Not True Quid Pro QuoWhen no “quid” is offered to third parties who are involuntarily injured by such taxation or regulation, what is involved is not an exchange of equal values, but the unjust imposition of harm on some, backed by government’s monopoly on the legal use of coercion. As Clarence Carson put it, “To the extent that force plays a role, quid pro quo is not the rule.” After all, force is only necessary when something is involuntary.
Perhaps Frank Chodorov summarized government interventions best when he wrote:
It is a quid pro quo arrangement, by which the power of compulsion is sublet to favored individuals or groups in return for their acquiescence to the acquisition of power. The State sells privilege, which is nothing but an economic advantage gained by some at the expense of others ... it is never an honorable exchange, and therefore has to be enforced.
The idea that exchanges must be equal further opens the door to envy, which always degrades social cooperation. If exchanges are supposedly equal, people can easily be led to object that any time any trading partner earns “too high” a profit from a voluntary arrangement, it is “unfair” to others, even if they agreed to the arrangement without being coerced or misled. Not far behind are threats of added burdens or regulations (as with regulated utilities), and the costly uncertainty they entail, which undermine extent of, and the gains from, voluntary arrangements.
Prices and Voluntary ExchangeIn the same vein, if arrangements are presumed to be equitable when made, price increases charged by sellers can always be characterized as inequitable, imposing unfair harm, and therefore something to be stopped. For instance, when demand rises sharply, the demand for “equal” exchanges mean that profits should not rise (after all, the producers didn’t do anything to “deserve” higher profits). Of course, it is those higher profit prospects that induce the increase in output over time in response to consumers’ wishes expressed in the marketplace. When reinforced by the widespread misunderstanding and demonization of profits (for which Karl Marx, who wrote in Das Kapital that “the exchange of commodities ... is an exchange of equivalents, consequently, no method for increasing value,” deserves much of the onus), this leads to further unneeded and unhelpful government oversight where none should exist, as with antitrust laws and gouging regulations.
The quid quo pro idea of exchanges involving equal values also brings with it the assumption that some outside body or person (e.g., the court system or the executive branch’s administrative apparatus) can determine whether an exchange was “equal” and potentially invalidate or forcibly modify it if it was not. Of course, absent fraud or coercion, all parties to such “unequal” exchanges expect to benefit, so both the question being asked and the potential “solution” of disallowing the arrangements are incapable of performing the Solomonic task set for them.
Perhaps even more important, as writers in the Austrian tradition have led the way in pointing out, no outsider can know all the determinants of value to everyone involved, including many the decision-makers themselves may be unable to articulate, but whose willing tradeoffs can nevertheless be revealed by their market choices. When government overrides those choices, that mode of communication is cut off, ensuring that any such attempt is an exercise in arbitrary government dictation in place of leaving both choice and responsibility in the hands of the owners involved.
Characterizing social arrangements as involving equal values is misleading. It sharply understates both the value created by voluntary market arrangements and the costs of government “improvements” to those results. It creates confusion and the leverage for envy to grow government, shrinking freedom and the social cooperation only freedom makes possible. And the new version of quid pro quo has offered society no compensation for the trouble it has caused.
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Common wisdom would purport that those on the so-called “right” are and have always been hawkish and pro-war, while those on the proverbial “left” have always been the tree-hugging, peacenik, anti-war folks. For many conservatives, unfortunately, this is more or less correct. However, progressives have once again airbrushed their own past, which is about as anti-war as, well, war.
Much of this perception is relatively recent and primarily boils down to the Iraq War.The neoconservative warmongering was in full swing and for his part, Barack Obama gave a rather pleasant speech about his opposition to the war before it began. In his book, Obama elaborated,
What I sensed, though, was that the threat Saddam posed was not imminent, the Administration’s rationales for war were flimsy and ideologically driven, and the war in Afghanistan was far from complete.Barack Obama, The Audacity of Hope (Vintage Books, 2006), p. 347.
Not terribly bad, at least for a politician.
Obama then proceeded to escalate the war in Afghanistan, go to war with Libya without Congressional approval, authorize airstrikes in Iraq as well as drone strikes in Yemen, Somalia, and Pakistan while saber-rattling at Syria, Iran, and the Ukraine. Even the American withdrawal from Iraq he oversaw — which is now being ballyhooed by clueless neoconservatives — was hardly different than the schedule George W. Bush had already agreed to.
Indeed, as far as Democratic, and ostensibly progressive, politicians were concerned, Obama was actually abnormal in his tepid opposition to the Iraq War. Senate Democrats voted in favor of letting George Bush go to war 25 to 20. Hillary Clinton, Joe Biden, Dianne Feinstein, and John Kerry all voted yes.
Furthermore, it wasn’t long ago that the supposedly conservative Republicans were the ones against war and the supposedly liberal Democrats in favor of it. The big difference seemed to be nothing more than which party’s politician was in office. For example, regarding the military action in Kosovo in 1999, Senate Republicans opposed the resolution giving Clinton authorization for military action 13 to 32 while the Democrats supported it 38 to 3. The 2000 Republican Party platform even criticized the Democrats for being too militaristic abroad. Only later, after almost unanimous support on both sides of the aisle for the war in Afghanistan, did the parties switch for Iraq. Well, sort of switched.
Progressive opposition to the Iraq War has been very much exaggerated. Both the left-liberal New York Times and Washington Post backed the war. Thomas Friedman, Christopher Hitchens, Jacob Weisberg, George Packer, and Jonathan Chait all supported the invasion. Current Senator and liberal-favorite Al Franken noted that “... I believed Colin Powell. I believed the presumption that the President is telling the truth. So I thought, ‘I guess we have to go to war.’” The popular liberal blogger Matt Yglesias explained his support for the war as having been because he “... adhered to the school of thought (popular at the time) which held that one major problem in the world was that the US government was unduly constrained in the use of force abroad by domestic politics.” In other words, progressives weren’t getting as much war in the 90s as they would have preferred.
Sure, most of them eventually repudiated their former support (with the notable exception of Christopher Hitchens). But almost everyone outside of a few neoconservative perma-hawks have done the same. When Republican Congressman Dana Rohrabacher was asked in 2010 how many of his Republican colleagues thought the war was a mistake, he responded, “I will say that the decision to go in, in retrospect, almost all of us think that was a horrible mistake.” Being against the Iraq War now is kind of like being against slavery now. It’s certainly the correct moral position, but it’s not a particularly brave or impressive stance to take.
And while there were more on the Left who opposed the Iraq War from the beginning, it must be noted that anti-war movement amongst progressives quickly dissipated as soon as Barack Obama was elected. And while some on the Left have opposed Obama’s many interventions (albeit quietly), you’ll find more support than opposition amongst progressives for Obama’s “kinetic military actions.” For example, Nancy Pelosi was pushing for a war with Syria while Progressive-favorite Elizabeth Warren wants to bomb Iraq. DNC Chair Michael Czin even channeled his inner-neoconservative by declaring that Rand Paul “blames America for all the problems in the world” because of Paul’s (unfortunately short-lived) criticism of intervening in Iraq once again.
Before airstrikes began in Libya, Slate ran articles titled “Don’t Let Qaddafi Win” and “Why Obama Doesn’t Need to Ask Congress Before Attacking Libya.” And it was no different for Syria, as Slate writer Fred Kaplan opined,
… [Obama’s] rationale for military strikes (which I agree with) puts him in a box. The organizations charged with enforcing international law are not joining in the attack. The U.N. Security Council is “paralyzed.” ... To gain some measure of legitimacy, Obama at least needs domestic support. And so, in addition to announcing that he’d decided to launch an attack on Syrian targets, he also announced that he would have Congress debate and vote on a resolution authorizing military force.
So Slate, the popular, progressive online magazine, supports the president asking Congress for authorization to go to war, but only when it is not practical or possible for the president to go to war on his own accord. Now that is a peace-loving position if there ever was one!
Democratic voters haven’t been much better. According to a Pew Study, Democrats were slightly more likely (47 percent to 45 percent) to support “conducting airstrikes in Libya” than Republicans. Furthermore, again according to Pew, only 19 percent of Democrats were opposed to taking military action against Iraq in January 2002. When the war began, it was only 37 percent and that number didn’t cross the half way mark until 2004.
It is important to note that Democrat is not a synonym for Progressive, and the party of old cannot be directly compared to the party of today. Still, generally speaking, the Democrats have supported greater economic control and redistribution by the federal government, at least since the New Deal. In other words, the Democrats have, generally speaking, been the party of the progressives. Thereby, it is not insignificant to point out that the United States became involved in all four major American wars in the twentieth century with Democratic presidents in office: Woodrow Wilson in World War I, Franklin Roosevelt in World War II, Harry Truman in the Korean War, and Lyndon Johnson in the Vietnam War. Indeed, in an interesting piece of research, Gallup found that the partisan difference regarding Iraq didn’t exist for Vietnam. In 1965, more Republicans were opposed to military action in Vietnam than Democrats (28 percent to 22 percent). The sides didn’t switch until about 1970 and remained close throughout the war.
Of course, many on the Left have been consistently opposed to war. The socialist Eugene Debs was even imprisoned during World War I for denouncing America’s participation in the conflict. And sometimes, unfortunately, it appears that such leftists are not so much anti-war, but simply on the other side. For example, while the American involvement in Vietnam was an abomination, that doesn’t mean Ho-Chi Minh’s communist regime was something to celebrate. And it’s hard to make the case that Jane Fonda was being “anti-war” when she was photographed sitting on a North Vietnamese anti-aircraft gun or that Noam Chomsky was pushing for peace while shilling for Pol Pot and Khmer Rogue during the Killing Fields in Cambodia.
And in general, the mainstream progressives of old were even more pro-war than the conservatives. For instance, the staunch progressive William Jennings Bryan was an adamant supporter of the Spanish-American War. In the words of historian William Leuchtenburg, “few political figures exceeded the enthusiasm of William Jennings Bryan for the Spanish War.William E. Leuchtenburg, "Progressives and Imperialism," Mississippi Valley Historical Review 39 (1952): 485. Thomas Woods further observes,
The humanitarian aspect of the war — namely, liberating Cuba from Spanish rule — appealed to Progressives. The response of feminist leader Elizabeth Cady Stanton was typical: “Though I hate war per se,” she wrote, “I am glad that it has come in this instance. I would like to see Spain ... swept from the face of the earth.”Thomas E. Woods, 33 Questions About American History You Are Not Supposed to Ask (New York: Random House, 2007), p. 53.
World War I was even worse. Theodore Roosevelt, who started the explicitly progressive Bull Moose Party, was more adamant then anyone about getting the United States involved in World War I. In fact, most progressives were in favor of the First World War, including Walter Lippmann, Herbert Croly, and John Dewey. Murray Rothbard described Dewey’s activism on the matter as follows,
… John Dewey prepared himself to lead the parade for war as America drew nearer to armed intervention in the European struggle. First, in January 1916 in the New Republic, Dewey attacked the “professional pacifist’s” outright condemnation of war as a “sentimental phantasy,” a confusion of means and ends. Force, he declared, was simply “a means of getting results,” and therefore could neither be lauded or condemned per se.”Murray Rothbard, "World War I as Fulfillment," The Journal of Libertarian Studies IX, no. 1 (1989): 96–97.
And the progressives’ support for war continued through World War II to the Korean War. Opposition to the war in Korea was scarce, but the little that was found was mostly on the Old Right, led by Robert Taft. It wasn’t until the Vietnam War was well under way that any real anti-war movement could be found on the Left. And as the politics of today show, a consistent anti-war sentiment is a minority opinion on the Left.
History is crystal clear that progressives have not been universally or even mostly opposed to war. Conservatives are in general no better, and of recent, they are somehow even worse. Thereby, it’s quite unlikely that a cure for the festering rot known as the warfare state will come from the right. But given its history, such a cure will probably not come from the Left either.
Image source: iStockphoto
In this Mises View, which is an excerpt from a recent seminar lecture, Mark Thornton explains how our standards of living improve through real economic growth. Thornton is a Senior Fellow at the Mises Institute.
Back in the 1980s, Irwin Schiff, anti-tax activist, political prisoner, and father of free-market pundit Peter Schiff, wrote a marvelous comic book titled How an Economy Grows and Why It Doesn’t, which teaches economic principles through a light-hearted story.
The comic starts with three islanders — Able, Baker, and Charlie — who live off of fish, which they catch in the sea. They have no tools to aid them, so they must fish with their bare hands. Fish, to the islanders, is a consumers’ good: something that is used to directly pursue their goals (in this case, the goals of satisfying hunger and not starving). But, fish can only be a consumers’ good when it is ready for consumption. The fish do the islanders no good while they are still swimming in the sea. So the islanders must engage in production. They must produce the product of “fish on a plate,” which is, to be exact, the true consumers’ good, and not simply “fish” per se.
To produce “fish on the plate,” the islanders must use productive resources, or factors of production. One factor the islanders must use is their own labor. In this case, their labor is the act of fishing: using their eyes to spot the fish, and their hands to grab them. Another factor they must use is land, or natural resources: in this case, “fish in the sea.” “Fishing labor” + “fish in the sea” = “Fish on the plate.”
Using only their bare hands, the islanders can only produce one fish per day, which is very low productivity.
As Schiff writes, with such low productivity, “This is survival and that’s about all.” It is a state of extreme poverty. The islanders have little time for leisure, or to produce anything else they might want to enjoy. They are also extremely vulnerable. What if they get sick, or break their hand? A single bad week of fishing could mean starvation. Life with such low productivity, is life on the brink.
Like a Disney princess, Able dreams of “something more.” He’s tired of being poor, and wants to somehow improve his living standard. He comes up with the idea of building a net to use to catch fish faster (boost his productivity).
The net is a third kind of factor: a capital good, or produced factor of production. Producing a net also requires factors, including natural materials (land), like sticks and vines, and net-building labor. Building the net would take a whole day.
That would be a whole day that Able wouldn’t be fishing. His labor is scarce; it cannot be dedicated to both fishing and net building at the same time, and so it must be economized: dedicated to one and not the other.
And if Able doesn’t fish, he goes hungry for that day. Building the net would require sacrifice: delaying consumption.
Able must decide between two different production methods. Does he stick to hand fishing, or does he switch to net fishing? He must consider the upsides and downsides of each.
The upside of hand fishing is that it has a short period of production. Able starts production, and then gets to eat later that very same day. The downside is its low productivity, and Able’s resulting chronic state of poverty.
The upside of net fishing is its higher productivity, which is two fish per day according to the comic; but for illustrative purposes, let us change the productivity of net fishing to three fish per day. The downside of net fishing is that it has a longer period of production at first. It takes one day to make the net, and then another day to use it. So, Able would start production, and only get to eat two days later.
Able is at a crossroads. He can either stay mired in primitivism, or he can rise above it. Rising above economic primitivism is often considered simply a matter of technology. However, simply having the idea of, and the know-how for, producing a net, is not an immediate, costless benefit for Able. It would be costless if it were simply a matter of choosing between “1 fish today” and “3 fish today.” Of course more is automatically better than less, other things being equal. But other things are not equal: a difference regarding time is an essential consideration here. It is not simply more vs. less; it is “more and later” vs. “less and sooner.”
So the decision for Able whether to adopt the “net fishing” technology involves a trade-off: an “exchange” he deliberates over in his mind. Will he give up the “less and sooner” yield that comes with hand fishing in exchange for the “more and later” yield that comes with net fishing?
The answer to that depends on Able’s personal time preference, or the premium he places on the immediacy with which he achieves his ends: the importance of “sooner.” The lower someone’s time preference is, the more willing someone will be to delay consumption. And the higher, the less.
For example, as the comic book later indicates, the time preferences of Baker and Charlie are too high for them to make the net. Giving up eating today is too great a sacrifice for them, even if it would mean being able to eat three times as much tomorrow. If net fishing were more productive, that might have sweetened the deal enough; i.e., if the net netted five times as much, they might have been willing to wait. Their time preferences are not infinitely high. But they are not low enough to embark on this particular capital project.
But Able’s time preference is low enough, so he is willing to delay consumption, produce the capital good, and increase his productivity.
Morevoer, the day after his first big net-aided catch, he has enough extra fish to not have to fish all day, because he can subsist on what he has already caught. Instead, he can spend the day creating even more capital goods to raise his productivity even higher. For example, he makes a rake to use to farm carrots. And he can use the additional yield from carrot farming to support even more capital accumulation. As he becomes ever more productive, he can also afford to devote more resources toward leisure and comfort as well.
Thus, Able’s low time preference puts him in the fast track of an ascending spiral: a virtuous “Cycle of Growth.” Saving (delaying consumption) supports more capital goods, which boosts productivity, which creates more to save, and around he goes.
With every lap around this loop, he becomes wealthier, as both his capital stock and living standard increases. And with every lap, he inches ever further away from the brink and toward greater security and peace-of-mind. A bad week of production becomes merely a bummer, and not a catastrophe. This Cycle of Growth, by the way, is the way living standards rise in a complex market economy as well.
But then others on the island start getting their own ideas about what Able should do with his newly abundant resources. One man says, “Divvy up.” This is an example of the envy-based egalitarian ethos that has afflicted peoples throughout history and pre-history, keeping them poor and primitive. As Murray Rothbard wrote:
In fact, the primitive community, far from being happy, harmonious, and idyllic, is much more likely to be ridden by mutual suspicion and envy of the more successful or better favored, an envy so pervasive as to cripple, by the fear of its presence, all personal or general economic development. The German sociologist Helmut Schoeck, in his important recent work on Envy, cites numerous studies of this pervasive crippling effect. Thus the anthropologist Clyde Kluckhohn found among the Navaho the absence of any concept of “personal success” or “personal achievement”; and such success was automatically attributed to exploitation of others, and, therefore, the more prosperous Navaho Indian feels himself under constant social pressure to give his money away. Allan Holmberg found that the Siriono Indian of Bolivia eats alone at night because, if he eats by day, a crowd gathers around him to stare in envious hatred.
If every time someone saves more, he is pressured to relinquish his “excess wealth,” that can only discourage savings. And knocking out savings knocks people off the Cycle of Growth. It also knocks them onto a Cycle of Impoverishment. This is because low savings can lead to capital consumption. “Consuming” capital doesn’t mean “eating the net.” It means that the net eventually wears out with use, and to maintain it requires diverting possibly consumed resources away from consumption and toward repair/replacement. Without sufficient savings, capital goods enter a state of disrepair. The net eventually tears and fish start swimming through it, at which point the fisherman must resort again to low-productivity hand-fishing, and finds himself back on the brink.
Another islander waves a club at Able, and suggests, “How about this?” threatening to plunder Able’s savings. Such brigandage has also kept entire peoples poor throughout history and pre-history. Constant raids by roaming hordes will also discourage savings and break the Cycle of Growth. Sometimes the raiders settle in, and, through propaganda, transform themselves into a “state,” and their plunder into “taxation.” What is particularly devastating to the Cycle of Growth is the kind of state plunder called, “proscription.” In ancient times, when an individual managed to accumulate enough wealth, he often became a tempting one-stop shop for loot, and so the state would find some excuse to imprison or execute him so as to facilitate his total expropriation. This explains the rage for “buried treasure” in times and places where princes were particularly grasping. Of course, modern democracies plunder too, often under the cover of egalitarianism and through “progressive taxation.” The more you save, the more you’re taxed. This too is particularly inimical to the Cycle of Growth.
Then a little bird asks if Able’s penchant for accumulation is “greedy” and bad. “Bad for whom?” responds a wise owl. There are only so many fish Able can eat, and only so many uses for his nets. To maximally benefit from his tremendous productivity, he must offer his products to others in the community in exchange for goods and services. And through exchanges like investments, loans, and wages, non-savers can get access to capital goods that would have otherwise been out of reach. For example, Able rents out his nets and loans out his fish at interest. This enables higher-time-preference islanders like Baker and Charlie to increase their productivity and living standards. And since all exchanges are, by definition, projected by both willing parties to be beneficial, the more exchanges the saver makes, the more he benefits the public.
Savings and capital benefit everyone, not just the saver and capital accumulator. The Cycle of Growth lifts the entire community. And so when egalitarianism and plunder discourage saving, it keeps the entire community down, hurting not only the savers, but everyone who might have exchanged with the savers.
There is nothing “fishy” about savings, capital accumulation, productivity, and peacefully acquired wealth. But to paraphrase an old saying, fish and plundering visitors start stinking very quickly.
As Ludwig von Mises wrote:
Every single performance in this ceaseless pursuit of wealth production is based upon the saving and the preparatory work of earlier generations. We are the lucky heirs of our fathers and forefathers whose saving has accumulated the capital goods with the aid of which we are working today. We favorite children of the age of electricity still derive advantage from the original saving of the primitive fishermen who, in producing the first nets and canoes, devoted a part of their working time to provision for a remoter future. If the sons of these legendary fishermen had worn out these intermediary products — nets and canoes — without replacing them by new ones, they would have consumed capital and the process of saving and capital accumulation would have had to start afresh. We are better off than earlier generations because we are equipped with the capital goods they have accumulated for us.
Image Source: from How an Economy Grows and Why It Doesn't
The modern health insurance industry, a by-product of government regulation and tax policy, has led to a system in which the consumer of medical services doesn’t know the costs or final prices charged for services. Without a functioning system of price signals, prices cannot be contained, writes Willem Cornax. This audio Mises Daily is narrated by Keith Hocker.
This article is also available as an Audio Mises Daily
Everyone loves making a buck, including governments. Unfortunately, the reality of many “great deals,” especially in the history books, has today been inflated to mythical proportions.
While most countries throughout history expanded their frontiers through peaceful trade or the spoils of war, the United States purchased much of its land, mostly from foreign governments. Today several of these land purchases are immortalized as great financial coups for the country.
Of the great land purchases, the three most famous are: the purchase of Manhattan from the natives in 1626; the Louisiana Purchase from the French in 1803; and finally the Alaska Purchase from the Russians in 1867. Each of these transactions shares in common the fact that they were voluntarily agreed upon by the parties directly involved, and that the sums involved are paltry by today’s standards. (Historians debate whether the natives that “sold” Manhattan to the Dutchman Pieter Minuit understood the concept of private property in the same sense as European merchants. The surviving documents for the purchase of Manhattan show a completed contract with no ensuing bloodshed or hard feelings on either side.)
The problem with reckoning costs in historical terms is that it compares apples to oranges. A dollar today just doesn’t buy what a dollar bought in 1626, 1803, or even a decade ago.
Adjusting for the effects of inflation throughout American history is a little complicated. Up until 1914 America had been on some form of gold (or silver) standard. There were several bouts of deflation during this time to mute the effects of inflation, which in general was quite tame. Inflation averaged 0.4 percent per year prior to 1914. In 1914, the creation of the Federal Reserve System changed everything dramatically. With the ability to economize on bank reserves and to create fiat money at whim, the inflation rate surged. Since 1914 the inflation rate has averaged about 3.5 percent per year.
Adjusting the original purchase prices for inflation, they still look pretty good. In fact, the price Pieter Minuit paid for all of Manhattan would today buy about a half square meter of condo real estate on the island. Not bad. Likewise, sitting smack-dab in the middle of the Louisiana Purchase, farmland in eastern Nebraska today sells for around $7,000 an acre. The United States government bought roughly 53 million acres in 1803 for the same price as 100,000 acres of Nebraska farmland would cost today. Again, that looks like a shrewd investment.
But wait. When these tracts of land were initially purchased they were undeveloped. It would take some time before the pioneers, capitalists, entrepreneurs, and settlers arrived and started to make improvements to the land. Land in Nebraska or Manhattan is now more valuable because of the infrastructure improvements — highways, canals, utilities, and other services — that were made throughout the centuries. This allowed the land and people to be more productive.
Agriculture, such as dominates the eastern Nebraska landscape, has experienced productivity in leaps and bounds over just the past decades. Wheat yields which averaged less than 1,000 kg/Ha in the 1950s have increased to over 2,500 kg/Ha since the mid-1990s. Advances in mechanization, fertilizers, irrigation, herbicides, and methods of planting have all had the effect of increasing what we can harvest from this land. (In 1900, 38 percent of the US labor force was still employed in agriculture; today the figure is less than 1 percent.)
There was virtually no productivity on Manhattan island at the time it was purchased, and thus of less value. Today, 388 years later, and much work by hundreds of thousands of people, Manhattan has been transformed from a wilderness into a global financial center.
Adjusting the purchase prices for inflation for these three tracts of land is a good start, but it still compares apples with oranges. An acre of rocky, uncleared Nebraska land in 1803 is just not the same as a tilled, fertilized acre of farmland today.
To see if the prices paid centuries ago were reasonable, we need to determine what the same land is worth today; this will allow us to see what the return on the original investment has been. One way is to treat the current level of production in each region as a perpetuity to determine its present value. (We will discount these future cash flows at the long-run rate of nominal GDP growth of 5.5 percent.)
The greater metropolitan area of New York City generated $1.3 trillion in income in 2012, roughly 8 percent of the American total. The present value of a perpetuity paying $1.3 trillion per year (ignoring growth), discounted at 5.5 percent, is just shy of $24 trillion dollars.
The Louisiana Purchase is more complicated, as its boundaries do not correspond to actual states today. If we include states that have at least half of their area within what was the Louisiana Purchase: Montana, Wyoming, Colorado, Oklahoma, Louisiana, Arkansas, Kansas, Missouri, Iowa, Nebraska, South Dakota, North Dakota and Minnesota, we find that their combined output is roughly $1.7 trillion, or 12 percent of total American GDP. The present value of such a perpetuity (again, ignoring growth for simplicity) discounted at 5.5 percent is about $30 trillion.
Finally we get to Alaska. The total output of this state was around $60 billion last year in 2013, or about 3.5 percent of the total GDP of the United States. This perpetuity is worth around $1 trillion.
So how good were these original purchase prices viewed with the benefit of hindsight? We can answer this by comparing the present value of their current output with their original cost.
While historians often give credit for these purchases to the foresight of the governments of Thomas Jefferson and Ulysses S. Grant, in reality they haven’t paid off as well as one might expect. The Louisiana Purchase in particular has only “returned” about 7 percent once we adjust the figures for economic growth since 1803. The purchase of Manhattan hasn’t fared much better, and the figure would even be worse if we were to include only output produced within Manhattan, instead of the greater New York metropolitan area. All three purchases experienced fairly standard rates of return compared to what the general American economy has been able to generate.
By all appearances, instead of being wonder-investments they are just par-for-the-course. In comparison to many investors, like Warren Buffet for example, these returns are downright dismal.
To be fair, there are intangible benefits to each of these purchases not apparent in the objective numbers. Manhattan provided a trading foothold in the new world. The Louisiana Purchase secured the Mississippi River watershed, and with it, removed the ability of Napoleon and the French from halting the westward advance of Americans. Finally, Alaska has suffered from centuries of public ownership of its lands with heavy-handed regulations stopping entrepreneurs from developing its resources and putting them to good use.
This exercise demonstrates the dangers inherent in looking at historical transactions and thinking of them in modern terms. Not only is adjustment for inflation necessary, it may be insufficient as improvements to productivity still create a comparison of apples to oranges. The real value and relevancy comes by adjusting historical amounts by economic growth; only in this way can we grasp how profitable certain ventures have been.
Image source: iStockphoto
In a free market, entrepreneurs profit by providing something of value that people will voluntarily purchase, writes Hans-Hermann Hoppe. This audio Mises Daily is narrated by Robert Hale.
As a frequent viewer of The History Channel I have come to appreciate several of its weekly programs, not only for their own sake, but for the many principles of economics demonstrated in each episode. I have written previously of the lessons from the pawn shop, describing a few notable economic concepts one learns from watching Pawn Stars and American Restoration. Another such television show is American Pickers. Here one sees not only classical economic theory in practice, such as comparative advantage and specialization and trade, but other Austrian insights as well.
American Pickers follows the daily business of two pickers, Frank Fritz and Mike Wolfe. They travel the country, stopping at junk yards and visiting collectors of old, obscure Americana, looking for bargains. Viewers learn the history of a few choice items and then the haggling begins. Buyers make their offers and sellers counter, back and forth, until they reach an agreeable price, or they reach an impasse and move to another item. The subjective values of each party are on display, indicating ex ante the expectations of both actors.
The goal of the pickers is to find valuable antiques at a discount, and sell them to retail customers for a profit. This activity is sometimes discredited by critics of the free market who perceive the pickers to be exploiting the owners. They see them negotiate a low price and the anticipated profit each item will bring, and conclude there must be unfair practices involved. The question they never ask is, if the owners were able to sell these goods at higher prices, why haven’t they done so?
The answer is that not everyone has the entrepreneurial judgment to see the future wealth in a pile of junk or an over-crowded garage. Ludwig von Mises, in his treatise Human Action, explains that the entrepreneur “does not let himself be guided by what was and is, but arranges his affairs on the ground of his opinion about the future. He sees the past and the present as other people do; but he judges the future in a different way.” In this way, the pickers are anticipating the future wants of the consumer and acting in such a way as to be ready to meet them.
Looking deeper, we see that not only is there such foresight involved, but an entire structure of production laid out to help them achieve their ends. They must employ capital in such a way as to bring these goods – which in some ways are comparable to higher order goods, in that they are not immediately available for the consumer — to the market.
Retail buyers do not have ready access to the particular items they wish to buy. The pickers undertake extensive labor, driving all over to find pieces that consumers will want at some future time. To this end, the pair must use money to cover such expenses as fuel, hotels, maintenance, shipping, and of course the purchase of inventory. It also takes an expert knowledge of the antiques market to know what items are sought after, and what buyers may be willing to pay in the future. Often the items they select require repairs and restoration to bring the highest return, or even to sell at all. This requires other specialists, more resources, and additional time, thus demonstrating the many roles capital plays, and the added benefits of changing the process of production into more roundabout ways.
This also reveals the risks associated with operating a business. The viewer has an idea of how much profit each item should bring, but it’s not always clear that they will sell for that price. One also sees that some items are harder to sell than originally anticipated, meaning a lower return for the pickers. They must pay their employee, Danielle, who expects regular wages, and cover other costs of the business, whether the inventory moves or not.
Sellers implicitly seem to understand this, which is why they are frequently willing to part with items they may have owned for decades. They do not possess the same production structure that Fritz and Wolfe have accumulated, and are happy to sell their goods to an intermediate buyer, even if it means a lower price than on the retail market. An offer of cash in the present is attractive enough to forego an even greater amount in the future, revealing their time preference. In some cases we find they once bought these pieces for much less than the pickers offer, providing the owner some return on his initial purchase. At other times, we see the owners are surprised that anyone places such a value in their property, in which case they are happy to sell to anyone, because it will benefit them in ways they had not previously understood.
Other potential barriers for the pickers are owners unwilling to sell anything. The two may spend many hours on the road and find it difficult to buy anything sufficient to cover the gas expense, let alone bring in revenue. While this is unfortunate for the pickers, it reveals the rational action of the owners, who see the bids and decide they are better off waiting. While we cannot know precisely why they choose to pass on the opportunity to sell something, we can conclude from praxeology that it is because of a perceived disutility in the transaction. Again, only mutually agreeable transactions take place in these markets.
Through this show we see wealth created before our eyes. What were once idle, all-but-forgotten pieces of antique history are given new life, and provide new wealth to all parties. What we often do not see in the show are the ultimate consumers, who benefit greatly from the work of the pickers, and for whom the latter must be ever mindful.
The Free Market 32, no. 4 (April 2014)One of my favorite economists in the history of economic thought is the great Austrian, Carl Menger (1840–1921). While the mainstream of the economics profession acknowledges Menger’s place due to his contribution to the Marginalist Revolution in the 1870s, it otherwise ignores him because his theoretical framework does not lend itself to policy prescriptions. In an era in which the economics profession largely views itself as a shadow branch of government which is itself charged with managing the economy, thinkers like Menger (and those who work in his tradition) are not going to be extolled or studied in the same way that thinkers like Irving Fisher, John Maynard Keynes, Milton Friedman, or Paul Krugman have been.
This is true if only because the government tends not to fund academics or economic schools of thought that do not promote its central role in the economy or provide economic justifications for its interventions in market forces. Absent this connection, the study of Chicago-School Monetarism or Ivy-League Keynesianism would have much less prominence in economic science today.
Menger’s theoretical framework differs from so many of the modern interpretations of economics because he represented the culmination of a pre-Progressive Era development of economic thinking that had occurred over centuries, mostly in continental Europe by scholastic thinkers in the Middle Ages as well as French liberals such as Turgot, Cantillon, and Say. Such people may have studied economics as a form of what was known as the Moral Sciences in the nineteenth century, but their impetus for doing so was often due to the innate human desire to better understand the world and the natural laws that govern it. Their interest was in economics as economics, and not simply as a policy tool to make government appear more scientific, efficient, or benign. (Government is actually the exact opposite of these things.)
So to study economics as a science, pure and simple, especially in an era in which it seems economic confusion reigns, it is not a bad choice to start with Carl Menger.
Menger was born in Galicia, a then-Austrian region that is now in Poland, to a wealthy family with roots in Bohemia. During breaks from the study of law at the Universities of Prague and Vienna, Menger worked asa financial journalist who developed some degree of prominence for writing novels and comedies that wereserialized in newspapers.
It was during his time as a journalist that Menger first noticed the significance of the discrepancies between Classical economic doctrines on market phenomenon and the actual business market that he covered over the course of his profession. Soon after receiving his law degree from the University of Krakow in August 1867, Menger embarked on the formal study of political economy in an attempt to better understand and resolve these discrepancies — an effort that resulted in the 1871 publication of Principles of Economics.
While Menger recognized that the Classical economists had made significant contributions to the development of economic theory, he believed one of their primary shortcomings was in their analyses of the consumer, a shortcoming which was perhaps epitomized by the Classicals’ emphasis on the labor theory of value and their rudimentary and even shallow price theory that explained prices as phenomena resulting mostly from the economic calculation of businessmen. Menger’s primary contribution in Principles was to insert the primacy of the consumer in determining value and (by extension) price, not only in the marketplace but in all economic activity.
The Mengerian approach, which we today call the science of praxeology, emphasized the importance of individual human action resulting from the desire to satisfy felt needs and the relationship of those needs to the external world. Having a felt need, and the knowledge that the external world possesses some characteristics that allow the individual to satisfy it, provide the basis for logical human action and the subjective valuation of goods and services both within and apart from the market. Menger further noted that as our knowledge about the external world changes, so do individually-felt needs. Efforts to satisfy felt needs presuppose recognition of cause-and-effect relationships that provide the basis for all of human action.
Note how completely irrelevant such a framework is to modern adherents of the Keynesian or Chicago Schools. The major difference is that both schools view the individual person (or actor) as an object that needs to be manipulated in the name of policy success. For Chicagoans, this success is based on market outcomes that are closer to their pre-conceived ideals regarding market efficiency, while for Keynesians, this success is based on the achievement of arbitrary short-run employment levels that are achieved in practice by penalizing saving and rewarding consumption. To both schools, the human person is a cog in an economic machine that must be coerced to act in ways that make their systems work. Such a view is modern — its roots are in the Progressive Era — and contrasts with economics as it developed from Aristotle through Menger (and beyond through those who developed Menger’s system).
But in the 1870s, Menger boldly applied its implications to the determination of value. He noted that since goods are external to the human person and recognized subjectively as possessing qualities that allow for need satisfaction, they could be differentiated between goods of different order. In Principles, he described first-order goods as being goods that we consume to satisfy needs. These are consumption goods. Second-order goods are goods required to produce the first-order good, so that while a car may be a first-order good satisfying a felt need for transportation, the second-order goods would include the glass, rubber, chrome, and all the other inputs which make up the car. The third-order goods are all of the goods that are required to produce the second-order goods, and so on, with more complex forms of production being characterized with more distant orders of production.
Nonetheless, the values of all of the goods of whatever order are derived from the initial subjective desire on the part of the individual to satisfy a felt need, so that rubber has value not in itself or in the work effort going into its production, but because of the initial human desire for transportation, leading to a human preference for cars. This understanding of goods contrasted greatly with the Classical economist’s notion that the value of economic inputs is based on their technical usefulness in production. Menger’s value theory represents an expansion of Say’s Law that supply creates its own demand, and is the proper theoretical response to the monetary and credit cranks (of Menger’s time as well as today) who see no difference between government-created and -directed capital and privately-created and -directed capital.
In truth, government-created capital satisfies the needs of the political classes and the special interests connected to it, whereas privately-directed capital is directed at the satisfaction of consumer wants.
Absent the state’s influence in the development of twentieth-century economic thought, it is likely Menger would be known today as an important Classical economist who corrected known shortcomings of the Classical School, and it would never have been deemed necessary for Classical economics to morph over time into various neoclassical schools characterized by tools appropriate for the hard sciences.
Volume 17, No. 2 (Summer 2014)ABSTRACT: Theorists of the Austrian school have long maintained that every realized price is market-clearing, in sharp contrast to the adherents of the neoclassical mainstream, who view realized prices as constituting a state of disequilibrium with a mismatch between demand and supply. The heart of these theoretical differences lies in the equilibrium constructs used by the members of the two schools of thought in their analysis of price formation. This paper seeks to clarify and developG.P. Manish (gmanish@troy.edu) is Assistant Professor of Economics at the Manuel Johnson Center for Political Economy, Troy University. is Assistant Professor of Economics at the Manuel Johnson Center for Political Economy, Troy University. the conceptual foundations underlying the Austrian position, especially the concept of the plain state of rest, which represents a state of market equilibrium with error. It also provides a brief sketch of the role that realized prices play in the process of error correction and entrepreneurial selection that forms a key part of the market process as described by Ludwig von Mises.
KEYWORDS: Austrian school, equilibrium, entrepreneurship, Walrasian, disequilibrium, neoclassicismJEL CLASSIFICATION: B53, B25, B21, D51I. INTRODUCTIONTheorists working in the tradition of the Austrian school have consistently maintained that every realized price establishes a momentary equilibrium between demand and supply and exhausts all the potential gains from trade. This maxim was enunciated by Carl Menger, the founder of the school, who in his pathbreaking Principles of Economics noted that “the prices of goods are symptoms of an economic equilibrium in the distribution of possessions between the economies of individuals” (Menger, 2007 [1871], p. 192), a conclusion echoed by his immediate follower Eugen von Böhm-Bawerk, who described such a “momentary equilibrium” not as “a metaphorical analogy” but “as living reality (Böhm-Bawerk, 1959, pp. 229, 231).” The leading “Mengerians” in the early twentieth century were equally emphatic. Frank Fetter led the way, arguing that “any price, no matter how temporary and unstable, is one that for the moment brings into equilibrium the quantities bought and sold, produced and wanted at that price (Fetter, 1910, p. 133),” while Herbert Davenport was just as categorical, stating that “every price level is, for its particular time, the point at which the supply and demand arrive at an equilibrium (Davenport, 1929 [1913], p. 42).”
In the post-World War II era, this proposition received further emphasis in the works of Ludwig von Mises and William Hutt. Mises, for instance, observed that “at any instant (on the market place) all those transactions take place which the parties are ready to enter into at the realizable price,” with only “those potential sellers and buyers who consider the market price too low or too high” abstaining from buying or selling (Mises, 1998 [1949], p. 245). Similarly, Hutt, that venerable foe of the Keynesians, argued that whereas “‘potential supplies’ of and ‘potential demands’ for things (at different values or prices) may be represented in supply schedules and demand schedules…actual supplies and actual demands are identical magnitudes with identical values or prices at the point of intersection of those schedules (Hutt, 2007 [1974], p. 15).”
The most elaborate and conclusive defense of the proposition that every realized price is market-clearing, however, was provided by Arthur Marget in his magnum opus The Theory of Prices (Marget, 1966, p. 231–263). While emphasizing that “the goal of any Theory of Prices, like that of any part of economics which undertakes to explain economic reality, is to explain why realized prices are what they are (Marget, 1966, p. 222, emphasis in the original),” Marget went on to argue that “the only type of “equilibrium” which is necessarily involved in the establishment of any “realized” price is an “equilibrium” between (in the sense of an equality of) the quantity demanded and the quantity supplied at a given price (Marget, 1966, p. 232, emphasis in the original).”
These claims of economists working in the Mengerian tradition stand in sharp contrast to the views of their neoclassical colleagues, who, for ultimate inspiration, look not to Menger but to two other giants of the economics scene of the late nineteenth century—Léon Walras and Alfred Marshall. J.R. Hicks, whose work is probably the best embodiment of this neoclassical Walrasian-Marshallian synthesis, believed that exchanges would most likely be made at disequilibrium prices; prices at which demand and supply will not be equated. In other words, Hicks believed that realized prices are not market-clearing in nature and that the construct of equilibrium is unrealistic and inapplicable to the economic phenomena of the real world.
Thus, commenting on Walras’ analysis of price formation in a pure exchange scenario, i.e., with given stocks of goods, Hicks states that “if there is no actual exchange until the equilibrium prices are reached by bidding, then Walras’ argument is beyond reproach on the score of logical consistency, although it may be called unrealistic (Hicks, 1934, p. 342, emphasis added).”For similar assessments of Walras’ equilibrium construct in a pure exchange setting see Schumpeter (1963 [1954], p. 1008-09), Patinkin (1956, appendix on Walras’ tatonnement), and Donzelli (2007). For an identical interpretation of Marshall’s treatment of equilibrium in a pure exchange economy (his ultra-short period equilibrium), see De Vroey (1999). Similarly, in his famous note on price formation in his treatise Value and Capital, Hicks first notes that “since, in general, traders cannot be expected to know just what total supplies are available on the market, nor what total demands will be forthcoming at particular prices, any price which is fixed initially can only be a guess,” and then concludes that “it is not probable that demand and supply will actually be found to be equated at such a guessed price.” It is to describe such realized disequilibrium prices that Hicks coined the phrase “false prices,” while defining exchanges made at such prices as “false trades (Hicks, 1946 [1939], pp. 127–128, emphasis added).”
In order to understand these differences between the Mengerian economists and their neoclassical colleagues, it is vital to note that in a pure exchange scenario (the only scenario that this paper considers), the former make use of two types of equilibrium constructs in order to gain an understanding of price formation.For the various equilibrium constructs utilized by the Mengerian economists both in a pure exchange setting as well as in a scenario allowing for production and the associated changes in the stocks of goods available for sale, see Salerno (1993, 1994, 1999) and Klein (2010, pp. 125–150). They employ, first, the inherently unrealistic construct of an equilibrium or a state of rest without any error; a state in which all market participants are engaging in action that is optimal. In addition, they also utilize the eminently realistic construct of an equilibrium with error, i.e., a state of rest that does not involve optimal action on the part of market participants. Indeed, as this paper seeks to illustrate, the latter concept is key to understanding the claim that all realized prices are market-clearing in nature. Moreover, it is also the key to clarifying the differences between the Austrian and neoclassical understanding of realized prices, since the latter employ only one equilibrium construct (in the pure exchange scenario), namely, the unrealistic one of an error-free equilibrium.
As mentioned above, the analysis in this paper is confined to the realm of a pure exchange economy, one in which the stocks of the goods being exchanged are assumed to be fixed and in which the complications introduced by the production of goods are completely ignored. The model utilized is an adaptation of the canonical Austrian pure exchange model, that of the horse market, first introduced by Menger (Menger, 2007 [1871], pp. 197–225) in his treatment of price formation and then made famous by Böhm-Bawerk (Böhm-Bawerk, 1959, pp. 215–235).
Section II of the paper lays out the basic structure of our model as well as the assumptions underlying the analysis that follows. Section III focuses on the error-free equilibrium construct. This section introduces and develops the crucial difference between the original valuations with which the market participants enter the market and the momentary valuations that prevail at the moment when the exchanges are completed. A grasp of these two concepts and the differences between them is crucial to understanding the construct of an equilibrium with error, which is developed in detail in section IV. Section V of the paper provides a brief adumbration of the process of error correction that operates on the market, all the while paying close attention to the crucial role that the error-filled, realized prices play in this process, while section VI summarizes the arguments developed during the course of the paper, thereby providing a conclusion.
II. THE HORSE MARKETConsider a small horse market in an isolated village. Potential buyers arrive on the market ready to offer sums of money in exchange for horses; whereas the potential sellers possess horses they are willing to part with for the right sums of money. The maximum buying prices, i.e., the maximum amounts of money that buyers are willing to part with for each additional horse are depicted in Table 1 below:
Table 1.
This list of maximum buying prices represents a snapshot of the value scales of each potential buyer when he enters the market. Each buyer places a valuation on an additional horse, a result of a comparison of the respective marginal utilities of the horse and a sum of money. Consider buyer A1, who is willing to part with a maximum of $50 for his first horse and ten dollars less for each subsequent horse. How did he arrive at these precise sums of money that he is willing to pay for each additional horse? He did so by comparing the marginal utility of the additional horse and the marginal utility of the sum of money, a comparison made in his “given situation” when he enters the market, i.e., with his given endowment of money and horses and his prevailing scale of ends. His willingness to part with the $50 for the horse shows that he ranks his first horse above that amount of money since the former’s marginal utility exceeds that of the latter.
There are, as can be seen, altogether five potential buyers of horses in our market. Given that the law of diminishing marginal utility applies to both horses as well as money, each buyer is willing to pay a smaller amount for each additional horse that he considers purchasing. Each additional horse will be used to serve an end ranked lower than that which the previous horse satisfied, and each additional sum of money has to be withdrawn from the service of an end or a complex of ends that ranks higher on the buyer’s value scale.
Standing athwart our five buyers are two potential sellers with five horses apiece. Like our buyers, each seller also places a valuation on each horse that he possesses; a certain minimum monetary sum that he is willing to accept in exchange for giving up the horse. These minimum selling prices of the two sellers are depicted in Table 2 below:
Table 2.
It is clear from the table that both the potential sellers place a minimum price of $0 on all the horses in their possession, an indication that they are willing to sell each of them for any positive sum of money. These minimum selling prices are a reflection of the fact that both B1 and B2 receive no marginal utility from any of the horses in their possession. Stated differently, there is no end for either of them that is dependent on the possession of a horse and that would remain unsatisfied if they were to lose a horse. Just like the buyers, B1 and B2 also form these rankings of their horses against sums of money in the given situation that they find themselves in when they enter the market, i.e., given their endowments of money and horses and their prevailing scale of ends.
The five buyers and two sellers are assumed to enter our imaginary market at the beginning of a market day. Their prevailing value scales (depicted in Tables 1 and 2) reflect their rankings of units of horses relative to sums of money as they enter the market. In the following analysis, it will be assumed that these initial valuations, which can also be termed original valuations, stay unchanged through the course of the given market day, i.e., as long as the market remains open for business. These original valuations, along with the stock of horses available for sale, can thus be said to constitute the underlying data of our market scenario. Moreover, it is also assumed that no market for horses exists in the foreseeable future, depriving sellers of the option of carrying over and selling any unsold horses on future market days. As a result, they must sell all the horses that they wish to by the end of the given market day.
The original valuations of our potential market participants throw up a host of opportunities for both buyers and sellers to make themselves better off by engaging in exchange. Indeed, the maximum buying prices of all the potential buyers for each additional horse are above the minimum selling prices placed by sellers B1 and B2 on the horses in their possession. In other words, there are a number of instances in which a buyer ranks a horse above a certain sum of money and a seller ranks those two things in reverse, thereby resulting in a reverse valuation that can be exploited via an exchange. By swapping the sum of money for the horse, the buyer obtains a good that he values more and thus ranks higher for one that he values less, thereby making himself better off. And the seller does likewise; he gives up a good he values less for a good he ranks higher, and thus achieves an improvement in his well-being.
III. THE FINAL STATE OF RESTLet us assume that B1 and B2 are endowed with perfect knowledge of the prevailing market conditions. Blessed with the ability to read the value scales of all the other market participants, each seller gains a window into the minds of his competitor and all the potential buyers. He learns that, just like him, the other seller also enters the market with five horses and a minimum supply price of $0 for each of them, enabling him to reconstruct the “original supply schedule” derived from the original valuations of the sellers. He knows, therefore, that all ten horses possessed by the sellers will be forthcoming for sale at any positive price.
Similarly, each seller is also in a position to know the maximum sum of money that each buyer is willing to part with for each additional horse, allowing him to form a correct estimation of the underlying “original demand schedule” that emerges from the original valuations of the potential buyers. In other words, he knows how many horses the buyers are willing to buy at any given price.
Upon reconstructing these original demand and supply schedules, each seller learns that our imaginary market clears at the price of $20, with the quantity of horses that buyers are willing to purchase at this price equaling the amount that is forthcoming on the part of the sellers, i.e., the entire stock of ten horses in their possession. At any other price, however, there is a mismatch between the quantities demanded and supplied. For instance, at a price below $20, the amount that buyers are willing to buy exceeds the amount that sellers are willing to part with, whereas the opposite scenario prevails at a price above $20, with the quantity supplied at such a price outstripping the quantity demanded.
Each seller undertakes this appraisement of the underlying market conditions in order to find the price that will maximize the flow of monetary revenue from the stock of horses in his possession. For while he would prefer to sell his horses for any positive sum of money, his preference for more money as compared to less makes him aim at selling them for the highest possible price. Thus, he endeavors to obtain an understanding of the given market situation in which he operates and the data underlying it so as to allocate each of his horses to satisfy the ends that he values the most, namely, that of obtaining the highest possible sums of money in exchange.
Now, based on his knowledge of the prevailing original demand and supply schedules, B1 concludes that it would be a mistake to sell any of his horses at a price below $20. For at any price below $20, the quantity of horses that buyers are willing to purchase exceeds the quantity of horses forthcoming for sale and it would pay for him to raise his asking price since he could sell his entire stock of horses at a higher price. In other words, the sale of any horses below the price of $20 would be at odds with his goal of maximizing the monetary revenue earned.
Similarly, B1 also realizes that any attempt to price a horse above $20 would ultimately prove to be counterproductive. For if he were to try and outfox B2 by pricing his stock of horses at a price higher than $20, B2 could out-compete him by pricing his horses a little lower, and as a result B1 would earn less revenue than he would have at the price of $20.
To understand why this is the case, let us examine the underlying data of our market in more detail. From the information presented in Table 1, it is clear that at the price of $20 the available stock of horses can satisfy the demands of all those buyers who value a horse at $20 or more. Buyer A1, for instance, would buy four horses at this price since he ranks his first four horses above the sum of $20, while the other buyers would do likewise; they would all purchase horses as long as an additional horse is ranked above $20.
Now, assume that B1 prices the horses in his stall at $30, indicating to the buyers that this price is non-negotiable. B2 could respond by pricing his horses slightly lower, say, at $29. This would induce the buyers who trickle into the marketplace to avoid B1’s stall and instead make all their purchases at B2’s stall. B2 would thus have no trouble in selling his entire stock of five horses at this price, with his horses being purchased by buyers who rank an additional horse above the sum of $29.
These purchases made at the price of $29, however, would reduce the remaining demand for horses at the initial market-clearing price of $20. To begin with, some of the buyers who would have happily bought a horse at the price of $20 have now made their purchases at the price of $29 instead. A1, for instance, purchases three horses at this price, although he would have been just as willing to purchase them at $20. This is the first factor making for a reduced demand at $20.
There is, moreover, a second factor at work. Some of the demand for horses on the part of buyers who would have purchased horses at $20 has now been effectively destroyed due to their decision to purchase horses at $29. Thus, A1 has a demand for four horses at the price of $20, but buys only three horses at the price of $29 before exiting the market, thereby destroying his demand for that fourth horse at $20. Similarly, A4, who leaves the market empty-handed when the price is $29, would have purchased one horse if the price had been $20. His exit from the market, however, implies that his demand for that first horse at $20 has now disappeared.
Thus, if B1 were to now revise his asking price down to $20, he would find himself unable to sell his stock of five horses at this price. For as a result of the two factors described above, the quantity of horses demanded at the price of $20 is no longer five horses but a lower quantity, which implies that B1 would have to lower his asking price below the figure of $20 in order to sell his stock of five horses. Thus, B1’s attempt to earn more revenue by pricing his horses above what he knows to be the final price necessarily ends in frustration. His revenues are now lower than what they would have been if he had priced his horses at $20 from the beginning. Meanwhile, the coffers of his competitor are now fuller, since he was able to sell his horses at the higher price of $29.Stated differently, the demand curve facing each individual seller is elastic above the price at which the entire stock of horses available can be sold. For a more elaborate discussion of this proposition, see Salerno (2003) and the sources cited therein.
Thus, B1 and B2 both decide to price the horses in their stalls at $20 apiece while buyers, in turn, trickle into the marketplace through the day and decide whether or not to make purchases at this price. As is evident from table one above, at the price of $20 buyer A1 is willing to buy four horses, whereas buyers A2, A3 and A4 are willing to buy three, two and one horse respectively. Buyer A5, meanwhile, leaves the market empty-handed since his first horse is ranked below the prevailing price. Thus, by the end of the market day all ten horses have been sold, with the sellers successfully getting rid of their entire stock of horses.
It is vital to note that the valuations of the sellers at the moment when these exchanges are made differ from the original valuations with which they entered our imaginary market. For when they initially entered the market, the sellers were willing to part with their horses for any sum of money. However, their appraisements of the original demand and supply schedules led them to revise these original valuations, giving rise to “momentary valuations” and a “momentary supply schedule” that prevails at the moment when the sellers decide to exchange their horses for sums of money offered by the buyersIn the words of Phillip Wicksteed, “…whenever equilibrium does not exist, and the conditions for exchange are present, the persons conducting the exchanges attempt to form an intelligent estimate of the price which would produce equilibrium, and the result of that attempt fixes the actual terms on which all the exchanges in the open market are for the moment made (Wicksteed, 1910, p. 214).”.Far from being willing to sell all of their horses at any positive price, B1 and B2 now choose to price their horses at $20, thereby indicating that they prefer to withhold their horses rather than sell them at a lower price.
All realized prices, in fact, are the result of the momentary valuations of the buyers and sellers that prevail at the moment when the exchanges are made.As Davenport notes, “The actual price at any instant is fixed by the demand bids as they are and the supply offers as they are, and by nothing else—by the actual rather than the potential facts (Davenport, 1929 [1913], p. 43).” Davenport uses the term “actual facts” to refer to what I have termed momentary valuations while the “potential facts” that he refers to correspond to the underlying data or the original valuations. In the analysis above, we assumed that only sellers have perfect knowledge and appraise the underlying market conditions, while buyers make their purchases without engaging in any appraisement. Thus, the momentary value scales of the buyers at the moment when they make their exchanges do not differ from their original valuations, thereby implying that the momentary and original demand curves are identical.
One can, however, assume that buyers also have perfect knowledge and that they too try to gain an understanding of the prevailing market conditions. Blessed with this ability to reconstruct the original demand and supply curves, each buyer, given that he would like to buy an additional horse at the cheapest price possible, re-adjusts his maximum buying prices to ensure that he does not pay more than he has to for a horse. Each buyer knows that at prices below $20 the quantity of horses supplied exceeds the quantity demanded. He thus concludes that it would be a mistake to pay anything more than $20 for a horse and proceeds to re-adjust his maximum buying prices that were above this price downwards, giving rise to the momentary valuation that underlie the momentary demand curve (which would no longer be identical to the original demand curve).As described by Marget, “…it is of course perfectly possible that the demand and supply schedules of the bargainers may themselves change in the process of bargaining. In the case under discussion, this means (1) that the original demand schedules, for example, may change when some demanders discover that the price they would have been willing to pay is higher than they need to pay; or (2) that the original supply schedules may change when some suppliers discover that the price that they would have been willing to accept is less than that which they need accept (Marget, 1966, p. 232, fn. 25).”, In the rest of the analysis below, we will continue to assume that only sellers appraise the underlying valuations of market participants and that buyers do not do so. This assumption, however, does not affect any of the conclusions derived in the paper.I have, however, chosen to stick with Mises’s terminology for two reasons. First, and most importantly, the conclusions derived during the course of the following analysis on the relationship between the momentary and original valuations and therefore on the relationship between the error-free equilibrium (the final state of rest) and the equilibrium with error (the plain state of rest) are equally valid in both a pure exchange scenario as well as in a scenario with production. Second, in light of this, I believe that the benefits derived from the avoidance of a multiplication of terms exceed the costs of any potential misinterpretation of the results derived.I have, however, chosen to stick with Mises’s terminology for two reasons. First, and most importantly, the conclusions derived during the course of the following analysis on the relationship between the momentary and original valuations and therefore on the relationship between the error-free equilibrium (the final state of rest) and the equilibrium with error (the plain state of rest) are equally valid in both a pure exchange scenario as well as in a scenario with production. Second, in light of this, I believe that the benefits derived from the avoidance of a multiplication of terms exceed the costs of any potential misinterpretation of the results derived.
The realized price of $20 has several interesting proerties that are worth analyzing in more detail. First, the sale of all ten horses at this “final price” brings our market to a “final state of rest.”The terms “final state of rest” and “final price” were first used by Mises (Mises, 1998 [1949], p. 246) to denote the state of long run equilibrium where all the factors of production have been allocated to their highest valued ends and no firm earns a profit or loss and the prices that prevail in such a state respectively. Given that our analysis is conducted in a pure exchange scenario where the stocks of goods are assumed to be given and all problems associated with production and the allocation of the factors of production are assumed away, an argument can be made for the use of another term to describe the price that clears the market given the underlying data in such a scenario. Indeed, others have chosen to go down this route. Professor Salerno, for example, has used the term “Wicksteedian State of Rest” to describe such a price (Salerno, 1994, p. 99). Alternately, one could follow Frank Fetter and term such a price “the logical or theoretical price (Fetter, 1915, p. 66 and fn. 5 on p. 66).”
I have, however, chosen to stick with Mises’s terminology for two reasons. First, and most importantly, the conclusions derived during the course of the following analysis on the relationship between the momentary and original valuations and therefore on the relationship between the error-free equilibrium (the final state of rest) and the equilibrium with error (the plain state of rest) are equally valid in both a pure exchange scenario as well as in a scenario with production. Second, in light of this, I believe that the benefits derived from the avoidance of a multiplication of terms exceed the costs of any potential misinterpretation of the results derived.
Given his prevailing value scale,Value scales that reflect the momentary valuations of both sellers and buyers, although given our assumptions the momentary and original valuations of the buyers coincide. no market participant has any further incentive to act at this price, for he has successfully exploited all the available opportunities to give up a good that he values less in exchange for a good that he values more. Thus, every buyer who ranks an additional horse above $20 has made his purchases, whereas every seller who values $20 more than a horse in his possession has parted with it, while the solitary buyer who finds no horse preferable to $20 has chosen to stay out of the market altogether.
Second, this final price is market-clearing in two ways. To begin with, it lies at the intersection of the original demand and supply schedules. Reading off Tables 1 and 2 above, the quantity of horses that buyers would be willing to buy at the price of $20 equals the number of horses that sellers would wish to put up for sale. However, the final price can also be said to lie at the intersection of the momentary demand and supply schedules that prevail at the moment when the buyers and sellers engage in the acts of exchange. The reason that it lies at the intersection of both sets of demand and supply schedules is the assumption of perfect knowledge and the resulting correct appraisement of the original valuations by both the sellers.Thus, as Wicksteed notes, “…if we could eliminate all error from speculative estimates and could reduce derivative preferences [momentary valuations] to exact correspondence with the primary preferences [original valuations] which they represent, and on which they are based, the actual price would always correspond with the ideal price [final price] (Wicksteed, 1910, p. 237).” The momentary supply schedule, in other words, is a faithful reflection of the underlying data.For a graphical illustration of this proposition see Rothbard (2009 [1962]), pp. 132–134.
Third, at the final price the available stock of horses finds its way into the hands of the most capable possessors, i.e., those individuals that place the highest monetary valuations on an additional horse. If we were to line up the maximum buying prices as shown in table one in descending order we would place A1’s valuation of $50 for his first horse right at the top, A1 and A2’s willingness to pay $40 second, etc. Now, if we were to distribute the ten horses amongst the ten highest bidders, we would end up with precisely the distribution that emerges when exchanges take place at the final price of $20. In both cases the horses finally end up in the hands of buyers A1 through A4, with A1 leading the way with four horses followed by A2, A3 and A4 with three, two and one horse respectively.
This brings us to the fourth and arguably most important characteristic of the final price: that it is error-free. A final price only emerges when market participants make choices on the basis of a correct appraisement of the prevailing original valuations. In other words, a final price is the result of momentary demand and supply schedules that are free of error and are a faithful reflection of the underlying original demand and supply curves.Professor Kirzner provides an excellent analysis of the emergence as well as the salient properties of the final price given the assumption of perfect knowledge on the part of market participants in Kirzner (2011 [1963]), pp. 113–120)
When neoclassical economists refer to an equilibrium price, it is the final price that they have in mind. However, given its error-free nature, such a price will be seldom realized in the real world.See the quotation of Hicks from Value and Capital in the introduction, where he makes the same argument. For while in our example we have assumed perfect knowledge on the part of the sellers, this unrealistic assumption never holds true in reality. Human beings, by nature, are denied the gift of omniscience and are thus liable to make errors in their estimations of the given market conditions, giving rise to prices that differ from the final price.
Thus, neoclassicals are consistent in maintaining that equilibrium prices are unrealistic and are different from the actual prices realized in real world markets. But what if final prices are not the only kind of equilibrium prices? What if realized prices that are not error-free are also equilibrium, market-clearing prices? In the following section, we turn to answering this question.
IV. THE PLAIN STATE OF RESTLet us drop the assumption of perfect knowledge on the part of the sellers. Each seller must now appraise the original valuations of the other market participants without the gift of omniscience. Both sellers will, nevertheless, try to form an understanding of the underlying data in an attempt to sell their horses for the highest possible price.
Given, however, that this understanding of the prevailing scenario is formed without perfect knowledge, both sellers could arrive at erroneous conclusions regarding the underlying original demand and supply schedules. Thus, B1, for instance, might overestimate the maximum buying prices of the buyers and might, as a result, arrive at the erroneous conclusion that the final price is $30. We now assume that B2 makes an identical incorrect estimation of the underlying conditions and also comes to believe that the final price for this market is $30.
Based on these erroneous momentary valuations, the sellers proceed to price the stock of horses they have on hand. For reasons identical to those discussed in the previous section, both of them decide to sell their horses at a price of $30, the price that they incorrectly believe is the final price for this market. Thus the momentary valuations formed by B1 and B2 in a state of imperfect knowledge yield a fresh momentary supply curve, different from the one that was based on the correct momentary valuations formed in a state of perfect knowledge.
The buyers, as they trickle into the market, find the horses at the stalls of both sellers priced at $30 apiece. Given their original valuations (that, by assumption, coincide with their momentary valuations) they purchase horses as long as they rank an additional horse above the price asked. As is evident by studying Table 1 (reproduced below), six horses are bought at the price of $30, with buyer A1 purchasing three horses and buyers A2 and A3 going home with two and one horse respectively. Buyers A4 and A5, on the other hand, stay out of the market completely since neither of them values his first horse above the asking price of $30.
Table 1.
Remember that each seller enters the market at the beginning of the market day with a minimum selling price of $0 for every horse in his possession. Thus, carrying home unsold horses at the end of the market day would be a sub-optimal situation for him given that he derives no marginal utility from any of the horses in his possession. Instead, each seller would prefer to sell his entire stock of horses for any positive price. Nevertheless, despite the fact that sales are sluggish at the price of $30, the sellers leave their asking price unchanged. Both of them are supremely confident in their assessments of the ultimate facts of the market and believe that all their horses will find willing buyers by the end of the day.
The realized price of $30 has several interesting characteristics that are worth examining. First, just like the final price, this price too brings our horse market to a state of rest, or a state of non-action. Once the six horses are exchanged, all our market participants have successfully exploited all opportunities to acquire a good that they rank higher on their value scales in exchange for one that they rank lower and thus no buyer or seller has any incentive to act given his momentary valuations. Every buyer who ranks one or more additional horses above the price of $30 has bought them and every seller who values the $30 more than a horse in his possession has successfully sold it. Meanwhile, the buyers who do not participate in the exchange process do not value any horse above the asking price, whereas the unsold horses in the stalls of the sellers at the end of the market day reflect their preference to hold on to them rather than sell them for a price less than $30.In the words of Mises, “…people keep on exchanging on the market until no further exchange is possible because no party expects any further improvement of its own conditions from a new act of exchange. The potential buyers consider the prices asked by the potential sellers unsatisfactory, and vice versa. No more transactions take place. A state of rest emerges. This state of rest, which we call the plain state of rest, is not merely an imaginary construct. It comes to pass again and again (Mises, 1998 [1949], p. 245).”
Second, the realized price of $30 lies at the intersection of the momentary demand and supply curves. Given the value scales of the market participants that prevail at the moment the exchanges are made, this price clears the market, with every willing buyer successful in finding a willing seller. Now, it is true that these prevailing momentary valuations of the sellers contain error, since they are the result of an erroneous appraisement of the underlying original valuations. Indeed, at the end of the market day the sellers will go home disappointed. They will realize, in retrospect, that they have erred in their judgment of the underlying market conditions and will therefore tell themselves that they should not have continued to maintain an asking price of $30 when sales were slow but should have dropped their price so as to sell their entire stock of horses.
Nevertheless, at the moment when the buyers made their choices of how many horses to buy, the sellers were only willing to part with a horse if the buyer paid $30. Their momentary value scales ranked a horse in their possession above any price less than $30 and they preferred to hold on to them rather than part with them for any smaller sum of money. Thus, at the moment when the exchanges were made, the number of horses that the sellers were willing to sell or the quantity of horses supplied is only six, which is equal to the quantity demanded.Stated differently, at any realized price there can be no “discrepancy between demand price and supply price” for the quantity actually sold and bought. “For if the sale of a given amount of a commodity is effected at a given price, this must mean that the seller was willing to sell that amount at that price, and that the buyer was willing to buy that amount at that price” (Marget, 1966, pp. 242–243, emphasis in the original). This, however, is different from the quantity that they planned or that they wished to sell at the price of $30 when they formed their appraisement of market conditions.“…the realized prices which may be sufficient to move successive parts of the stores from the market may not necessarily be the same as the price which would have removed the whole if, again in Marshall’s own words, a single price had been “fixed on at the beginning and adhered to throughout”(Marget, 1966, p. 233, emphasis in the original).
The market-clearing nature of the plain state of rest can also be understood if we keep the necessary conditions required to engage in exchange firmly in mind. As Menger pointed out in his Principles of Economics, three conditions are essential for any act of exchange to take place, namely:
(a) one economizing individual must have command of quantities of goods which have a smaller value to him than other quantities of goods at the disposal of another economizing individual who evaluates the goods in reverse fashion, (b) the two economizing individuals must have recognized this relationship, (c) they must have the power actually to perform the exchange of goods. (Menger, 2007 [1871], p. 180)
Once the potential buyers have left the market making the purchases that they wish to make at the price of $30, however, condition (a) is no longer satisfied and the necessary conditions for interpersonal exchanges to be made no longer exists. There are no buyers present who have command of sums of money with a desire to purchase a horse. Thus, there are no further reverse valuations to be exploited since none exist and there are no more willing buyers to take the remaining unsold horses off the hands of the sellers at their asking price. Nevertheless, as long as the necessary conditions for exchange are present, every willing buyer finds a willing seller and vice versa.
Now, while the price of $30 does lie at the intersection of the momentary demand and supply schedules, it does not lie at the intersection of the underlying original demand and supply schedules. As is evident from Tables 1 and 2, at the price of $30 the original valuations of the market participants do not generate a market-clearing outcome. Instead, at this price there is an excess of the quantity of horses supplied over the quantity demanded. But as has been stressed above, the valuations of the market participants (only the sellers in our example) at the moment when they enter into market transactions is different from the valuations with which they entered the market. And it is the erroneous nature of the prevailing momentary supply schedule that explains why the price of $30 does not lie at the intersection of the original demand and supply schedules.
Coming now to the third characteristic of the realized price of $30, it follows from the discussion above that the state of rest established by this price is a market equilibrium with error. It can thus be termed a “plain state of rest (Mises 1998 [1949], p. 246)” in order to distinguish it from the final state of rest, which represents an equilibrium that is free of all error on the part of the market participants. The choices of our market participants at the plain state of rest (PSR) price are, unlike those made at the final price, not optimal. The sellers do not achieve their goal of selling all their horses at any positive price and end up having to take four horses back home.
The erroneous nature of the plain state of rest also affects the distribution of the available stock of horses amongst its competing claimants. If we consider the original valuations of the market participants, it is evident that the horses do not end up in the possession of the most capable possessors. This is evident from the fact that four horses remain unsold in the hands of the sellers, who place a $0 valuation on them, while there are buyers who evaluate an additional horse at a higher sum. For instance, buyers A1 through A3 place a higher monetary valuation on an additional horse despite already possessing horses that they purchased at the price of $30, while A4 and A5 have a higher valuation of their first horses.
Nevertheless, when the momentary valuations of the market participants are considered, one can conclude that the stock of horses is in the hands of the most capable possessors once the six exchanges have been made. For in this case, all those individuals who place a valuation of $30 or higher on a horse possess one, whereas those who have a lower monetary valuation of a horse do not possess any. It is true that the sellers only value the horses in their possession at $30 due to an erroneous understanding of the given market conditions. But they nevertheless choose to hold on to them.A similar plain state of rest would also emerge if the sellers underestimate the final price instead of overestimating it. Thus, they might misread the original demand curve and conclude that the available stock of horses in the market will sell at a price as low as $10; an incorrect appraisal that gives rise to a new momentary supply curve.
Now the buyers would walk into the market to find the horses priced at a much lower $10 and would proceed to make their purchases. Given their prevailing value scales as they enter the market, each buyer will buy as long as he ranks an additional horse above $10. As a result, all ten horses fly off the shelves at this price. Assuming A1 is the first buyer to enter the market and A2 follows, the former purchases five and latter four horses. When A3 enters, he has just the solitary horse available for purchase. The sellers, confident in their assessment of the underlying market conditions, leave their prices unchanged despite the rapid pace of their sales. They continue to believe that $10 is the highest price at which they can sell all the horses in their possession and that there will be unsold stocks at any higher price.
Now the buyers would walk into the market to find the horses priced at a much lower $10 and would proceed to make their purchases. Given their prevailing value scales as they enter the market, each buyer will buy as long as he ranks an additional horse above $10. As a result, all ten horses fly off the shelves at this price. Assuming A1 is the first buyer to enter the market and A2 follows, the former purchases five and latter four horses. When A3 enters, he has just the solitary horse available for purchase. The sellers, confident in their assessment of the underlying market conditions, leave their prices unchanged despite the rapid pace of their sales. They continue to believe that $10 is the highest price at which they can sell all the horses in their possession and that there will be unsold stocks at any higher price.
Thus, given the prevailing value scales of the buyers and sellers, the price of $10 also exhausts all the potential gains from trade and clears the market, thereby establishing a plain state of rest. In other words, it lies at the intersection of the momentary demand and supply curves that prevail as long as the market remains open for business and the possibility of engaging in exchange exists. And this holds true despite the fact that the sellers erroneously underpriced their horses, resulting in buyers who go home disappointed. For A3, A4 and A5 would have all been willing to buy more horses at the price of $10, but are unable to do so since the shelves of the sellers are empty. However, once A3 purchases the last remaining horse, the necessary conditions for an interpersonal exchange are no longer present since condition (a) is no longer satisfied. The sellers no longer have command of any horses that they could potentially sell, and as a result, no reverse valuations exist even though A3, A4 and A5 would prefer to purchase more horses at the prevailing price. Stated differently, the absence of the necessary conditions for an exchange implies that our market comes to a close once the last horse is sold to A3. Thus, as long as the necessary conditions for an exchange are present and our market is open for business, every willing buyer finds a willing seller and the quantity of horses demanded equals the quantity supplied.
Thus, when Austrian or Mengerian economists claim that every realized price is market-clearing, they are referring to PSR prices and not final prices. Given that human beings do not possess perfect knowledge and thus are bound to make appraisements that are erroneous in nature, realized prices represent equilibrium with error. Final prices, as the neoclassicals emphasize, are unrealistic and unrealizable.
V. THE ERROR CORRECTION PROCESSIn the previous section, we showed that the prices realized during the course of exchange in real world markets are market-clearing, equilibrium prices that establish a plain state of rest. They result from the momentary valuations of buyers and sellers; valuations that contain error due to an incorrect appraisement of the ultimate facts underlying the given market scenario. Thus, although actual prices realized in clock time do establish a state of equilibrium, they nevertheless contain error and result in a less than optimal distribution of resources. In our example, the ten horses do not find their way into the hands of the most capable possessors. Instead, at the end of the market day, four of them remain in the hands of the sellers who value them at $0 despite the fact that there were potential buyers who were willing to pay a positive price in exchange for these horses while the market was in operation.
The question that now arises is whether there are any forces operating on the market that succeed in correcting these erroneous judgments made by market participants. In other words, are there any forces that work to establish a more optimal allocation of resources? And what role, if any, do the actual, real world PSR prices play in this process? This section seeks to provide an answer to these questions.
To begin with, let us drop the assumption that both sellers make an identical incorrect assessment of the underlying data. This, after all, is an assumption with little empirical justification. To the contrary, one would expect each individual to form a different understanding of the data. Moreover, some individuals would be better appraisers of market conditions than others. Indeed, it can be assumed that the inherent skill of sizing up the original valuations underlying any given market situation is not distributed uniformly across human beings.“The operation of the market reflects the fact that changes in the data are first perceived only by a few people and that different men draw different conclusions in appraising their effects. The more enterprising and brighter individuals take the lead, others follow later. The shrewder individuals appreciate conditions more correctly than the less intelligent and therefore succeed better in their actions. Economists must never disregard in their reasoning the fact that the innate and acquired inequality of men differentiates their adjustment to the conditions of their environment” (Mises, 1998 [1949], p. 325).
Thus, we now assume that B2 is the better appraiser of the two sellers. While B1 overestimates the maximum buying prices of the potential buyers and concludes that the final price is $30, B2 does better. Given his lack of omniscience he too makes an erroneous judgment of the underlying data and overestimates the final price; but his guess of $25 is less incorrect than that of his competitor.
Now, based on his assessment of the underlying market conditions, B1 proceeds to price his horses at the rate of $30. B2, meanwhile, responds by raising his price to a little below B1’s, say $29, thereby outcompeting him. The buyers who trickle into the market proceed to buy only from B2, shunning B1’s stall. B1, however, has supreme confidence in his judgment and believes that it is B2 who is making an error by pricing below what he believes is the final price. Thus, he makes no adjustments to his asking price.
For reasons identical to those we described in section II,See pp. 9–10 above.the price that B1 will be able to obtain for his stock of horses once the purchases at $29 have been made from B2’s stall will be lower than the original final price of $20. The errors of B1 have hurt him, reducing his revenue, while benefitting his competitor who could take advantage of his errors, not because he was blessed with perfect knowledge of the underlying data, but because he was a better appraiser than B1. In the words of Wicksteed:
…if any dealer correctly surmises that his rivals are standing out for a higher price than the state of market justifies, he may raise his own price above it too, so long as he is careful to keep below that of his rivals, knowing that while he is getting more they will ultimately have to take less than what is now the true equilibrating price (Wicksteed, 1910, p. 225).
Similarly, if we assume that B1 had initially underestimated the final price and B2 had done likewise, but had come closer to guessing the correct final price, a similar conclusion would follow. B1, say, believes that the final price is $10, whereas B2 believes it is $15. Thus, B1 proceeds to price his stock at $10 and B2 places a price tag of $15 on his horses. All the buyers initially make a beeline for the former’s stall and ignore that of the latter. B1, noticing that all the buyers are making their purchases from him, raises his price to $14, just below that of B2’s, and proceeds to sell his entire stock of horses at that price. B2, meanwhile, holds firm and does not lower his price. He is confident in his judgment that the final price is $15.
Now, as we noted in section II, at the price of $20 the available stock of horses can satisfy all those buyers who value a unit of a horse above this asking price. It thus follows that if five horses are sold at a lower price of $14, some purchases are made at this price that would not have been made if the price had been set at $20. Buyer A1, for instance, would purchase five horses at this price, whereas he would have bought only four at the final price. Similarly, buyer A4 would now buy two horses instead of one. Thus, some of the five horses sold by B1 at this lower price serve purposes that would not have been served at the higher price of $20.
As a result, once B1 sells his stock of horses at the price of $14, his competitor is able to sell his five horses at a price that exceeds the underlying final price. In other words, B2 is able to sell his horses at a price that exceeds $20. Once more, the errors of B1 have benefitted his competitor, who is the superior appraiser.
Thus, on any market, as a general rule, the revenues of the better appraisers exceed those of the sellers less adept at judging the underlying data. And as can be seen from our analysis above, the PSR prices that are formed as a result of exchanges taking place at every moment on the market perform a key role in deciding this allocation of revenue. Stated differently, assuming that the costs of production for all the sellers are equal, the sellers that form a better appraisement of the final price and who therefore have momentary valuations that are relatively less erroneous earn a higher rate of profit. Indeed, depending on the prevailing cost of production, the poorer appraisers might not only earn a lower rate of profit but might also earn a loss.
These differential rates of profits and losses that emerge as a result of the different appraisements made by the sellers will lead to a re-allocation of the pool of capital available for investment. Thus, the better appraisers, by earning a higher rate of profit gain a greater share of this available pool, at the expense of the poorer appraisers, who earn lower rates of profit or fail to break even. In the words of Mises,
…one of the main functions of profits is to shift the control of capital to those who know how to employ it in the best possible way for the satisfaction of the public. The more profits a man earns, the greater his wealth consequently becomes, the more influential does he become in the conduct of business affairs. (Mises, 2008 [1951], p. 23)
Now, given that the underlying data of any market is characterized by ceaseless flux, the sellers are forced to be on their toes, constantly trying to form an understanding of the prevailing original valuations of the market participants. Each market day throws up a fresh set of original valuations and might involve changes in the stock of horses available for sale, thereby requiring fresh appraisements and new momentary valuations on the part of the sellers. It follows that those sellers who consistently misread the market conditions will be gradually forced to exit the market and will be replaced by those sellers who are blessed with superior abilities of appraisement.
Thus, the process of error correction on the market is essentially one of entrepreneurial selection.On the selective process inherent in the market process see Mises, (1998 [1949], p. 308–310). Given the lack of omniscience and the constantly changing data, errors are never completely eliminated except by sheer chance. Instead, the market ensures that the best appraisers are the ones given the responsibility of reading the underlying data and pricing the available stock of goods, thereby ensuring that the allocation of the same is as optimal as possible given the inherent frailties of men.
VI. CONCLUSIONEconomic theorists working within the broad Mengerian tradition conceive of the actual market prices realized in clock time as being market-clearing in nature. These prices thrown up by the exchange process undertaken in real world markets are said to establish momentary equilibria, with an equality of the quantities demanded and supplied and an exhaustion of all potential gains from trade. This view contrast sharply with those of the economists comprising the neoclassical mainstream, who instead view realized prices as disequilibrium prices, with a prevailing inequality of supply and demand.
The heart of these differences lies in the equilibrium constructs used by the proponents of the two schools of thought in a pure exchange setting. The Austrian economists employ two different equilibrium constructs in their explanation of price formation, namely, an equilibrium with error and an another without error. The former, also termed the plain state of rest, is inherently realistic in nature, whereas the latter, termed the final state of rest, is not. The neoclassicals, however, employ only the latter construct in their theorizing.
The conceptual foundations of the Austrian view lie in the differentiation between original and momentary valuations. Whereas the former reflect the value scales of market participants when they enter the market at the beginning of the market day, the latter are those that prevail at the moment when exchanges are made during the course of the given day, and are the formed by the buyers and sellers after an appraisement of the underlying data of the market, i.e., the prevailing original valuations.
The final price that brings about the final state of rest clears the market given the original valuations. At this price all the market participants are making choices that are optimal given the valuations with which they entered the market. PSR prices, meanwhile, establish a state of rest that is a result of the momentary valuations that prevail at the moment when exchanges are made during the market day. Thus, while they lie at the intersection of the momentary demand and supply schedules; they do not, given the erroneous appraisements of the market participants, clear the market given the original valuations. In other words, while they are market-clearing from one point of view, they are not from another. Moreover, they establish equilibria that contain error, with the buyers and sellers making sub-optimal choices given the underlying market conditions.
These PSR prices play a key role in the process of error correction that is unceasingly at work on the marketplace. These moment-to-moment prices decide the winners and losers of the exchange process, with the better appraisers earning greater profits than those that are poorer at judging the underlying data, thereby shifting the available pool of capital into the hands of the former at the expense of the latter. As a result, the exchange process selects who is entrusted with the job of appraising the underlying data and pricing the goods available for sale, with those that prove themselves to be the best equipped to gauge the underlying market conditions by consistently outdoing their competitors being the ones given the responsibility of making these decisions.
Volume 5, No. 3 (Fall 2002)Böhm-Bawerk is the most important Austrian economist after Ludwig von Mises. The author says this on the basis of the fact that his writings provide by far the best and most comprehensive development of the law of diminishing marginal utility and its application to price theory that is to be found anywhere. And to this, of course, must be added his major contributions on the subjects of capital and interest, including his critiques of the Marxian exploitation theory. The serious study of Böhm-Bawerk's writings is an essential aspect of the education of every true Austrian economist. For those who have not yet embarked upon such a study, this essay of Böhm-Bawerk's, "Value, Cost, and Marginal Utility," can serve as an excellent starting point. For those who have so embarked, this essay should certainly not be missed.
Volume 8, No. 4 (Winter 2005)Nonetheless, Rothbard and Mises have been criticized by Nozick (1977) and Caplan (1999), for inconsistency in admitting the concept of indifference into economic analysis after all, even if only indirectly. These criticisms have been answered by Block (1980, 1999) and Hülsmann (1999). However, their answers, although largely correct, seem to bring less than full clarity to the matter. Setting out from Nozick’s criticism, I hope to remedy this deficiency here.
Volume 8, No. 4 (Winter 2005)
The circular-flow approach is decidedly Neoclassical, and suffers from many problems which traditional Austrians would notice. The circular-flow diagram’s greatest problem is, in fact, its circularity. While real-world economic analysis has a beginning, an ending, and ever-changing processes, the circular-flow diagram has no beginning or ending. It is drawn as though entire macroeconomies sprang into existence from whole cloth. While the circular flow appears to be dynamic, it allows no room for change on any margin: consumer preference, production technique, or availability of factors of production.
Volume 10, No. 3 (2007)
In this paper I clarify the long-running debate between Block and Demsetz over the potential impact of psychic income on the Coase Theorem. Each of the protagonists appear to have erred on how to integrate psychic income into an analysis of the Coase Theorem. Block’s psychic income case, when properly interpreted, goes beyond the standard transaction costs qualification and represents a conceptually distinct limitation of the “Coase Theorem.” Review of Econspinning: Economists are familiar with the cliché “lies, damned lies and statistics,” which puts statistics at the top of the pyramid of lies. ESPN sports radio personality Colin Cowherd, on the other hand, insists, “People lie, the numbers don’t.” Since people create the numbers the line between liars and bad numbers may be less than bright and clear, but Gene Epstein—economics columnist for Barron’s magazine and author of Econospinning—essentially sides with Cowherd. Epstein finds little fault with government’s economic numbers and plenty of fault with the reporters and pundits who use those numbers.
Volume 11, No. 3 (2008)
Teaching Microeconomic Principles well, a blend of good pedagogy and good economics, is the professional obligation of many economists. Since such courses are conventionally grounded in neoclassical theory, professors who embrace the theoretical perspective of the Austrian School may seem to confront a dilemma unfamiliar to other teachers: Teach the course well, or teach good economics? The thesis of this paper is, simply, that there is no such conflict. Incorporating properly chosen attributes of Austrian theory makes one's Microeconomic Principles course better. This conclusion would be rejected by those who identify Austrian economics as adding complex disequilibrium propositions to an equilibrium analysis indistinguishable from that of neoclassical theory, or who think it dismisses equilibrium entirely, but both positions misunderstand the School's nature. Among Austrian theoretical attributes that enrich a Microeconomic Principles course are methodological individualism, ordinal subjective utility and cost, future orientation, entrepreneurship, a process view of competition, and consideration for market participants' knowledge. In this paper these characteristics—many ostensibly shared, but not consistently respected, by neoclassical theory—are applied by developing conventional smooth supply and demand curves, and their interaction in markets, from individuals' value comparisons of discrete units. The paper concludes that an Austrian foundation is simultaneously more theoretically accurate and closer to the student's everyday life, a combination that means a better Principles course.
Volume 12, No. 1 (2009)
The author provides a commentary. Despite Hoppe’s more elegant way of describing choice, it still remains a logical contradiction to oppose indifference and embrace interchangeable commodity units. For what does “interchangeable” mean other than “indifferent between”?
Volume 12, No. 1 (2009)
Hoppe's response to Block’s foregoing criticism of his previously published notes on the subject of preference and indifference in economic analysis, including a summary of agreements and reconstruction of differences.
Volume 12, No, 2 (2009)
Mises created an artificial construct, the evenly rotating economy (ERE), from which to ascertain the source of entrepreneurial profit and loss. In particular, the ERE is characterized by two distinct elements. First is the elimination of the temporal element, second is the removal of changing market data. The second point necessarily arises from the first. Is it possible that the efficient market hypothesis (EMH), despite its practical flaws, may be used as a similar theoretical construct? If we envision a similar state of affairs as under the ERE, is it possible to grasp more fully the effect that information has on prices? We argue that it cannot, for two main reasons.
Volume 13, Number 1 (Spring 2010)ABSTRACT:
We examine the strict preference approach to the interpretation of human action and the assertion that a choice cannot be made between actions in which the actor is indifferent to the outcomes. We show that this view is incompatible with decision problems involving equally optimal actions and we examine various attempts to avoid the existence of these decision problems. We argue that attempts to avoid these decision problems are contrary to the causal-realist approach and lead to unnecessary confusion about the nature of choice and indifference. We show that the alternative approach of using non-strict preferences allows indifference to be given a praxeological interpretation and derived directly from non-strict preference relations as a praxeological category. This leads to a sensible approach to economic analysis that is compatible with the causal-realist approach of the Austrian School. This also avoids the attendant problems of the strict preference approach and allows decision problems to be described in accordance with ordinary language
Indifference and choice are surprisingly tricky issues in economics. They have been the subjects of much debate, particularly within the literature of the Austrian school. At the core of the matter is the question of whether indifference has any praxeological meaning or whether its meaning is purely psychological, a matter which falls outside the domain of economics. This question has important ramifications, at least for the proper exposition of economic theory. Since praxeology is concerned with intentional action, a praxeological concept of indifference has implications for the relationship between indifference and choice. Most particularly, it determines whether choice of an action contradicts indifference between that action and other foregone actions.
The praxeological conception of indifference between actions is naturally suggested by the subjective theory of value expounded by Carl Menger, which stresses that goods attain value—and therefore equality or inequality of value—only through their serviceability to our needs. According to Menger (2007):
In the value of goods, …we always encounter merely the significance we assign to the satisfaction of our needs—that is, to our lives and well-being. If I have adequately described the nature of the value of goods, if it has been established that in the final analysis only the satisfaction of our needs has importance to us, and if it has been established too that the value of all goods is merely an imputation of this importance to economic goods, then the differences we observe in the magnitude of value of different goods in actual life can only be founded on differences in the magnitude of importance of the satisfactions that depend on our command of these goods. (pp. 121–22)
This suggests that a praxeological conception of indifference between actions must be understood in terms of equality of the magnitude of importance of the satisfactions of needs obtained by these different actions. That is, we are indifferent between two actions when we judge that there is no difference in the magnitude of the satisfactions of needs obtained from those actions (the actual needs may be different, but the magnitude of the satisfactions from these needs must be equal). Similarly, we are indifferent between two goods when we judge that there is no difference in the magnitude of the satisfactions of needs that depend on our command of those goods.
In addition to a praxeological conception of indifference, the subjective theory of value can also be used to obtain a praxeological conception of homogeneity. This approach was recently expounded in Machaj (2009) where the author explains:
How can we define homogeneity in this framework? It’s very easy—two objects are homogeneous if they both can serve the same end. If so, it follows these are two units of the same supply, because they are capable of satisfying the particular need. From the point of view of an actor’s particular need they are homogeneous and interchangeable or equally serviceable. It does not have anything to do with psychological considerations or physical characteristics, but rather with the possibilities of action….
This solution rejects the neoclassical concept of indifference and saves the concept of homogeneity. … All this solution offers is the concept of homogeneity in the Mengerian tradition without falling into the murky waters of psychology. (pp. 234–35; some emphases removed; spelling corrected)
Under this approach, homogeneity and indifference are both praxeological and are directly related in praxeological terms. Different goods are homogenous if command of those goods allows the satisfaction of the same needs. Since value is derived solely from this satisfaction, this means that homogeneity implies indifference, though the converse is not true (i.e., it is possible to be indifferent between goods that are not homogeneous).The fuller quotation of this part of Machaj (2009) shows that he uses indifference and homogeneity interchangeably, and thereby defines indifference between goods as homogeneity. In fact, indifference between goods is a more general relation, since two goods may serve different needs, but may do so in such a way that the magnitudes of the satisfactions of those different needs are equal. In this case, a person would be indifferent between goods that are not homogenous.
Now for the tricky part: While the praxeological conception of indifference and homogeneity might seem perfectly natural for followers of the Austrian school, it implies that choices can be made between indifferent alternatives, something which flies in the face of the preference theory maintained by many eminent Austrian school economists. It is clearly possible for different goods to be equally serviceable to our needs, and for us to judge them so. Moreover, it would seem to be possible to make choices between these goods (later we will consider and refute an argument denying this). But if this is the case, then a praxeological conception of indifference and homogeneity implies that choice between indifferent alternatives is possible—in fact, it would appear to occur very often.
STRICT AND NON-STRICT PREFERENCE ORDERINGSThe possibility of choice between indifference outcomes is accommodated within the general framework of standard mathematical expositions of preference and action. These presentations use the concept of a “preference ordering” on a set of possible outcomes of action, where this ordering is interpreted as meaning that certain outcomes are regarded as “no worse than” other outcomes, with respect to the ex ante preferences of the decision maker.Throughout this paper, I leave out discussion of uncertainty as to the outcome of the actions, or other complicating factors, which do not change the nature of the argument. For the purposes of the discussion of indifference and preference, a reference to the “outcomes” of an action is a reference to the ex ante expected outcomes, from the point of view of the actor, with all uncertainty and other complicating factors taken into account. Action by the decision maker then establishes the existence and direction of these relations, in that it establishes that the outcome of the chosen action is no worse than the outcomes of the actions which were foregone—this is the law of “revealed preference”.
Under this approach, the primary relation established by action is the “no worse than” relation, which is the absence of a strict preference contradicting the action taken. This relation is an example of a non-strict preference ordering (also sometimes called a weak preference) in that it includes the possibility that the decision maker is indifferent between the chosen action and one or more foregone actions. Strict preferences and indifference between outcomes are then regarded as derivatives of this primary relation, and can be explained in terms of this relation (the standard mathematical presentation of this subject is given in the Appendix).
One plausible alternative to this non-strict preference approach, and the one adopted by many eminent Austrian school economists, is to treat action as demonstrating a strict preference for the chosen end (also sometimes called a strong preference). That is, to take an action in pursuit of some end as meaning that the outcome pursued is regarded as strictly “better than” other outcomes which were not pursued, again with respect to the ex ante preferences of the decision maker. This position denies the possibility of choice between actions in cases where the actor is indifferent between the outcomes.
THE AUSTRIAN SCHOOL APPROACH TO INDIFFERENCEIt is unclear whether the strict preference approach is the established Austrian school viewpoint or not. Mises (1998) does not appear to explicitly consider the distinction between strict and non-strict preferences in his analysis of human action, saying only that “[s]trictly speaking the end, goal, or aim of any action is always the relief from a felt uneasiness” (p. 93).It is not surprising that Mises did not analyze this distinction, given that it became most obvious during the later rise of the foundations of mathematical economics in the late fifties and early sixties (see, e.g., Debreu 1959). It was in these mathematical systems that the derivation of indifference from preference orderings, and the distinction between strict and non-strict orderings became most clear. Some incidental remarks that could be interpreted as support for the strict preference approach are found in Mises (1980), though these remarks are ambiguous and are also obiter dicta.In arguing against Irving Fisher’s indifference analysis, Mises talks about an example of an individual faced with a choice of goods who “...finds it impossible to decide between the two, i.e. he values both equally” (p. 56). This could be interpreted as a statement of the strict preference approach, or it could be interpreted merely as meaning that the inability to decide implies indifference, but is not necessarily implied by it. Moreover, in the context of the argument (a critique of cardinal utility) it is not clear whether Mises had the distinction between strict and non-strict preferences in mind at all. What is certain is that he is less clear on the subject than Rothbard, who confronts the distinction explicitly. Whatever Mises view of the matter, the strict preference viewpoint has been adopted by some later Austrian school economists. In particular, Rothbard (1997) explains the theory of action and indifference as follows:
Indifference can never be demonstrated by action. Quite the contrary. Every action necessarily signifies some choice, and every choice signifies a definite preference. Action specifically implies the contrary of indifference…. If a person is really indifferent between two alternatives, then he cannot and will not choose between them. Indifference is therefore never relevant for action and cannot be demonstrated in action. (p. 87)
This strict preference conception of human action has also been explicitly adopted in Hoppe (2005) and Block (2009a) in debate over preference and indifference, with both authors referring with approval to the Rothbardian view.
As we have seen, the denial of the possibility of choice under indifference contradicts the use of a praxeological conception of indifference and homogeneity. This opens up the question of whether or not indifference is a tool that can properly be used in the Austrian school’s theory of economics at all. Rothbard is in no doubt about the answer, saying: “[t]here is …no role for the concept of indifference in economics or in any other praxeological science” (Rothbard 2004, p. 307). But this presents a potential problem: that of forming the notion of homogeneity, and the consequent notion of “units of a commodity.” Nozick (1977) criticizes the Austrian school for their allegedly implicit use of indifference in this task (see also Caplan 1999):
…the Austrian theorists need the notion of indifference to explain and mark off the notion of a commodity, and of a unit of a commodity. … Without the notion of indifference, and, hence, of an equivalence class of things, we cannot have the notion of a commodity, or of a unit of a commodity; without the notion of a unit (“an interchangeable unit”) of a commodity, we have no way to state the law of (diminishing) marginal utility. (pp. 370–71)
This critique presents a serious challenge to Austrian school economists who adopt the strict preference view. If it is correct, it requires that they either reverse their position on indifference, or abandon the notion of homogeneous goods and the entire marginalist revolution of Menger.
Nozick’s critique has been taken up in previous analysis in Block (1980), Hülsmann (1999), Hoppe (2005), and in recent debate in Block (2009a) and Hoppe (2009). It receives further attention in Block (2009b) where the author rejects the praxeological conception of indifference and homogeneity, admitting that “If homogeneity is praxeological, if it is really equally serviceable, then Nozick and the critics are correct; Austrians must jettison either the law of diminishing marginal utility, or, embrace indifference” (pp. 69–70).
While the responses contained in these papers have been useful in clarifying some ways in which one can proceed from the strict preference approach, the result, as this paper will argue, has been to construct a rather strange interpretation of indifference and choice, consisting of assertions about choice and action that are contrary to the plain meaning of the terms and contrary to the Mengerian causal-realist approach which exemplifies the Austrian school.
It is the purpose of this paper to argue that the root of the problem is that the strict preference approach adopted by Rothbard and subsequent Austrian school economists is mistaken and the non-strict preference approach is correct—that is, that people can and do choose between alternatives to which they are indifferent. This view leads to a praxeological conception of preference and indifference under which neither is the primary relation established directly from action. Instead the primary praxeological category established by action is a judgment of non-preference for one action over another, as is used as the basis for standard mathematical models of preference and indifference. Strict preference and indifference can then both be derived through consideration of various combinations of non-preference, and can both properly be regarded as praxeological relations. While non-preference is observed directly, strict preference and indifference cannot be inferred solely from observed actions and must instead be inferred counterfactually.
EQUALLY OPTIMAL MUTUALLY EXCLUSIVE ACTIONSTo establish this claim, let us first consider the basic process by which hypotheses can be tested, and accepted or rejected. The essence of this process is built on the fact that contradictions do not exist in reality, so that any contradictory finding manifests an error. Thus, if one begins with several mutually exclusive hypotheses, and the law of non-contradiction, one can deductively eliminate false hypotheses by determining when these hypotheses contradict known facts of reality.
In the case of preference and indifference, we must therefore ask: does a choice of a particular action contradict the possibility that the actor is indifferent between the action taken, and some action foregone? Rothbard clearly thinks that it does; in remarking on the use of indifference maps in contemporary mathematical economics, he says, “The crucial fallacy is that “indifference” cannot be a basis for action” (Rothbard 2004, p. 307, emphasis removed). Hoppe (2005) agrees with this view, and further elaborates on the reasons, saying that “…any attempt to explain why one chooses to do x rather than y with reference to indifference rather than preference strikes one as a logical absurdity, a ‘category mistake’” (p. 87).
Now, it is certainly true that indifference cannot “be a basis” for action and cannot explain the action; this much is freely admitted by Machaj (2009) in his exposition of the praxeological conception of homogeneity. It is also true that an attempt to explain a choice by reference to indifference is absurd. But this does not rule out the possibility of choice under indifference, so long as there is some other explanation for the choice, some other basis for the action. If this can be established, then we avoid this alleged “category mistake.”
To see that this is possible, consider the situation in which there are two or more actions which are regarded by the actor as equally optimal actions—that is, the actor is indifferent between the outcomes of these actions, but strictly prefers any of those outcomes to the outcomes of any other available actions. In such a situation, a choice of one of the equally optimal actions is required in order to avoid the other, less preferred alternatives. To adopt the words of Mises, the aim of the action is “…the relief from a felt uneasiness,” the uneasiness in this case being the alternative less preferred outcomes of the other available actions.
Thus, in such a case, the actor will take one of the equally optimal actions. Because there are several of these actions and they are mutually exclusive, there is no choice but to forgo one (or more) of these actions in order to take another, notwithstanding indifference between them. Here the explanation for the chosen action is not by reference to indifference, but rather, by reference to preference—the preference for any one of these actions over all the available alternatives.
To take an example used in Hoppe and Block’s debate on indifference, suppose that a mother sees her two young sons Peter and Paul drowning, and has time to rescue only one of them. In this situation she has three choices: rescue Peter, rescue Paul, or do not rescue either of them. Put in terms of the consequences of her actions, these three choices amount to:
A Paul drowns;
B Peter drowns; or
C Peter and Paul both drown (the conjunction of A and B).
Now, since parents do not want their children to die, it is clear that A and B will each be preferred to their conjunction, C. If the mother loves her sons equally and is indifferent between outcomes A and B then the options of rescuing Peter or rescuing Paul are equally optimal—both are preferred to the other available alternative. In this case, despite her equal love for her sons, the poor distressed mother will nonetheless be forced to rescue either Peter or Paul, in order to avoid the deaths of both of them.
One important special case of a decision problem involving equally optimal actions is the case where the actor is indifferent to all the available actions (and there is more than one), including the action of “doing nothing.” For example, a medieval convict shackled to a cell wall, may be completely indifferent between the available actions of “doing nothing” and “rocking side to side.” If this is the case, then he simply must take one action or another, not because the outcomes of these actions are preferred to some other outcome, but because this exhausts all the possible actions available to him, including “inaction.” Here the explanation for the chosen action is not by reference to indifference, but rather, by reference to impossibility—it is simply not possible to choose an action outside the class of equally optimal actions.
WAYS OF GETTING AROUND THE PROBLEM OF EQUALLY OPTIMAL ACTIONSThe case of equally optimal actions which are preferred to some alternative, or which exhaust all available actions, is very problematic to the strict preference viewpoint, which holds that choice under indifference is impossible. Indeed, if not rebutted, it presents a fatal case against the strict preference approach.
Interpreted mathematically, the problem of equally optimal actions is represented by the following decision problem. Suppose we have a decision space (S, ≽) consisting of a set of available actions S and a non-strict preference ordering ≽ which induces an indifference relation ∼ and a strict preference ordering ≻ (see the Appendix for more details; also Takayama 1985, pp. 175–79). The problem of equally optimal actions occurs when the decision space (S, ≽) is such that:
a. There exist some actions a,b∈S such that a∼b and a≽c for all c∈S (this also implies that b≽c for all c∈S).
Under this condition, actions a and b would be equally optimal actions. To see why this would be fatal to the strict preference approach, we note that this approach asserts that the chosen action x∈S is such that x≻y for all other actions y∈S. But this is contradicted by the above condition, which implies that either x≼a or x≼b (or both).
It is clear that the strict preference approach must, in one way or another, deny the possibility that such a decision problem can ever exist. Now, since the decision problem in question is formed by the structure of a decision space composed of two elements (the set of available actions and the preference relation), there are only two ways of doing this. One is to deny that the preference relation ≽ can be structured so as to obtain an equally optimal action problem. The other is to deny that the set of available actions S can be structured so as to obtain an equally optimal action problem. Of course, there may be any number of particular arguments asserting these general conditions. However, all arguments against the existence of equally optimal action problems must fall within one or both of these categories.
Rothbard (2004) denies the possibility of equally optimal actions as follows:
Since indifference is not relevant to human action, it follows that two alternatives for choice cannot be ranked equally on an individual’s value scale. If they are really ranked equally, then they cannot be alternatives for choice, and are therefore not relevant to action. Hence, not only are alternatives ranked ordinally on every man’s value scale, but they are ranked without ties; i.e., every alternative has a different rank. (pp. 309–10)
Looking at this statement, we can see that Rothbard is making the following two assertions (assuming comparability of all actions):
b. If S is such that a,b∈S then ≽ must be such that a≁b; and
c. If ≽ is such that a∼b then S must be such that a∉S or b∉S or both.
Of course, these are actually two ways of expressing the same assertion:
d. The decision space (S, ≽) is such that a≁b for all a,b∈S.
Rothbard’s assertion is slightly stronger than is required to deny the equal optimality condition. He not only denies the equal optimality condition, but also the possibility that the decision maker can be indifferent between any of the available actions. This is sufficient, but not necessary, to avoid condition (a) and therefore to save the strict preference approach from the problem of equally optimal actions.
Having considered the general methods by which one may attempt to avoid equally optimal action problems, we are now in a good position to consider some possible resolutions for this problem which are put forward in Block (1980) and Hoppe (2005) and are further debated in Block (2009a) and Hoppe (2009). Hoppe and Block’s positions represent the two methods by which the existence of the problem of equally optimal actions can be denied. One is to deny that the preference relation can be structured so as to obtain an equally optimal action problem (Block’s approach). The other is to deny that the set of available actions can be structured so as to obtain an equally optimal action problem (Hoppe’s approach). In the former case, it is assumed that the choice itself induces a change in the preference structure, so that there are no longer equally optimal actions. In the latter case, the indifference between the equally optimal outcomes is used to deny that they can properly be regarded as different choices, so that there are again no longer equally optimal actions.
STRICT PREFERENCE INDUCED AS A RESULT OF CHOICEBlock (1980) holds that indifference between different actions can exist prior to the choice between them, but, as soon as a choice from the class of equally optimal actions is made by the actor, some preference between the individual actions must be formed, in order to choose one of the actions over the other. In an example involving the sale of one pound of butter from a supply of one-hundred units, Block says:
Before the question of giving up one of the pounds of butter arose, they were all interchangeable units of one commodity, butter. They were all equally useful and valuable to the actor. But then he decided to give up one pound. No longer did he hold, or can he be considered to have held, a homogeneous commodity consisting of butter pound units. Now there are really two commodities… [—the butter that is retained, and the butter that is given up]. (Block 1980, pp. 424–25).
This approach means that the preferences between the units of butter change during the course of the transaction, not as a result of any change in the owner’s view of the serviceability of these units, not as a result of any disparity in their purchasing power or their ability to satisfy his wants, but solely as a result of the necessity of choice, brought about only by the introduction of a more preferred alternative (selling a unit of butter). Under this view, the units of butter were homogeneous before the choice, but are not homogeneous after the choice.Block’s further elaborations on the subject make things all the worse. He explains that the “indifference” in this situation is a psychological, rather than a praxeological or economic category, claiming that this alone is sufficient to establish homogeneity of goods and the law of diminishing marginal returns (Block 1980, p. 425). Of course, this would appear to establish the law of diminishing marginal returns, not as an economic law, but as a psychological phenomenon, something that has been strongly denied by Austrian school economists (e.g., Rothbard 2004, p. 73). But Block is having none of this—he elaborates on his views, saying: Homogeneity is, properly, at least in the context of diminishing marginal utility, a thymological, not a praxeological category. ... It is satisfied when goods are indistinguishable chemically, or physically, not praxeologically. ...it is my view that decreasing marginal utility is praxeological, and, for this law to not logically imply illicit indifference, supply cannot consist of equally serviceable units; rather, it must be (thymologically) composed of physically or chemically identical units. (Block 2009b, p. 70) But there are many problems with this view of homogeneity. The first problem is that it still fails to explain how the preferences can change due to the decision to give up a pound of butter. Surely, if the units of butter were physically indistinguishable before the transaction, then they must remain so after the instant of choice. Secondly, unless “physically distinguishable” has some special watered-down meaning, this requirement is incredibly strong. The requirement would rule out homogeneity in almost all cases in which an actor scrutinizes goods with any semblance of rigor. It would rule out homogeneity of even such simple things as coins or monetary bills of the same denomination, and maybe even pounds of butter, since these items will inevitably have some physical imperfections that distinguish one “unit” from the other. Even physical differences which are totally irrelevant to the actor then become a basis for a break with homogeneity, so long as he notices them. If the actor notices that a particular dollar bill has a crease in the top left corner and another one does not, then they are no longer homogeneous. He probably will not care about this difference, and will regard both bills as equally serviceable for the satisfaction of his needs, but now we are again in the realm of praxeological indifference and homogeneity.
To this author, this kind of reasoning seems unconvincing, in that it violates the causal-realist approach and reverses the causal relationship between preference and choice—it posits choice as the reason for a change in preference, and not the other way around. Now, while it is true that the praxeological approach uses the notion of preference as an explanatory instrument for actual human action, so that preference is secondary to action in this sense, the actual causal relation between wanting and doing must surely not be made topsy-turvy in order to try to support the strict preference theory.
The approach of positing choice as the cause of preference cuts forcefully against the grain of the causal-realist method adopted by the Austrian school. Indeed, it runs completely contrary to the causal-realist explanation of the subjective value of goods given in Menger (2007). If goods obtain their value only from their capacity to satisfy our needs, then this requires that any strict preference between goods must follow from some difference in the magnitude of the satisfactions that depend on command of those goods. Under the causal-realist approach, if the actor is genuinely indifferent between each pound of butter prior to the sale, it is difficult to see why his preferences between the units of butter should change during the course of the transaction, unless there has been some underlying change in the satisfactions that can be derived from command of these different units of butter. The mere introduction of another more preferred alternative, if it does not change the relative satisfactions that can be gained from the different units of butter, would not seem to meet this criterion.As far as the relative preference between the units of butter is concerned, the introduction of the trade would be an “irrelevant alternative” (see Ray 1973), since it does not affect the ultimate satisfactions that depend on command of the units of butter (i.e., each unit of butter still allows the same ultimate satisfactions) and therefore must not affect the preference (or indifference) between them. Contrarily, in Block’s argument, the new alternative of exchange for another good is allowed to affect the preferences between the units of the sold good.
It is important to note that Block’s suggestion of a change in preferences being induced by the act of choice is not contingent on any greater scrutiny being applied to the evaluation of the units of butter once the necessity of choice is evident. So long as the person need not choose between the units of butter, he may make a meticulous comparison of them and conclude his own indifference no matter how conscientiously they are examined and appraised. He may consider them equally serviceable as a unit of payment and equally serviceable in satisfaction of all his wants, so long as he does not currently prefer to make such a payment. But, should he then be put in a position where it is preferable to give up one unit—in payment or otherwise—and he therefore chooses to do so, now—voila—a phenomenon occurs in which his preference between them is altered.
AMALGAMATING MUTUALLY EXCLUSIVE ACTS INTO A SINGLE “CHOICE”Another possible solution to the problem of equally optimal actions is given by Hoppe (2005) following the work of Searle (1984). Unlike Block, Hoppe rejects the view that a choice between equally optimal actions induces a strict preference and instead holds that indifference between outcomes may remain even when a particular action is taken, and another foregone. However, he denies that this constitutes a “choice between” the actions. Instead, his approach in such a case is to interpret the action as a choice of the conjunction of the various specific actions which are equally optimal, amalgamating them into a single chosen action. Hoppe (2005) explains the situation of the drowning children as follows:
…a mother who sees her equally loved sons Peter and Paul drown and who can only rescue one does not demonstrate that she loves Peter more than Paul if she rescues the former. Instead, she demonstrates that she prefers a (one) rescued child to none. On the other hand, if the correct (preferred) description is that she rescued Peter, then she was not indifferent as regards her sons. (p. 91)
Put in terms of the above taxonomy of actions, Hoppe is saying that, if the mother is indifferent between A and B, then rescuing Peter demonstrates a preference for the exclusive disjunction of A and B (one child drowning) over the conjunction of A and B (both children drowning). In other words, what you regard as the “chosen action” depends on how you frame the choices.Rothbard makes a similar argument (though nowhere near as well developed) when he states: If it is a matter of indifference for a man whether he uses 5.1 or 5.2 ounces of butter for example, because the unit is too small for him to take into consideration, then there will be no occasion for him to act on this alternative. He will use the butter in ounce units, instead of tenths of an ounce. (Rothbard 2004, p. 307)
Hoppe’s explanation of the situation is an ingenious way of attempting to rescue the strict preference approach from the problem of several equally optimal and mutually exclusive actions. Hoppe is claiming that, although the mother rescues Peter, she did not actually choose outcome A. Since she was indifferent between A and B, she could not choose A, and forgo choosing B. Rather, she chose outcome “A or B” even though she actually happened (for whatever reason) to do the specific action that led to outcome A. Thus, by her action of rescuing Peter, she shows that she prefers outcome “A or B” to outcome “A and B”. To Hoppe, the preferred description of the action is that the mother is “rescuing one of her sons,” not “rescuing Peter.”
This argument is grounded in the fact that actions have both an external-behaviorist and internal-mentalist aspect (Hoppe 2005, pp. 89–90; Searle 1984, pp. 57–58). Two actions can be different even if they are behaviorally identical, so long as the intentions of the actor are different in both cases. To take an example used in Hoppe’s analysis, a walk to Hyde Park may be behaviorally identical to a walk in the general direction of Patagonia, though they are not the same action. Similarly, two different behavioral acts can be regarded as the same action if the intentions of the actor are the same in both cases. Thus, a walk to Hyde Park beginning with the left foot, then the right foot, etc., is the same action as a walk to Hyde Park beginning with the right foot, then the left foot, etc., so long as the actor does not have any particular intention as to which foot to put forward first.
To understand the implications of this kind of approach, observe that Rothbard only claims that a person cannot “choose between” actions if he is indifferent between them. He does not say that he cannot do one specific thing, and not another. This leaves open the possibility that he could choose the action which is the conjunction of all the equally optimal actions (between which he is indifferent). If Hoppe is correct, and this action is properly to be regarded as a choice of the conjunction, rather than a choice of a particular equally optimal act, then this would indeed remove the problem presented by equally optimal mutually exclusive actions.
While there is no a priori logical contradiction in Hoppe’s approach, his attempt to rescue the strict preference approach from the problem of equally optimal actions is a gargantuan task. It is not at all enough for Hoppe to establish that specific acts can be properly described in this amalgamated way. To avoid the problem of equally optimal actions, it requires him to show that all cases where a person faces mutually exclusive equally optimal actions should be assessed by regarding the conjunction of these actions as the proper description of the action. Moreover, this must be the case—according to the criteria he adopts—on an examination of the actual external behavior and the internal mental processes of the person in question.
While the present author agrees with Hoppe’s view that the proper description of an action depends on the intention of the decision maker, it is highly dubious (on this very basis) to assert that all cases of mutually exclusive equally optimal actions should be assessed as yielding a single preferred action which is the conjunction of these distinct acts. Just as a causal-realist approach to subjective value destroys Block’s argument, so too a causal-realist approach to the subjective framing of the set of available actions destroys Hoppe’s argument. It is only by a process of inferring what aspects of the action were in the mind of the actor, and what aspects were not, that we can then say that the choice to move the left foot first, and then the right, or the choice to rescue Peter, and not Paul, was part of the action.So then, let us consider the case of a mother who is indifferent between her drowning children, on the basis of her internal mental processes. In such a situation, it is almost unthinkable that her mind would not turn to the choice between rescuing Peter, versus rescuing Paul, notwithstanding her equal love of both of them. These acts would certainly not be regarded by her as one action, with no choice between the two, even if she were completely unable to see any difference in the degree of satisfaction these two “goods” afford her. In fact, a major reason that this particular dilemma would be so stressful to the mother is the fact that she would inevitably turn her mind—even if only for an instant—to the question of which child to rescue and which to allow to die. If the issue were framed in her mind as a choice between one dead son or two, then it would be a trivial decision problem, at which she would not feel even the slightest pressure or difficulty. But surely her conception of the problem would not be thus. It is highly unlikely to be properly described as a choice to rescue “one son” as opposed to the one she actually does rescue. On seeing her children drowning, and knowing her limited time, she will inevitably turn her mind—in the small time she has—to the question of which to save and she will make a choice. She will go left or she will go right. She will dive into the water, not with the intention of rescuing “one son,” but with the intention of rescuing Peter. From both an external-behavioral and an internal-mentalist perspective, she has chosen to rescue Peter, not Paul. Indeed, if she did not do this—if she intended only to rescue “one son”—then her action would surely be plagued by indecision and delay. She would brace to dive into the water, but her cognitive processes would not be able to tell her whether to dive left or right—to Peter or to Paul. She would stand on the riverbank, shifting from foot to foot, thinking, “I’ve decided—I’ll rescue one of my sons... um, one of my sons.” To dive in, to choose a direction, she would need more than this. She would need to really decide—Peter or Paul? Who lives and who dies? When the media arrive at the riverbank to report on the incident, she will not tell them “I swam into the river to rescue one unit of child, but the other unit drowned.” No! Even if it is genuinely the case that she loves her sons equally, she will say, “I swam into the river to rescue Peter, but my darling son Paul drowned!” Years later, the poor woman would look back on her action ex post and think: “Did I make the right choice? Should I have rescued Paul instead? Has Peter had a good life, and how does it compare to what Paul would have done had he been alive today?” She would not, unless she was deranged or in serious denial, think that she had merely made the choice to rescue “one son.” Nor could she follow the strict preference approach of Rothbard and say, with a straight face, “I really didn’t have a choice of which to save; after all, I loved them both equally!” Of course, some may object to this whole line of argument, on the basis that “choice” and “preference” have special meanings in economics, which are not necessarily congruous with the ordinary usage of the terms employed by a distressed mother. If so, then we must surely ask whether such an esoteric use of terms is necessary to obtain a sensible theory. Ceteris paribus, we should prefer a theory which avoids artful interpretations of ordinary words in ways that are contrary to their common meaning.
Hoppe’s position does not demonstrate the impossibility of choice under indifference. Instead, Hoppe takes this as the starting point for his analysis, and uses it to deny any possibility that equally optimal actions can be regarded as distinct choices. Although he refers in detail to the internal-mentalist aspects of action, his merging of optimal actions into a single choice does not appear to follow from any genuine assessment of the internal mental processes of actual people; it applies a capite ad calcem in all equally optimal action problems, mental processes be damned! Thus, just as Block’s approach is contrary to a causal-realist assessment of preference, Hoppe’s approach is contrary to a causal-realist assessment of the framing of decision problems.
This approach could perhaps be rescued semantically by being careful to define “indifference” and “choice” in a way that ensures that never the twain shall meet. The problem with this is that it imposes a serious restriction on the way in which decision problems can be described, a restriction which bears little resemblance to a causal-realist assessment of decision framing or the ordinary meaning of choice.To give a simple example of the disparity between the ordinary meaning of choice and the Hoppean approach, suppose that an economist following this approach tries to order dinner at a Chinese restaurant, and that he is indifferent between his two favorite dishes, the Peking Duck and the Szechwan Beef. The following exchange occurs: Waiter: What would you like tonight, sir? Economist: I’ll have the Peking Duck, please. Waiter: The duck is an excellent choice, sir. It is an especially succulent dish. Economist: Wait right there! I didn’t choose the Peking Duck; I chose the Peking Duck or the Szechwan Beef! I like them both equally. Waiter: Oh, I’m sorry, sir. I thought you said you were ordering the Peking Duck. Economist: I did. Waiter: So you want to change your order? Economist: No, I will have the Peking Duck. Waiter: Oh, okay, so you’re choosing the Peking Duck. Economist: No, I’ve already told you: I choose the Peking Duck or Szechwan Beef. Waiter: But which would you like, sir? Economist: I like them both equally. Waiter: Okay, so which do you choose? Economist: I choose the exclusive disjunction of the Peking Duck and the Szechwan Beef! Waiter: Do you mean you want them both? Economist: Of course not! I’m not hungry enough to have two dinners! There are diminishing marginal returns on these things, you know. Waiter: I’m sorry, sir. My English is not so good. Perhaps you could tell me again which you are choosing. Economist: Look here, it’s perfectly simple! I choose the Peking Duck or the Szechwan Beef, but not both. Now bring me the Peking Duck immediately! Waiter: You don’t want the Szechwan Beef? Economist: I want them both equally. Waiter: I’m a little bit confused, sir. Perhaps I could give you half-and-half—would that be alright? Economist: I am indifferent. Make it half-and-half if you want. Waiter: I don’t usually add extra choices to the menu, sir, but I want to make sure you get what you want. Economist: You didn’t add an extra choice! You just changed the nature of an existing choice. Now, I choose the Peking Duck or the Szechwan Beef or half-and-half. Waiter: Oh dear. I’m getting more confused, sir. You see, my English is not so good. I have only been in this country for twenty-six years. I will go and get a manager. Who is at fault here, the waiter or the economist? (If this exchange reminds the reader of an episode of The Three Stooges then perhaps this should give us pause before adopting the Hoppean approach.)
Another, smaller problem with Hoppe’s approach is that it makes the available actions depend on the preferences of the actor, which complicates our description of action. If an actor judges that there are twenty different behavioral options available in a given situation, then Hoppe could not take this as the number of choices. Instead he would be forced to conclude that there are at most twenty choices available and that the actual number of available choices, and their content, depend on the preferences of the actor. Thus different actors, confronted with the same situation, and facing the same constraints, have different “choices” available to them.Continuing the Chinese restaurant example, the exchange continues as follows: Waiter: Good evening again Sir. I’m sorry about before. Please let me offer you a glass of wine on the house to apologize. We have a large number of choices of wine tonight Sir. Economist: Hmm. I’ve been looking at your wine list—you only have twelve choices. Waiter: Perhaps you didn’t look at all the pages Sir. We have over fifty different selections, including many excellent foreign and domestic wines. Economist: I’ve done that. There are only twelve choices. Waiter: Perhaps your copy of the wine list is defective Sir. I’m terribly sorry. Here, let me give you my copy. Economist: Hmm. This looks exactly the same to me. I still see only twelve choices. Waiter: I’m sorry, sir. If you just look here, you’ll see that they’re numbered: one to fifty. See? Economist: Yes, I see that. That’s the number of wines, not the number of choices. Perhaps there are fifty choices for other diners. But for me there are only twelve. Waiter: I’m sorry, sir. Perhaps I wasn’t clear. You can have any wine you like—there are no restrictions. Economist: Thank you. I understand that. Waiter: May I recommend the Montedam Shiraz—it would make an excellent choice. Economist: I can’t—that’s not a choice available to me. Look, I don’t want to get into all this again. Just take my word for it: I only have twelve choices, and that isn’t one of them. Waiter: I’m sorry, sir. As I said, my English is not so good. I am usually much better at this, but perhaps I am not being clear. You can have any wine on the wine list—even the Shiraz. I don’t want to restrict you in any way. Economist: Yes, yes, I already told you, I understand that. I think the best choice here is the exclusive disjunction of the Curtis Hill Merlot, the Di Georgio Cabernet Savignon and the Yalumba Rose. I am going to choose that. Waiter: Oh dear. I think I am going to have some trouble again. I will get the manager. I am very sorry, sir.
It would certainly be mistaken to claim that that all people are bisexual, on the basis that all select partners from the class of “men and women.” To do this would be to infer indifference between different options from the fact that a choice is made from a class of options. The error in the Hoppean approach is the converse of this: to infer the narrowing of the choice frame from the fact of indifference.This does not mean that Hoppe would make the claim that all people are bisexual—his approach is the opposite of this. In fact, his approach only looks at a partner choice this way in cases where a person is indifferent between a male or female partner, in which case the person surely is bisexual. The point here is that by amalgamating decisions indiscriminately in all equally optimal action problems, he must surely contradict the actual decision framing of some people. Hoppe’s analysis of indifference and choice is certainly compelling and innovative. But it is ultimately at odds with the plain meaning of choice and the causal-realist approach to decision framing. If applied indiscriminately to all equally optimal actions the assessment of choice framing is unconvincing.
FIXING THE PROBLEM: NON-STRICT PREFERENCE AND THE LAW OF REVEALED PREFERENCEIt is quite easy to fix all these problems by accepting the possibility of choice under indifference. Rather than reinventing the meaning of ordinary words to try to avoid the problem of equally optimal actions, Austrian school economists can simply accept the full implications of the praxeological conception of indifference and homogeneity, accepting with it the possibility of choice under indifference.
Contrary to Rothbard and other Austrian school economists who have followed his approach, an action does not demonstrate a definite preference between ends. Indeed, the appellation “law of revealed preference” is misleading, if taken in the strong sense. Human action does not actually reveal strict preferences—instead, it reveals inconsistency with some strict preference possibilities. If a person takes action A, but could have taken action B instead, and didn’t, then this reveals that the ends of action B were not strictly preferred to the ends of action A—after all, if action B were strictly preferred to action A then action B would have been taken. Now, it could be that the person prefers action A to action B, or it could be that he is indifferent between the two. Both are logically consistent with the action taken, and must be so, in order to avoid the problems presented by equally optimal actions. Thus, the law is, more accurately stated, a “law of revealed non-preference” if preference is interpreted in the strict sense. It reveals only that any preference possibilities that would have led to a different action must not be correct.
Of course, if there were a situation in which all but one strict preference possibility were found to be inconsistent with the observed action or some counterfactual analysis, then that would indeed reveal this particular strict preference to be correct, through a process of elimination. But it is only by this process—not by any more direct method—that a particular strict preference can be revealed. That is, it is through the revealing of the absence of strict preferences that we gain information about other strict and non-strict preferences.
Continuing the above example, suppose that the mother rescues Peter, allowing her son Paul to drown. This action is inconsistent with the possibility that she strictly prefers Peter drowning to Paul drowning. It is also inconsistent with the possibility that she strictly prefers both of her children drowning to Paul drowning. This is all that is revealed by the action of rescuing Peter. This action is therefore consistent with two possible preference explanations vis-à-vis Peter and Paul: either the mother strictly prefers Peter to Paul, or she is indifferent between the two, but prefers (strictly or non-strictly) to have only one of her sons die than both of them.
The non-strict preference ordering embodied in this explanation is sufficient to derive the notion of indifference and strict preferences between outcomes. This is because any non-strict ordering relation induces a corresponding equivalence relation and strict ordering relation (see Appendix). Unlike the derivation of indifference from strict preferences, this result does not require any assumption of the comparability of all possible outcomes, a property that should be particularly pleasing to Austrian school economists who are apt to stress the fact that preferences are an explanatory tool for action rather than a set of comprehensive orderings ever-present in the human mind (see e.g., Mises 1998, pp. 94–95).
INDIFFERENCE AS A PRAXEOLOGICAL CATEGORYUnder the non-strict preference approach, a choice of a particular action demonstrates that this action is no worse than the available alternatives, assessed in terms of the ex ante judgment of the actor. Thus, the “no worse than” relation is established directly from action—it is the primary praxeological relation embodied in action.
The relationship between this non-strict preference and indifference is simple. If the actor regards outcome A as “no worse than” outcome B and also regards outcome B as “no worse than” outcome A then the actor is indifferent between outcomes A and B (the converse also applies). Thus, indifference can be established as a derivative of the primary praxeological relation —it is also a praxeological relation.This does not mean that we need to define indifference as a derivative of non-strict preference; we have already seen that indifference can be defined directly in praxeological terms (as can strict and non-strict preference). It simply means that we can relate indifference to the primary praxeological relation if we want to. The reason to do this is that our direct inferences from observed actions are about non-strict preferences (the primary relation) and any inference about indifference or strict preference will be derivative to this (secondary relations).
Of course, it is never possible to observe indifference manifested in action according to revealed preference. For this would require an actor to choose A over B, and also choose B over A in the same exact context (even at the same time). Clearly this cannot occur, since these two actions are mutually exclusive. However, this is no objection to the formation of the praxeological category of indifference, since these relations still hold from an examination of the nature of human action, not the observation of any particular action. In other words, since we know from action that the “no worse than” relation can exist, this logically implies that the indifference relation also exists, even though we never observe it in action!Machaj makes a similar point when he discusses the fact that indifference and homogeneity must be described in terms of what is unseen as well as what is seen (see Machaj 2009, p. 233). This point should not be taken to mean that we cannot infer indifference; it simply means that we cannot observe it in action and any such inference must involve some assumption or belief about counterfactual action.
Under the non-strict preference approach, the resulting preference ordering directly induces an equivalence relation which is properly interpreted as indifference. This approach is therefore sufficient to establish the notion of indifference and the notion of homogeneous goods, without any of the attendant problems raised against the strict preference approach in this paper. The best interpretation of these is praxeological, following the subjective theory of value in Menger (2007).
EXPLAINING THE CHOICE BETWEEN ECONOMICALLY IRRELEVANT ALTERNATIVESLest there be any possible misunderstanding, it is important to note that the non-strict preference approach, resting on the praxeological interpretation of indifference, does not explain why the actor chooses the particular equally optimal action that is chosen. However, it does explain the fact that one of the equally optimal actions will be chosen, and that this necessitates some selection between the equally optimal actions. Under this view, the particular choice from among equally optimal actions is a matter that is outside the domain of praxeology and economics. It is an economically irrelevant choice in that it does not affect any of the satisfactions anticipated to be gained from action. The explanation of the particular choice from among equally optimal actions, if such is thought to be necessary at all, must arise from some other source, whether this is psychology, neuroscience, or some other field.
Even with this limitation, the non-strict preference approach is still markedly superior to the strict preference approach adopted by Rothbard and later Austrian economists. Where the non-strict preference approach merely limits its explanation of action to economically relevant choices, and does not seek to explain economically irrelevant choices, the strict preference approach says that the latter choices are not possible at all! Where the non-strict preference approach easily accommodates equally optimal action problems, the strict preference approach denies their existence. Where the non-strict preference approach allows Austrian economists to follow the subjective theory of value to its logical conclusion and adopt praxeological indifference and homogeneity, the strict preference approach sees even the most ardent Austrian methodologists drop praxeology like a hot potato and instead appeal elsewhere for their theory of diminishing marginal returns.
4 CONCLUDING REMARKSIt is this author’s view that the non-strict preference approach is the only approach that is compatible with the causal-realist view of economics personified by Carl Menger, as well as an analogous causal-realist view of the subjective framing of decision problems. In light of problems in attempts to avoid equally optimal action problems, the strict preference approach adopted by Rothbard and others seems to require contortions that render it unrealistic as a description of action.
The praxeological conception of indifference and homo-geneity which leads to the non-strict preference ordering is perfectly natural for Austrian school economists. It follows directly from the subjective theory of value. For the rest, we can let Block do the talking:
Once we concede that two units of anything are equally serviceable in the view of the economic actor, we might as well fold our tents and go home as far as warding off the charge of consorting with indifference is concerned. (Block 2009b, p. 69)
This author is at a loss to understand the desire of Austrian school economists to avoid weakening the preference ordering to non-strict preferences. This approach allows them to easily avoid the difficulties—and the resulting contortions to escape—in optimal action problems. It also allows them to interpret both preference and indifference as praxeological relations, consistent with the causal-realist approach and consistent with Menger’s excellent explanation of the theory of value. While Nozick might gloat a bit from beyond the grave, this would seem to be, not a defeat for Austrian economics, but a triumph of its praxeological method.
APPENDIXStrict and Non-Strict Preference Orderings
Suppose we have a set S of outcomes of various possible actions. On the set S we have a preference ordering ≽ which is the “is no worse than” relation (i.e., a≽b means that outcome a is no worse than outcome b). This is a binary relation that is both reflexive and transitive:
Reflexivity: a≽a for all a∈S.
Transitivity: a≽b and b≽c implies a≽c for all a,b,c∈S.
The preference ordering ≽ induces an equivalence relation ∼ which is the “is no worse or better than” relation. If a≽b and b≽a then we say that a∼b which means that outcome a is no worse or better than outcome b (i.e., the decision maker is indifferent between a and b). This is a binary relation that is reflexive, symmetric and transitive (i.e., an equivalence relation):
Reflexivity: a∼a for all a∈S.
Symmetry: a∼b implies b∼a for all a,b∈S.
Transitivity: a∼b and b∼c implies a∼c for all a,b,c∈S.
Having defined this equivalence relation, the preference ordering ≽ is, by definition, anti-symmetric with respect to the equivalence relation (i.e., a non-strict ordering):
Anti-symmetry: a≽b and b≽a implies a∼b for all a,b∈S.
The preference ordering ≽ also induces a strict preference ordering ≻ which is the “is better than” relation. If a≽b is true but b≽a is false we say that a≻b, which means that outcome a is better than outcome b. This is a binary relation that is non-reflexive, asymmetric and transitive (i.e., a strict ordering):
Non-reflexivity: a≺a is false for all a∈S.
Asymmetry: a≺b contradicts b≺a for all a,b∈S.
Transitivity: a≺b and b≺c implies a≺c for all a,b,c∈S.
All of this can be derived directly from the decision space (S, ≽). However, it can only be derived from (S, ≽) with an assumption of comparability of all actions:
Comparability: For all a,b∈S we have either a≼b or b≼a or both.
Volume 13, Number 4 (Winter 2010)
There are two Coase theorems. The simplistic one deals with the unrealistic world of zero transactions costs. The more important one addresses itself to the real world, where transactions costs are positive, and, often, larger than any possible gains that might ensue from market transactions. Demsetz and I have been having a decades-long dialogue about the first of these; to wit, is resource allocation invariant to judicial findings as to property rights. Demsetz says yes, I say no. Of late, Brooks joins the fray, finding some good, and some bad, in the position of each of us, Demsetz and myself. This paper is a response to Brooks.
I would like to thank Joe Salerno for his kind invitation to present the Ludwig von Mises lecture for 2010, in this way giving me the opportunity to present these views on the classical theory of the cycle and Say’s Law to a wider audience. I would also like to thank my good friend, Peter Smith, who provided excellent and sympathetic advice on an earlier draft of this paper.
Ludwig von Mises LectureAustrian Scholars ConferenceLudwig von Mises InstituteAuburn, AlabamaMarch 13, 2010
It is a great honor for me to have been asked to present the Ludwig von Mises lecture here at the Austrian Scholars Conference.
Let me begin with a story. When I came to select my list of the ten most influential economists of the twentieth century in an article published in the Canberra Times on December 1999, an article which can still be found on the Societies for the History of Economics website, the economist I chose as the most influential—not the best nor the greatest, mind you, but as the most influential—was John Maynard Keynes. No one, I regret to say, has had more influence than Keynes.
Then, second on my list, was Friedrich Hayek, placed there because of his recognized relevance for the economies of Eastern Europe that were then emerging from beneath the horrors of their communist regimes.
But third was Ludwig von Mises, who might have just as easily been second, about whom I wrote these words:
Ludwig von Mises took the fight up to the socialist dogmas of the early twentieth century and showed on paper that no economy could ever solve the problem of allocating resources without a price mechanism, free markets and private property. Who doesn’t know it now? He knew it eighty years ago.
Ludwig von Mises is an economist for whom I have had the greatest imaginable regard which is why having been given this opportunity to speak to you today means as much to me as it does.
And in beginning this address, I would like to mention something that Mises and I have in common. He had been for twenty-four years the economist for the Austrian Chamber of Commerce. Well, as it happens, I had myself been, also for twenty-four years, the economist for the Australian Chamber of Commerce.
And while to some extent this is mere coincidence, I believe that for both of us, as the economic representative of the business communities in both of our countries, even though more than two generations apart, it was this experience that allowed us to understand the workings of an economy with certain kinds of insights that may generally not be appreciated by others.
But it was one aspect of my work that ended up having an immensely large impact on my life, and that is the discovery of Say’s Law for myself. It is because I reinvented this principle that I believe I understand it so well.
And what happened was this. As part of the way in which the Australian economy is managed, we have what was once known as the National Wage Case. It is a court case in front of a panel of industrial relations judges who at the time determined the level of wages for something like ninety percent of the working population.
And as part of the union claim for higher wages, it was always argued that increased incomes would be good for the economy because it would increase demand. I would counter this by pointing out how useless it would be for businesses to find their revenues increased through first increasing their costs by an equivalent amount. And then, a year after I had formulated this argument, I came across the identical argument in a passage in an essay by John Stuart Mill, published as long ago as 1844. This is what Mill wrote:
The utility of a large government expenditure, for the purpose of encouraging industry, is no longer maintained.... It is no longer supposed that you benefit the producer by taking his money, provided you give it to him again in exchange for his goods. There is nothing which impresses a person of reflection with a stronger sense of the shallowness of the political reasonings of the last two centuries, than the general reception so long given to a doctrine which, if it proves anything, proves … that the man who steals money out of a shop, provided he expends it all again at the same shop, is a benefactor to the tradesman whom he robs, and that the same operation, repeated sufficiently often, would make the tradesman’s fortune. (Mill, 1874 [1974])
Although it would be years before I would work this out, what Mill wrote is based on a proper understanding of Say’s Law. High levels of public spending do not encourage industry. Spending does not of itself create growth and employment. You cannot make an economy prosper through expenditure but only through value adding production. Demand does not drive an economy forward, nor does demand deficiency cause recessions.
It was this most fundamental of all economic propositions that Keynes deliberately and willfully destroyed. Say’s Law has, for all practical purposes, now disappeared from economic discourse and policy. And until it returns, the ability for the economics profession to provide sound and sensible advice during recession will remain sharply constrained. But to understand what Say’s Law means one must first understand the role Say’s Law played in the Keynesian Revolution.
UNDERSTANDING THE KEYNESIAN REVOLUTION The Keynesian Revolution, and therefore the origins of virtually all macroeconomic theory today, can only be understood in relation to Keynes’ coming across Malthus’ economic writings in 1932. In particular, it was his reading of the Malthus side of the Malthus-Ricardo correspondence, which had been unearthed in 1930 by his close associate Piero Sraffa, that turned Keynes’ mind to the possibility of demand deficiency as a cause of recession. Until that time, economists had been near unanimous in arguing that insufficient demand as a cause of recession was fallacious.
There has been universal recognition amongst historians of thought that something does happen in late 1932 to turn Keynes in a new direction. Yet not one of the works devoted either to understanding the nature of the Keynesian revolution nor to examining the road between the Treatise on Money published in 1930 and the General Theory published in 1936, has suggested that the reason for this change in direction occurs specifically because Keynes was at that time updating his essay on Malthus.Keynes was at the time completing the essay for inclusion in his Essays in Biography which would be published the following year. Indeed, there is no reason given of any kind why at that particular moment Keynes came to the conclusion that demand deficiency was the missing link in the theory of the cycle. Yet it is as close to a certainty as one can have in such reconstructions that Keynes would never have written the General Theory as he did, focusing on demand deficiency, had he not become deeply interested at the end of 1932 in Malthus’ economic writings. It was Malthus, of course, who had been the leading advocate in the nineteenth century of demand deficiency as a cause of recession and of increased levels of unproductive spending as the cure. Reading Malthus’ letters to Ricardo, and then the text of Chapter VII of Malthus’ Principles, ought to be recognized as the single most important reason why Keynes was to write what he wrote in the way he did.
Recognizing that this was the inspiration should make it easier to understand what the intent of the General Theory was and to understand the nature of the change in economic theory that occurs as a result. In the General Theory Keynes is very clear about what he has learned from reading Malthus.
The idea that we can safely neglect the aggregate demand function is fundamental to the Ricardian economics, which underlie what we have been taught for more than a century. Malthus, indeed, had vehemently opposed Ricardo’s doctrine that it was impossible for effective demand to be deficient; but vainly. For, since Malthus was unable to explain clearly (apart from an appeal to the facts of common observation) how and why effective demand could be deficient or excessive, he failed to furnish an alternative construction; and Ricardo conquered England as completely as the Holy Inquisition conquered Spain. Not only was his theory accepted by the city, by statesmen and by the academic world. But controversy ceased; the other point of view completely disappeared; it ceased to be discussed. The great puzzle of Effective Demand with which Malthus had wrestled vanished from the economic literature. (Keynes, 1936, p. 32, emphasis added.)
It was the “great puzzle of Effective Demand” that Malthus had been wrestling with which had disappeared and it was this that Keynes was intent on restoring to economic theory.
Nor was Keynes wrong on the implications of Say’s Law to his contemporaries. It was precisely this issue that is the dividing line between pre-Keynesian economics and the economics that has dominated theory ever since. Mainstream economists before 1936 had actively denied any role for aggregate demand in understanding the business cycle. Although there had been some attempts to overturn the law of markets, demand deficiency as an explanation for recession was until then almost entirely the province of cranks.Keynes discussed a number of these in the General Theory, referring to them as his “brave army of heretics” (Keynes, 1936, p. 371), a band of brothers that included Bernard Mandeville, Malthus, Major Douglas, Silvio Gesell and J.A. Hobson. The two most important diagrammatic innovations of the 1930s were the IS-LM curves published by Hicks in 1937 and the Keynesian cross diagram first published by Paul Samuelson in 1939 (see Schneider 2010). Both were developed in response to Keynes’ General Theory, and both feature in economics texts to this day.
The problem of recession as conceived in the General Theory was that an economy, once it has passed a certain level of production, will run out of demands for the goods and services it produces.
This is not excess supply for individual goods and services, the “particular glut” whose existence no one had ever denied, but an actual excess supply of all goods taken together, that is, a “general glut.” Keynes made the possibility of demand failure the culminating point at the end of the introductory chapters of the General Theory.
The celebrated optimism of traditional economic theory, which has led to economists being looked upon as Candides, who, having left this world for the cultivation of their gardens, teach that all is for the best in the best of all possible worlds provided we will let well alone, is also to be traced, I think, to their having neglected to take account of the drag on prosperity which can be exercised by an insufficiency of effective demand. (Keynes, 1936, p. 33)
The possibility of a failure of effective demand is the very point behind the Keynesian-cross diagram, IS-LM curves or the AD-AS relationship. It is taught to undergraduate economists worldwide, and is embedded almost universally in our present policies designed to pull economies out of recession. And while other possible explanations for recession are now usually discussed as well, demand failure remains the single most important concept most economists are taught in relation to the causes of recession and involuntary unemployment. It is the argument that recessions can best be understood as occurring because of a fall in aggregate demand that continues to mark economic theory to this day, along with the implication that stimulating demand through deficit spending is the optimal approach to take in dealing with recessions when and where they occur.
Aggregate demand is intrinsic to the modern understanding of the level of economic activity. The implication is that it is the level of aggregate demand that is responsible for the level of output, the rate of economic growth and the number of persons employed. An insufficient level of aggregate demand is held generally responsible for high levels of unemployment and it is almost universally accepted that deficit financed public spending can permanently raise the level of output and thereby lower the rate of unemployment. There is an aggregate supply curve associated with aggregate demand, but its principal role is the determination of the rate of inflation. Production levels are not determined by supply capabilities but by the willingness of individuals to buy what has been produced with the incomes they have received.
Indeed, the issue went farther than this. Keynes argued that if Say’s Law were valid, continuing and persistent unemployment simply could not occur and this was unrecognized by classical economists whom he was about to correct. As he wrote:
Say’s law, that the aggregate demand price of output as a whole is equal to its aggregate supply price for all volumes of output, is equivalent to the proposition that there is no obstacle to full employment. If, however, this is not the true law relating the aggregate demand and supply functions, there is a vitally important chapter of economic theory which remains to be written and without which all discussions concerning the volume of aggregate employment are futile. (Keynes, 1936, p. 26, emphasis added.)
For the vast majority of the economics profession even now, this is the way in which Say’s Law and its implications are understood. It is the very meaning of the Keynesian Revolution. Mises made the same point in 1950:
Lord Keynes’s main contribution did not lie in the development of new ideas but “in escaping from the old ones,” as he himself declared at the end of the Preface to his “General Theory.” The Keynesians tell us that his immortal achievement consists in the entire refutation of what has come to be known as Say’s Law of Markets. The rejection of this law, they declare, is the gist of all Keynes’s teachings; all other propositions of his doctrine follow with logical necessity from this fundamental insight and must collapse if the futility of his attack on Say’s Law can be demonstrated. (Mises, 1950 [1980])
It is precisely here that we find the division between the economics of the classics and virtually all modern economic theory, especially of the mainstream variety. As was recognized at the time, and as Mises clearly notes, Keynesian economics, that is all of modern macroeconomics with its focus on aggregate demand, must collapse if the attack on Say’s Law turns out to be wrong.
It is only to be regretted that Mises did not recognize how singularly important it was to hammer home this point. He treated Say’s Law as so obviously valid, beyond any possibility of argument, that I suspect he found it impossible to understand how anyone who called themselves an economist could accept Keynesian theory. All he ever directly wrote on Say’s Law he contained in a brief article in a collection of essays. But as for the validity of Say’s Law, he could not have been more clear:
The exuberant epithets which these admirers have bestowed upon his work cannot obscure the fact that Keynes did not refute Say’s Law. He rejected it emotionally, but he did not advance a single tenable argument to invalidate its rationale. (Mises, 1950 [1980])
Mises accepted Say’s Law as unquestionably valid, as part of the “perennial laws” of economics. But because he found rejection of Say’s Law inconceivable he did not do what he might otherwise have done, which was to explain why it must remain an integral part of the bedrock foundation of economic theory if that theory is to provide us with the guidance needed when recessions and high unemployment occur.
UNDERSTANDING SAY’S LAW—MALTHUS AND THE “GENERAL GLUT” DEBATE What is relevant about Say’s Law cannot be contained within a single statement. Say’s Law, if it is to be understood in full, must be understood as a series of related propositions which when taken together constitute the basic ingredients of the classical theory of the cycle. The most extraordinary of the many ironies that have surrounded this issue since Keynes first pronounced on it in 1936 is that Say’s Law was the foundation stone within classical theory for understanding why a cycle exists at all. Keynes’ argument was that belief in Say’s Law meant that classical economists assumed there was never at any stage an obstacle to full employment. The reality is that Say’s Law was an integral part of the explanation of why in fact unemployment actually occurred.
Keynes, in attacking “Say’s Law” in 1936 was not attacking some one-sentence statement of principle. In attacking Say’s Law, he was attacking the entire classical theory of the cycle. Unless this is understood, it is impossible to understand in full exactly what Keynes was able to do. The propositions associated with Say’s Law need to be seen as the constituent elements of the classical theory of the cycle and to understand why this was so, it is necessary to enter into some of the early history of economic theory itself.
What became the classical theory of the cycle was formed during what is now known as the “General Glut” debate that lasted from the publication of Malthus’ Principles of Political Economy in 1820 through until John Stuart Mill published his own Principles of Political Economy in 1848. Malthus was, in 1820, the single most famous economist in the world. His 1798 publication, On Population, had been an international sensation. As a result, when he published his text on economic theory, it was not just another text but a work that would instantly attract the widest attention.As an interesting parallel, Keynes, too, was the most famous economist of his time after having written his Economic Consequences of the Peace at the end of World War I. It had also been a worldwide sensation in its time.
What in particular distinguished Malthus’ arguments from virtually all other writings on economic issues at the time was his belief that the recessions experienced by England at the end of the Napoleonic Wars had been caused by oversaving and demand deficiency. And so a debate was commenced across the whole of the economics community of the time, with a raft of books on economic theory published over the next few years in which much of the argument centered on a discussion of what Malthus had written. All agreed it was possible to have an excess supply of individual goods and services. The question was whether there could be an excess supply of all goods and services taken together.
Importantly, it was not a debate over whether recessions and large-scale unemployment were possible. On this there was obviously unanimity. The only question was whether recessions, when they occurred, were the result of too much saving and too little effective demand. That this could never be a realistic explanation was ultimately accepted by the whole of the mainstream of the economics community.
Moreover, during classical times there was no economic principle known as “Say’s Law.” The term would not be coined until the twentieth century or enter economic discourse until the 1920s (see Kates, 1998, pp. 148–149). There was Jean-Baptiste Say’s théorie des débouchés, known in English as the “law of markets,” which stated that demand was constituted by supply. It was the law of markets that was employed as part of the response to Malthus’ views but as only one strand in a far more complex series of counter arguments. It was a crucially important part of the argument, but it was only one of the arguments in a longer chain of reasoning. It was the entire set of counter arguments that when taken together became the related propositions that formed the classical theory of the cycle. Leaving Say’s Law in Keynes’ desiccated form of words—“supply creates its own demand”—not only reverses the point that classical economists had tried to make—that demand in real terms can only be derived through the production of value adding goods and services—but ignores every other related aspect that was central to an understanding of the classical theory of the cycle.
By discrediting the crucially central idea that demand is formed on the supply side of the economy, the related propositions that had emerged from the debate over Malthus lost their coherence. The publication of the General Theory caused the entire classical perspective on the business cycle to disappear. The propositions presented below are therefore intended to reassemble the arguments that were at the core of pre-Keynesian business cycle theory and need to be seen as the full meaning of Say’s Law as it emerged during the General Glut debate.For historical accuracy I will note that these arguments had been first brought together by James Mill in 1808 where he, too, specifically invoked the théorie des debouches to explain why demand deficiency is a fallacious explanation for recession. It is for this reason that in my view James Mill had been the first to properly state “Say’s Law” (see Kates, 1998, pp. 24–29). They are also put in a form so that the entire argument can be seen as a full and complete response not just to Keynes and the arguments of the General Theory, but also as a reply to modern macroeconomics to the extent that it continues to rely on demand deficiency to explain why recessions occur.
THE RELATED PROPOSITIONS OF SAY’S LAW The related propositions that make up Say’s Law are discussed below, along with concrete examples from the pre-Keynesian literature to demonstrate their importance as integral components of classical thought.
Proposition 1: Recessions are never due to demand deficiency. An economy can never produce more than its members would be willing or able to buy. A general glut (i.e. general overproduction) is impossible. Neither high levels of saving nor the redirection of resources into higher levels of capital formation cause recessions to occur.
This is the starting point for any understanding of the pre-Keynesian theory of recession and Say’s Law. Four examples of how this statement was an integral part of economic theory across the entire classical period will help put the law of markets into its proper context.
First Adam Smith. He specifically denies that there is any danger from oversaving and that a community has anything to fear from the saving of its more provident members. It was this argument that Keynes specifically set out to deny.
What is annually saved is as regularly consumed as what is annually spent, and nearly in the same time too; but it is consumed by a different set of people. That portion of his revenue which a rich man annually spends, is in most cases consumed by idle guests, and menial servants, who leave nothing behind them in return for their consumption. That portion which he annually saves, as for the sake of the profit it is immediately employed as a capital, is consumed in the same manner, and nearly in the same time too, but by a different set of people, by laborers, manufacturers, and artificers, who reproduce with a profit the value of their annual consumption. His revenue we shall suppose, is paid him in money. Had he spent the whole, the food, clothing, and lodging, which the whole could have purchased, would have been distributed among the former set of people. By saving a part of it, as that part is for the sake of profit immediately employed as capital either by himself or by some other person, the food, clothing and lodging, which may be purchased with it, are necessarily reserved for the latter. The consumption is the same, but the consumers are different. (Smith, 1776 [1976], p. 359)
A second example is Alfred Marshall writing in a publication co-authored with his wife, Mary Paley Marshall, in 1879. Here it is made abundantly clear that deficient aggregate demand is not the proper explanation for depression.
After every crisis, in every period of commercial depression, it is said that supply is in excess of demand. Of course there may easily be an excessive supply of some particular commodities; so much cloth and furniture and cutlery may have been made that they cannot be sold at a remunerative price. But something more than this is meant. For after a crisis the ware-houses are overstocked with goods in almost every important trade; scarcely any trade can continue undiminished production so as to afford a good rate of profits to capital and a good rate of wages to labour. And it is thought that this state of things is one of general over-production. We shall however find that it really is nothing but a state of commercial disorganisation. (Marshall and Marshall, 1879 [1881], p. 154)
And lest it be thought that this is the early Alfred Marshall which was later subsumed by a different point of view, in a section introduced into the fifth edition of the Principles in 1907 he emphatically made the point again. Note that problems on the demand side are seen only to exacerbate a problem that has been due to other causes.
It is true that in times of depression the disorganization of consumption is a contributory cause to the continuance of the disorganization of credit and of production. But a remedy is not to be got by a study of consumption, as has been alleged by some hasty writers. (Marshall, 1907 [1961], p. 711n)
Finally, Friedrich Hayek. His 1931 article, “The ‘Paradox’ of Saving,” is a full-scale discussion, more than 40 pages in length, on the arguments of Catchings and Foster who during the 1920s and 1930s had argued that over-saving was the cause of recessions. Hayek’s opening paragraph is not only an attack on the belief that excess saving is a cause of recession, but he also specifically refers to the théorie des débouchés as providing the appropriate position. And while Hayek had his own theory of the cycle, the article is not in the least dependent on such views. It is nothing other than a straightforward statement of the classical position. Hayek wrote:
The assertion that saving renders the purchasing power of the consumer insufficient to take up the volume of current production although made more often by members of the lay public than by professional economists, is almost as old as the science of political economy itself. The question of the utility of ‘unproductive’ expenditure was first raised by the Mercantilists, who were thinking chiefly of luxury expenditure. The idea recurs in those writings of Lauderdale and Malthus which gave rise to the celebrated Théorie des Débouchés of James Mill and J.B. Say, and in spite of many attempts to refute it, permeates the main doctrines of socialist economics right up to Tugan-Baranovsky, Thorstein Veblen and J.A. Hobson. But while in this way the idea has found a greater popularity in quasi-scientific and propagandist literature than perhaps any other economic doctrine hitherto, fortunately it has not succeeded as yet in depriving saving of its general respectability. (Hayek, 1931, pp. 74–75, bolding added)
It is highly noteworthy that it was only five years later that the General Theory would in fact do what Hayek had feared, and “deprive saving of its general respectability.”The existence of this critique of Catchings and Foster may also help explain why Hayek, having invested the time and effort in dealing with their arguments, almost completely ignored Keynes’ attempt to achieve the same result. By the time Keynes wrote, Hayek may well have found trying to explain the fallacies in such reasoning completely stale. To have bothered responding to Keynes in the detail required would have for him involved going over old ground.
Proposition 2: Demand is constituted by supply. Aggregate demand is not independent of aggregate production but is identical with it. A community’s purchasing power is constituted by its value added. Aggregate demand can only increase when the value of the goods and services produced is greater than the value of the inputs used up in the production process.
This proposition is a restatement of Jean-Baptiste Say’s original théorie des debouches, wrongly characterized by Keynes as “supply creates its own demand.” Moreover, the statement that “demand is constituted by supply” may be the most important concept in coming to grips with the classical theory of the cycle, but because it is so foreign to modern macroeconomic thought, it may also be the most difficult. Yet it was fully accepted by pre-Keynesian economists.
Here is James Mill, in the first presentation of what would become the classical theory of the cycle, explaining the significance of this principle. He could not be more emphatic nor does he leave any doubt about just how crucial he believes this principle to be.
No proposition however in political economy seems to be more certain than this which I am going to announce, how paradoxical soever it may at first sight appear; and if it is true, none undoubtedly can be deemed of more importance. The production of commodities creates, and is the one universal cause which creates a market for the commodities produced. (Mill, 1808 [1966], p. 135)
Moving forward a century, the same concept is found in the following passage from one of the most widely used economic texts ever published, in which this principle is stated in very clear terms:
It is only because our exchanges are made through money that we have any difficulty in perceiving that an increase in supply is (not “causes”) an increase in demand…. An increase in the supply of cloth is an increase in the demand for other things; and vice versa, an increase in the supply of anything else may constitute a demand for cloth. What is divided among the members of society is the goods and services produced to satisfy its wants; and the same goods and services are both Supply and Demand. (Clay, 1916, p. 242)
The notion of aggregate demand separate from aggregate supply was foreign to pre-Keynesian economic thought. Aggregate demand grows at the same rate and by the same amount as aggregate supply, and will not grow unless supply has grown. It is not, however, just any production that will lead to an increase in aggregate demand. What creates demand is the production of forms of output for which enough buyers can be found to cover in aggregate the entire costs of production. Only if the goods and services produced can be sold for more than was paid for the inputs that went into their production can it be said with certainty that value has been added during the production process. Conversely, if the goods and services produced do not create more value than is used up in the production process, there can be no increase in aggregate demand because there has been no increase in aggregate supply in any relevant sense.
Proposition 3: The process involved in purchase and sale is the conversion of one’s own goods or services into money and then the re-conversion of the money one has received back into other goods and services. There is no implication of a barter economy. Money is intrinsic to the processes involved.
At the very core of the classical propositions surrounding Say’s Law is an appreciation that money is infused with value only by being received in exchange for value adding production. The process is one that may be characterized in the formula C–M–C’ where the set of goods or services in one’s own possession (C) is converted into a different set of goods or services (C’) by the sale of what one owns for money (M) and then the reconversion of the money received into what one wishes to buy.This is the formula used by Marx to explain the classical mechanisms associatedwith the law of markets but was used by him as a criticism. Keynes had accused classical economists of confusing a barter economy with the operation of a money economy, but from the first statements on Say’s Law by Say himself that had never been the case. Here is J.B. Say, in the fourth edition of his Treatise,It is the fourth edition that has been the one translated into English because that was the latest edition available when Malthus published his Principles in 1820. There would be a fifth edition in French that has not been translated. trying to explain the obvious.
Should a tradesman say, “I do not want other products for my woollens, I want money,” there could be little difficulty in convincing him that his customers could not pay him in money, without having first procured it by the sale of some other commodities of their own. … You say, you only want money; I say, you want other commodities, and not money…. To say that sales are dull, owing to the scarcity of money, is to mistake the means for the cause; an error that proceeds from the circumstance, that almost all produce is in the first instance exchanged for money, before it is ultimately converted into other produce. (Say, 1821, pp. 163–165)
But more importantly, the process lay in ensuring that those who produced made sure that they created value in the process. Demand was only constituted by the value added that arose from the sale of goods or services to others. If output could not be sold at prices that repaid the costs of production, then no value added had occurred. That this frequently did take place provided the core insight into the classical theory of the cycle. That demand was built on productive activities was also pointed out by Mises, who was explicitly following Say in making this point:
Commodities, says Say, are ultimately paid for not by money, but by other commodities. Money is merely the commonly used medium of exchange; it plays only an intermediary role. What the seller wants ultimately to receive in exchange for the commodities sold is other commodities. (Mises, 1950 [1980])
To understand demand being constituted by supply, it is necessary to recognize that in a properly functioning economy, purchases are effected with the revenue from the previous sale of goods and services or with money borrowed from others who have earned incomes by producing. For those who earned their incomes from the sale of goods and services, the process is direct. The creation of value and the sale of what had been produced provided the income for the purchase of other goods and services. For businesses investing borrowed funds, the purchases are effected through the transfer of funds through a saving-investment process. For governments, purchases are effected through revenues raised through taxation of the incomes of those who had sold goods or services to the market.
Proposition 4: Recessions are common and result in high levels of involuntary unemployment.
It really ought to be unnecessary to point out that this proposition ought to be completely non-controversial. It really ought to have been inconceivable to have suggested, as Keynes did in 1936, that economists until then had had no explicit theory of involuntary unemployment and recession. Yet one of the consequences of the publication of the General Theory was the belief that classical economists had no theories to account for recessions and involuntary unemployment. It is therefore necessary to make the explicit statement that classical economists did indeed have such theories of recession and they most assuredly did understand that involuntary unemployment was a frequent feature of economic life. The theory of the business cycle had been developing for over a century by that stage, so that for Keynes to have stated of his fellow economists that they had no theory of involuntary unemployment was absurd.
A compendium of all of the theories of the cycle is found in a League of Nations publication by Gottfried Haberler, titled Prosperity and Depression whose first edition was published in 1937, the year following the publication of the General Theory. The first words of the preface ought to make it absolutely plain that recession and unemployment were amongst the most important questions under examination by the economics community of the world during the 1930s, and had been for generations:
This book has its origin in a resolution adopted by the Assembly of the League of Nations in September 1930 by which it was decided that an attempt should be made to co-ordinate the analytical work then being done on the problem of the recurrence of periods of economic depression. The literature concerning economic depressions and what is currently and somewhat loosely described as the trade cycle is abundant…. It is apparent from the persistence with which depressions occur, from the gravity of their economic and social effects, and from the growing consciousness of that gravity, that – however abundant the literature on the subject, however elaborate and specious the theories – our knowledge of the causes of depressions has not yet reached a stage at which measures can be designed to avert them. (Haberler, 1937, p. iii)
That what ought to have been seen as absurdly improbable was nevertheless accepted from the moment it was first published is an issue that demands the attention of historians of ideas. Here we merely note that Keynes’ statement, that economists before him had no theories to explain recessions and unemployment, is false as a moment’s reflection ought to have led anyone to recognize at the time, just as it ought to be recognized today.
Proposition 5: Recessions are due to structural problems of one kind or another. In particular, recessions occur where the structure of supply does not match the structure of demand. Recessions occur when the pattern of demand is different from the actual composition of output so that a significant proportion of the goods and services put up for sale remains unsold.
For anyone basing their understanding of these issues on Keynes’ writings, it is something of a surprise to discover that the law of markets was at the very centre of the classical theory of the recession and, in fact, provided the foundation for the theory of the cycle as understood by classical economists. Because demand was constituted by supply, cyclical activity was understood to be the result of individuals and businesses producing what could not be sold at prices which covered costs. Why this might happen was the underlying issue, but that it frequently did happen, of this no one had the slightest doubt. The more than one hundred year classical literature on the nature and causes of the business cycle is a testament to the recognition that pre-Keynesian economists gave to unemployment and recession.
Torrens, writing in 1821 in a direct response to the arguments presented by Malthus, makes the point as explicitly as it is possible to make it. The classical theory of the cycle was built on these very concepts. Demand is constituted by supply but only so long as supply consists of what those with incomes to spend want to buy. Keeping demand and supply properly proportioned was the imperative, but once that had been achieved all went well. It was when the proportions were not maintained that recessions would occur. Torrens firstly notes that there is no possibility that supply will ever outrun demand.
So long as the proportion is preserved, every article which the industrious classes have the will and power to produce, will find a ready and profitable vend. No conceivable increase of production can lead to an overstocking of the market…. Increased production will create a proportionally increased demand [sound familiar?] …. (Torrens, 1821 [1965], pp. 370–372)
What is particularly notable is that Torrens uses almost the very words Keynes would use to summarize Say’s Law. “Increased production will create a proportionately increased demand” is the lineal ancestor of “supply creates its own demand.” Torrens is invoking Say’s law of markets to show that demand deficiency is never a problem. But he does not conclude from this that economies cannot therefore go into recession or that there are no obstacles to full employment. He instead uses this very principle to explain why recessions occur. Following on from the above passage, Torrens immediately sets out the consequences should something happen to disturb the balance between the structure of production and the structure of demand.
This happy and prosperous state of things is immediately interrupted when the proportions in which commodities are produced are such as to disturb the equality between effectual demand and supply…. Then gluts and regorgements are experienced. (Torrens, 1821 [1965], pp. 370–372)
Torrens was not the first to make this point, but he made it very well. A lack of proportion between supply and demand is the cause of a descent into recession. The problems of recession are due to structural problems in an economy, not because of a failure of demand. And it required an understanding of the law of markets to understand that recessions occur when what has been produced does not coincide with what those with incomes want to buy.
In these passages, Torrens captured the theory that became during the following century the common ground amongst the economics community in discussing the business cycle. Recessions and depressions were due to structural problems. Haberler, in his Prosperity and Depression, provided a synopsis of the theory of the cycle as it had been understood until then. In summarizing the views of the economic profession of his time, he wrote:
An expansion or contraction may be interrupted on the one hand by an accident…or it may on the other hand itself give rise to maladjustments in the economic system…. Most cycle theorists have tried to prove that the second type of restraining force is all-important. (Haberler, 1937, p. 245)
This is Torrens once again. It is this maladjustment in the structure of production, where demand and supply are out of proportion with each other, that was the fundamental explanation for recession. Demand deficiency played no part in the process within orthodox theory.There was, however, an under-consumptionist literature which argued that too little demand from consumers was the systematic cause of economic recession. This was at the time almost entirely the province of economic cranks, as Keynes’ reference to the “brave army of heretics” plainly shows. Hobson was seen as the leading exponent of this view as both Keynes (Keynes, 1936, pp. 364–370) and Haberler (1937, p. 115) make clear.
Where demand was crucial was in relation to the structure of demand relative to supply, that is, in situations where what buyers would have been willing to pay the full costs of production for did not match what suppliers had actually put on the market. Starting from the proposition that demand is constituted by properly proportioned supply, recessions are caused by events that mislead producers into producing goods and services that cannot be sold at cost covering prices.
Proposition 6: Partial overproduction of individual goods and services occurs continuously within economies and can lead to a general downturn in an economy. The transmission mechanism is from a reduction in earnings in some sectors of the economy where sales have been below expectations to a fall in demand in other sectors and therefore to a wholesale downturn in activity.
Walter Bagehot, as editor of The Economist, wrote one of the most influential nineteenth century works on the operation of the money market. As part of this work, he included a chapter on the nature of the business cycle, in which he described the evolution of a general downturn built out of a downturn in one part of the economy. Given Keynes’ accusation that classical economists had ignored monetary factors and their effects on economic activity, it should not go unnoticed that the following is from Bagehot’s Lombard Street which had as its subtitle, A Description of the Money Market. What Bagehot wrote was this:
No single large industry can be depressed without injury to other industries; still less can any great group of industries. Each industry when prosperous buys and consumes the produce probably of most (certainly of very many) other industries, and if industry A fail and is in difficulty, industries B, and C, and D, which used to sell to it, will not be able to sell that which they had produced in reliance on A’s demand, and in future they will stand idle till industry A recovers, because in default of A there will be no one to buy the commodities which they create. (Bagehot, 1873, 121–122)
The essence of this process is the creation of an economic downturn built upon the systematic failure of producers to sell what they have produced in their own markets. This is not a description of a Keynesian multiplier but a trail of purchase and sale between different producers. It accepts that when the recovery comes there may be different firms and industries in different proportions. But the conception that lies behind it is that the pieces in the economy must interlock as firms provide a market for each other with the entire structure ultimately aimed at producing goods and services for final home consumption.
Proposition 7: Monetary factors, most notably structural imbalances in the market for credit, can also be and often are an important cause of recession. Even where monetary instability has not been the originating cause of recession, monetary factors will often deepen a recession brought on for other reasons.
It is because Keynes argued that classical economists thought only in terms of real variables that such an obvious statement even needs to be made. It was, in fact, the specific conclusion reached by Becker and Baumol that ought to have put this issue to rest for all time, and also have raised some questions about the foundations of the Keynesian economic theory that had been built on the rejection of so flimsy a straw man. Becker and Baumol could not have been more explicit in dealing with this caricature of classical theory, which they labeled “Say’s Identity.” In discussing what they term “the clearest statement on the point”—Mill’s second essay in his Essays on Some Unsettled Questions of Political Economy—they wrote:
It is all there and explicitly—Walras’ Law, Say’s Identity which Mill points out holds only for a barter economy, the “utility of money” which consists in permitting purchases to be made when convenient, the possibility of (temporary) oversupply of commodities when money is in excess demand, and Say’s Equality which makes this only a temporary possibility. Indeed, in reading it one is led to wonder why so much of the subsequent literature (this paper included) had to be written at all. (Becker and Baumol, 1952, p. 374.)
Monetary factors can and do cause recession. It is stating nothing but what ought to be obvious, that classical economists were fully aware that monetary factors were often part of the process even when not the initiating factor in causing recessions to occur.
The approach to economic policy becomes very different if one begins from a classical perspective rather than from one built that commences with demand deficiency. These different perspectives are part of the matrix of ideas that were part of the structure of understanding that existed under a theory of the cycle built on classical foundations.
Proposition 8: Because recessions are not due to a failure of demand, practical solutions to recession do not encompass increased levels of public spending. While such expenditure may provide some limited benefit if spending is concentrated on value adding goods and services, such expenditure is merely a palliative rather than a cure.
The policy consequences of Keynesian theory have over the years provided ample evidence that on this matter classical economists were correct. There has been no instance of a peacetime increase in public spending during recession that has led to recovery. Reductions in taxation have a different effect on economic outcomes, and can be consistent with classical principles in generating economic growth. Increases in public spending, however, are not. John Stuart Mill’s statement, found at the start of this paper, is about as clear-cut as one could find.
The utility of a large government expenditure, for the purpose of encouraging industry, is no longer maintained.... It is no longer supposed that you benefit the producer by taking his money, provided you give it to him again in exchange for his goods. (Mill, 1874 [1974])
The stimulus packages that have been associated with attempts to revive economies internationally following the onset of the Global Financial Crisis, especially in the US and UK, have been failures. The absence of signs of success and the growing problems related to the rising levels of public debt are indications that these Keynesian policies did not work as their advocates suggested they would. The outcomes of these stimulus packages ought to be recognized as the major test of Keynesian theory and policy that they have been. Based on this experience, the macroeconomics that is almost universally taught should be recognized as of no theoretical or practical value. Ridding economic theory of the aggregate demand curve should be the single most important theoretical issue of our time.The downturn in activity, because the cycle is cyclical, will end at some stage with an upturn. What is evident already, however, is that the spending programs which have been introduced have not been factors in generating recovery. Indeed, not only have they been of virtually no use in creating a net addition to employment they have also coincided with deteriorations in economic conditions generally that have been unexpected by those who introduced the stimulus programs. The argument has been made that economic conditions would have been even worse than they were had these programs not been introduced even though at the time of their introduction, the expectation was that there would be a generally rapid upturn in activity and the labor market. None of this has occurred, as anyone looking at these programs from a classical perspective would have expected.
If public spending and deficit finance are recognized to have failed, just as they failed in Japan during the 1990s and in the United States during the Great Depression, support for Keynesian theory and policy should erode and a search for an alternative theoretical approach should commence. The proper place to begin such as investigation is amongst the long-forgotten theories of the cycle, which were discarded after the publication of the General Theory. There should be a newfound recognition that perhaps, after all is said and done, that so far as Say’s Law is concerned, Keynes was wrong and the classical economists were right.
MEN ERR IN THEIR PRODUCTIONS, THERE IS NO DEFICIENCY OF DEMAND It was Keynes himself who made it clear that the economics of the General Theory was to be seen as a refutation of Say’s Law. Recessions, he wrote, were caused by a deficiency of aggregate demand.
This was utterly contrary to mainstream classical thought. Classical economists understood that economies are not driven by demand but by value adding production, which is what they referred to as “supply.” They understood perfectly well that raising demand without an increase in the level of value adding output cannot be an answer to recession and unemployment.
This was summarized by classical economists in various ways: demand is constituted by supply, there is no such thing as a general glut, overproduction is an impossibility. However, the most remarkable short statement, not just on the nature of aggregate demand but also on the related issue of how recessions occur, can be found in Ricardo’s reply to Malthus in a personal letter written on October 9, 1820. Ricardo was writing a few months after Malthus’ Principles had been published: “Men err in their productions, there is no deficiency of demand.” (Ricardo, 1951–73, p. 277)
This is, first of all, a statement on the causes of recession: “men err in their productions,” that is, there is some kind of market disequilibrium which has occurred across the economy. And beyond that, it is a statement of what does not cause recessions: “there is no deficiency of demand.” Whatever might have caused the recession, it is not due to a lack of demand. What is found in Ricardo’s short statement is in summary form the entire classical theory of recession with its explicit rejection of demand factors as their cause. To understand what Say’s Law really means and why it matters, this is what you need to know.
What if Ricardo’s short and to-the-point statement were at the core of modern macroeconomics in the way it was at the core of the classical theory of the cycle? Here there is no ambiguity of meaning, none of the uncertainty that currently exists over what “supply creates its own demand” does or does not mean. Ricardo’s brief statement of classical principle means that when recessions occur, they cannot be understood as a consequence of too little demand but should be understood as some sort of derangement within the
market process. Were this understanding at the core of modern macroeconomics, policy makers would have no excuse for the levels of deficit spending that occurred after the commencement of the Global Financial Crisis but would understand that far different measures are needed to get markets and an economy back on track.
My book, Say’s Law and the Keynesian Revolution, which covers in far more detail all that has been discussed in this paper, has as its subtitle, How Macroeconomic Theory Lost Its Way. Macroeconomics replaced the classical theory of the cycle in the 1930s and has been Keynesian ever since. No metaphorical statement on the death of Keynes or of Keynesian economics can be true so long as aggregate demand maintains its presence at the core of macroeconomic theory and policy. Macroeconomics, with its focus on aggregate demand, has been systematically misleading economists since the 1930s. Because of the near universal acceptance of Keynesian theory within the mainstream, economists have repeatedly formulated policies around the need to stimulate demand during periods of high unemployment. Keynesian economics has, however, not had a single peacetime success but has recorded many, many failures to which one more can now be added. It is the very concept of aggregate demand that must be removed from economic theory. Its pervasive presence has caused a blackout curtain to fall across the whole of macroeconomic theory making it all but impossible to understand the underlying workings of an economy or to provide useful advice when recessions occur.
The use of public spending and deficit finance to deal with the Global Financial Crisis has been massive and worldwide. This ought to be recognized as having been a decisive test of the validity of Keynesian theory and policy. These policies have been tried to their utmost limits in the United States and elsewhere and should be recognized as having been an abject failure. A return to an economic theory based around a proper understanding of Say’s Law and the classical theory of the cycle should be the direction in which economic theory now moves.
Volume 14, Number 2; Summer 2011
This short note is a contribution to the solution of the problem of indifference in Austrian economics (“Nozick’s problem”). The problem is divided into two questions: (i) Can the stock of a commodity be defined without a reference to indifference? (ii) What is the praxeological interpretation of the fact that one unit of a homogenous stock is chosen over another? It is argued that the answer to the former question is negative; in the answer to the latter question it is demonstrated that indifference can already be included in the description of choice alternatives and strict preference ordering on the set of these alternatives can thus be preserved.
Volume 14, Number 2; Summer 2011
This paper deals with the meaning and the limits of the subjective theory of value. Economists deploy this theory in such various areas as utility, marginalism, knowledge and expectations . Yet, despite its wide spread use in economics, the meaning of subjective value remains equivocal and imprecise. This paper seeks to provide a more accurate praxeological interpretation of subjective value by anchoring it on preferences that are effectively demonstrated in action. This praxeological approach appears to be particularly pertinent for explaining the misuses of subjectivism in relation to utility and marginalism, and in showing the limits of various attempts to extend subjectivism to knowledge and expectations.
Volume 6, No. 1 (Spring 2003)Neoclassical utility functions are an invalid means of analyzing consumer behavior for three reasons: first, and most important, because such functions, and their attendant rankings, are cardinal, not ordinal in nature; second, because, with respect to the set of bundles relevant to actual human beings, such functions are not continuous and, therefore, not differentiable; and third, because such functions do not correctly, consistently, and properly include dimensions/units.
Volume. 5, No. 1 (Summer 2002)The times are past in which one could naively teach the cost theory without getting involved in more precise explanations concerning in particular the origin of the value of the cost goods itself and the laws determining its magnitude. Whoever begins, however, really to explain, instead of merely assert, will find all of the logical and factual rocks in his way on which Dietzel’s explanation has run aground. And may he employ the art of navigation and steering as such as he likes, he will find the way out from the labyrinth of rocks under no other sign than we marginal-value theorists have sought and found it. The simple truth remains, indeed, that it is ultimately a locomotive which pulls the last car and not a last car that pulls the locomotive!
Volume 14, Number 1 (Spring 2011)
To analyze the feasibility of applying the Coase Theorem, this article uses two traditional arguments, economic calculation and non-neutral effects, found in the Austrian literature. This article argues that the efficiency calculation a judge undertakes is problematic and that his decision should not be considered neutral with respect to the general equilibrium (even with zero transaction costs). These problems imply serious challenges to the application of the Coase Theorem.
Volume 3, No. 4 (Winter 2000) Economic science, as handed down to us from Menger and Mises, explains observed human behavior by referring to other features of the real world. Both the phenomenon to be explained and the explanation itself are thus strictly realistic—a charm and advantage of the Menger-Mises approach as compared to other approaches.
However, there are exceptions. The most blatant is the way Mises (1998, pp. 248ff.) conceived of the nature of equilibrium analysis. His account relies on an intellectual fiction, namely, on what he has baptized the evenly rotating economy (ERE). The ERE is admittedly unrealistic; it is an “imaginary construct” that has no—and can never have any—counterpart in the real world.
The present article offers an entirely realistic account of equilibrium analysis, thus closing a disturbing gap in economic science. We will argue that human choice involves a dichotomy of success and failure, and that equilibrium analysis is the method of explaining observed success by contrasting it to counterfactual failure, and observed failure by contrasting it to counterfactual success. This approach gives us the clue needed to reconstruct the role of equilibrium analysis within economic science and economic policy, and to discern the problems of applying it.
THE ESSENCE OF EQUILIBRIUM ANALYSIS On a purely physical level, choosing means to select between competing projects, that is, between mutually exclusive ways of using our brains, bodies, and other objects that we control. We cannot pursue all of our goals at the same time. We have to decide between the realization of some and the postponement of other projects. Whatever we choose to realize through our action is bought at the expense of something else that, because of that very choice, cannot come into existence.
However, there is also a value-aspect of choice, and this aspect confronts the acting person with a problem. The fundamental fact is that the various alternatives do not have the same relative importance or value. Some are more important than others, even though this relative importance varies from one person to another and depends on the particular circumstances of time and place in which one and the same person makes his decisions. The acting person therefore has to identify to the best of his abilities the alternative that, under the given circumstances, is for him the most important one.
This identification process is future-oriented and, therefore, heavily speculative. For example, when buying stocks, one estimates the future prices of alternatives. Yet, even when buying a shirt, one not only has to determine which shirt is best now, but how one will value it in the future.
Now, subjectively—that is, as far as the mere opinion of the acting person is concerned—he always chooses the most important project. By the very fact that he acts in this manner rather than another, he “demonstrates” his belief that this action is better than any other he could have performed instead. Ex ante, then, his choice is always optimal.The expression “demonstrated preference” is Rothbard’s (1956). However, see also Windelband (1904, pp. 35ff.), Schumpeter (1908, pp. 64ff.), and Mises (1998, pp. 95, 102). In addition, see the analogous argument of Herbert Spencer (1970, pp. 75ff., esp. p. 79) for limiting the scope of political philosophy to the study of justice.
However, his subjective deliberation does not necessarily grasp what is really the most important thing for him to do under the circumstances. This applies both to the ends he chooses to attain and the means he chooses to realize them. The plain fact is that the beliefs guiding his choice of ends and means might be right—but they might just as well be wrong.
Often we find, ex post, that no other behavior would have been preferable to our chosen behavior. We then think we made the right choice, and call our action successful. Economists describe this phenomenon using more technical jargon. They say that the successful actions of entrepreneurs are based on “rational expectations,” or that they stem from “perfect foresight.” When all entrepreneurs act successfully, economists say they are “coordinated,” or that the market is in “general equilibrium.” All these expressions are synonymous in the sense that they refer to successful human action, as distinguished from action that is less, or is not successful.
However, we find at least as often, ex post, that we should have done something other than what we actually did. Other actions would have been preferable. We then think that we made the wrong choice, and say that we erred.
This experience is, of course, familiar to all human beings. There is something like “right choice” (correct judgment, success), as opposed to “wrong choice” (error, failure), and it is meaningful to distinguish between them, for our subjective beliefs about the world do not always reflect the world as it really is.
This distinction is also reflected in the vocabulary of price theory. Economists have traditionally distinguished “market prices,” established as a consequence of ex ante deliberations, from “right” prices (or natural prices, equilibrium prices, etc.). The former does not necessarily coincide with the latter. Market prices can be equilibrium prices, yet can also be—and are indeed most likely—disequilibrium prices, because of the ubiquity of error.
Error has many psychological faces that are difficult to grasp in exact terms. We call them whims, fancies, follies, greed, jealousy, illusion, etc. However, the economic aspect of error can be precisely circumscribed. Error is constituted by the fact that a person chooses to pursue a project that is less important for him than another project he could have pursued, but did not because of that very choice. In short, error is the failure of the choosing person to select the project most important for him. This point is not only common sense, but, as we have just seen, is rooted in praxeological bedrock—namely, in the fact that both success and failure are contained as possibilities in human choice. Not surprisingly, therefore, the distinction between success and failure is familiar to all equilibrium theories in economic science. And most of them even rely on the assumption that, under any circumstances, there is a best option in comparison to which all others are worse. As Frank A. Fetter said, “in any given set of conditions there is a best proportion in which to combine agents.”Fetter (1915, p. 130). Similarly, Hicks (1946, p. 255, n. 1) stated, about the assumption that the system of relative prices is uniquely determined: “If it is not justified anything may happen.” See also Menger (1883, app. 6), Knight (1956, p. 164), Hicks (1965, pp. 24, 41), Nash (1950, 1951), Hahn (1973, p. 7), and Harsanyi and Selten (1988). For the view that there are several or multiple equilibria, see, for example, Hildenbrand and Kirman (1988), Billot (1995), and Creedy and Martin (1994). We will deal with this latter view below.
Now, the crucial fact that needs to be emphasized is that our distinction is dichotomous. All human actions are either successes or failures. Either we could have performed a more important action, or no better alternative was available. Hence, any possible choice is either right or wrong, any possible action either a success or a failure.
A casual reflection shows that everybody, in his daily life, makes ample use of this common-sense dichotomy of success and failure. Thus, we say things like, “I should have read Mises rather than Marx at the age of twenty-three,” or, “he should have become a lawyer rather than a painter,” or, “how good that we decided to go to this concert tonight.” All such statements judge a real-world action in terms of an explicit or implicit reference to unrealized alternatives conceived to be either inferior or superior to the alternative that came to be realized. And, irrespective of whether the action under scrutiny is a success or a failure, we must necessarily apply the same method to describe what it is—in both cases, we must judge the actual choice by reference to its counterfactual alternatives.
The foregoing everyday statements would not by themselves justify any closer examination of their logical structure. Yet, here they are relevant because that structure is identical to that which we encounter in quite sophisticated descriptions of factor pricing and income distribution on the market. In fact, as we shall see, equilibrium analysis is nothing but the method we just outlined. It describes what exists in the real world as being more or less important than what could have existed instead—from the standpoint of the acting persons involved. The difference between the application of equilibrium analysis in daily life and its application in economic science is merely a gradual one. The latter is more sophisticated, since it generally focuses on more remote implications of the fact that an observed state of affairs is either more or less important than the one that could have existed.
Consider, therefore, the fundamental theorem of the theory of production and distribution. It states that, in general equilibrium, the price of a factor of production (that is, the marginal income of its owner) is identical to that factor’s discounted marginal value productivity (DMVP). All elements of this description refer to features of a particular state of affairs—one without entrepreneurial error. If no entrepreneur errs, the market is said to be in equilibrium. Furthermore, if the market is in equilibrium, the prices paid for factors of production, whatever they may be, are called the DMVPs of these factors. By contrast, if at least one entrepreneur commits an error, market prices will ipso facto differ by some amount from the DMVPs. These differences are called profit (if the marginal income is higher than it would have been in equilibrium) and loss (if it is lower).
Fundamentally, error on the market can occur here in either one of two directions. Either the factor under consideration—say, a truck—is paid less, or it is paid more than its DMVP. If it were paid less, there would have been an opportunity for arbitrage. Another entrepreneur could have bid this factor away and still profited from it. The very fact that this did not happen demonstrates that an error occurred on the part of other entrepreneurs. As a consequence, our entrepreneur realizes a special kind of income, namely, profit. By contrast, if our entrepreneur paid more than the DMVP for the truck, his income would be negatively affected. It would be lower than it would have been had he paid a lower price. In this case, the error occurs on his part rather than on that of other entrepreneurs.
Let us emphasize that, just as in our examples from daily life, the above analysis does not touch on the question of whether the market actually is, or is not, in equilibrium. In fact, this question does not need to be answered to do what we have done: describe what market participants do as being, from their standpoints, more or less important than what they could have done.
We are now in a position to define equilibrium analysis. Equilibrium analysis is the method of comparing actual behavior with its counterfactual alternatives in terms of success and failure.
Applying this method, we can describe a common aspect in all imaginable cases of market behavior. There are indeed only three possibilities: (1) a factor is paid according to its DMVP, (2) it is bought for more, or (3) it is bought for less than its DMVP. That is, either there is no error at all, or an error occurs in one of the two directions of “too much” or “not enough.”
Let us point out that this is not to say that the role of DMVP in equilibrium analyses of the market is to be a standard by which we define profit and loss. For it would be equally pertinent to say that the occurrence of profit and loss is the standard by which we define DMVP. The point is that equilibrium analysis does not give us a picture of “normal” reality; rather, it is a method to describe reality, and this method can be applied irrespective of what observed reality happens to be. Observed equilibrium can be meaningfully conceived of only by reference to errors that could be avoided, just as observed error can be understood only by reference to a foregone equilibrium. This putting-in-relation of what is and what could have been—in terms of success and failure—is what equilibrium analysis does.The counterfactual nature of equilibrium analysis is the reason why equilibrium analysis, although it explains observed facts by relating them to other facts, is not empirical in the sense that all elements of the analysis (the behavior to be explained and the fact that explains it) can be observed. Since the explaining fact in equilibrium analysis is a foregone alternative, it cannot be observed. Our very knowledge of the existence of foregone alternatives is not derived from observations, but from acquaintance with the a priori nature of human action. All we can see, for example, is that a shop opens its doors one day, that people go in and out carrying commodities in one direction or the other, and that on another day the shop closes its doors forever and something else takes its place. These observations do not reveal whether the shop owner was forced to cease operations against his initial intentions (bankruptcy), whether he was forced to cease operations in accordance with his initial intentions (which might be a case of fraud), or whether he just retired. Our knowledge of what bankruptcy is, or fraud, or retirement does not stem from observations at all, but from our knowledge of such invisible features of human action as choice and intentions.
A standard criticism of equilibrium analysis holds that it does not adequately reflect observed behavior. What such critics have in mind is that human action is often, is perhaps even usually, not in equilibrium—a pertinent observation which, however, misses the main point. It is true that human life is fraught with errors. Each time we choose to pursue an action other than the most important one we commit an error in the sense of economic theory. Yet this does not refute equilibrium analyses—quite to the contrary! We can analyze all instances of human error in the real world only because choice implies the possibility of success and failure. We could not even conceive of something like error without having in mind an alternative action compared to which an observed action could be erroneous. We could not identify a single instance of error in the real world if we did not presuppose the existence of a foregone success.
Hence, the applicability of equilibrium analysis does not at all rely on the question of whether the world actually is or is not in equilibrium. And who-ever seeks to point out success or failure in any given situation inevitably applies this method because otherwise he could not grasp the success-failure aspect of life.
In conclusion, let us stress that equilibrium analysis is entirely realistic since all its constituent factual and counterfactual elements can be found in real human action. It does not postulate that human beings “normally” or “generally” do not commit errors. And while it is a method for the exact description of the observed real world, it is not itself such a description.
SOME PROBLEMS CONSIDERED The Problem of Indifference
A possible objection to our approach could stress that human beings occasionally are indifferent as to their options, or that their decision making is sometimes “fuzzy” (Billot 1995). In this case there would be no genuine dichotomy between the best alternative, which we called success, and other alternatives, which are relative failures. And it would not be clear at all which meaning should be attached to the notion that alternatives differ in their objective importance.
Before we take a closer look at this contention, let us point out that it would also apply, in at least some sense, to all other approaches to equilibrium analysis. For even though the notion of indifference is an important element in contemporary mainstream analysis of value and choice, it is no substitute for choice. The main purpose of stressing indifference is to provide the groundwork for a quantitative treatment of value. It does not replace the role of choice in the argument of equilibrium theorists. The fundamental fact is that one cannot make sense of equilibrium other than by reference to somebody correctly choosing one option rather than another. Hence, even if valid, the above contention would only lead to a limitation and reformulation of our results. Rather than saying that, “in equilibrium analysis that we contrast observed success with a foregone failure,” we would have to say “we contrast a chosen action to a set of foregone actions (which might be equally desirable).” And we would have to admit that explaining success by referring to avoided failure, as well as failure by referring to foregone success, is only possible in the case of actions involving choices between superior and inferior alternatives.
This limitation and reformulation is superfluous however: it is futile to stress indifference as an objection to our approach to equilibrium analysis. The fundamental fact is that indifference is a psychological phenomenon. What economists have in mind when they refer to indifference, and what people mean when they acknowledge its existence, is a state of mind in which an individual contemplates two alternatives, but does not or cannot pick one because he finds them equally desirable. However, our argument does not rely on considerations about states of the human psyche, but on an analysis of human action. Whatever else might be obscure about action, there can be no doubt that if a given individual does something at a given moment, and what he does can always be distinguished from alternative things that he does not do. This is not to deny that a given behavior has various aspects, or that it could serve different purposes—for example, by taking a walk in the park, I can enjoy the landscape, think about indifference, and relax. What it means is that, as far as human action is concerned, all alternatives do not have the same status. Rather, one alternative is realized, while all others are not.
Genuine choice alternatives, which come to bear on action and not merely on the mind, are therefore categorically unequal. And genuine action—not the musing of the brain about action—is never indifferent. The very activity of feeling indifferent about two alternatives is itself an expression of preference: one prefers to indulge in indifferent feelings, thus foregoing alternative activities. It is therefore conceivable that an individual is in his mind indifferent about the alternatives he faces. However, it is impossible that he is indifferent about them in his actions. He always does something. And by virtue of the fact that he does A rather than B, he demonstrates that he is not indifferent as to these particular actions, but prefers the former to the latter.
The Problem of Multiple General Equilibria
Another aspect of the problem we just discussed concerns the possibility of multiple general equilibria. Consider the case of a husband and his wife watching television. The value scale of the husband is as follows:
watch a football game with his wifewatch a romantic movie with his wifewatch the football game without his wifewatch the romantic movie without his wife The wife has slightly different preferences:
watch the romantic movie with her husbandwatch the football game with her husbandwatch the romantic movie without her husbandwatch the football game without her husband This scenario is characterized by two features that seem to contradict what we said about equilibrium analysis.
First, it is impossible that both husband and wife end up with what they most want—that is, that they reach general equilibrium. It thus follows that general equilibrium is not possible under all circumstances, for there are conditions that allow only for the contest of second- and third-best outcomes.
Second, there are several outcomes that seem to be ranked equally prefer-able. When the couple chooses to watch the football game, the husband realizes his first preference, his wife her second. When they watch the romantic movie, the wife realizes her first preference, her husband his second. Since there is no rationale to accord a higher importance to the wife’s preferences than to the husband’s—or vice versa—one could argue that both of these outcomes are equally desirable. We thus have a case of multiple general equilibria.
This argument is fallacious, however, for the same reason the reference to indifference is fallacious. The fundamental error is to conceive of value scales as purely psychic entities that can be analyzed independent of human action. Yet there is no such thing as value or a value scale detached from concrete action. And as far as concrete action is concerned, it is obvious that there never can be something like “multiple action,” but only one action at any point in time. This action can be a relative success or a relative failure, as counterfactual equilibrium analysis will reveal, but, irrespective of whether it succeeds or fails, the only meaningful procedure is to first look at what people do, and then compare it to what they might have done.
Assume, therefore, that the couple watches the football game together. There is, then, no problem with explaining the husband’s behavior in equilibrium terms: this common activity is his most preferred outcome. But what can we say about the wife? Is her activity not a relative failure since she would have enjoyed watching the romantic movie with her husband even more? Again, from a psychological point of view, this might be so, but this perspective does not concern us here. We are interested only in whether she has performed the best possible action under the given circumstances. Her husband watches football. Given this fact, the best possible action for her is to join him rather than watch the romantic movie in another room, on another television, alone.
But what if the couple had watched the romantic movie together? Would we not have to admit, for exactly analogous reasons, that this too is an equilibrium outcome, thus acknowledging willy-nilly the case for multiple equilibria? With this question, we are again in the realm of psychological speculation, and the only way to avoid this pitfall is, as we have said, to first look at what people actually do, and then compare that to the other alternatives. The assumed fact was that the couple did not watch the romantic movie. They watched the football game. If we accept this fact, we can explain their behavior with the help of equilibrium analysis. If we do not accept it, we throw ourselves into the realm of fancies, desires, and fantasies—the realm of poetry, not of science.
In light of these considerations, it also becomes obvious that all I-know-that-you-know-that-I-know-etc. paradoxes are not paradoxes of action (and therefore paradoxes for economic analysis), but paradoxes of psychological deliberation.It is no accident that one of the pioneers of game theory unearthed these problems with the famous “Holmes–Moriarty paradox.” See Oskar Morgenstern (1928, p. 98).
It is true, for instance, that in social games like chess or tennis, the behavior of each player determines the success of both. Player A wants to beat player B, who wants to beat player A. The outcome of their game depends on the degree to which both anticipate the actions of the other. Now, a plan in which A seeks to account for the behavior of B can never be successful on a priori grounds since it is possible that B anticipates A’s plan in his own plan. Yet, neither can B’s plan be successful on a priori grounds, since A could engineer a still better plan that takes into account B’s plan, and so on.
None of this has any effect on the fact that both A and B do something, and that, as a consequence of these actions, one of them will win and one will lose. No paradox can possibly appear that will impact this fact of action. And it is in light of this fact that we can again explain the behavior of both players in terms of equilibrium analysis.
Yet, do these games, which by their very design have winners and losers, not exclude the possibility of general equilibrium? As we shall see, this is not the case.
First, participation in the game is voluntary—otherwise, it would not be a game. And since participation is voluntary, one has always the choice between taking part in the game and not taking part in it. Persons who consider playing for the sake of winning (prize-seeking players) can therefore avoid games they are going to lose, and can do so under all conceivable circumstances as long as participation is voluntary. (There can be no general equilibrium involving only prize-seeking players, of course, for at least one of them would see his endeavors thwarted.)
Second, in the case of what one might call true players, a similar result obtains. The true player plays for the mere sake of playing. He wants to win not because he prefers winning to losing, but because this is how the game is played. In fact, he prefers “playing and losing” to “not playing at all”—that is, to all other activities. General equilibrium is therefore possible in this case as well.
The Problem of Objective Value
Comparing success and failure presupposes some criterion by which one can gauge whether a given action is “really” more or less important than an alternative action that could have taken its place. Yet, how is it possible, one might ask, to ascertain the objective importance of different projects? Although it seems a given that human beings choose—that is, exercise their subjective judgment—it is not at all clear how it is possible to distinguish alternatives that are objectively more important from those that are objectively less so.
There can be no doubt that this is a considerable problem. However, as we shall see in more detail below, this problem relates to the application of equilibrium analysis rather than to its conceptual framework as such. For our present purposes, it is entirely sufficient to make the general point that different alternatives do have different objective values, even if we cannot tell exactly what they are.
What we mean by saying that a choice alternative has an “objective” value is that its value does not depend on the choice itself, but on something else entirely. This something else could still be bound up with the choosing person—we only stipulate that it is different from the choice itself. For if the value of an alternative were to depend on choice itself, then everything we choose or do would demonstrate not only that we think this action the most valuable one, but that it truly is the most valuable one. Each individual would then be in a perpetual state of equilibrium, and the only question left would relate to the scope and existence of general equilibrium.
However, the idea that each individual determines by his own choices what to him is more or less valuable is self-contradictory. He who chooses must from the outset presuppose that the projects he can realize can be ranked according to their objective importance. If he did not presuppose that one state of affairs were more objectively important than another, he could not choose at all. For if all projects were equally important to him, his choice would make no difference.
Moreover, the very notion of subjectivity is meaningful only if one presupposes an objective reality to which subjective value judgments refer. Something does not have high utility because we value it highly. Our valuing must be reasonable; it must assess the object’s utility correctly. In other words, something is not (objectively) important because we think it is or want it to be. Our thoughts must be fitting and our wants rightly understood to gauge its real importance. Fasting twenty days per month, for example, will have certain effects on my body and character. If the bundle of effects that results from such fasting is really more important than the bundle of effects all other actions would produce, then fasting twenty days per month is the proper behavior. I then rightly prefer fasting, and if I preferred other actions we would have to qualify them as fancies that prevent more important action.
Man can succeed in choosing the most proper, most important action, and through his creativity can enlarge the realm of possibilities. However, it is not because he thinks an action the most important that this it is. Similarly, it is not because he considers an action to be just that it is just. Success on the economic level and justice on the moral do not depend on our intentions and wishful thinking, but on whether or not our action is objectively proper.
In light of these considerations, one understands that, in a way, it is wrong to represent economics as a subjectivist science. It is impossible to conceive of choice and value judgments without assuming the existence of an objective importance of options, even if this objective importance is valid only for one individual at one point in time, and even if it is difficult to discern objective importance in applied analysis.The distinction between the subjective and objective importance of choice alternatives has a prominent if neglected place in the history of subjective value theory. Thus, Condillac (1795, p. 6) and Jevons (1965, p. 38) called the objective importance of a project its utility, distinguishing it from its subjective importance, which they called its value. A scientific treatment of objective value is possible because this concept refers to an aspect of individual choice. However, as an emanation of choice, objective value is necessarily relative. There is no such thing as absolute value; whether subjective or objective. And both subjective and objective values are always bound up with individual human action.
Successful Action and Perfect Foresight Compared
It might be useful to extend the foregoing discussion by clarifying the relationship of successful action and perfect foresight, which has a long tradition in our science.See, for example, Knight (1985, p. 76f.), Hayek (1928, p. 39), and Hicks (1946, pp. 6, 123ff.). Many economists believe that, for equilibrium economics to be empirically meaningful, it is necessary to assume that market participants have “perfect foresight,” “perfect knowledge,” “perfect information,” etc.
The fact that successful action in some sense implies perfect foresight should not convince us that we can overlook differences between the present approach and those of our predecessors. The great advantage of referring to successful action is that such reference does not imply the absence of uncertainty. Economists commonly believe that they have to offer reasons why human beings should have perfect foresight. Some argue that equilibrium refers not to reality, but to an imaginary state of affairs in which conditions no longer change, which therefore would bring about certainty. Others argue that market participants have rational expectations, etc. The offshoot of all such theories is that the possibility of error is banished from equilibrium economics. In equilibrium, man “knows” what will happen in the future.
This point of view has received a well-deserved and devastating criticism by G.L.S. Shackle (1972). If equilibrium deals with a world without uncertainty, he argued, it does not apply to our world.
By contrast, we have seen that it is realistic to refer to successful action in counterfactual equilibrium analysis. This analysis does not presuppose an unchanging universe or certainty, but can be applied to any instance of concrete human action simply because human action can be successful under uncertainty. Moreover, as we have argued, it is immaterial for economic science whether real action is successful because the notion of success is only a comparative element of our understanding of the world.
Let us pursue this argument further. The success of one’s action depends crucially on a pertinent judgment of future data with which that intended action will be confronted. These data can never be known in the sense that they can be experienced. Any equilibrium construct that presupposes that human beings know all data is therefore unrealistic. However, economists do not have to make assumptions about what market participants know or expect, or about how they come to have the knowledge or expectations they happen to have.In particular, economics is not based on a theory of the acquisition and communica-tion of knowledge. See on this point Selgin (1990, p. 62f.), Hoppe (1996), and Hülsmann (1997). The data, or given conditions of human action, are not given in the sense that they are known but in the sense that they exist independently of human action. Neither does “given” imply that all conditions are given now. Some conditions will be given in the future only, yet are and will be given in the sense that they are independent of our recognition and choices. Acting man can hardly know everything. He can, though, act successfully under all conceivable conditions since this means nothing but that, in any situation, he can choose the most important action.
One might object that it is contradictory to insist on freedom of choice while cherishing the notion that a market participant can correctly anticipate another’s decisions. How can he do this? If others are truly free there should be no way for him to determine how they will choose.
However, determining and anticipating choice are two different things. In order to determine some future event, we have to know all the factors bringing it about. This is clearly not the case as far as human action is concerned. Yet we can anticipate human action without knowing any of these factors. We can even anticipate it by chance, for instance—and for this reason alone, successful action or equilibrium is possible under uncertainty.
It follows, then, that one needs to revise equilibrium economics, at least in some respects. However, it is our conviction that introducing the category of successful action does not necessitate any major adjustments of established doctrine. In particular, it does not necessitate a modification of the theory of profit and loss since this theory, at least in Mises’s account, does not stress uncertainty (as distinguished from risk) and does not even raise the question of whether risk and uncertainty are subjective or objective notions. Instead, Mises casts his exposition of the nature of profit and loss exclusively in terms of entrepreneurial judgment and choice:
What makes profit emerge is the fact that the entrepreneur who judges the future prices of the products more correctly than other people do buys some or all of the factors of production at prices which, seen from the point of view of the future state of the market, are too low. ... On the other hand, the entrepreneur who misjudges the future prices of the products allows for the factors of production prices which, seen from the point of view of the future state of the market, are too high. ... Thus profit and loss are generated by success or failure in adjusting the course of production activities to the most urgent demand of the consumers.Mises (1980, p. 109). See also Mises (1998, pp. 660ff.) and Rothbard (1993, pp. 464ff.).
It is true that, for Mises and for many other economists, failure is a consequence of changing conditions. However, the point is that this issue can be treated separately. Whether success and failure have “causes,” what the specific causes of success and failure are, and whether these causes are intelligible is one question. What profit and loss are is another. In respect to this latter question, we can state that our approach is perfectly congruent with established doctrine. And as far as the causes of success and failure are concerned, even if they were to exist, there is no need to identify them in equilibrium analysis, for it covers both equilibrium and profit and loss without regard to their possible causes.
The Meaning of Equilibration and Arbitrage
Since human action is either successful or in error, there is no middle ground between equilibrium and disequilibrium. Based on this observation, we can make two further inferences that have some relevance to the current debate.
First, one has to reject the fashionable notion of “equilibration,” which implies a movement in time from a situation of disequilibrium to one of equilibrium. The fallacy of this notion lies in the attempt to understand equilibrium as a feature of the environment of action, rather than of action itself. As advocates of equilibration see it, human action transforms its environment (or circumstances or conditions, etc.) and thereby brings this environment into equilibrium.
However, equilibrium and disequilibrium are essentially features of human action, which includes as possibilities both error and success. Only in a derived sense are they features of the environment of action. For example, disequilibrium exists when Smith spends all of his income on present consumption and at the same time contracts with Brown to build him a house. On a purely physical level, these actions (Smith’s consumption and Brown’s building a house for expected payment) are not incompatible as demonstrated by the very fact that they are performed. It is only on the level of choices and intentions that contradictions exist between what Smith does and what Brown does and, consequently, it is only in light of these contradictions that the observed physical activities also appear contradictory.
If equilibrium and disequilibrium are essentially features of human action, it therefore follows that both are possible under all conceivable circumstances. At any point in time and at all places, action can be successful or in error. Conditions of action therefore cannot play a role in the question of whether equilibrium does or does not exist. Yet, since action itself is either successful or erroneous—that is, since it is either in equilibrium or in disequilibrium, but never in an intermediate position—“equilibration” is a meaningless expression, a myth that has no place in economic science.
As a corollary, there is no such thing as “arbitrage ex post.” One cannot import a past state of disequilibrium into a present or future state of equilibrium precisely because both equilibrium and disequilibrium are features of action, not the conditions there of. Action does not involve conditions of the past, only those of the present. Hence, error and equilibrium must also refer exclusively to present action. Insofar as an action is successful (and it can be at any time) this action can be described as arbitrage. Yet arbitrage, then, does not connote a comparison between a past and a present state of affairs, but a counterfactual comparison between a given successful action and an erroneous action that could have been performed instead.
A related reason for the impossibility of arbitrage ex post is that past errors create the very conditions under which present action takes place, and by reference to which present success and failure must be gauged. The idea that one can resolve past errors by choosing correctly in the present is therefore contradictory and meaningless (see Robinson 1973, pp. 362ff.).
Action and Conditions of Action
Let us develop the foregoing consideration further. The most common reason why past attempts to make sense of equilibrium analysis have failed can be stated in one word: consequentialism. Economists have not taken human choice as an ultimate given, but sought to explain it in more fundamental terms. They have not accepted success and failure as dichotomous elements of economic analysis, but have sought to present them as necessary corollaries or consequences of certain conditions of action. Let us briefly state why this is impossible.For a general critique of consequentialism and consequentialism in business cycle the-ory, see Hülsmann (1998, pp. 2ff.). A state of equilibrium is characterized by the absence of error. If one claims, for example, that equilibrium is omnipresent, one has to explain why error cannot ever occur in reality. And if one claims that equilibrium merely tends to be achieved under certain circumstances, one has to prove that error cannot—or is less likely to—occur under these circumstances. In any case, one has to prove that error is invariably related to certain conditions of action.
If we define choice as a “condition” of action, error is surely related to such a condition. It is a fact that we have to choose—and this condition of action never changes. However, it is important to realize that choice cannot be said to cause either error or correct judgments. Both success and failure are merely implied in choice as possibilities. In other words, whereas choice is the necessary condition for error, there is no sufficient condition for it: we neither err necessarily nor are able to err intentionally.
Hence, the crucial question is whether error depends on conditions of action besides choice. Only if this were true could one prove that equilibrium would realize itself. If we always choose correctly under certain conditions, equilibrium will be achieved whenever these conditions are present. Are there such conditions? The answer to this question is unambiguous. As long as human beings choose, there is no possibility of proving that we either cannot err or must err under certain conditions. The idea of a determination of error contradicts the very essence of choice.
Consider the widespread conviction that equilibrium analysis refers to an unchanging state of affairs. The underlying assumption is that there can be no error if conditions do not change. Error frequently occurs, of course, when acting persons have to confront changing conditions. But from the sole observation that one has erred in such a case, it does not follow that one had to err. Rather, we have to concede that a correct judgment is possible in any situation. Even if the conditions of action were in perpetual flux, we could not deny the possibility that market participants correctly anticipate future conditions. The much-discussed question of whether the real circumstances of action display regular features, or whether they change in a “kaleidic” manner, is therefore irrelevant for economic science.The best introduction to the debate surrounding this question, and an excellent discussion of problems relating to equilibrium economics, is Selgin (1990). For our disagreements with Selgin, see the section entitled “Selgin’s Concept of Subjective Profit,” below.
We see, therefore, that the concept of equilibrium can be meaningful only if it refers to an aspect of action itself rather than to a particular state of the conditions of action. Only as a category of action can it be given a clear-cut and meaningful definition.
UNDERSTANDING ARBITRAGE AND PSYCHIC INCOME Let us now turn to the problem of applying equilibrium analysis. The comparative analysis of success and failure gives us a tool for the understanding of reality that is both realistic and a priori. We have seen that there is no need to prove that people do not or tend not to err, for such a proof is irrelevant for the applicability of equilibrium analyses. All possible cases are covered by the theory of equilibrium prices and its comparative counterpart, the theory of profits and losses. This view is realistic because success and failure are potential features of human action. And it is a priori because success and failure cannot be perceived on the basis of mere sense impressions and thus cannot be validated or refuted by observations. The problem of applying equilibrium analysis, then, is to identify instances of success and failure in the real world.
This problem of identification defies mechanical rules and generalizations. It is the problem of the specific Verstehen of historical investigations. Observation allows us to identify two cars running into each another, or a factory closing its doors, but one cannot see an accident or a bankruptcy. Identification of the latter requires understanding on the part of the historian, who must treat each case on its own. In other words, every instance of success and error must be identified in individual historical cases. One cannot single out some kind of action and claim that, in general, it is successful or erroneous. Rather, its success and failure must be determined by reference to the individual conditions in which it takes place. Saying “Hi, old chap!” might be the right thing to do when meeting a friend. It would most likely be wrong to do so when introducing oneself to a potential employer. Building a football stadium might be profitable in a prosperous society. It would most likely be a waste of resources if the society went to war and the population starved. To be sure, one cannot explain success and failure as a necessary consequence of the conditions of action. Introducing oneself to a potential boss, one can do the wrong thing and say “Hi, old chap!” even if we would qualify such behavior as either silly or pathological. Implied as possibilities in choice itself, success and failure are possible under all conceivable circumstances. Man can choose the most important of realizable alternatives, but can also fail to do so.
However, once a choice is made, its success or failure depend exclusively on the circumstances of the individual case. In other words, before a choice is made its success or failure is self-determined, and all other conditions of action are irrelevant. After the choice is made its success or failure depends exclusively on empirically given conditions. One has to look to see whether the chosen action was indeed the most important one among the realizable alternatives, or whether it rendered impossible the performance of a more important action. Only in the first case could we speak of success; the second would be failure. Applying our a priori equilibrium analysis, we make errors intelligible by comparing their implications to the implications of better courses of action that could have been taken. Or ,we make successful action intelligible by comparing its implications to the implications of erroneous actions that could have been taken. Again, the important point is that equilibrium analysis can be applied only by reference to concrete conditions of the individual case. One has to identify other concrete actions that would have been possible and determine whether they would have been more important. In short, one cannot apply equilibrium analysis by reference to any a priori standards. The standard of comparison must be a concrete action that also could have been performed in the same concrete historical situation.The only other way to approach the problem would be to identify a kind of choice that is inherently wrong. The analysis of this kind of choice could run in purely theoretical terms (for such an approach, see Hülsmann 1998). The equilibrium analysis of all other choices must refer to empirical conditions. We will discuss the problems of identifying such actions in the remainder of this section.
The crucial problem in applying equilibrium analyses is a twofold lack of evidence that concerns both, the value scales of acting persons and the possibility of alternative actions.
These problems are particularly difficult to solve in Crusoe economies—that is, when one analyzes the actions of isolated persons. One can observe Crusoe’s actions, but cannot observe his value scales or what he could have done instead of what he did. The only way to deal with such cases is to guess what he might have tried to do. Except for instances of what strikes us as pathological behavior, we will have to assume that he wanted to produce the effect his behavior brought about, thus assuming what is commonly called “rational” behavior on his part. Still in our interpretation of his behavior, we will sometimes suppose that he failed to pursue the most important project, namely, when we are convinced that he acted against his own rightly-understood interests. We then look at him as a mother looks at her child when it does something that strikes her as stupid, or as a benevolent dictator looks at his subjects when they behave in a manner he deems improper. We could also suppose that Crusoe has failed if we know of a better alternative action by which he might have tried to attain the same end that he supposedly attempted. Again, we assure the perspective of enlightened parents or of a higher civilization. There is only one way to establish some (although insufficient) evidence about Crusoe’s value scales, namely by relating his currently observed actions to his past actions. If we assume that his value scales are by and large stable over time, we can interpret a change of behavior as a discovery of past error (but to be sure, it could also be interpreted as a change of value scales).
These cursory observations help us draw two preliminary conclusions. First, we get a glimpse of just how muddy the waters of such historical analysis
are. Nothing is left of the clarity and apodictic certainty that characterized our theoretical exposition. Although we are certain that there is only one historical truth (because to assume otherwise would be contradictory), we cannot prove that we have captured it. Arguing our perspective on Crusoe’s value scales and the alternatives he faced, we cannot refer readers to an objective basis they cannot circumvent. We can only try to understand, and try to make our understanding intelligible. Second, we also clearly see that all assumptions about stability of value scales, “rationality,” homo oeconomicus, etc. are nothing but crutches for historical research. They have nothing to do with economic theory, entering the scene only when necessary to apply economic theorems to understand concrete reality. What economics has to say about equilibrium is apodictically true and, as we shall argue in more detail, highly relevant for a correct assessment of the political significance of profits. However, as far as our understanding of real-world action is concerned, equilibrium analysis merely gives us a few—although valuable—tools. These tools need to be complemented with empirical ad hoc assumptions that spring from our personal understanding of each case under consideration.
One can derive still further insight from the case of the Crusoe economy. One of the problems of applying equilibrium analyses, we have stated, is in establishing the value scales of the acting person. We can exclude one view of his value scales from the outset, namely his own view at the moment of decision. The reason, of course, is that at the time he is convinced he is performing the most important action. He does not err intentionally, and he could not do so if he tried. Even if someone consciously brought about a “failure,” it would be no failure at all. The very fact that the action was intended to produce an ostensible failure implies that it was a success. For example, let us suppose that it is my intention to bring about a failure by jumping from the top of a skyscraper and smashing myself on the ground. If I am smashed, I have not proven that one can err intentionally, for it was my very purpose to be smashed. My action was successful. What we see here is that, as a phenomenon, error can occur only ex post an action (see Menger 1871, pp. 21ff.). If the effects of action did not spread in time, all would be present in the very moment of choice. There could be no difference between expectation and reality, we would thus always engage in the best possible action, and there could be no error.
Equilibrium analyses, therefore, cannot fruitfully be applied by referring to the acting person’s ex ante perspective on his own value scales. However, once a choice is made, any person can meaningfully analyze this choice in equilibrium terms. One does not have to resign oneself to contemplation and wait for all the effects the choice will bring about. Both acting persons and outside observers can criticize the choice, pointing out that it is not the most favorable that could have been made. Business observers in newspapers and journals, for instance, do this all the time. Instead of waiting for evidence of the error to manifest itself they anticipate it. This kind of critique is legitimate because error manifests itself ex post an action only insofar as it is a phenomenon, that is, only insofar as it is evidence of our senses. Objectively, however, error is always manifest in the very action that brings it about. From the sole fact that no acting person thinks he errs, one may not infer that there is no such thing as error or, to take a more specific example , that markets are always in equilibrium. Thus, error is revealed in ex post deviations between plans and reality. But these deviations are not errors themselves, only their manifestations. Error is committed in decision itself. As soon as a decision is made, that is, as soon as choice becomes an ultimate given, a legitimate critique can set in and offer recourse to the terms of equilibrium analysis.The impossibility of applying equilibrium analysis from an ex ante point of view also highlights the methodological division of the social sciences into a theoretical and an applied part. See, on this point, Salerno (1995, pp. 307ff.).
Now let us turn to the application of equilibrium economics to analyses of entrepreneurs in a market economy. The first thing to emphasize is that we are still interested exclusively in the success or failure of individual actions. It would be groundless to argue that the choices of other market participants determine which of our actions are right or wrong, for this does not affect whether our actions actually are right or wrong. General equilibrium is reached when all individuals choose what is for each the most important course of action. We do not have to bother with the question of whether general equilibrium is ever reached, however, as long as we are sure that it can be reached.
Fortunately, one can neglect the question of whether other market participants, consumers in particular, act according to their best interests. Their actions are data for the entrepreneur under consideration. He has to adapt his actions to prevailing conditions, and the choices of other market participants are part of these conditions. Analyzing the individual actions of entrepreneurs on the market, we enjoy the considerable advantage market action affords in yielding evidence for valuations and alternatives. When Jackson exchanges ten ounces of gold for Jefferson’s car, we can infer that Jackson had the chance to keep his gold or sell it to somebody else, and that Jefferson could have kept his car and put it to other uses. Moreover, we know that Jackson valued the car more highly than the gold, Jefferson valued the gold more highly than the car.
Most importantly, however, we know that action on the market determines several types of income, and that one such type is profit and loss. On the market, the error of an entrepreneur leads to monetary losses. The returns he realizes for his product do not cover what he paid for capital goods and interest. In other words, the prices he paid for his factors of production were excessive in comparison to his returns, which, in short, constitutes his error. Paying “excessive prices” means that he would have been better off not exchanging his property at all, or purchasing other factors of production and engaging in other enterprises. This way, he would have either realized higher returns, or avoided losses. Similarly, the existence of profits is also an infallible sign of error, for it demonstrates that other producers could have done better by engaging in the profitable activity. The existence of profit implies that some market participants would have been better off making other investments, just as the very existence of loss implies that it would have been wiser not to engage in this (or, eventually, any) market transaction. Moreover, it is clear that the market compares the action of the individual entrepreneur not only to the alternatives he considered when choosing, but to the alternatives constituted by the activities of all other entrepreneurs on the market. This is the market’s ruthless quest for economic truth. Consumers constantly compare products of entrepreneurs by selecting only the most important ones.
Even on the market, though, evidence for success and failure is not absolutely clear cut. Even in the realm of money calculation, where the categories of wage rate, interest, and profit and loss are especially precious tools, one must guess the entrepreneur’s value scales, as well as the alternatives he faced, to establish which part of his income is profit or loss.
Consider the case of two ice cream dealers selling the same product—which buyers also perceive as the same product—at different prices. The one with the higher income sells in front of a school, the other in front of an old-age home. Let us analyze the impact of value scales on this situation from two sides. First, suppose that the second dealer hates teenagers. In this case, as we shall see, his behavior might not involve error. Selling in front of the school would increase his monetary income, but reduce his psychic income, and it is the latter which counts. We might identify error on the side of other persons who could have sold ice cream in front of the school, thereby increasing their psychic income. We might also find that there is no other person who might successfully step in to sell ice cream in front of the school at a lower price. In this case, there would be no profit in the present dealer’s monetary income. All of his receipts would be wages for his specific labor services.
Now suppose that the students love the present ice cream dealer. They will buy only his product, and would renounce ice cream altogether rather than buy it from someone else. Again, there might be no profit in his income, only wages. Without reference to the value scale of potential customers, one cannot tell whether an action on the market will represent profit or loss.
Let us now consider the problem of standards of comparisons. The central difficulty is in gauging whether other market actions would have been economically realizable. When analyzing the market, we enjoy advantages arising from the fact that the actions of other market participants sometimes provide the evidence necessary to solve the problem. Consider again the case of our two ice cream dealers. The fact that both sold the same product permits us to say that both could have sold at either place. We can tell the dealer selling in front of the old-age residence, “Look, you could have taken your car and sold in front of the school.” Yet, again, this evidence does not enable us to make apodictical judgments, such as in the field of pure theory. For it is possible that no other dealer than the present one could sell in front of the school. (The present dealer might be the only one strong enough to defend himself against a gang of nasty schoolboys, for instance.) In this case, there would once again be no profits in his income, merely wages for his specific labor services. Thus, the fundamental difficulty is that we cannot provide clear-cut evidence to answer the question of what the person under consideration might have otherwise done. The very fact that he did what he did prevented him from performing other actions and thereby demonstrating what he might have done. There can be no empirical evidence for his specific alternatives, because there is no evidence for the counterfactual.
Apart from this problem, there are questions as to which kind of alternative action should form our base for comparing market actions. Should it be an action that the decision maker considered at the moment of choice, or should it be any better action, even one he did not think of when choosing? Consider the case in which two groups, while ignoring each other, exchange the same good at different prices. Is this a case of error, or not? According to Stephen Shmanske (1994, p. 210), “this market is only in disequilibrium with reference to some perfect information benchmark; this perfect information does not exist in the hands of the relevant actors in the market and, therefore, is irrelevant.” Shmanske concludes that the market is in equilibrium—that is, that no error can be identified. Israel Kirzner (1985, p. 158f.), by contrast, sees here a case of disequilibrium. Who is correct?
Remember that we can use the distinction between success and failure as an analytical tool for comparison. It is obvious that, in the case cited above, the group selling at a lower price could have sold at a higher price somewhere else. We can therefore meaningfully compare their actual actions to actions they did not consider when making the choice. This is a common practice of daily life. With the benefit of hindsight, we look at a choice and compare what has happened to what could have happened if we had made other choices. We might be able to “forgive” ourselves more easily if we look back convinced that we did not even think of other actions at the time. (As an outside observer, one of course has the additional difficulty of finding evidence that the alternative really was considered.) However, this does not change the fact that one can meaningfully compare past actions to alternative actions that were ignored at the time of the decision. A completely different question revolves around which importance should be accorded the errors we so identify. Everyone might judge for himself whether this kind of comparison is relevant or not.
In retrospect, one always finds evidence that puts past decisions in a new light. Although in many cases it might be difficult to say whether our past actions have indeed been successful, such difficulties do not at all invalidate the fact that there is always a best or optimal action. They often stem from the reality that not all effects of our actions have as yet become visible. We often have to wait to see whether our past judgment was or was not the best possible. If we wait long enough, we shall always be in a position to gather evidence to gauge whether or not we chose the most important action. For example, investments that at first seemed to be ruinous can eventually realize important returns. And even the most initially promising enterprise might go bankrupt because of unforeseen events. If, looking back, we find no fault with our past decisions, if we find that we always chose the best option possible, our life has been optimal. And if, in retrospect, we discover errors, we are only capable of identifying them because we can conceive of a better alternative that we could have realized instead.
The fact that the future might produce new evidence for and against the success of past endeavors implies that the standards of comparison by which we gauge such success are constantly being modified. What was formerly considered the best option now seems only second-best, or, in other words, wrong. We see it as wrong now because we realize that carrying it out prevented the execution of a more important alternative. What does this imply for the writing of history, as far as history is an application of economics? It implies that history must of necessity be “revisionist.” It criticizes our old view of what was right and wrong in light of the new evidence. Although we always employ means that, in our ex ante judgment, realize the most important end, we sometimes discover ex post that another course of action would have been more favorable. We then see that our ex ante judgments deviated from what events now show us was reality. This deviation is the manifestation of error. Ex ante, we always choose what we think is the most important option. Ex post, we compare what is with what would have been, and thereby discover our errors.
It would be groundless to object that this conception of success and failure is too restrictive, that it would lead to every plan being thwarted except that made by a clairvoyant or a very lucky planner. As should be clear from our foregoing discussion, equilibrium is nonetheless realistic, and nonetheless important for economic analysis, even if nobody attains it.
The purpose of the foregoing discussion was to highlight the intricacies of applying equilibrium analysis and to contrast it with the result that this kind of research can bring. Instances of proper applications can be found in investment newsletters and business reports as well as in biographies of business executives and other leaders. Let us emphasize that these applications do not add one iota to the political debate surrounding profit, income, and distribution, however. This is not because applications of equilibrium analysis refer to individual cases instead of to the economy as a whole, but because applications themselves teach us nothing about the nature of profit, but rather use this category as a tool. Theory, not historical applications thereof, must guide us in political decision making.
THE ANALYTICAL AND POLITICAL SIGNIFICANCE OF EQUILIBRIUM Let us now briefly examine the analytical and political significance of equilibrium economics. As we shall see, our realist approach underscores precisely the views Mises held on the role of equilibrium in economic science.
First, let us recall that equilibrium analyses do not give more or less accurate pictures of reality. If this were their purpose, they would not be relevant to our understanding of the world. They are relevant because they enable us to understand our world through comparisons with the counterfactual, and because the counterfactual is implied in the choice under consideration. All human undertakings contain both success and failure as possibilities. Equilibrium analysis not only encompasses both the possibility of success and of failure, but consists of a comparison of the two.
Second, equilibrium analysis is only a part of economic science, and there-fore must not be equated with it. One can discuss most issues of relevance to economic theory and policy on grounds other than those of equilibrium analysis. Virtually all issues relating to monetary theory and policy, for instance, can be discussed by reference to the nature of money, and inflationary schemes can be rebutted by pointing out, in various contexts, that more paper money does not increase factors of production. Or, socialism can be criticized for lacking the possibility of monetary calculation (that is, independent of the question of whether monetary calculation always brings about equilibrium). The very existence of such other fields of analysis proves that equilibrium analysis is just one part of economic science.
What, then, is the specific task of equilibrium analysis? It is limited to—and necessary for—the determination of income streams on the unhampered market. Here it performs two important tasks. On the one hand, it enables us to determine the relative height of wages and interest. Without the notion of equilibrium, we would know only that and why labor services command a price on the market, and that and why rents paid for unit services of land and capital represent interest on the present value of these goods. Yet only equilibrium analysis shows us, for example, that interest must be uniform throughout the economy, or that wages correspond to the discounted marginal value product of labor services. On the other hand, equilibrium analysis enables us to distinguish a third kind of income, namely profit and loss. It shows that profit and loss represent a residual income, and that this income springs from error. These are the main theoretical propositions of this branch of economic inquiry.
The politically relevant implications that one can derive from equilibrium analysis concern schemes for income redistribution. Demonstrating the residual character of profits and losses, for instance, can be used to vindicate just such income. It is obvious that the entrepreneur who makes profits must not be blamed for low wages, for, without him, wages would be even lower. His profits spring from omissions of other entrepreneurs who could have realized higher incomes by bidding underpaid labor away from him.
Moreover, because profits and losses are the result of error, they cannot be “abolished” by government intervention. Irrespective of who controls the means of production—be it a central planning administration or private property owners—one cannot deny that they commit errors. Government interference may provide for a redistribution of profits and losses different from what would have been occurred on the free market. Burdening the taxpayers, government may help incapable entrepreneurs who otherwise would have had to pay for losses out of their own pockets. However, no government (or anybody else) can create schemes that preclude error, which is a fundamental feature of human nature.Also, no government can “tax profits away.” The distinction that equilibrium analysis establishes between profits and other kinds of income cannot be readily ascertained in the incomes of market participants. Looking at the annual income of a an opera singer, one cannot tell which part of this money stream is “profit” and which is payment for his specific labor services. It is therefore not surprising that, when seeking to “tax profits away,” the practical solution does not consist in taxing profits but in taxing income. Yet, in this case, the taxes become a part of the entrepreneur’s costs of production , and are incorporated into his calculations. And profits (and losses) remain what they were, namely residual income components that add to the so-calculated income.
Many economists believe that equilibrium analysis not only serves to evaluate schemes for income redistribution but to evaluate institutional set-tings in efficiency terms. The idea underlying this view is that some institutions might be more able than others to bring about equilibrium. The former institutions are then said to be more efficient, the latter less so. Because the conditions of action determine success and failure—so the reasoning goes—the task of the economist is to identify the set of conditions that creates the best outcome, thus making the world safe for success and efficiency. This view has already been severely challenged.See, for example, Schumpeter (1908, pp. 196ff.) and Buchanan (1979 and 1969). The specific Austrian approach to the analysis of socialism and interventionism, moreover, is an implicit challenge to this widespread view. Indeed, there are two decisive criticisms.
First, to act successfully means to act successfully under given conditions. Success is not an absolute detached from the environment of action. It is relative. Successful actions are those best suited to present and future conditions, whatever these conditions are. From this, it follows that equilibrium can exist under any institutional setting.The only conceivable exception is, again, that these institutions are inherently erroneous. See footnote 11, above. Equilibrium can exist in an individualist as well as a totalitarian society. By modifying the institutional setting in which human action takes place, one does not increase efficiency but the terms in which it is gauged. Thus, if an accountant spends his time watering his boss’s flowers instead of doing his job, this might be highly efficient in a totalitarian system, but would be a waste of time in a free market. Watering the flowers in the first case, and abstaining from doing so in the latter, he could be said to act successfully in both cases. In this context, it can hardly be overemphasized that Mises’s economic calculation argument, which claimed that socialism lacked the indispensable tool for a rational allocation of resources (namely, market prices), and which brought about the comparative evaluation of economic systems, was not cast in equilibrium terms. Mises argued that socialism lacked something present in capitalism, something indispensable to the allocation of resources. He did not argue that capitalism was more likely to reach equilibrium.
The profession did not choose to follow Mises, however, but pursued the efficient-outcome path to its logical dead end. Many economists will probably be unsatisfied with the way we presented equilibrium analysis, namely, as dealing with individual success and error. However, the comparative advantages of this approach are too obvious to be overlooked. It is both logically impeccable and meaningful to speak of individual success and error in any concrete historical setting. By contrast, it is not meaningful to speak of the “success” or the “efficiency of the system,” since success and failure are categories of action, and action is always individual action.
It is meaningless to ascribe individualistic terms to some aggregate entity. There is, for instance, no such thing as an absolute scale of values by which economic progress or regress of society can be gauged. To perform economic calculations, we must compute market exchange rates (prices). Yet, this presupposes two owners who have different views about the good, lest no exchange would take place and no exchange rate could be established. How, then, could one possibly estimate the value of a single good from one point of view (the point of view of “society as a whole”)? Indeed, this is entirely impossible.
Moreover, when it comes to money prices, what entrepreneurs calculate is the profitability of possible investments. These calculations serve to compare these investments with one another to identify the best course of action. No other meaningful use can be made of market prices.For further discussion of the problems of economic calculation, see Hülsmann (1996, pp. 133ff.).
The second criticism of the attempt to apply equilibrium analysis to institutional settings in efficiency terms focuses on the consequentialism of this approach: the attempt to identify the institutional setting that brings about equilibrium presupposes that success and failure are consequences of the conditions of action.
This fallacy is strikingly present in all claims that equilibrium is omnipresent (which, politically, implies an economic justification of the status quo). Many modern economists, for whatever reason, have failed to notice that equilibrium analysis is essentially a comparative study, and that encountering economic error is an integral part of it. Instead, they have focused on the success-side of such analysis and interpreted it as a more or less faithful picture of the world. In their eyes, the more reality conforms or tends to conform to equilibrium, the more meaningful equilibrium analysis becomes.
As a consequence of this misapprehension, many economists tend to regard error as merely a disturbing feature of reality. They believe that the existence of error reduces the importance of equilibrium analysis. Therefore, they try to demonstrate that error is a minor phenomenon, and explain why this is so. All such attempts fail, and necessarily must, because one cannot explain in a general way why error comes about. All who assume this line of reasoning fall prey to the consequentialist fallacy.
One can divide the various consequentialist views on equilibrium analysis according to the conditions from which equilibrium allegedly must follow. The most widespread assumption is that equilibrium ensues whenever conditions do not change any more.The conviction that equilibrium implies an absence of change is and was common to most modern economists. Marshall (1920, p. 305), on the stationary state: “in it the general conditions of production and consumption, of distribution and exchange remain motionless.” Clark (1925, p. 28) observed the following about the static state:It is conceivable that production might go on in an organized way without any change in the character of the operation. Men might conceivably produce to the end of time the same kinds of goods, and they might do it by the same processes. Their tools and materials might never change; and they might not alter, either for the better or for the worse, the amount of wealth that industry would yield. Social production can thus be thought of as static.Fetter (1915, p. 130) wrote the following about equilibrium:Where this best proportion is attained, is a point of economic equilibrium in the sense that there is in the situation itself (and until some other conditions change, as invention, increased demand, etc.) no motive to change the proportion. In such a case the effort is made to repeat the process, to maintain just that proportion which has been found to be on the whole best.Pareto (1966, p. 153) held that: “economic equilibrium is the state of affairs that would maintain itself indefinitely if there were no change in the conditions under which it is observed” (my translation). Böhm-Bawerk (1968, p. 412f.) speaks of “Dauerpreis” (permanent price) or “dauernder Stand der Preise” (permanent level of prices). Mises’s (1935, p. 109) thoughts on the matter seem to be based on the Clarkian conception of a static state: “The static state can dispense with economic calculation. For here the same events in economic life are ever recurring.” See also Mises’s (1939, pp. 106ff.) statements about the “économie immuable.” Speaking of the “evenly rotating economy,” Mises (1998, p. 247f.) says that it is characterized by “the elimination of change in the data and of the time element. ... All factors, including those bringing about the recurring disarrangement of the plain state of rest, are constant. Therefore prices—commonly called equilibrium or static prices—remain constant too.” On the ERE, see also the section “On Mises’s Evenly Rotating Economy,” below. An interesting case is that of Hayek. In an early German-language paper, he (1928, p. 38f.) advocated perfect foresight or perfect knowledge as the condition necessary for equilibrium. Then, in the middle of the socialist calculation debate, Hayek (1935b, p. 212) apparently changed his mind: “We should not expect equilibrium to exist unless all external change had ceased.” For a good overview of the manifold ways economists have conceived of static equilibrium, see Machlup (1963, pp. 13ff.) Marshall assumes that equilibrium results when changes are sufficiently quick or sufficiently slow enough not to affect analysis (see 1920, p. 307), or when market participants can recontract (see p. 335). Other authors consider equilibrium the consequence of market participants enjoying rational expectations (see, for example, Miller 1984), or of error being negligible (see Walras 1988, pp. 11, 110; Edgeworth 1961, p. 12). Still others believe equilibrium characterizes a world lacking entrepreneurial activity (see Wicksell 1934; Schumpeter 1911); one that does not generate messages that cause agents to change their views and ideals (see Hahn 1973, p. 25); or one without market prices, which operate as road signs toward success.For a critique of the road-sign theory as embodied in the contemporary Hayek–Kirzner theory of the market process, see Hülsmann (1997). On equilibration, see also Hicks (1965, chap. 2), who claimed that comparative statics consist in the comparison of “any basic process” and an “amended process.” A more recent instance of consequentialism in equilibrium analysis is the argument that markets dominated by big players will provide less reliable expectations (see Butos and Koppl 1993, pp. 302ff.).From these consequentialist fallacies one must distinguish imprecise uses of language. Thus, according to the young Hicks (1946, pp. 133ff.), the causes of error are inconsistencies of price expectations, inconsistencies of plans, incorrect forecasts of wants, and cases in which only second-best solutions are pursued from the outset. These are obviously not causes, however, but manifestations of error. The same fallacy is present in Hicks’s (1946, p. 254) claim that instability is “ explained” by the assumption that people start doing silly things like giving unlimited credit, etc. Similarly, the “conditions” of equilibrium that Hicks (1946, pp. 86, 197) enumerates are manifestations or characteristics of equilibrium.
A CRITIQUE OF OTHER APPROACHES TO EQUILIBRIUM ANALYSIS On Equilibrium Selection in Game Theory
Although game theory is a comparatively recent approach, it is useful to deal with it first. Its perspective on equilibrium analysis is different from all others in that its primary aim is not descriptive but prescriptive. Game theory sees equilibrium as the “solution” to a “game” that should be chosen by rational people taking part in it.See, for example, Neumann and Morgenstern (1944), Nash (1951), Damme (1987), Harsanyi and Selten (1988), and Baird et al. (1994). Game theorists use the expression “rational” in its colloquial sense of “what a smart person would do” or “what is objectively suited to attain a given end.” By contrast, Austrian economists cherish a subjective notion of rationality by virtue of which human beings always act rationally, since they believe that the means they employ are appropriate to their desired ends.
This normative orientation is in itself an elegant solution to the crucial problem posed by the relationship between equilibrium economics and observed reality. Insofar as the purpose of economics is to enable an observer to describe reality, one must account for the relationship between economic theory and the observed real world. While all other traditional approaches to equilibrium analysis deal with this problem, albeit inadequately, game theoreticians consciously and elegantly sidestep it.Awareness of this problem can be found in works of the pioneers of game theory. See, in particular, Morgenstern (1928, 1934, 1935, 1937), and Neumann and Morgenstern (1944). They neglect the question of how people behave and focus instead on how people should behave. They analyze constellations of human interaction (games) in order to unearth the best strategy for each player, thus determining the likely outcome when rational players play them. As we have said, this is an elegant approach since, conceivably, an ideal can be right or wrong even if it does not correspond to anything that exists in the actual world—provided that it can, possibly, be put into action.
Before we set criticize the game-theory approach to equilibrium analysis, let us observe that it does not directly contradict the realist approach advocated in this article. We have dealt with equilibrium analysis here as a descriptive tool, primarily, and discussed its role in the theory of economic policy. We have argued, that in each setting, a unique equilibrium exists—a position also emphasized by several champions of game theory (in particular, Harsanyi and Selten 1988). And we were able to neglect the question of whether it is possible to determine the equilibria of concrete forms of interaction (games) for all times since the crucial point for us was that there simply be a unique equilibrium. One could be inclined to believe, therefore, that the two approaches are complementary. Game theoreticians could develop standard solutions for various constellations of human interaction, which we could then apply in counterfactual descriptions of success and failure in the real world.
Assessing the prospects of such a division of labor, we have to examine the question of whether games can be so formulated that they precisely describe real-life conditions of action. If this were not so, it would be impossible to discern to what degree the “solutions” of game theory are relevant to real human life. They would then be solutions just as any arbitrary utopia is a solution instead of in the sense that the best concrete alternative is a solution. The postulate that games be so formulated that they exactly fit corresponding features of the real world does not, of course, mean that a game must somehow reflect all features of the real world. Rather the question is whether its constitutive elements—that is, those from which the results of game theory derive—adequately correspond to certain real-world features of action. With this in mind, we will now examine the following constitutional elements of game theory: the number of players, strategies, and rewards.
There should be no problem as far as the number of players is concerned. A two-person game, for instance, is applicable to all situations in which two persons interact in the manner determined by the game.
The matter is entirely different when it comes to strategy, which in game theory is defined so broadly as to imply actions taken to attain a given end. The problem here is that game theory postulates the possible strategies of players as a given. More precisely, it postulates that in each game, all possible strategies are defined from the outset. This can take the form of an explicit statement of each strategy (for example, confessing a crime or not confessing a crime) or a definition of the boundaries within which strategies might be chosen (for example, drawing any number between 0 and 1). Most game theory analyses found in the textbooks assume that there are only two possible strategies.
There are games in which all possible strategies can be defined at the outset—but, not surprisingly, only children or fools can play them for any considerable length of time. The characteristic feature of such engaging games as chess, tennis, or boxing is that they allow for the application of countless strategies unknown at the outset. And, when it comes to real life, there are unlimited possible but unknown strategies, for human creativity constantly overthrows old patterns, adding new strategies previously unimagined. This fact prevents the identification of something like a timeless solution to problems of human life. Game theory can handle only those strategies the analyst himself can imagine. Yet, when someone conceives of what nobody thought before, and puts these ideas into action, we would have to confine the former “solution” to the dustbin of history.
We encounter even greater problems once we turn to rewards. In most expositions of game theory, rewards are physical consequences of the various modes of interaction between players—for example, sums of money that player A receives when he performs action x and player B performs action y.Some of the following arguments will focus on this type of exposition since it appeals to common sense and is largely responsible for the recent success of game theory. In the original exposition in Neumann and Morgenstern (1944), as well as in some strands of later literature, rewards are cardinal utilities that obtain as a consequence of the various modes of interaction. Most game theorists would probably deny that this approach is subject to the standard criticism leveled against the notion of cardinal utility, in particular the criticism that one cannot compare cardinal utilities of different persons (see Rothbard 1956). They would point out that cardinal utilities of rewards in game theory are derived from a purely ordinal ranking. The rewards are ranked, in the words of Baumol (1958, p. 666), “against an arbitrarily chosen imaginary lottery ticket which is used as a standard of comparison.” The player is supposed to interpret each reward as a “compound lottery ticket” and to evaluate it “in terms of the probabilities of winning the ultimate prizes” (p. 670). However, first, a ranking in terms of some prizes quickly leads us back to physical rewards, and thus to criticism we will point out below. Second, this ranking does not encompass those rewards that are more highly valued than the total lottery prize, as well as those that are valued less than the participantion in the lottery. Third, any real-life lottery faces the following problem. Either the total sum of prizes is fixed beforehand—then it is uncertain whether the lottery can be successfully carried out, and the standard of our ranking is no longer fixed. Or the sum of prizes depends on overall participation in the lottery—then the standard is un-certain, too. Fourth, and finally, Baumol’s utilities are gained through a purely intellectual exercise. Their empirical determination would require such a ranking to be actually carried out—but this would entail the problems we just mentioned. Game theoreticians make the (mostly tacit) assumption that these rewards are per se desirable (rather than being desired by a person), and that the degree of their desirability can be expressed in terms of their physical characteristics. For example, 100 dollars is preferable to 80 because it is a larger sum, and one year in prison is preferable to ten because it is a shorter term, etc.
There are light years, obviously, between this way of evaluating players’ strategies and the approach known as subjective value theory. But, since this is not the place to go into great detail, we will point out only a few of the most significant shortcomings of this approach.
First, it does not cover the overwhelming majority of cases in which the rewards are heterogeneous. This is no birth defect of game theory that could be remedied by improvements to the approach, but an essential feature that makes it what it is. In each game, all rewards must be of the same kind, for their ranking would otherwise would be too obviously arbitrary . It is plausible to argue that 100 dollars is always and everywhere preferable to 80. It is far less plausible to contend that 25 bananas are always and everywhere preferable to a rib-eye steak. For the same reason, game theoreticians take into account only rewards that most people find either desirable or undesirable, such as money or prison terms. It is plausible to assume that everybody likes money—any quantity of money—just as it is plausible that no rational person likes prison terms of any length whatsoever. It is far less plausible that everybody always and everywhere prefers more perfume to less.
Second, the game-theory view of physical rewards does not account for such widespread phenomena as charity. People who deliberately renounce a bigger sum of money in favor of a smaller one are branded as “irrational,” which simply means that they contradict game theorists’ preconceived notions of what it means to be rational.
Third, and most decisively, the strategies themselves are never considered part of the rewards—which they are in virtually all real-world cases. In game theory, rewards can only be events that happen as a consequence of players’ actions. It is not allowed that a player prefers a given strategy for its own sake, say because it is beautiful or ethically satisfying. Engaging in scientific research because it is gratifying, of instance, is not allowed. Game theory considers any behavior rewarding only insofar as it yields a rewarding result different from the behavior itself. All other considerations are excluded—only instrumental reason is “rational.”
Again, this is no accidental defect but an inherent feature of game theory’s very enterprise. Homogenous rewards in game theory are to serve as standards by reference to which the heterogeneous strategies of players can be evaluated. Rewards must be homogeneous, for, otherwise, strategies could not be compared in the same terms. Strategies can never be homogeneous by virtue of the fact that they are different. If a strategy were desirable for its own sake, it could no longer be compared to other strategies in terms of the same physical standard and the whole delicate edifice of game theory would crumble.
These considerations suffice to demonstrate that game theory does not and cannot reach its self-chosen purpose of selecting timeless equilibria. More generally speaking, game theory is unsuited for the scientific analysis of human action.23In a recent article, Nicolai Foss (2000) argues that game theory and Austrian econom-ics are compatible and therefore well-suited for cross-fertilization. Foss claims that, from an Austrian perspective, the main insufficiencies of game theory are its formal character, its equilibrium orientation, and its assumptions about the knowledge players possess. Yet these difficulties can be resolved, and as a result, one should expect an improvement of both Austrian economics and game theory. However, even if we admit for the sake of argument that the Austrian approach is less formal than other approaches, that equilibrium plays no role in Austrian economics, and that knowledge, learning, and discovery are important Austrian themes, the gulf between game theory and Austrian economics is still unbridgeable. The whole program of game theory—selecting standard solutions—utterly fails, for it cannot cope with the fundamental facts of human life we have discussed above. It is an intellectual pastime of university professors and their students that remains genuinely unrelated to the real features and problems of human life.
On Profits and Prices in Knightian Equilibrium
Past approaches to equilibrium analysis, insofar as they conceived of equilibrium as a tool for the descriptive analysis of the real world, suffered from one of two shortcomings. Either they were noncomparative—that is, constructed upon the idea that equilibrium analysis could only be relevant if and insofar as equilibrium was realized in the real world, or they were comparative, but did not identify the correct elements of comparison.
The latter deficiency is manifest in F.H. Knight’s very influential view on equilibrium. In his seminal work Risk, Uncertainty, and Profit, Knight claimed that equilibrium is a feature of a world of perfect foresight. This world is characterized by the existence of risk and the absence of uncertainty. Because the market participants can weather risk, no profits or losses exist in such a world. By contrast, uncertainty prevails in the real world, and uncertainty defies perfect foresight. Therefore, we observe profits and losses.
This conception of the problem at hand was taken up by virtually the entire profession. It provides, in principle at least, the basis of the twentieth century’s economics of profit and equilibrium. Knight’s specific distinction between risk and uncertainty has since been challenged and modified, but his fundamental idea is still alive. The idea is to explain why, and under which conditions, there is error on one hand and certainty on the other, and to gain insight into the workings of our error-ridden world by comparing it to one of certainty.
On Knight’s lasting contributions, George Stigler (1985, p. x ) writes the following:
profit, which of course may be negative or positive, arises only when there is uncertainty in the outcome of the productive process. When and to the extent that events are predictable individually or en masse, they give rise only to wages or rents (including risk premia).
In the Knightian conception, profits and losses are ultimately bound up not with choice, but with the circumstances of action. It is not that man errs, but that events are “unpredictable.” In short, uncertainty is a feature of the conditions of action that imply error. No equilibrium can exist in an uncertain world. Only in the never-never land of certainty could all opportunities for arbitrage be utilized and all profits and losses disappear. Accordingly, today’s dominant interpretation of profits is that they are “the outgrowth of uncertainty” (Rothbard 1993, p. 465), whereas equilibrium is considered the out-growth of certainty. Among economists, there are in this regard differences of opinion concerning only two questions: on the one hand, which conditions of action create certainty and uncertainty, and on the other, the universality of these conditions.
The offshoot of this view was a permanent separation of equilibrium from the real world. Equilibrium economics refers to the never-never land of certainty. It is only indirectly meaningful for our world, and it is still not clear exactly what “indirectly” means. Not surprisingly, this conception has proved fatal for the reputation of economics among the broader public, and for the development that our science has since taken. Laymen and students learned that economics dealt with equilibrium, but that equilibrium had nothing to do with our world. What conclusion could they possibly draw from such a view?It is not our task to rewrite the history of twentieth-century economics under the influence of Knightian nihilism. We have to deal exclusively with its analytical significance, and in this regard we have to make three points.
First, there is no such thing as a certain world that can be meaningfully distinguished from our real, uncertain world. Any world relevant to economic science is peopled by human beings, human beings are free to choose, and this this very freedom of choice that defies any attempt to determine “laws” of what they choose.See Rothbard (1997, chaps. 1–6), and Hoppe (1982; 1989, p. 112f.; 1993, chap. 7; 1995, pp. 36ff.). Lacking of such laws, everybody is confronted with the inescapable fact of uncertainty.
Second, there is no need to separate equilibrium from the real world. Equilibrium is constituted by successful action, and action can be successful under any circumstances. Therefore, one does not have to postulate that uncertainty is absent in equilibrium. We must phrase our arguments about equilibrium in a comparative manner, that is, by comparing it to the features of error, another potential feature of real action. This comparative approach to equilibrium economics is applicable to each instant of our real world.
Third, Knight’s approach was not only vitiated by the assumption of perfect knowledge. His conception of equilibrium marked a return to the holistic approach of many of the classical economists. He did not address individual actions, but an “imaginary society” the members of which are “a ‘random sample’ of the population of the industrial nations of today” (1985, p. 76). He argued that theory modeled or represented an actual or imaginary society. As a consequence, he took recourse to those contestable assumptions that sometimes are used in historical research. Thus, he (1921, pp. 76ff.) assumes that each member of his imaginary society acts “in response to real, conscious, and stable and consistent motives, dispositions and desires,” that “nothing is capricious or experimental,” that he “controls his own activities with a view to results which accrue to him individually,” that he “is to act as an individual only, in entire independence of all other persons,” and that “productive operation must not form habits, preferences, or aversions.”
If Knight were right, one would have to conclude that economics is much more restricted than it actually is. A student getting acquainted with economics via the Knightian approach must find a concept like profit, and the determination of the height of wage and interest rates is contingent to particular conditions—very particular conditions.
Yet, whereas these conditions might obtain under certain rare circumstances of time and place, Knightian “perfect equilibrium” also requires conditions that, like perfect knowledge, are never given. Thus, Knight (1985, p. 77f.) presupposes the “complete absence of physical obstacles to the making, execution and changing of plans at will”—that is, that there is “no cost involved in movement or changes,” that “all the elements entering into economic calculation ... must be continuously variable, divisible without limit,” and that there prevails a “continuous, costless intercommunication between all members of society.” These statements by an outstanding practitioner of economic analysis were instrumental in spreading the conviction that the meaning of economic doctrine depends upon just such assumptions. Yet their true purpose is to prepare a holistic (and completely unhistorical) model of reality.
Based on this account of economic science cannot answer the pressing political questions of mankind. To the question, “What determines my wage rate?” Knightians cannot just answer, “the discounted marginal value product of your labor.” They must also add the proviso, “provided that all goods are perfectly divisible, that you and all other members of society are rational and omniscient, and that neither you nor any person or good encounters physical obstacles.” Is it any wonder that people do not listen to what economists tell them about the determination of incomes? Knight and his followers thus fall under the verdict of one of the great masters of our science, Jean-Baptiste Say, who wrote the following about such attempts to model reality:
Such persons as have pretended to do it, have not been able to enunciate these questions into analytical language, without divesting them of their natural complication, by means of simplifications, and arbitrary suppressions, of which the consequences, not properly estimated, always essentially change the condition of the problem, and pervert all its results; so that no other inference can be deduced from such calculations than from formula arbitrarily assumed. (1971, p. xxviin)
On Mises’s Evenly Rotating Economy
Mises’s equilibrium construct, the “evenly rotating economy,” is another instance of a comparative approach to equilibrium analysis that fails to identify the correct elements of comparison. Whereas in Knightian equilibrium acting man knows what will happen in the future, his colleagues in the ERE are, in Mises’s (1998, p. 249) words, “soulless unthinking automatons.” They do not act. They react—mechanically and uniformly—to conditions that manifest themselves again and again. The ERE is thus characterized by
the elimination of change in the data and of the time element. ... [It is] a fictitious system in which the market prices of all goods and services coincide with the final prices. There are in its frame no price changes whatever; there is perfect price stability. The same market transactions are repeated again and again. ... The system is in perpetual flux, but it remains always at the same spot. It revolves evenly round a fixed center, it rotates evenly. The plain state of rest is disarranged again and again, but it is instantly reestablished at the previous level. All factors, including those bringing about the recurring disarrangement of the plain state of rest, are constant. Therefore prices—commonly called static or equilibrium prices—remain constant too.Mises (1998, p. 247f.). Before Mises, Hayek (1928) had pointed out that equilibrium, or the state of rest, was an imaginary construction, that is, a tool of economic analysis and not a description of reality. In his eyes, prices are “the guides and regulators of all economic activities” (p. 34), and, since equilibrium therefore tends to be reached, equilibrium analysis makes it possible to summarize (zusammenfassende Darstellung) a great number of different tendencies in the economy (see 1928, p. 38). In a slightly different account of the function of equilibrium analysis, Hayek (1928, p. 39) claims that the results of equilibrium analysis are relevant only insofar as future changes in data are known (bekannt sind).
The ERE can avoid the uncomfortable assumption of perfect knowledge by postulating that the conditions of action do not change. The evenly rotating market participants are not omniscient. They do not have perfect knowledge of the future. What the ERE presupposes is that, given any knowledge of technology and of the particular circumstances prevailing in the market, there will be a tendency toward equilibrium as soon as circumstances and knowledge (a part of the conditions) stop changing. The result is a neat picture of the market process: If conditions stop changing, sooner or later only those enterprises most important under these conditions will survive. All other enterprises will be given up because there are other more important enterprises. All less important enterprises will in fact become unprofitable because the more important ones, which will realize higher receipts, will be able to pay higher factor prices, thereby ever increasing the costs of less important firms until they incur losses. Because nobody can incur losses indefinitely, sooner or later only the most important firms will survive. The economy will have arrived at its “final state of rest,” and turns into an ERE.This view seems to have been current among Viennese economists of the 1920s and 1930s. See also Conrad (1936), Strigl (1934, p. 89), Rosenstein-Rodan (1927, p. 1206), and Weiss (1923, p. 16).
Mises claimed that the ERE is “both appropriate and indispensable” to analysis of the market process. More precisely, he found it necessary to treat “the problem of the relation between the prices of products and those of the factors required for their production, and the implied problems of entrepreneurship and of profit and loss.”Mises (1998, p. 249). In an earlier essay, he (1939, p. 110) wrote the following about the purpose of the ERE, that it is: “the study of the relationships that exist between prices and costs, and, consequently, of entrepreneurial risks” (my translation). But why is the ERE appropriate and indispensable for these endeavors? Mises’s answer is highly significant. He sees the ERE as an instrument of a more general method of economic investigation. Its function is not merely to explain entrepreneurship and profit and loss, but to “comprehend in what respects the conditions of a living world in which there is no action differ from those of a rigid world. This we can do only by the argumentum a contrario provided by the image of a rigid economy.”Mises (1998, p. 251). Consider also Lindahl’s (1939, p. 34) quite similar position: “we need the static structures as instruments of analysis. If we can state under what conditions the variables studied do not change, we can better understand the course of their actual fluctuations.” He thus adheres to the Knightian method of contrasting our world with an avowedly unrealistic, imaginary construct.
Mises saw more clearly than Knight, though, that the idea of equilibrium is only one part of a comparative investigation. He was very conscious of the fact that the validity of economic theorems did not presuppose the fact that equilibrium exists. He clearly saw that the concept of equilibrium is but a tool of analysis. It does not matter whether conditions will ever be stable and, consequently, whether the ERE will ever be achieved. Its function is to serve as a standard of comparison from which we can derive insights about the implications of unstable conditions.
However, neither Mises nor any other advocate of the ERE has denied that this concept is rife with contradictions. One cannot imagine, for example, a demand for money in a world of certainty. It would be senseless for the market participants to hold a medium of exchange, for all exchanges could be effectuated in kind. Another problem concerns the fact that some resources can be depleted.
The crucial point, however, is that even unchanging physical conditions do not independently bring about equilibrium on the market. Equilibration toward the ERE is supposed to operate according to the view of the market process as outlined above: in time, only the most important firms will survive. It is important that, according to this view, firms driven out never come back, while firms later to be part of the ERE exist at the outset. The equilibration process uncovers which firms out of many are the most important. Only these firms survive in the equilibration process and arrive at the “final state of rest,” which then reproduces itself endlessly, thus becoming an ERE. However, it must be noted that one must count the distribution of wealth among the supposedly stable conditions of action, and that the market process always leads to a redistribution. Whenever a firm is driven out of the market, its employees will have to work elsewhere, accepting lower wages. Other members of society, the immediate competitors of this firm, for instance, will realize higher incomes. (What will they do with the money? Are they already robots or is there still some entrepreneur in them? We find no statement in Mises as to when the persons living in this equilibrating world will become the automatons they are in the ERE. Let us suppose, for the sake of argument, that they are still entrepreneurs.) If these beneficiaries of the redistribution process do not use their increased income in precisely the same way as before, a new set of market conditions will obtain. Firms that before were among the most important will become submarginal. Firms that before incurred losses will become profitable. There is no reason to assume that the same firms will endure any economic process, even under stable, physical conditions. Therefore, the conditions under which the final state of rest is supposed to be established—namely, stable conditions—can never be given. The market process itself brings about continual change, it implies a constant need for readjustment. Under such circumstances, only the successful actions of entrepreneurs can establish equilibrium. It might be this fact that prompted Mises to state that
It is even out of the question to carry the imaginary construction of an evenly rotating system to its ultimate logical consequences. For it is impossible to eliminate the entrepreneur from the picture of a market economy.Mises (1998, p. 249). For a somewhat different perspective on the inconsistencies of the ERE, see Cowen and Fink (1985). As Salerno (1993; 1995, p. 306) points out, in Mises’s view, the validity of economic theorems does however not depend on the possibility of reaching the ERE.
But if we cannot even reason conclusively about the ERE, of what use can it be to our understanding of the world?As Cowen and Fink (1985, p. 868) point out in a related criticism, “if the ERE reflects everything that the world is not, introducing a change into the ERE and letting it work its way through the system cannot be a promising endeavor. At best, all such a procedure could be used for is to tell us how the real world does not react to change.” What we see here is, in fact, another instance of the failure of consequentialism. Stable conditions do not imply the eradication of profits. Entrepreneurial judgment is required to make them disappear. More generally stated, it is an impossible undertaking to define equilibrium in terms of conditions of action. There is no discernible final state of rest upon which the economy might more or less automatically “converge.”
The ERE thus contradicts itself. However, even if, for the sake of argument, we accept such a self-contradictory equilibrium construct, we still encounter another problem. For the ERE is not in harmony with Mises’s general view on the nature of economic science. He claimed that economics is composed of synthetic propositions a priori, that is, propositions that are derived from unaided reason and directly applicable to the real world. Now, one can hardly pretend that the ERE agrees with this conception. It obviously does not hold true wherever there is human action, and could never be realized in a world of human beings. It is simply an arbitrary and unrealistic assumption.
Mises did not integrate equilibrium into his general a priori approach. He found it an uncomfortable but necessary crutch, a tool of thought, an “imaginary construction.” The ERE was the second-best solution while a genuinely economic approach to equilibrium was lacking. This begs the question of why Mises adopted the ERE rather than another view of equilibrium. The answer might be found in the following statement (Mises 1998, p. 291): “If we want to construct the image of changing economic conditions in which there are neither profits not losses, we must resort to an unrealizable assumption: perfect foresight of all future events on the part of all individuals.”
However, as we have seen, a sound equilibrium concept does not presuppose that individuals know the future, only that they can act successfully under any circumstances. This cannot be denied without contradiction. Moreover, equilibrium analysis does not presuppose an “image” of an economy in equilibrium throughout a given period. It refers to concrete individual actions, without regard to the rest of the economy. The possibility of successful action is a real feature of any human world, whereas the assumption of evenly rotating robots (of which the ERE is composed) is admittedly unrealistic.
Hence, the decisive consideration is that there is a genuinely economic approach to equilibrium. One does not need the ERE to analyze profits and losses. Basing equilibrium analysis on the categorical distinction between success and failure is in perfect harmony with Mises’s view on economic science. In the approach outlined above, equilibrium is part of a comparison of two possible outcomes of action. Success and failure both refer to human action, and cover its entire range. Their distinction is both a priori and directly applicable to our understanding of any instance of human action in the real world.
On Hicks’s Concept of Counterfactual Equilibrium
In one of his last works, Sir John R. Hicks defined equilibrium as “a condition in which all actors were taking all opportunities for gain that were open to them.”Hicks (1979, p. 78). Note that, according to this definition, equilibrium can prevail under any circumstances (see also p. 46). With this notion of such universally successful action at hand, characterized the “equilibrium method” as follows:
A model of this kind [in which all market participants act under correct expectations] is not realistic; it makes no claim to be realistic. We are just to use it as a standard of comparison with the actual. For the historical application, at least, it is not inappropriate. We admit that in actuality, in “1975,” things that were unexpected did happen, so that there was no such equilibrium during that year. But the model is to show us what would have happened if some cause had been different. ... So the model can be, indeed should be, in equilibrium; though reality is not. (1979, p. 83)
Hicks thus clearly perceived that equilibrium analysis is counterfactual in nature. In his eyes, equilibrium analysis does not contrast a living and a dead world, but two living worlds.
This view is, however, defective in several important respects. First, in Hicks’s eyes, equilibrium is by and large a (counterfactual) yardstick by which we evaluate the real world. He did not understand that equilibrium is part of a larger whole—namely, equilibrium analysis—or that the latter is a method, as opposed to a mere standard of comparison. Not surprisingly, counterfactual analysis is for Hicks a one-sided affair. The ideal is ever the unrealized model of the theoretician. It cannot be realized on earth and identified as such by comparisons with inferior counterfactual alternatives.
Second, it is not entirely clear to what extent Hicks fell prey to the consequentialist fallacy. His statement, that the economic model’s function is to show us what would have happened if “some cause” had been different obtains only if by “cause” he means human choice, and nothing but human choice.
Third, Hicks did not understand that the counterfactual comparison must be founded on individual actions. His view is of the year 1975 as a whole. Individual equilibria are impossible in this approach; in ours, they are not.
Fourth, as an offspring of this holistic approach, Hicks does not compare the implications of (successful as opposed to erroneous) choices. He compares the effects of expected events to the effects of unexpected events. At first glance, this might seem to be only an insignificant difference that refers to the point of view from which the comparison is performed. However, a closer look reveals that Hicks’s approach makes it almost impossible to apply equilibrium analysis. For when analyzing a disequilibrium of the entire economy, it is not clear at all which cause would have had to be different to bring about equilibrium. Any single event that would have been different not only would have rendered some actions successful, but it would also have rendered other actions unsuccessful. Therefore, it would be impossible to discern something like the “over-all” effect of a single event on the fulfillment of expectations. Only a simultaneous consideration of all events could lend significance to an “equilibrium of events” as a standard of comparison. Yet, even then, the counterfactual variation of a single event would be meaningless since it could be in equilibrium only with reference to all other factors.
As a consequence, this approach would be completely worthless in practice. Even if it were possible to construct equilibrium by referring to events instead of individual choice (which is not the case), one would end up comparing one totality of ideal events to another totality of real events only to state that they are different in almost every respect. What kind of “analysis” would this be? The general conclusion to be drawn from these considerations is that it is not only extremely difficult to define equilibrium by referring to conditions of action, but is an entirely worthless undertaking: it does not advance our understanding at all. By contrast, focusing our analysis on human choice, we arrive at clear-cut distinctions that, as we will see, apply to both historical analyses and political decision making.
On Selgin’s Concept of Subjective Profit
Among the noncomparative approaches to equilibrium analysis, one can distinguish three primary groups.
The first is composed of those economists who claim that the economy is always in equilibrium. We addressed this group in our critique of consequentialist approaches that attempt to explain why and when equilibrium exists.
According to the second group, in which we find the ultra-subjectivists, applications of equilibrium analysis presuppose that acting man has knowledge of the future. Because this is not and can never be the case, equilibrium economics simply cannot help us understand the real world. We will deal with this view in the next section.
The third group attempts to establish a kind of middle ground between the two previous positions. These economists want to conserve the sound tenets of equilibrium analysis without, however, abandoning the notion of profit and loss, and without falling prey to ultra-subjectivist nihilism. Basically, there are two solutions within this middle-ground group. The first is the Hayek-Kirzner theory of the market process, an outstanding example of consequentialist reasoning (for a critique, see Hülsmann 1997).
George Selgin proposed the second solution in his important essay Praxeology and Understanding. According to his approach, profit and loss is an entirely subjective phenomenon that defies objective analysis. Selgin (1990, pp. 40–41) explains that:
entrepreneurial profit opportunities in general are ephemeral phenomena, formed in the imaginations of enterprising people and defined by the very actions that “eliminate” them.
It follows that praxeology must refrain from grouping the services of enterprising people according to “objective” standards, referring to earnings differentials as entrepreneurial profit. It instead assigns these differentials to the category “rent to labor services.” Such rent may be said to include an element of profit only insofar as it actually gives rise to imitation by other individuals or to replication by the entrepreneur in question. ... Every entrepreneurial action ... begins with the subjective imagination of a profit opportunity (or belief that a loss may be avoided) and ends with the destruction of the imagined opportunity. This ... is what praxeology means when it asserts that all action is “equilibrating,” i.e., that action leads to the systematic elimination of profit and loss.
Let us begin our assessment with two minor remarks. First, the expression “profit gives rise to imitation or replication” seems to imply some sort of consequentialist reasoning. But what Selgin delivers, in fact, is an essentialist definition of profit and loss. He clearly states that profit or loss is given only “insofar as it gives rise.”
Second, Selgin’s comes close to a contradictory regressus ad infinitum. For although profit and loss are subjective, this subjectivity refers to the interpretation of monetary surpluses. It is therefore in the earning differential of a past action that an entrepreneur sees a profit opportunity, which in turn “gives rise” to imitate or replicate this action. However, this past action must have been performed in light of a preceding interpretation, which must have referred to earlier earning differentials, and so on. There is a regress on evermore past actions and earning differentials. Clearly, at some point in the past, somebody must have initiated production for the market. There must be a logical stopping point for this regress. In Selgin’s account of it, however, there is not. The first entrepreneurs cannot rely on past earning differentials because they are the very ones who had brought about the first earning differentials. However, this is not a very grave objection, because the important aspect of Selgin’s definition is that profit and loss are subjective. They are emanations of the individual’s arbitrariness and therefore do not require a foregoing interpretation of monetary surpluses.
The decisive shortcoming of Selgin’s approach is its very subjectivity. What Selgin has done, in fact, is to define away both error and disequilibrium. In light of his definition, there can be no failure. Error is caught up in the subjective box of imagination. It is “ephemeral”; it peeks through only at the very instant of choice, and then only in t he mind of the decision maker. But it cannot manifest itself in ex post reality. On the premises of Selgin’s approach there can be nothing on the unhampered market but equilibrium .
As far as definitions are concerned, this procedure is unobjectionable. However, it is one thing to propose a definition and another to make it stick. Choice exists. Choice does imply the possibility of error. Erroneous action has real-world repercussions. Not only is it impossible to deny these facts, but everybody recognizes them daily. People look back on what they have done, or have not done, and say to themselves, “I should have done this rather than that.” This goes unnoticed in Selgin’s approach. As he has it, people think of other actions just before they make their choice. Whatever happens afterward is just reward for their labor services. This blurs the important difference between profit and loss as choice-dependent income (which can be arbitraged away), and income for the specific qualities of one’s labor services (which cannot be arbitraged away).
And even if one were willing to cling to Selgin’s definition, one could not fail to notice that it does not even begin to consider choice as possible error.For a critique of the subjectivist denial of error, see Kirzner (1992, pp. 23ff.). Attempting to fill the gap in equilibrium theory, Selgin only creates another void when trying to distinguish between the various forms of market income.
ON THE ULTRASUBJECTIVIST REJECTION OF EQUILIBRIUM ANALYSIS Let us now deal with the subjectivist rejection of equilibrium economics. According to Shackle and Lachmann, the champions of ultrasubjectivism, equilibrium economics adds nothing valuable to our science. Their criticisms focus on the idea that equilibrium implies the absence of uncertainty. They believe that equilibrium analyses are useful only if equilibrium’s existence can be proven, or at least appear possible to prove. Yet they also emphasize that no theory can explain why equilibrium exists or is even likely to exist in reality. From this correct observation they conclude that equilibrium is useless for economic analyses and, moreover, that economic science cannot be used for predictions.See, in particular, Shackle (1972) and Lachmann (1994). Similar criticism is to be found in Kaldor (1972). A forerunner is Struve (1936, p. 522f.), who also mentions Simiand (1932, p. 93).
Though, it is possible, to conceive of equilibrium without renouncing uncertainty, and such a construct certainly adds something to our knowledge of the real world. The very existence of the approach we have outlined in this essay refutes the far-reaching claims of the advocates of ultra-subjectivism. And even if one denied the validity of this approach, one could not subscribe to their tenets. Even if a conception of equilibrium without uncertainty could not add to our understanding of real human action, it does not follow that there can be no realistic equilibrium economics. Shackle and Lachmann did not even attempt to explain why realistic equilibrium analysis is impossible from the outset. Yet it is precisely such an a priori proof that is required to justify their general claim. All they have done is point out the insufficiency of past approaches to equilibrium analysis.
This leads us to a concluding general interrogation about the significance of subjectivism to economic science. Is subjectivism one of its central features?To some degree, at least, the opinion that this is the case seems to rest on semantic vagueness. Indeed, the term “subjective” has two quite different meanings: (a) “arbitrary” and (b) “individual.”
There can be no doubt that modern economics is a subjectivist science in the sense that it deals with individual actions. Starting with the writings of Menger, Jevons, and Walras, economists abandoned the class analysis of their predecessors. There were no longer capitalists, landlords, and workers buying and selling labor, land, capital, and consumer goods. But individuals buying and selling specific quantities and qualities of goods. With the help of the new marginal analysis it was possible to demonstrate for the first time that, ultimately, all prices paid on the market, as well as the structure of production, could be explained in terms of individual utility. However, utility was not conceived to be subjective at all. It was not a matter of individual arbitrariness, not something determined by choice. Neither Menger, Walras, nor Jevons believed that subjective decisions were the standard by reference to which prices could be explained.34See Menger (1871, p. 121f.) and Walras (1988, §50), in particular the passage “ces dis-positions n’en existent pas moins.” Jevons (1957, p. 38) advocates Say’s definition of utility, as, the “faculté qu’ont les choses de pouvoir servir à l’homme.” Jevons expressly refers to the distinction established Condillac established between utility and value. See ibid., pref-ace to the second edition, p. XXVIII; Condillac (1795, p. 6). Characteristically, one of the f irst historians of the Austrian School, James Bonar (1996, p. 12), described the theory of value in Menger’s Grundsätze as an “investigation of certain principles, fixed independently of individual will, which determine what makes a thing ‘useful,’ a ‘good,’ and a thing ‘valuable’ to me.” See also Bonar (pp. 13, 26). Incidentally, Karl Pribram (1983, p. 612) argues that even the Scholastics had an equilibrium concept in the form of equivalence between actual value and intrinsic value, and Peter Struve (1936, p. 486) observes the notion of equilibrium price in Aristotle’s Nicomachean Ethics.
The new perspective was first and foremost the achievement of an analysis cast in terms of individual actions and specific quantities of goods. By contrast, subjectivism in the sense of arbitrary decision making or freedom of choice did not play a comparable role, at least in the initial phase of the marginal revolution.See, for example, the categorical statement in Rosenstein-Rodan (1927, p. 1210).
It was only later that economists became increasingly aware of the prob-lems inherent in a “logic of choice.” How can one even assume that choice is both free and subject to laws without running into inner contradictions? For economists working within the framework of the cost-of-production theory of value—that is, within the framework of Smith and Ricardo—this problem did not and could not exist. As they saw it, prices were objectively determined by toil and trouble, that is, by the cost of labor. Individual decisions did not interfere here at all. Obviously, what one wants to invent is irrelevant for the question of how much labor one must invest in order to produce a given commodity. Preference rankings, interpretations, and anticipations were also irrelevant in this regard. Choice could not determine value and prices.
Compare this to the viewpoint of modern economists, who try to deduce the analysis of prices and the structure of production from the analysis of individual utility. The minor problem is to discern the objective character of utility. The utility of consumers’ goods is as objective as the physical productivity of a machine. Neither can be discussed away by acting man. The major problem is inherent in the fact that all our actions are manifestations of choice. We know, to be sure, that neither the rightfulness nor the economic success of human action depends on human will. Yet we cannot dispute the fact that our actions per se are exclusively directed by subjective interpretations of our environment. This being so, how can one reconcile the notion that there are laws of human action, laws of market pricing in particular, with the existence and nature of choice? This is the fundamental problem of modern economics, and the purpose of this article has been to show how it could be solved in the case of equilibrium analysis.
CONCLUSION Science seeks to explain objective facts by reference to constant relationships that link them to other facts. Yet economic science deals with human action, which is directed by individual choice, which seems by its very nature to contradict the notion of constancy. How can we reconcile the idea that there are laws of human action, that manifest themselves in market prices and the structure of production, with the idea that there is also freedom of choice? All modern discussions of the relevance of equilibrium economics revolve around this problem.
We have argued that there are constant relationships in choice itself—in particular, in the dichotomy of success and failure. Recognizing this fact paves the way toward a realistic equilibrium analysis, which consists in comparing an actual choice with its counterfactual alternatives in terms of success and failure. This approach underscores Mises’s insight that equilibrium analysis deals only with a very limited range of phenomena—it is only a part of economic science. And, in distinct contrast to all previous approaches, it does not rely on fictions of the mind or unrealistic constructs. It is an integral part of a realistic science, a precious tool for the understanding of reality.
Volume 16, No. 1 (Spring 2013) ABSTRACT: The law of association as espoused by David Ricardo and generalized by Ludwig von Mises cannot directly convey what is at stake in exchanges involving specialization in uncertainty bearing. In this article we explain why the entrepreneurial function as conceptualized by Frank Knight and Mises does not fit in, and what other rationale for association is involved whenever specialization in uncertainty bearing takes place. We also explain how this other raison d’être of association is related to the Ricardian/Misesian law of association and how these insights can be combined to produce a more realistic picture of the market process. We show how specialization in uncertainty bearing, though itself escaping the law of comparative advantage, indirectly but decisively allows for an intensification of the Ricardian division of labor.
KEYWORDS: comparative advantage, uncertainty bearing, division of labor, entrepreneurship, speculation, risk aversion JEL CLASSIFICATION: B53, D80, D90, E44, G00, J24, O16, O40 1. INTRODUCTION The law of comparative advantage is a cornerstone of economics. Little can be said by economists without using it, at least implicitly. The basic preliminary facts are familiar (Rothbard 2004 [1962], pp. 95–102). First, for two people to engage in a voluntary exchange, they must think that they will benefit from it. The two goods must be different goods in the eyes of the parties, and they must have reverse valuations on their respective value scales. Second, in order to give up some goods, parties to the exchange must own them first and they must possess a different proportion of the two goods under consideration in relation to their wants. And since goods do not appear out of thin air in their possession, they first must have specialized in their acquisition.
In order for such a specialization to occur, there must be differences between people regarding the suitability and yield of capital goods, consumer goods, and ultimately nature-given factors they have come to own as well as in human labor skills and desirability of different tasks. Otherwise, each individual could only give up the same amount of goods in order to acquire other goods in interpersonal exchanges than in isolation. There would be no interest in specializing in the production of goods one does not use oneself—no interpersonal division of labor—and no point in participating in market exchanges.
Therefore, whenever and to the extent that variety exists among men’s skills and in their environment, there is room for increased productivity for everybody through division of labor and exchanges compared to isolation. And this is true, not only when each party has an absolute superiority in productivity in regard to one of the goods exchanged (“absolute advantage”) but even when one party is more productive in all fields and each one specializes in the field where he has the greatest relative superiority. This is the “law of comparative cost,” the “law of comparative advantage,” or, since it actually includes absolute advantage and since the law of comparative cost is usually associated with a special case analyzed by Ricardo (1821, pp. 140–141),Several authors have contested that the discovery of this law was made by Ricardo. James Mill and Robert Torrens have also been credited. On this controversy, see for example Aldrich (2004) and its references. My mention of the “Ricardian law” in this article should not be interpreted as a stance in this debate. The law is usually associated with Ricardo and since I am not concerned here with who was the actual originator but with the law itself, the designation I use is only chosen so as to make it obvious to the reader what law I am alluding to. it can be considered as the more universal “law of association” (Mises 1998 [1949], pp. 157–164). Nothing except the economy of a hypothetically isolated Robinson Crusoe can be discussed if one overlooks this fundamental insight.
So far, except for the reverse valuations requirement, no insight that could be considered as specifically “Austrian” has entered the picture.Exchanges can occur while people are “indifferent” between the goods traded, in the neo-classical framework. It is by and large common to the “neo-classical” and the Austrian schools. What happens now if we introduce uncertainty and uncertainty-bearing for which there is a sharp difference of treatment between the schools? Will specialization in uncertainty bearing fit the comparative advantage story in both cases? Or will the scope of application of the law have to be altered depending on which theoretical framework is used? To the extent that the neo-classical framework operates with a notion of risk-bearing which has the characteristics of a factor of production (Pigou, 2002 [1952], p. 771–781), an account of specialization in risk-bearing can be provided by the law of comparative advantage. Commenting on Arrow’s (1992 [1965]) classic article on insurance and “risk-bearing,” Dionne and Harrington (1992 [1990], p. 1) explain in no ambiguous terms that “Arrow presented a framework of analysis that explains the role of different institutional arrangements for risk-shifting, such as insurance markets, stock markets, implicit contracts, cost-plus contracts, and futures markets. All of these institutions transfer risk to parties with comparative advantage on risk-bearing.”As far as I can see, Arrow has not been that explicit regarding comparative advantage in his article, but that Dionne and Harrington would interpret Arrow’s position in such a way as a matter of course is telling and illustrates the point. [emphasis added]
Absent any explicit qualification to the contrary in the two general Austrian treatises, Ludwig von Mises’s Human Action and Murray Rothbard’s Man, Economy, and State, absent any explicit treatment of this question by Austrian economists, one might be tempted to conclude that the views on uncertainty and risk exposed by Knight and Mises do not make a difference as far as this question is concerned, that specialization in uncertainty bearing can directly be accounted for by the law of comparative advantage. Another reason would be that if most economists pay tribute to the law of comparative advantage in one way or another, its generalization by Mises makes its role even more central in the contemporary Austrian edifice. After all, the law of association provides us with the most basic reason for society to exist in the first place: “The fundamental social phenomenon is the division of labor and its counterpart human cooperation” (Mises, 1998 [1949], p. 157). It would then be easy to jump to the conclusion that specialization in uncertainty bearing is part of this division of labor as accounted for by the Ricardian principle of comparative advantage.
I want to show here that the law cannot be directly applied to exchanges involving specialization in uncertainty-bearing, what rationale for association is involved in such cases and how it relates to the Ricardian law of association. Such an endeavor aims at clarifying the role of entrepreneurship vis-à-vis the division of labor from an Austrian perspective and, as a consequence, at improving our understanding of the market process. By focusing on a difference between the Austrian and the neo-classical approaches regarding the possible scope of application of the law of comparative advantage, it also aims at revealing a peculiar way in which the weaknesses of the neo-classical treatment of uncertainty vitiate attempts at explaining the nature and function of specialization in uncertainty-bearing, a way which has to my knowledge hardly been previously stressed.For instance, there is no trace of such an issue in Robert Hébert and Alfred Link’s historical overview of the theories of entrepreneurship (Hébert and Link, 1988).
In order to reach these goals, section 2 will first briefly remind the reader of the Knight/Mises view of uncertainty and will introduce the concept of specialization in uncertainty bearing. Section 3 will explain why this view of uncertainty is such that the law of comparative advantage does not apply to specialization in uncertainty bearing while it can with a measurable risk account of uncertainty. Section 4 will introduce Frédéric Bastiat’s “law of association,” explaining specialization in uncertainty-bearing on the basis of the diversity of preferences among actors regarding uncertainty-bearing. Section 5 will explore what I propose here as the key relationship between Bastiat’s and Ricardo’s laws which should lie at the heart of an integrated Austrian edifice. A conclusion on applications and direction for further research follows.
- SPECIALIZATION IN UNCERTAINTY BEARING Though it is easy to recognize how the law of comparative advantage applies when one considers the division of labor between say, a coffee producer and a corn producer, it is not immediately clear how comparative advantages would operate and a division of labor would occur between someone who produces corn and the speculator who buys it in advance at an agreed upon future price in hopes of selling it later at a higher price (or even any speculator who would instead buy the corn on the spot market in the hope of selling it later at a higher price). It is not intuitively clear what is the division of labor in the corn or coffee-producing firm between the worker and his employer who buys his services in advance in the hope that he will get a profit from the future sale of the product. It is not obviously clear either what the comparative advantages involved are between this employer and the person who lends him money at a contractually agreed upon interest rate.
What all these examples have in common is that some form of uncertainty bearing is involvedAnother example would be a contract between shareholders specifying that apart from the founders of the company and those who would eventually get their initial shares, the buyers of additional shares will benefit from a limited liability status. and is an object of the transaction.Of course, there are other aspects involved, especially in the last two kinds of deals which have to do with the exchange of present vs. future goods and that can be meaningfully analyzed in some respects without referring to uncertainty, but this is not our concern here since we focus on uncertainty-bearing as such. More precisely, since for the Austrian economist, any action occurs in a context of uncertainty after all (general uncertainty), what all these examples have in common is that uncertainty bearing regarding some particular events (specific uncertainty) is transferred from one partner in the exchange to the other. The corn producer is relieved of bearing the uncertainty regarding the price of corn in the future by the speculator who will instead be exposed to that specific uncertainty. The worker is relieved by his employer of the uncertainty regarding the price of his product in the future compared to the situation in which he would be self-employed or a member of a workers’ cooperative. Instead, the employer bears this specific uncertainty. And the lender is relieved of the additional uncertainty involved in directly investing his funds as the borrower bears it to some extent. The figure we see emerging here has a familiar face in Austrian economics: the Knightian or Misesian entrepreneur/speculator as uncertainty-bearer who earns a residual monetary income, positive or negative, profit or loss, depending on the quality of his and other people’s judgments regarding future prices.See Knight (1964 [1921]) and Mises (1998 [1949], pp. 105–118). The views of Knight and Mises on these topics are not exactly the same actually. See Foss and Klein (2012, pp. 81–88). However, what is of interest for this article’s purpose is essen - tially what they share., To avoid equivocation, entrepreneurship refers here to the function of uncertainty-bearing. It does not refer to Mises’s narrower concept of a “promoter” (Mises 1998 [1949], p. 256). And the process described is—as far as entrepreneurs/speculators are concerned—specialization in uncertainty-bearing. Mises (1998 [1949], p. 256) describes the example of futures markets transactions as follows:
The futures market can relieve an entrepreneur of a part of his entrepreneurial function. As far as an entrepreneur has “insured” himself through suitable forward transactions against losses he may possibly suffer, he ceases to be an entrepreneur and the entrepreneurial function devolves on the other party to the contract. The cotton spinner who when buying raw cotton for his mill sells the same quantity forward has abandoned a part of his entrepreneurial function. He will neither profit nor lose from changes in the cotton price occurring in the period concerned.
- SPECIALIZATION IN UNCERTAINTY BEARING DOES NOT FIT IN THE LAW OF COMPARATIVE ADVANTAGE Let us give in to temptation then; let us try to apply the law of association to such cases and see where it leads us. The story should run like this: the futures contract, by placing the “risk” on those who want to bear it and who might be more able to bear it, makes it possible for our cotton or corn producers to concentrate on what they do best and not spend resources in acquiring relevant knowledge on See Murphy (2006).. This is the specialty of the speculator who could not exert his talents to the same extent if he also had to care about the specific knowledge required to produce corn. The same thing could be said of the labor contract. The laborer, relieved of the necessity of working for an uncertain future income, can concentrate on what he is best at, and the entrepreneur, bearing instead this uncertainty while being relieved of the necessity to provide a kind of labor for which he is relatively unfit, can concentrate on uncertainty bearing. Finally, the same thing could be said of the production loan contract. The lender is relievedExcept for the risk of default. of the burden of bearing uncertainty regarding future prices in the process of production he invests in, and can concentrate on his best skills as a capitalist advancing present goods, while the borrower can deploy his entrepreneurial talents at grasping what the future is made of. And it should be clear that this specialization leads to a more productive economy and higher overall output.
However, the situation here is more complicated, and it is my contention that the Austrian economist would fall into a neo-classical trap with such a narrative. The reason is the following. Again, the law of comparative advantage tells us that when each person specializes in the production for which he has relative if not absolute advantage, beneficial subsequent exchanges can occur. In other words, in isolation, one might be able to produce a quantity x of something or a quantity y of something else per day so that one has an internal exchange ratio of x/y and that each one can obtain a better ratio of exchange if one specializes in the field in which one has a relative superiority and trade with other specialists. Now, if one would apply this insight to the division of tasks between the speculator and the producer of corn for example, as I did above, that would presuppose that the contribution of the speculator could be grasped through an x or a y, or, more precisely, through the concept of a monetary or physical productivity schedule. Otherwise, the very idea of a comparative advantage would be meaningless since there would be no basis for the comparison involved between the skills of different people.
This view of a productivity schedule for entrepreneurial skills is of course incompatible with Knight’s (1964 [1921]) and Mises’s views on the entrepreneur as uncertainty-bearer, for strictly speaking, entrepreneurship is not a factor of production according to them. As Klein (2010, p. 70) puts it, commenting on Knight’s take on the entrepreneur, “Entrepreneurship represents judgment that cannot be assessed in terms of its marginal product and which cannot, accordingly, be paid a wage.” Or, as Blaug (1997, p. 463) wrote, commenting on Knight’s views about profit as the income of the entrepreneur:
The entrepreneur as a residual, noncontractual income claimant may make a windfall gain if actual receipts prove greater than forecasted receipts. We cannot describe this noncontractual, windfall gain as a necessary price that must be paid for the performance of a specific service, the cost of bearing uncertainty, for that would imply a definite connection between the level of profit and the burden of uncertainty. But no such connection exists. If it did exist, uncertainty-bearing would have all the characteristics of a productive factor and marginal productivity theory would apply to it: profits would equal the marginal product of entrepreneurship and would therefore constitute a charge on production. [emphasis added]
In other words, profits and losses would not be residual but permanent incomes that do not vanish in general equilibrium, or in Mises’s imaginary construct of the evenly rotating economy where uncertainty has disappeared and where entrepreneurs are replaced by automatons as a consequence. There is therefore no way, on standard Austrian grounds, to argue that the contribution of an entrepreneur can be reduced to a marginal productivity schedule, and therefore no way to directly apply the law of comparative advantage when specialization in uncertainty-bearing is involved.
On the other hand, the charm of the neo-classical approach is that such a problem does not need to arise in its framework. Indeed, authors normally do not see it there as the above quotation from Dionne and Harrington (1992 [1990]) illustrates. That the aforementioned issue would not arise in this framework makes perfect sense. For, to the extent that it allows uncertainty to enter the picture, it is mostly the kind of uncertainty that Knight and Mises called “risk,” which can be dealt with by insurance, assigning to it a permanent production “cost.” As Kirzner (1997, p. 70) puts it,
For neoclassical microtheory each decision, whether made by consumer, firm, or resource owner, is made within a definitely known framework made up of a given objective function, a given set of resource constraints, and a given set of technologically or economically feasible ways of transforming resources into desired objectives. (Uncertainty, while of course recognized as surrounding each decision, expresses itself in the form of known probability distributions relating to the given elements of this known framework.) [emphasis added]See also Hoppe (1997, p. 56) on “rational expectations.” There are exceptions, however. Not all mainstream studies use this framework. In recent years, Knightian uncertainty has been taken more seriously by some. On this, see Foss and Klein (2012, p. 90) and its references.
Now if risks can be dealt with as mere “production costs,” the contribution of specialists in charge of them can be grasped through the concept of a productivity schedule. This advantage of the neo-classical view is hardly a real one since it can only be obtained at the price of sacrificing realism in getting rid of true uncertainty and therefore of genuine entrepreneurship. The kind of uncertainty people have to deal with on an everyday basis is not simply or only actuarial risk. As Blaug’s (1997, p. 462) favorable take on Knight makes clear,
Many uncertainties of economic life are like the chances of dying at a particular age: their objective probability can be calculated and to that extent they can be shifted via insurance to the shoulders of others.Such risks thus become an element in the costs of production, a deduction from and not a cause of profits or losses. There are other uncertainties, however, which can never be reduced to objective measurement because they involve unprecedented situations. [emphasis added]
Indeed, the problem here is that uncertainty regarding future prices, the uncertainty we are concerned with, cannot be subsumed under the heading of “risk” because the events defined as more or less favorable price conditions are social phenomena or outcomes of human action. And actions are not automatic responses to external stimulus but the deliberate employment of chosen means to reach chosen ends. Different actors or even the same actors facing the same situation at different times can make different choices. Therefore, there can be no question of grouping some acts in a class of supposedly homogeneous events (Mises, 1998 [1949], pp. 110–113) whose frequency distribution could be experimentally discovered, and for which probability calculus would apply.See also Hoppe (2007, p. 11) Each action is a class of its own and it cannot be known for sure, even in probabilistic terms, what will be its outcome before the future becomes the past.
The Austrian economist can certainly enjoy the advantage of having a theory of the entrepreneur, but he is left with a conundrum since his views on entrepreneurship are such that specialization in uncertainty-bearing does not fit in the seemingly all-encompassing law of association. There is a solution, however, based on already existing insights which just need to be combined properly.
- UNCERTAINTY BEARING AND BASTIAT’S LAW OF ASSOCIATION If our corn producer can shift uncertainty-bearing regarding the future price of its product to a speculator, or a laborer to his employer, or a lender to the borrower, no comparative advantage can or need be directly involved. Instead, it must be realized that even if two people are identical in every respect but their subjective distaste toward uncertainty, one could be ready to abandon any possible future gain to make a safe deal in advance at or above a certain price P1 for a certain quantity of one’s product, while the other one could take his chance and agree to bear the uncertainty by buying the product in advance, provided he does not pay more than a certain price P2. If P2 happens to be higher than P1, there is room for exchange.
Though the concept of risk-aversion is not exactly new and is of course routinely used in the contemporary mainstream literature, Frédéric Bastiat had elaborated on this idea far before economists started to discuss agency or game theory, for example. Bastiat’s neglected “law of association,” as Lane (2001) termed it,I am indebted to Georges Lane for pointing out to me Bastiat’s text as well as his own article on this issue. See also Salin (2002) who draws from the same source material some more implications for the theory of the firm. I am indebted to Gil Guillory for this reference. is explained in the chapter on wages in Economic Harmonies. It consists entirely in explaining association as caused by different attitudes toward uncertainty-bearing along the same lines as above.Except that Bastiat had the unfortunate tendency to equate uncertainty with a form of measurable risk. Bastiat does not allude there at all to the Ricardian law of comparative costs, not even implicitly. Referring to a productive partnership between two people, Bastiat (1964, p. 371) explains that “one of them may assume all the risks in consideration of a stipulated payment.” He adds:
It is easy to understand in what respects it is to their advantage. One party, by assuming all the risks of the undertaking, gains the advantage of having it completely under his control; the other gains that stability of position so dear to men’s hearts…. Evidently there is in mankind a longing for stability that is constantly working to restrict and circumscribe the role of chance and uncertainty. When two persons share a risk, they cannot eliminate the risk itself, but there is a tendency for one of the two to assume it on a contractual basis. If capital takes the responsibility, then labor receives a fixed return, which is called wages.
He goes so far as to say this was the origin of wages, ignoring time preferences as the other relevant aspect to explain why someone could buy someone else’s labor in advance of the delivery of its product (“Capital, will take all the risks and all the extraordinary profits, while the other party, Labor, will enjoy all the advantages of stability. Such is the origin of wages”). Bastiat (1964, p. 372) also explains that the same phenomenon occurs in a productive loan, except that in this case it is the capitalist who partially gives up uncertainty bearing in exchange for a fixed interest:
Often it is the entrepreneur who says to the capitalist: “We have worked hitherto on the basis of a common sharing of the risks. Now that we have a better knowledge of our expectations, I propose that we draw up a contract. You have twenty thousand francs invested in the enterprise, for which one year you received five hundred francs, and another year fifteen hundred. If you are willing, I will give you a thousand francs a year, or five per cent, and will free you of all risk, on condition that I direct the enterprise as I wish.” Probably the capitalist will reply: “Since, with considerable and vexatious ups and downs, I receive on the average no more than a thousand francs per year, I prefer to be assured of this sum regularly. Therefore, I shall continue the association by keeping my capital invested in the business, but without assuming any of the risks.”
Now, the question is, if one wishes to call Bastiat’s insight the second law of association: how are the first and second laws of association related or, how interpersonal exchanges based on the Ricardian division of labor are related to interpersonal exchanges based on different preferences toward uncertainty-bearing, if they are related at all?
- ON THE RELATIONSHIP BETWEEN THE FIRST AND THE SECOND LAW OF ASSOCIATION Let us come back to Mises’s views on the law of association. Mises (1998 [1949], p. 160) writes:
The task with which science is faced in respect of the origins of society can only consist in the demonstration of those factors which can and must result in association and its progressive intensification. Praxeology solves the problem. If and as far as labor under the division of labor is more productive than isolated labor, and if and as far as man is able to realize this fact, human action itself tends toward cooperation and association. [emphasis added]
The first “if” refers to the Ricardian/Misesian explanation of comparative advantage based on differences in commensurable productivity schedules. The second “if” refers to the fact that the recognition of comparative advantages by actors is not automatic. It takes entrepreneurs or speculators to realize where comparative advantages are, to see what other people will want, and to act on these insights. In this context, we can now see how Bastiat’s law and Ricardo’s law of association can be articulated.
Let us then imagine a simplified economy in which we have two sectors (see the diagram below) where people are engaged in the production of corn on the one hand and coffee on the other hand. We can easily depict how Bastiat-type associations and Ricardo-type associations are involved, how complementary and intertwined they are. On the left we have the corn sector and on the right the coffee sector. At the bottom of each, we have laborers A and B working in one or the other. We find above them the capitalist-entrepreneurs D and E who relieve them of the uncertainty regarding the prices of their future products by employing them for a wage paid in advance. We can also see their partners C and F on the same line, some capitalists who are eager to participate in these productive ventures but who mobilize their savings insofar as they can be relieved from uncertainty by a specialized entrepreneur. Therefore D and E are the central figures here as far as specialization in uncertainty bearing is concerned, unless they too partially abandon this entrepreneurial function through futures or other derivatives contracts, transferring uncertainty bearing to the speculators G and H who are at the top. All the exchanges involving transfers of uncertainty bearing are Bastiat-type relationships and are depicted with red arrows. We know that Ricardo-type relationships can only occur between factors whose contributions are reducible to productivity schedules, i.e. between individuals A and B found at the bottom of each sector. not want to suggest that there is a direct exchange between these factors. The products are owned by some specialists in uncertainty bearing before their final sale and the exchange of the products therefore go through them. But ultimately, the Ricardian relationship holds between A and B even if they do not directly exchange their products. They are depicted with a blue arrow.That these relationships seem to hold here only between individuals contributing in different sectors is the outcome of our simplified presentation which is only intended to outline the relationship between Bastiat’s law and Ricardo’s law. Since we have here two workers, one in each sector, the Ricardian-type relationship will be visible only between actors of the two different sectors. They actually hold between all individuals at the bottom regardless of the sector in which they are employed, if we allow more than two people to fit in.
Figure 1. Diagram of Bastiat-Type and Ricardo-Type Relationships
Now, people who are to some extent relieved of uncertainty bearing by the specialized uncertainty-bearers in a Bastiat-type relationship become specialized in a particular field or more specialized in a particular field than they otherwise would. Indeed it is clear that insofar as one is protected against failure in a field, the costs of specializing in this particular field are lowered. As Rothbard (2004 [1970], p. 1313) explains in the context of discussing the relationship between employers and employees: “Imagine the universal risk if laborers could not be paid until the final product reached the consumers! The pain of waiting for future income, the risk in attempting to forecast consumer demands in the future, would be almost intolerable.” And as Arrow (1992 [1965], p. 223) puts it: “The possibility of shifting risks, of insurance in the broadest sense, permits individuals to engage in risky activities which they would not otherwise undertake.”
As far as the relationship between the capitalist-entrepreneur D or E and the speculator G or H is concerned then, the capitalist relieved of an obstacle will be more eager to invest at any hypothetical rate of return than otherwise. As far as the relationship between the entrepreneur-capitalist D or E and the laborer A or B is concerned, it means that the supply schedule of labor will be raised compared to the amount of labor that would be used at any hypothetical implicit wage in a self-employment setting or in a workers’ cooperative. As far as the relationship between the lender C or F and the borrower D or E is concerned, it means that the lender will be ready to bring more funds at any hypothetical rate of return than he otherwise would if direct finance were the only option available. Since this phenomenon is not specific to one sector, but will appear wherever specialization in uncertainty bearing is possible,ill be possible because people will have discovered the possibility of engaging in the corresponding transactions, because these transactions will be allowed by the existing legal apparatus (ultimately because public opinion will be mature enough to allow such a legal apparatus to be born in the first place and to be heretofore sustained), and insofar as the proceeds from these transactions can be kept without the threat of coercive expropriation. there is no question that this intensification effect should come in one sector at the expense of another one. What is at stake here is the general intensification of efforts in all sectors and for all productive functions—a higher supply schedule of labor in general and a higher supply schedule of savings in general—to the extent that there is specialization in uncertainty-bearing. true that by specializing in uncertainty bearing, some people—typically new business owners—are likely to abandon the work they would have otherwise done. However, this is hardly a factor of decrease of the supply schedule of labor “in general,” in Rothbard’s (2004, p. 574) words. For new business owners are likely to be managers, to switch jobs that is. And all investors, even those who do not engage in day-to-day business operations, must not only cope with uncer - tainty regarding the “state of the market” (Mises 1998, p. 290) and earn profits or losses as a consequence. Their decisions must also reflect the energy spent in figuring out and dealing with the (insurable) risks involved and other essentially technological concerns (Mises 1998, pp. 288–290). See also Salerno (2008, p. 201) for a discussion of Mises’s views on the subject. i n line with our discussion above of contributions to production which can and cannot be grasped through produc - tivity schedules, this expenditure of energy is to be properly referred to as a kind of “labor” which commands a rent dependent on the skills of the business owner in dealing with this aspect of decision making. And these tasks are imbedded in capital ownership, as well as the purely entrepreneurial aspects of investing. Now, strictly speaking, one can meaningfully refer to a higher schedule of labor in general only as a way to say that the supply schedules of all labor factors rise, for there is no such thing as one labor market “in general” since labor factors are not homogeneous goods. And insofar as people are switching from one labor market to another (say a management market) and/or to the necessary labor of the capitalist-entrepreneur or investor, not all kinds of labor activities might expand. This minor caveat must be kept in mind when we speak of a higher schedule of labor.
Now, it should be clear that the intensification of Bastiat-type relations implies an intensification of Ricardo-type relations. If specialization in uncertainty-bearing implies as the other side of the same coin further specialization of people into their roles as workers or savers, the Ricardian division of labor between the hedged laborers engaged in the coffee and corn sectors in our example is de facto pushed further. This is done in two ways.
First, the emergence of a separation between capitalist-entrepreneurs and laborers, and further specialization of such a type, makes the general supply schedule of labor rise by relieving laborers (to some extent) of the burden of bearing uncertainty, as we have just explained. This in itself allows for a higher specialization and brings about a higher output out of the social fabric. Second, the emergence of a production loan market, as well as of speculation on spot and derivatives markets, allows for a higher supply schedule of present goods on the time market by relieving to some extent savers from the uncertainties of investing, which pushes the pure interest rate downward and the level of aggregate investment upward. The corresponding reallocation of funds toward the higher stages of the production structure favors on average longer processes of production over shorter ones and hence allows for more roundaboutness in the structure and therefore a higher overall productivity.See Rothbard (2004 [1962], pp. 517–550) for the basics regarding such a change in the time market and production structure.
This process implies an intensified division of labor since the comparative advantages of specializing in the production of different capital goods at various stages cannot be exploited to the same extent when production is less roundabout. Without the additional savings, people can only work in the shortest processes. All the tasks in higher stages in which some people could specialize are out of reach. The lower the supply schedule of present goods is on the time market, the more people find themselves in such a situation where possibilities to become more specialized are absent (including specialization in research on new technologies). Therefore, specializations in uncertainty bearing that make the supply schedule for present goods in the time market rise will trigger an intensification of the division of labor by the same token.The division of labor can also be intensified in a third way. The higher produc - tivity of labor under a more roundabout structure of production implies that the overall demand schedule for labor is higher in real terms if not in nominal terms, which means that it intersects the overall supply schedule at a higher real price (higher real wages). This higher position along the supply schedule implies that a higher amount of work hours is offered on the market, unless workers profit from these higher wages to consume more leisure. To the extent that the predominant tendency is for a higher supply offered, this allows for the exploitation of some comparative advantages which could not be exploited otherwise.
In other words, the specialized entrepreneurs have an indirect but decisive role in the Ricardian division of labor since in ultimately directing workers toward more specialized roles they participate in its intensification. And the Ricardian/Misesian insight regarding comparative advantages as the fundamental basis for social bonds remains central once enriched by explicit considerations of “aversion to uncertainty”-based associations since the second are hardly conceivable without the first. Deals involving the transfer of uncertainty-bearing regarding the price of corn or coffee would make no sense at all without the physical conditions of variety in human skills and environmental conditions giving rise to the possibility of specialization and allowing for the very existence of a market for corn or coffee or any other product in the first place.
- CONCLUSION Specialization and the division of tasks in a market economy cannot all be subsumed under the Ricardian law of comparative advantage. The law cannot be all-encompassing from an Austrian point of view, precisely because the Knightian/Misesian view of uncertainty is not compatible with the idea of uncertainty-bearing as a factor of production whose contribution could be conceptually grasped through a marginal productivity schedule. In order to obtain a more complete picture of the market process at work, one needs to take into account specialization in uncertainty-bearing under what has been called Bastiat’s law of association, purely based on the different attitudes actors can have in regard to uncertainty bearing. “Aversion to uncertainty”-based specializations and exchanges are related to comparative advantages only in the sense that specialization in uncertainty-bearing indirectly fosters a higher degree of exploitation of comparative advantages between factors which are hedged by the entrepreneurs/speculators. The emergence or intensification of specialized uncertainty bearing allows for an extension of the Ricardian division of labor.
The above analysis focuses on voluntary exchanges. It holds insofar as actual transfers of uncertainty bearing are voluntary. Applications to the present world must be carefully handled since interventionism is part of the picture. Two broad lines of theoretical research which would be helpful to pursue in this regard are the following. On the one hand, there is certainly room for more explorations on the impact of obstacles to exchanges—forced exclusion—involving specialization in uncertainty bearing. On the other, it should be clear that an important part of what interventionism entails in the present circumstances is a form of forced integration, the forced transfer of uncertainty bearing from privileged firms toward taxpayers and users of money which find themselves on the wrong side of the Cantillon effect of monetary expansion. This too calls for additional research.
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