Prices: Recent Episodes
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Prices includes how prices are determined, concentrating on monetary prices. How the market determines prices.
It is easy to think of supply and demand curves as being key to economic analysis. In reality, they can't tell us much, and emphasizing them actually stands in the way of better understanding economic processes.
Original Article: "What Do Supply and Demand Curves Really Tell Us? Not Very Much"
This Audio Mises Wire is generously sponsored by Christopher Condon. '
While Bitcoin's S2F Model has come under some criticism, the best analysis of its flaws comes from perspective of Austrian Economics.
Original Article: "A Critique of the Bitcoin Stock-to-Flow Model"
This Audio Mises Wire is generously sponsored by Christopher Condon.
While government officials and politicians denounce high drug prices, they have created monopoly privileges for drug firms, thus ensuring higher-than-competitive prices for pharmaceuticals.
Original Article: "Patents, Legal Monopolies, and the High Prices for Drugs"
This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Michael Stack.
In contrast to the classical cost (labor) theory of value, the so-called marginal revolution ushered in the modern, subjective theory, whereby market price is determined by the marginal utility of a good.
This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Millian Quinteros.
Original Article: "A Critique of the Labor Theory of Value".
If the hallmark of conventional economics is unrealistic models, the hallmark of Austrian economics is a profound appreciation of the price system. Prices provide us with critical information about the relative scarcity of goods and services.
This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Michael Stack.
Original Article: "The Core of Austrian Theory".
By day Jeff Booth is an entrepreneur and builder of companies, but now he's written one of the most compelling and important books of 2020. The Price of Tomorrow: Why Deflation is the Key to an Abundant Future makes the case for a better and more prosperous world simply by accepting the natural order of falling prices and fast-improving technology. The book is entirely free of jargon, ideology, and politics, yet pulls no punches when it comes to describing the fiscal and monetary mess we're in. But it is an optimistic book, with a message for every worldview: deflation is a good thing, it is inevitable, and we should embrace it rather than fight it!
Mr. Booth was kind enough to join the show, and has a fascinating discussion with Jeff Deist you don't want to miss!
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
Marion Mass is a pediatrician in the Philadelphia area where she has practiced in hospital, Emergency Room, delivery room, outpatient, and urgent care settings. She graduated from Duke University Medical School and trained in Pediatrics at Northwestern Memorial Hospital in Chicago. She has been writing about life inside medicine, published in the WSJ, Washington Times, and the Philly Inquirer. She is also co-founder of Practicing Physicians for America, a physician lead organization that advances the interests of practicing physicians. She has written extensively on the role of third party intermediaries in medicine.
Dr. Rupali Chadha is a Board Certified Psychiatric Physician who diagnoses and treats mental illness. She is also Board Certified Psychiatric Physician in the specialty area of forensics. She serves the LA Superior Courts in identifying inmates who are incompetent to stand trial and has also served as a forensic expert in criminal trials. She recently traveled to Washington DC to visit the White House and witness signing of a recent Presidential Executive Order on intermediaries in healthcare.
SHOW NOTES White House Executive Order
Overview of third parties that suck up most of the health-care dollars
The rebates that may fuel higher drug prices
John Arnold in statnews discusses the role of Pharmacy benefit managers (PBM)
A detailed look at Group Purchasing Organizations and PBMs
Needle stick story referenced in the podcast
Watch the episode on YouTube
George Reisman is economics professor emeritus at Pepperdine University. He is one of the few people to get his PhD under Mises. After sharing anecdotes about Mises and Rand, he discusses his contributions to economic theory. In particular, Reisman argues that profits, not wages, are the original form of income.
Mentioned in the Episode and Other Links of Interest: The YouTube version of this interviewGeorge Reisman’s website and Capitalism.net, and his Twitter accountReisman’s book Capitalism. #CommissionsEarned (As an Amazon Associate I earn from qualifying purchases.)Reisman’s Notes on his translation of Bohm-Bawerk on value theoryReisman on James Mill and Say’s LawIsrael Kirzner’s review of Capitalism For more information, see BobMurphyShow.com. The Bob Murphy Show is also available on iTunes, Stitcher, Spotify, and via RSS.
AOC and Paul Krugman are wrong: we can't just pay people money to stay home and expect "stuff" to materialize around us. This show explains why—as we cover Rothbard's Man, Economy, and State Chapter 5, "Production: The Structure," with our great friend Dr. Shawn Ritenour from Grove City College.
Don't miss a great discussion of that critical missing link in mainstream economics—capital theory—and its corollaries, from the temporal and uncertain nature of production to cost fallacies. This show also features plenty of examples from today's economy and a short but dynamic exposition of the evenly rotating economy by Dr. Ritenour.
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 Dr. Joe Salerno's introduction to Man, Economy, and State: Mises.org/SalernoMES
Man, Economy, and State: Mises.org/MES
Professor Jonathan Newman joins the show to discuss exchange and prices through the lens of Rothbard's Man, Economy, and State (chapters 2–4). This is vintage Rothbard: precise definitions; hardcore explanations of property, prices, and exchange; the problems of "hegemonic" state violence; and a "beautiful" (per Dr. Newman) conception of social cooperation. Menger and Mises are important in this discussion too, as Rothbard elaborates on the origins of money and the Regression Theorem. Don't miss this great show!
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 Dr. Joe Salerno's introduction to Man, Economy, and State: Mises.org/SalernoMES
Man, Economy, and State: Mises.org/MES
Michael Sandel doesn't like capitalism. But he can't seem to manage an economic argument for why. He's content to claim that capitalism is morally corrupting, converting anticapitalism into a sort of pseudoreligious faith.
This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Millian Quinteros.
Original Article: "Does the Free Market Corrupt People?".
Bad theories have a long life in the social sciences, and the crude quantity theory of money is one that refuses to go away.
This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Millian Quinteros.
Original Article: "The Quantity Theory of Money and the Equation of Exchange".
The real problem with inflation, properly understood is that it is essentially a wealth transfer away from the most productive parts of the economy. This causes bubbles and economic fragility.
This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Millian Quinteros.
Original Article: "Defining "Inflation" Correctly"
Abstract: This paper extends subjective expectations theory to form a new approach called the discovering markets hypothesis (DMH). Market participants form expectations on the basis of subjective knowledge and communicate with each other through narratives to improve their understanding of factual information before acting in markets. Thus, market prices are shaped by the subjective interpretation of emerging facts and shared narratives. To understand how new narratives replace existing ones, we refer to the theory of scientific revolutions. Winning narratives shape market prices until their victory is confirmed by the facts or they are discredited by facts and replaced by new narratives.
JEL Classification: B53, D84, E71 Marius Kleinheyer (marius.kleinheyer@fvsag.com) is a research analyst at the Flossbach von Storch Research Institute in Köln, Germany and PhD candidate at the University Rey Juan Carlos, Madrid. Thomas Mayer (thomas.mayer@fvsag.com) is the founding director of the Flossbach von Storch Research Institute and honorary professor at the Universität Witten-Herdecke.
INTRODUCTION Prices fluctuate, and especially in financial markets, where they are heavily influenced by expectations of the future. Some economists have explained price fluctuations with the myopia of market participants. For instance, bid and ask prices are based on prices observed in the past, and when supply and demand do not match, prices are adjusted. Other economists have replaced myopia with perfect foresight in their models. According to them, all market participants always have all the necessary information to agree on a price equating supply to demand so that prices change only when they receive new information. However, actual price behavior is neither consistent with complete myopia nor perfect foresight among market participants. Sometimes, prices move as if market participants were myopic, sometimes as if they were forward looking. This has prompted another theory, according to which price fluctuations reflect market participants’ collective oscillation between rational and irrational behavior.
This paper argues that there is a better way to explain price fluctuations in financial markets. Market participants form their price expectations on the basis of information that they collect and interpret with their individual skills and knowledge of economic relations. They act in the market or communicate with others through narratives to improve their understanding of their factual information before acting. Thus, market prices are shaped by the subjective interpretation of emerging facts and shared narratives. The resulting price movements in return influence narratives and the subjective interpretation of facts.
First, the theories of adaptive and rational expectations and the concept of adaptive markets will be discussed. These theories will then be connected to the theory of subjective expectations and an extension to the latter suggested, the discovering markets hypothesis (DMH). Empirical evidence is presented to support this approach, and finally, its utility in making predictions.
OBJECTIVE THEORIES OF EXPECTATIONS Economist John Hicks took issue with the idea put forward by Léon Walras that transactions take place at prices where demand is equal to supply. Since traders generally could not know what would be supplied and demanded at certain prices, they could only guess. Hence, Hicks (1939) argued, transactions would generally occur at prices which did not equate supply and demand. Following Hicks, we could describe the market as a mechanism that matches expectations and prices, but not necessarily potential supply and demand.
John Maynard Keynes raised the question of how expectations about the future are formed. Where they could, people would rationally calculate subjective probabilities for different outcomes and choose the most likely. But they would also often fall back on whim, sentiment, or chance. The latter was especially the case in capital markets, where participants were driven by “animal spirits.” There, it was often necessary to forecast “what average opinion expects average opinion to be” (Keynes 1936). Keynes left the formalization of his macroeconomic expectations theory to his disciples, which often led to a mechanistic reduction of his arguments. An example of this is the theory of adaptive expectations.
In the adaptive expectations model an expected market price depends on the expected price of the previous period and an “error correction” term that is given as a fraction of the difference between the expected and the actual price in the previous period. This model is not only intuitively appealing but benefits also from the advantage that expected prices can be expressed as a weighted average of past prices. Given its user friendliness the adaptive expectations theory has been built into many macroeconomic models and has been used by many econometricians. However, even its most enthusiastic users have had to admit that it describes the formation of expectations in a very mechanical way that falls far short of Keynes’s more sophisticated view (see also Gertchev 2007).
In the early 1960s, the US economist John Muth contradicted the theory of adaptive expectations. He argued that the expectations of economic agents were nothing more than predictions, which could be made with the appropriate economic theory (Muth 1961). In the formation of rational expectations only the future counted, which would be fathomed with the help of economics. If people used all available information efficiently and knew how the economy really worked, then realized prices would differ from expected prices only as a result of random influences. And if the expected value of random influences were zero, market prices would over the longer run equilibrate supply and demand.
Muth’s theory, originally intended to explain price formation in specific markets, was incorporated into an economy-wide, dynamic general equilibrium model by Robert Lucas. According to Lucas, economic agents form their expectations of the future with full knowledge of all economic relations and using all available information. Based on these expectations they maximize their utility over their lifetime. With his work Lucas not only solved Hicks’s problem of imperfect information but also challenged established Keynesian macroeconomics. He argued that robust economic predictions could be made only with models founded in microeconomic theory because macroeconomic relations observed in the past were unstable over time.Lucas‘s challenge to Keynesian macroeconomics went down in the history of economics as the "Lucas Critique." Economic agents would change their behavior in response to economic policy. For instance, the famous relationship between unemployment and inflation proposed by the Phillips Curve would go up in smoke once people realized that the gains in purchasing power afforded by higher nominal wages were subsequently eroded by higher inflation.
Eugene Fama applied the concept of rational expectations to financial markets and hypothesized that financial prices contained all available information. At a minimum, it should not be possible to use past prices to predict future prices, and at best there would be no difference between market prices and fair prices of financial assets (Fama 1970). Thus, if markets are “weakly efficient,” future prices cannot be predicted on the basis of past prices. Already this rather restrained statement contradicts the theory of adaptive expectations, which assumes that past prices contain valuable information for future prices. Markets are “semi-strongly efficient” when prices reflect all publicly available information. In this case, forecasting on the basis of past price movements as well as by considering new publicly available information is impossible. Finally, Fama classifies markets as “strongly efficient” when prices not only reflect all relevant public information but also proprietary insider knowledge. In this case, market prices and fair values of assets would be identical.
Rational expectations theory and the efficient markets hypothesis (EMH) were not only very successful academically—Robert Lucas and Eugene Fama were both awarded Nobel Memorial Prizes for their work—but also highly influential in business and politics. EMH provided the theoretical foundation for “passive investing” through index funds. If no single fund manager could reliably beat the market, why pay fees for active portfolio management? Greater returns could surely be obtained by investing in the entire market at lower costs. And EMH also had a strong influence on government policies. If the market always knew best, why let government bureaucrats regulate it? “Light” regulation was in this case surely better than heavy-handed intervention.
However, Ricardo Campos Dias de Sousa and David Howden (2015), among others, have shown that EMH suffers from logical contradictions. If, as it stipulates, all market participants have all relevant information and interpret it in the same way, all would agree on a price and there would be no incentive to sell or buy. On the other hand, if only a sufficiently critical mass of market participants interpreted relevant information in the same way, transactions could take place, but the price allowing this transaction would be seen as efficient by one and inefficient by the other group. Thus, “efficient prices for one group requires inefficient prices in the eyes of the other” (Campos Dias de Sousa and Howden 2015, 396).
Rational expectations theory and EMH suffered their first practical setback in the early 2000s, when the “technology stock bubble” burst. Apparently market participants were not just cool-headed homines oeconomici but could get carried away by emotions. The experience gave a big boost to behavioral economics and finance. Until that point, behavioral economics had largely been an experimental science confined to the laboratories of a few universities—its key protagonists, Daniel Kahnemann and Amos Tversky, were Israeli psychologists. US economist Robert Shiller (2000) applied behavioral economics to finance, publishing a book in which he diagnosed the wild rally of technology stocks towards the end of the 1990s as a bubble just as it was peaking. Not least because of the excellent timing of the release of his book, a serious challenge to the EMH had emerged in science and financial business.
Rational expectations and EMH suffered another setback with the Great Financial Crisis of 2007–08. The systematic mispricing of risk, which became apparent when the credit bubble burst, was inconsistent with the idea that people would base their financial decisions on all available information and with a full knowledge of the true “economic model.” Obviously people in the credit markets had based their actions on inadequate information and a false economic model that indicated risk reduction through asset pooling when risks in fact accumulated as a growing number of people acted on this model.
Despite its obvious failure, EMH has remained the predominant theory of market behavior in academics and large parts of the business world simply because there has been no other theory in mainstream economics to displace it.The confusion in academics about how markets work became evident with the awarding of the 2013 Nobel Memorial Prize to both Eugene Fama and Robert Shiller. In 2017, however, the US financial economist Andrew Lo came up with another challenger to EMH. Conscious of the difficulty of dethroning a theory taught widely at universities and perhaps with the ambition to follow in the footsteps of Nobel Prize winners Fama and Shiller, he named his theory the adaptive market hypothesis (AMH) (Lo 2017).
Lo’s intention was not to scrap EMH entirely, but to restrict its validity to times of continuous market development. During those times people act rationally, based on a wide knowledge of facts and a good understanding of the valid economic model. But when markets are disrupted for whatever reason, people turn from rational analysis to instinctive behavior. They join others in either rushing into markets for fear of missing out or fleeing them for fear of losing their fortunes. Lo (2017, 188) summarizes his theory in five key principles:
We are neither always rational nor irrational, but we are biological entities whose features and behaviors are shaped by the forces of evolution.We display behavioral biases and make apparently suboptimal decisions, but we can learn from past experience and revise our heuristics in response to negative feedback.We have the capacity for abstract thinking, specifically forward-looking what-if analysis; predictions about the future based on past experience; and preparations for changes in our environment. This is evolution at the speed of thought, which is different from but related to biological evolution.Financial market dynamics are driven by our interactions as we behave, learn, and adapt to each other, and to social, cultural, political, economic, and natural environments in which we live.Survival is the ultimate force driving competition, innovation, and adaptation. Thus, during normal market conditions reward increases with risk. But at times of negative disruption people may shun risks irrespectively of the associated reward. The Capital Asset Pricing Model may work in normal times but fail in other market environments. Similarly, portfolio optimization according to Markowitz may work in good times but fail in bad times. When there is contagion among different markets, asset diversification may no longer reduce risk (Lo 2017, 282).
Lo’s AMH is an intriguing effort to overcome the contradiction between EMH and behavioral finance and connect them by making them state dependent. However, why should “rationally” acting professional investors suddenly turn “irrational” in market downturns, and why should “irrationally” acting retail investors suddenly turn “rational” in normal markets? And why do environments change from “normal” and continuous to “abnormal” and discontinuous? Perhaps we can get a better idea of how markets behave when we study more closely the way that market participants process information.Lo’s auxiliary assumption of shifting market environments to retain the EMH could be interpreted, in Lakatos’s (1976) words, as a “degenerative problem shift” in a descending research program (see below).
A SUBJECTIVE THEORY OF PRICE AND EXPECTATIONS FORMATION Like Hicks, Austrian economists in the tradition of Carl Menger and Eugen von Böhm-Bawerk acknowledged that people act with imperfect knowledge. However, these economists claimed that although prices realized in transactions may not equilibrate potentially available supply and demand they always cleared the market (in the sense that actual supply matches actual demand). The early Austrian economists introduced real-world outcomes as “points of rest” (Menger) or “momentary equilibria” (Böhm-Bawerk), where market exchanges are carried out without the adjustment of buyers´ and sellers´ preferences (Klein 2008, 172). Mises coined the term plain state of rest (PSR) as opposed to the imaginary construct of the final state of rest (FSR) (where all supply equals all demand). He explains: “When the stock market closes, the brokers have carried out all orders which could be executed at the market price. Only those potential sellers and buyers who consider the market prices too low or too high respectively have not sold or bought” (Mises 1949, 245). As an analytical tool, the FSR serves as a hypothetical scenario in which basic data of the market are frozen and market participants have perfect information and knowledge. In the FSR all feasible gains from trade are exhausted (Klein 2008, 173). But in reality the FSR never materializes, because market participants have imperfect knowledge that they continuously seek to improve. Thus, during the market process entrepreneurs shuffle and reshuffle resources and capital combinations in response to new knowledge to take advantage of profit opportunities and avoid losses (Salerno 2006). Hence, realized prices generally can be characterized as representing an “equilibrium with error” (Manish 2014). Since the errors of actors with superior knowledge are smaller than those of others, their profits from transactions are larger. As more profitable actors attract more capital at others’ expense, their influence on the exchange process increases. Thus, competition improves the functioning of markets and the economy at large.
Without perfect information and knowledge about the workings of the economy, prices are based on expectations, which are derived from the subjective interpretation of information (Manish 2017). Mises points out: “As action necessarily is directed toward influencing a future state of affairs, even if sometimes only the immediate future of the next instant, it is affected by every incorrectly anticipated change in the data occurring in the period of time between its beginning and the end of the period for which it aimed to provide” (Mises [1949] 1998, 253) From this it follows, according to Mises (1962), that “Every action is a speculation, i.e. guided by a definite opinion concerning the uncertain conditions of the future.” That is—in short—expectations. Thus, expectations “form a crucial component of every act” (Manish 2007, 209). The knowledge used to form expectations is somewhat different in each individual mind, because it reflects the individual’s experience and the specific and unique ability to collect and interpret information. The knowledge is often implicit. Actors may not be able to articulate it, and it certainly cannot be objectively measured. Mises coined the term thymology to describe a method that allows historians to “understand” a complex historical event (Mises [1985] 2007). In the same way that historians look into the past, market participants look into the future. This means that just as thymological experience serves as the basis for the historian´s interpretative understanding of past events (so far as they depend on social and not natural causes), it also conditions the actor's “specific understanding of future events” (Salerno 1995, 309).
After the Austrian revival in the 1970s, debates about expectations and the market process’s possible convergence towards equilibrium took on a central role. For Lachmann (1976), expectations are radically subjective and as such radically unpredictable. In consequence, he states: “Expectations must be regarded as autonomous, as autonomous as human preferences are” (Lachmann 1976, 130). This radicality has been criticized as nihilistic (Hülsmann 1997, 25). Of course, experience-based knowledge is fundamentally different from experimentally established facts of the natural sciences, but it is still real knowledge (Salerno 1995, 312). As Mises puts it: “To know the future reactions of other people is the first task of acting man.” (Mises [1985] 2007, 311). Kirzner (1973) argued that the alertness of entrepreneurs for profit opportunities leads to a general systematic tendency toward equilibration.
Thus, the market is in a state of continuous disequilibrium but moving toward an equilibrium. Although Mises sees a theoretical final state of equilibrium resulting from the exploitation of profit opportunities from disequilibria by capable entrepreneurs (see above), in reality continuously emerging new facts are changing this equilibrium so that it can never be attained.
THE DISCOVERING MARKETS HYPOTHESIS In order to shed more light on the formation of expectations, subjective expectations theory will be extended by including two further observations: (i) The subjective reception of complex contents is communicated in narratives, and (ii) shared narratives shape prices and are shaped by them.
The Role of Narratives
Before they act, individuals communicate with each other to cross-check their subjective knowledge against the knowledge of others. Complex knowledge is difficult to communicate. When expressed in the form of narratives it is easier to “get across ideas” (Shiller 2017). Robert Shiller has launched a research program (dubbed ”narrative economics”) to study the influence of popular narratives on seminal events such as the depression of 1920–21 or the Great Depression of the 1930s (Shiller 2019). Among other things he has found that narratives can spread like epidemics and influence people’s behavior, which can feed back into the narratives. While Shiller traces the effects of “big” narratives on historical economic developments, the focus of this text is on the effect of “narrow” narratives on financial market prices. As market participants share narratives and act on them in the market, prices move. In turn, the movement of prices feeds back into the narratives. The legendary stock market trader Jesse Livermore (alias Larry Livingston) explains in the classic book Reminiscences of a Stock Operator: “Observation, experience, memory and mathematics—these are what the successful trader must depend on…He must bet always on probabilities—that is, try to anticipate them,” (Lefevre 1922, 416).
Battles of Narratives
Shiller explains the emergence and disappearance of narratives in terms of contagion and recuperation. This can be well applied to “big” narratives evolving and fading with time. The “small” narratives in financial markets, however, do not die of old age but are replaced by other “small” narratives. To understand how new narratives replace existing ones in financial markets, we recur to the theory of scientific revolutions developed by Thomas Kuhn (1970). He argues that scientific knowledge normally increases around a widely accepted paradigm. In normal times, the paradigm itself is not challenged but is fleshed out more by new insights. However, when a critical mass of new facts emerges that is inconsistent with the ruling paradigm a scientific revolution may occur. Previously widely shared and accepted beliefs are questioned and overturned. Uncertainty and confusion may reign until a new paradigm is found that better explains the new facts. After a turbulent period (“extraordinary science”), scientific work returns to its normal state of work (“ordinary science”).
Imre Lakatos (1976) speaks of research programs that have a paradigm at their core. According to him, however, the paradigm shift is not abrupt, but a tough struggle between the defenders of the old paradigm in the old research programs and the challengers who question it. When new facts put pressure on a paradigm, defenders find supporting auxiliary hypotheses to save it, but the original core of the paradigm is weakening. Lakatos calls this “degenerative problem shift.” The challengers, on the other hand, find new explanations for the facts and develop a theory with a higher explanatory value. This leads to a “progressive problem shift.” In contrast to Kuhn, who combines paradigm shifts with radical breaks, Lakatos sees continuous gains in knowledge through the problem shifts in research programs.
The insights of Kuhn and Lakatos into the creation of new scientific knowledge are valuable guides for understanding the effects of the emergence of new knowledge in the market. Participants acting on a new shared narrative influence market prices. For some time, there may be a battle of the ruling and the new narratives. The new narrative may change or bear new narratives during this battle. And eventually the argument will be settled, and a new narrative will rule until the process begins anew. It is possible that the battle of narratives is intense and the victory of the new one absolute, as Kuhn has described the revolutionary paradigm change in science, or that it is drawn out and the new narrative displaces the old one gradually, as Lakatos has argued.
Continuity and Discontinuity in Price Discovery
When knowledge improves incrementally narratives change only little and the process of price discovery proceeds gradually. Financial markets are then characterized by relatively small spreads between offer and demand prices (or “bid-ask spreads”) for securities and by moderate price volatility. This notwithstanding, market clearing prices are being found through a process of trial and error and may move around until all participants agree on the price that best reflects their shared narrative. A market “equilibrium with error” (or “plain state of rest” according to Mises [1949] 1998)At the “plain state of rest” markets are cleared, but not necessarily in an equilibrium free of all market participant error. This is the “final state of rest,” towards which the market is pushed by competition but which may never be reached in reality. has then been established, only we don’t see much of these movements.
One way to illustrate the search process for a market clearing price is the old-fashioned cobweb model shown in Figure 1. The suppliers want to supply quantity Q0 at price P0. However, the price they get when they offer Q0 is much lower than P0. Consequently, many cut their offer so that supply now falls below demand. Excess demand brings suppliers back into the market, but at the new price there is excess supply. They cut back again, only to face excess demand again. The process of trial and error continues until the market clearing price is found.
Figure 1. Finding the Market Clearing Price in a Cobweb[[{"fid":"90046","view_mode":"image_no_caption","fields":{"format":"image_no_caption","alignment":"left","field_file_image_alt_text[und][0][value]":"Market Clearing Price","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""},"type":"media","field_deltas":{"3":{"format":"image_no_caption","alignment":"left","field_file_image_alt_text[und][0][value]":"Market Clearing Price","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""}},"attributes":{"alt":"Market Clearing Price","class":"media-element file-image-no-caption media-wysiwyg-align-left","data-delta":"3"}}]]
In this graph, the market clearing price is found, because the supply curve is more elastic than the demand curve. In consequence, suppliers adjust their prices by large amounts in response to excess supply or demand. But what if suppliers react less and demanders more elastically to excess supply and demand than before? In this case, excess demand and supply grow with each step and a market clearing price cannot be found (Figure 2). This is, incidentally, also true when both sides react with the same elasticity.
Figure 2. Searching for the Market Clearing Price in Vain in a Cobweb[[{"fid":"90048","view_mode":"image_no_caption","fields":{"format":"image_no_caption","alignment":"left","field_file_image_alt_text[und][0][value]":"Market Clearing Price","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""},"type":"media","field_deltas":{"4":{"format":"image_no_caption","alignment":"left","field_file_image_alt_text[und][0][value]":"Market Clearing Price","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""}},"attributes":{"alt":"Market Clearing Price","class":"media-element file-image-no-caption media-wysiwyg-align-left","data-delta":"4"}}]]
Let’s now assume that the combination of a fairly inelastic demand with an elastic supply curve characterizes a market where the demanders represent the “wisdom of the crowd” in the eyes of suppliers. This is how people intending to sell securities probably would look at the market. They would adjust their intentions relatively strongly in response to the feedback they get from the market. This is how markets normally behave, when most people share similar knowledge about market circumstances. New knowledge emerges gradually, and prices converge to clear the market.
However, when new and disturbing knowledge drops like a bombshell into the market there will probably be determined (or even forced) sellers in the market and many demanders will be very unsure about what to make of this. In this case, the demanders overreact to sales by the suppliers, and the suppliers in turn underreact to the demand changes by the demanders. No new equilibrium can be found. Bid-ask spreads widen and price volatility increases, because suppliers and demanders are out of synch with each other. Only when the new knowledge has been absorbed and evaluated by everyone can the market return to its “normal” mode of operation.
Battles of Narratives and Fractal Geometry
Can we identify patterns in the emergence of gradual and revolutionary new narratives in the markets? Fractal geometry, developed by the mathematician Benoit Mandelbrot, may help (Mandelbrot and Hudson 2004). According to Mandelbrot smoothness and roughness alternate in nature and financial markets. There are long periods when little happens and short periods of high turbulence. To borrow from Kuhn, markets are calm when an accepted narrative is not seriously challenged, and they experience heavy turbulence when an accepted narrative is overturned by a radically new one. Or, to borrow from Lakatos, markets shift as new narratives gradually displace old ones. We call the evolution of prices in response to the spread of narratives the discovering markets hypothesis (DMH).
AMH and DMH Compared
Although Lo’s adaptive markets hypothesis and the DMH start with the same insight that markets may alternate between continuity and discontinuity, there are important differences. First, AMH takes the change in states as given while DMH explains it as the way in which knowledge emerges and spreads in the form of narratives. Second, AMH assumes schizophrenic minds in market participants and employs psychology to explain alternating behavior while DMH assumes psychologically stable market participants who act continuously and consistently—in a subjectively rational way. By focusing on the process of augmenting subjective knowledge in a battle of narratives, DMH provides a more consistent framework for analyzing and predicting market behavior.
EMPIRICAL SUPPORT FOR THE DMH Can we relate market price movements to the emergence of new facts and the spread of new narratives? In this section, DMH is applied to explain a few highly visible market movements, although this does not constitute a test of the theory in the spirit of Karl Popper, in which researchers aim to establish a numerically quantified causal relationship between exogenous and endogenous variables. In view of the complexity of the object of research, F. A. von Hayek’s (1974) “pattern recognition” method is employed. Hayek has argued that numerical predictions based on causal relationships between endogenous and exogenous variables are less reliable the more complex the system to which these variables belong is. The complexity of social systems in particular is such that the establishment of causal relationships between variables and their quantification are next to impossible. But this does not mean that falsifiable hypotheses cannot be created and that predictions are unable to be made (Hayek 1974).
Applying Hayek’s theory to the analysis of markets, it is possible to establish whether or not the DMH can explain the pattern of market price movements. What cannot be expected is to find a theory with which market outcomes can be predicted. Below a number of cases in which existing narratives were suddenly overturned by new ones (cases 1–2) is examined. This is followed by a study of two cases in which new narratives emerged after a battle of narratives (cases 3–4). A look at two cases in which the narrative shifted more gradually (cases 5–6) concludes the analysis.
Case 1: Diesel Shock
On September 22, 2015, the German car company Volkswagen AG (VW) published a profit warning acknowledging that Diesel engines had been manipulated so as to disguise the true level of NO2 exhaust. As Chart 1 shows, this attracted a lot of public attention and news coverage of Volkswagen surged (measured by the number of queries including the term “Volkswagen,” Chart 1).
Chart 1. News Concerning “Volkswagen,” 2014–19[[{"fid":"90043","view_mode":"image_no_caption","fields":{"format":"image_no_caption","alignment":"left","field_file_image_alt_text[und][0][value]":"Volkswagen","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""},"type":"media","field_deltas":{"5":{"format":"image_no_caption","alignment":"left","field_file_image_alt_text[und][0][value]":"Volkswagen","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""}},"attributes":{"alt":"Volkswagen","class":"media-element file-image-no-caption media-wysiwyg-align-left","data-delta":"5"}}]]
Source: Bloomberg, Google Trends, Flossbach von Storch Research Institute. The share price plunged on the news and then moved along with other share prices represented by the DAX30 stock market index (Chart 2). The observed share price movement is consistent with one-off repricing in response to unexpected news as postulated by the efficient markets hypothesis. It is also consistent with a radical shift of the narrative about the profitability of Volkswagen. From the analysis of the share price development, it is not evident which theory gives a better explanation of the observed pattern.
Chart 2. VW Shares Compared to the DAX30 Equity Price Index, 2015–19 (100 = 01.06.2015)[[{"fid":"90050","view_mode":"image_no_caption","fields":{"format":"image_no_caption","alignment":"","field_file_image_alt_text[und][0][value]":"Volkswagen","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""},"type":"media","field_deltas":{"7":{"format":"image_no_caption","alignment":"","field_file_image_alt_text[und][0][value]":"Volkswagen","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""}},"attributes":{"alt":"Volkswagen","style":"float: left;","class":"media-element file-image-no-caption","data-delta":"7"}}]]
Source: Bloomberg, Flossbach von Storch Research Institute. However, things become clearer by looking at a corporate bond of the company. Until the release of the news the bond fluctuated around the bond price index iBOXX (Chart 3). In response to the release the price plunged in a way similar to the movement of the share price (though somewhat less) and volatility increased. Both markets seemed to follow the same narrative. Thereafter, however, the price of the bond recovered and returned to the level of the bond price index while volatility declined again. The narrative of a company in deep trouble was superseded by the narrative that the company would survive and creditors were fairly safe. If the market was “efficient,” the bond price should have reacted much more calmly than the stock price. But market participants needed to digest the news and differentiate the new narrative in the stock market from that in the bond market before prices in both markets settled.
Chart 3. Price of VW 4.625 Percent Perpetual Bond and iBOXX, 2015–19[[{"fid":"90051","view_mode":"image_no_caption","fields":{"format":"image_no_caption","alignment":"left","field_file_image_alt_text[und][0][value]":"Volkswagen","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""},"type":"media","field_deltas":{"8":{"format":"image_no_caption","alignment":"left","field_file_image_alt_text[und][0][value]":"Volkswagen","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""}},"attributes":{"alt":"Volkswagen","class":"media-element file-image-no-caption media-wysiwyg-align-left","data-delta":"8"}}]]
Source: Bloomberg, Flossbach von Storch Research Institute. Likewise, the cost of insuring Volkswagen debt against default rose significantly (Chart 4) in September 2015, but it fluctuated at a lower level in the aftermath of the crisis outbreak.
Chart 4. Price of a Credit Default Swap for Volkswagen (in Basis Points), 2015–18[[{"fid":"90052","view_mode":"image_no_caption","fields":{"format":"image_no_caption","alignment":"left","field_file_image_alt_text[und][0][value]":"Volkswagen","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""},"type":"media","field_deltas":{"9":{"format":"image_no_caption","alignment":"left","field_file_image_alt_text[und][0][value]":"Volkswagen","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""}},"attributes":{"alt":"Volkswagen","class":"media-element file-image-no-caption media-wysiwyg-align-left","data-delta":"9"}}]]
Source: Bloomberg, Flossbach von Storch Research Institute. Case 2: Brexit
On June 23, 2016, for many people unexpectedly, the British people voted in favor of the country’s exit from the European Union. Unsurprisingly, news coverage surged (Chart 5). The exchange rate of sterling against the US dollar took a dive and volatility surged (Chart 6). Following the nosedive, the exchange rate of sterling continued to weaken as it had done before the unexpected news. After some time, however, the initial shock faded and the exchange rate recovered part of the lost ground. Volatility also fell, suggesting that the initially high level of uncertainty gave way to a more stable pattern of views. The observed pattern is consistent with a weakening of the new Brexit narrative over time. As the debate about the terms of Brexit dragged on and the eventual outcome became ever more obscure, the exchange rate flattened. The confusion prevented any narrative from dominating the market.
Chart 5. News Concerning “Brexit,” 2014–19[[{"fid":"90053","view_mode":"image_no_caption","fields":{"format":"image_no_caption","alignment":"left","field_file_image_alt_text[und][0][value]":"Brexit","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""},"type":"media","field_deltas":{"10":{"format":"image_no_caption","alignment":"left","field_file_image_alt_text[und][0][value]":"Brexit","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""}},"attributes":{"alt":"Brexit","class":"media-element file-image-no-caption media-wysiwyg-align-left","data-delta":"10"}}]]
Source: Bloomberg, Google Trends, Flossbach von Storch Research Institute. Chart 6. Price Quotation USD/GBP and Volatility, 2014–19[[{"fid":"90055","view_mode":"image_no_caption","fields":{"format":"image_no_caption","alignment":"left","field_file_image_alt_text[und][0][value]":"Brexit Prices Currency Pound Dollar","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""},"type":"media","field_deltas":{"11":{"format":"image_no_caption","alignment":"left","field_file_image_alt_text[und][0][value]":"Brexit Prices Currency Pound Dollar","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""}},"attributes":{"alt":"Brexit Prices Currency Pound Dollar","class":"media-element file-image-no-caption media-wysiwyg-align-left","data-delta":"11"}}]]
Source: Bloomberg, Flossbach von Storch Research Institute. Case 3: Eurocrisis
Following Greece’s debt restructuring in early 2012 markets moved their focus to Italy. While the Greek debt crisis had posed only a limited threat to the survival of the euro an Italian debt crisis could spell its end. Hence, news reports mentioning a “euro crisis” increased (Chart 7). At the same time, Italian bond yields rose (Chart 8). On July 26, 2012, however, European Central Bank President Draghi said that the ECB would do “whatever it takes” to protect the euro. As a result, the Italian bond yields plunged. However, it took the rest of the year for the new narrative of the ECB’s survival guarantee to find its way fully into market prices. The pattern observed here is consistent with a new narrative (“whatever it takes”) replacing an old one (“euro crisis”) in the market.
Chart 7. News Concerning the “Euro Crisis,” 2004–18[[{"fid":"90057","view_mode":"image_no_caption","fields":{"format":"image_no_caption","alignment":"left","field_file_image_alt_text[und][0][value]":"Euro Crisis","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""},"type":"media","field_deltas":{"12":{"format":"image_no_caption","alignment":"left","field_file_image_alt_text[und][0][value]":"Euro Crisis","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""}},"attributes":{"alt":"Euro Crisis","class":"media-element file-image-no-caption media-wysiwyg-align-left","data-delta":"12"}}]]
Source: Bloomberg, Google Trends, Flossbach von Storch Research Institute. Chart 8. Ten-Year Italian Government Bond Yields, 2004–13[[{"fid":"90059","view_mode":"image_no_caption","fields":{"format":"image_no_caption","alignment":"left","field_file_image_alt_text[und][0][value]":"Italian Bonds","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""},"type":"media","field_deltas":{"13":{"format":"image_no_caption","alignment":"left","field_file_image_alt_text[und][0][value]":"Italian Bonds","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""}},"attributes":{"alt":"Italian Bonds","class":"media-element file-image-no-caption media-wysiwyg-align-left","data-delta":"13"}}]]
Source: Bloomberg, Flossbach von Storch Research Institute. Case 4: Subprime Crisis
In early 2007 defaults in a segment of the US mortgage market—called “subprime”—received public attention. Initially the events were described as problems caused by the mis-selling of mortgages to financially weak debtors and hence as a limited problem in a relatively small market segment (Chart 9). Money markets in the US and Europe were affected as banks lost trust in each other’s solvency, but the stock market remained calm (Chart 10). The narrative changed with the default of Lehman Brothers, causing news on the subject to surge again (Chart 9). Through the remainder of the year and into 2009 stock prices fell and volatility increased. However, by the end of the first quarter of 2009 the crisis narrative had weakened sufficiently to be superseded by a more positive one, first along the lines of “the worst is over” and then of the recovery beginning. The fear of missing out by sticking to the old narrative was a key motivation in the skeptics becoming optimistic.
Chart 9. News Concerning “Subprime,” 2005–18[[{"fid":"90061","view_mode":"image_no_caption","fields":{"format":"image_no_caption","alignment":"left","field_file_image_alt_text[und][0][value]":"Subprime Crisis","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""},"type":"media","field_deltas":{"14":{"format":"image_no_caption","alignment":"left","field_file_image_alt_text[und][0][value]":"Subprime Crisis","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""}},"attributes":{"alt":"Subprime Crisis","class":"media-element file-image-no-caption media-wysiwyg-align-left","data-delta":"14"}}]]
Source: Bloomberg, Google Trends, Flossbach von Storch Research Institute. Chart 10. S&P 500 Price and Historical Volatility, 2006–09[[{"fid":"90062","view_mode":"image_no_caption","fields":{"format":"image_no_caption","alignment":"left","field_file_image_alt_text[und][0][value]":"SP500","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""},"type":"media","field_deltas":{"15":{"format":"image_no_caption","alignment":"left","field_file_image_alt_text[und][0][value]":"SP500","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""}},"attributes":{"alt":"SP500","class":"media-element file-image-no-caption media-wysiwyg-align-left","data-delta":"15"}}]]
Source: Bloomberg, Google, Flossbach von Storch Research Institute. Case 5: Recession
Although during the Great Recession of 2007/08 money markets were already experiencing severe tensions as of mid-2007, recession fears in the US gained momentum only in August 2007 and peaked in December 2007 (as measured by the number of queries for the word “recession” on Google and Bloomberg, Chart 11). Fears subsided during the first half of 2008 but surged again in August 2008, peaking in October 2008, one month after the bankruptcy of Lehman Brothers. Recession fears eased again during the second quarter of 2009.
The absolute peak of Google recession queries in the observation period occurred just at the beginning of the recession in the US in the first quarter of 2008. The return to a more normal level of recession fears in mid-2009 coincided with the (later proclaimed) official end of recession in the US. At the beginning of 2008 the stock market (as measured by the S&P 500 price index) broke below its 2007 trading range but remained in this range until the end of August. Only after the news of the Lehman bankruptcy on September 15 did stock prices plunge. They reached a nadir in early March 2009, coinciding with the easing of recession fears (measured by the number of Google and Bloomberg queries).
Chart 11. News Concerning “Recession” and Year-on-Year Percent Change of S&P 500 (Inverted)[[{"fid":"90064","view_mode":"image_no_caption","fields":{"format":"image_no_caption","alignment":"left","field_file_image_alt_text[und][0][value]":"SP500 Recession","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""},"type":"media","field_deltas":{"18":{"format":"image_no_caption","alignment":"left","field_file_image_alt_text[und][0][value]":"SP500 Recession","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""}},"attributes":{"alt":"SP500 Recession","class":"media-element file-image-no-caption media-wysiwyg-align-left","data-delta":"18"}}]]
Source: Bloomberg, Google Trends, Flossbach von Storch Research Institute. Case 6: Austrian Economics
Conventional New Keynesian economists had not seen the financial crisis and recession coming. This created renewed interest in the explanation of credit and investment cycles in Austrian economics, an explanation which became a narrative of its own. Chart 12 shows queries for “Austrian economics” worldwide. Queries surged in October 2008, the month after Lehman Brothers’s bankruptcy. They jumped to an even higher level in January 2012, when fears rose that Italy would crash out of the European Monetary Union (EMU). As central banks flooded the banking sector with money and Mario Draghi, president of the ECB, effectively guaranteed the existence of the EMU by promising to do “whatever it takes” to preserve the euro, the narrative of “Austrian economics” lost some of its attraction. Past experience suggests that interest will increase again when the financial system comes under renewed pressure in the next economic downturn.
Chart 12. Queries for “Austrian Economics”[[{"fid":"90065","view_mode":"image_no_caption","fields":{"format":"image_no_caption","alignment":"left","field_file_image_alt_text[und][0][value]":"Austrian Economics","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""},"type":"media","field_deltas":{"17":{"format":"image_no_caption","alignment":"left","field_file_image_alt_text[und][0][value]":"Austrian Economics","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""}},"attributes":{"alt":"Austrian Economics","class":"media-element file-image-no-caption media-wysiwyg-align-left","data-delta":"17"}}]]
Source: Google Trends. PATTERN PREDICTIONS WITH THE DMH Having found the DMH to explain the pattern of market movements as a competition between different narratives, its use in making “pattern predictions” can now be discussed. Hayek uses the example of a ball game to illustrate what can and cannot be predicted: if we knew precisely the skills and fitness of the opposing teams in addition to the rules of the game, we should in principle be able to predict the outcome with a relatively high degree of certainty. However, the closer the teams come in skills and fitness, the greater will be the role of chance in determining the outcome (Hayek 1974).
The legendary German coach Sepp Herberger once said: “People go to soccer games because they don’t know how the game ends.” In reality, no one has precise information about the skills and fitness of the players at the time of the game, so that not only pure chance but also a lack of information will prevent a reliable anticipation of the outcome. Nevertheless, knowing the rules of the game helps observers focus their attention on what is important to the result. Moreover, as people observe the game they acquire more information about players’ ability and can improve their prediction of the outcome. It is obviously easier to correctly predict the result of a soccer match at halftime than at the beginning, but even then a lot of uncertainty remains.
All this implies that one should not expect to be able to predict market outcomes. But by understanding how markets move we can better focus on what is important to the outcome. Observation of the important drivers of market developments can then help us narrow down the possible range of outcomes. Specifically, the discovering markets hypothesis suggests that we focus on how new facts influence narratives, which shape prices and are themselves reshaped by them. By identifying narratives shared by a large number of people and by finding out whether they are ascending or descending, we may be able to assess the persistence of market price movements. In some cases, narratives that precede price movements may even be identifiable. This is illustrated in Figure 3.
Figure 3. Formation of Prices[[{"fid":"90068","view_mode":"image_no_caption","fields":{"format":"image_no_caption","alignment":"left","field_file_image_alt_text[und][0][value]":"Price Formation","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""},"type":"media","field_deltas":{"19":{"format":"image_no_caption","alignment":"left","field_file_image_alt_text[und][0][value]":"Price Formation","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""}},"attributes":{"alt":"Price Formation","class":"media-element file-image-no-caption media-wysiwyg-align-left","data-delta":"19"}}]]
Facts create subjective knowledge, which may induce financial market participants to act. More likely, however, they will exchange this knowledge with other participants with a view to identifying shared narratives, which have a more powerful influence on prices than individual action does.
SUMMARY AND CONCLUSION Expectations of the future shape the movement of prices, which clear markets, although not necessarily at the point where potential supply is equal to potential demand. This paper followed the argument of Lachmann and Mises that market participants form their expectations on the basis of their ability to collect information and interpret it. In keeping with Shiller, it was observed that market participants tend to communicate their views about the future in the form of narratives and that they learn by listening to the narratives of others. Narratives compete, and winners emerge by knocking out or gradually wrestling down competitors. Winning narratives shape market prices until the facts confirm their victory or until they are discredited by the facts and replaced by new narratives. When we understand how market prices form we can predict the way they adjust to changing economic conditions.
Could artificial intelligence and machine learning replace human actors in financial markets? Those who believe in more mechanical models of expectations—assuming “rational,” “irrational,” or state-dependent “rational/irrational” behavior—may be inclined to say yes. However, if market participants indeed act subjectively rationally and interdependently based on proprietary knowledge accumulated through experience and incomplete information transmitted through narratives—as described in the discovering markets hypothesis—the hurdle to clear for artificial intelligence to beat human intelligence seems fairly high.
Although the money supply has greatly increased, accompanying growth in production has it possible to keep the current system of immense debt increase going for a long time.
This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Millian Quinteros.
Original Article: "Decades of Productivity Gains Have Made Our Debt Bomb Manageable (For Now)"
We dive into Part Four of Human Action with Professor Jeffrey Herbener, Chair of the Economics Department at Grove City College.
This is a fantastic discussion of money and market exchange, with Mises proving timely as ever given the current financial meltdown and crazed response from Washington. Dr. Herbener and Jeff Deist cover catallactics and how imaginary constructs help us understand basic economics; markets as a system of social cooperation; how ordinal preferences find expression in money prices; the structure of production; consumer sovereignty; Mises's conception of monopoly; and the various media of exchange which complicate what ought to be the market's provision of commodity money.
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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.
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Bob Murphy's Study Guide to Human Action: Mises.org/Study
Abstract: Abstract: This paper analyzes Brazil’s 2004–16 business cycle, which subsumes what is now regarded as the nation’s most severe macroeconomic recession in more than a century. During the steep recession, which stretched over more than two years, national production at one point fell 3.8 percent per annum while the unemployment rate rose from 4.6 to as high as 11.9 percent. This study, after delineating its methodology, examines the behavior of different Brazilian macroeconomic aggregates during the cycle. These aggregates include GDP, the money supply, interest rates, savings, industrial production of higher- and lower-order goods, and inflation. Also examined are the Brazilian government’s interventions that rearranged Brazil’s structure of production and ignited an unsustainable boom, the role of price controls in prolonging economic recovery, and the recovery per se using the theoretical lens of the Austrian-adjustment process. Finally, empirical data from the recent Brazilian cycle will be analyzed in light of the predictions of Austrian business cycle theory (ABCT). The data were found overall to support the theory.
central bank price controls monetary policy business cycle brazil JEL Classification: E14, E21, E31, E32, E51, E52 Henrique Lyra Maia (henriquelyramaia@gmail.com) is a doctoral student at FUCAPE Business School (Vitoria, Brazil). Dale Steinreich (dsteinreich@drury.edu) is an instructor of economics at Drury University. Bruno Saboia de Albuquerque (brunosaboia@alu.ufc.br) is a researcher in economics at Universidade Federal do Ceará.
The authors wish to thank the Grant Aldrich Committee of the Austrian Economics Research Conference (AERC) 2018 for making an earlier version of this paper a Grant-Aldrich Prize finalist, and Timothy D. Terrell, Joseph T. Salerno, Robert Barclay, and two anonymous referees for their encouragement and guidance.
I. INTRODUCTION It has long been recognized in Brazil that the nation’s economy has tremendous difficulty sustaining long-term growth. Brazilian economists jokingly call this “the flight of the chicken,” referring to the fact that among birds, chickens are only capable of flying a maximum distance of a few hundred feet. In the same way, Brazil’s economy typically enters a period of impressive-looking growth before this growth quickly gives way to crisis or stagnation. This has happened over and over again.
The central macroeconomic debate in Brazil has been about the real causes of the nation’s lack of sustained growth. Motivated by this discussion, this article will deconstruct Brazil’s latest economic boom and bust in light of Austrian business cycle theory (ABCT), using ABCT to explain the recent cycle’s causes and why this period became yet another “flight of the chicken.”
The recent crisis carries a special meaning for Brazilians. It is the most severe recession since GDP measurement was introduced in Brazil in 1901. It persisted over two full and consecutive years, inflicting an annual decline in GDP of more than 3 percent.As the recession entered 2017, the authors ended their analysis for this study at December 2016. Subsequent sections in this article will provide deeper analysis of the data discussed in this paragraph. In the boom, the unemployment rate fell to 4.6 percent before skyrocketing to 11.9 percentFor these data, the authors used two different series because one was discontinued in February 2016. For the boom phase, the Central Bank of Brazil’s (Banco Central do Brasil, BCB for short) series number is 10777. The series for the bust phase is 24369. during the bust. This was the most agonizing crisis for Brazilians in at least 115 years (Cury and Silveira 2017).
The most important features of ABCT were first introduced by Mises (2008, 2009), amended with lengthy contributions from Hayek (1931, 1933, 2008), Rothbard (2000, 2009), and Garrison (1978, 1997, 2001, 2004, 2012). Recently, another set of articles was published, each article making new contributions (Carilli and Dempster 2001, Evans and Baxendale 2008, Macovei 2015, Engelhardt 2012, Salerno 2012, Giménez Roche 2014). For Brazil’s economy during the 2004–16 business cycle, data for all the macroeconomic variables relevant to ABCT have been obtained.
This article is divided into nine sections. After this brief introduction (section one), section two will introduce ABCT and its main theorists. Section three will explain the methodological aspects of this study while section four will deconstruct the recent Brazilian cycle into distinct phases for a better understanding of the whole. For the reader, this fourth section is key to interpreting and understanding data presented later in the article. Sections five and six will be dedicated to explaining in detail phase two (“reset” and the New Matrix boom) and phase three (bust) and how government intervention re-arranged Brazil’s structure of production. Section seven will analyze the inflation component of the business cycle and how government price controls postponed Brazil’s recovery. The eighth section will summarize all the results from the data and make some final observations. Finally, the last section (nine) will conclude this study.
II. AUSTRIAN BUSINESS CYCLE THEORY (ABCT) Economic transactions occur when individuals pursue their objectives (Mises 2008, 11). Every individual analyzes the costs and benefits of searching for information and gaining knowledge to achieve his or her goals (Mueller 2014). However, individuals do not possess all the information available in the economy. Each individual only retains the bits of knowledge that he or she uses for his or her own purposes (Hayek 1945).
Considering that economic transactions and knowledge are dispersed, it is difficult to conceive of how markets can act in synchrony over the long term. People have diverse goals and act in different ways. As a consequence, only small clusters of errors are theoretically possible, restricted to relatively few firms (Rothbard 2009, 17). It would be just about impossible for all firms in the entire economy to go bankrupt in unison. In other words, when business cycles—a boom followed by a bust--occur, it is rational to attribute an external variable as the force that is influencing individuals to engage in systemic entrepreneurial error (Rothbard 2000, 9). Hence, in an unhampered market a massive crisis will not be possible (Mises 2008, 562).
Instead of boom and bust, economic development aims for a more sustained growth model. To avoid creating cycles and systemic economic instability, economic transactions must be built upon stronger foundations. There are three major sources of sustainable growth for an economy. The first is increasing levels of voluntary savings from individuals. When true voluntary savings are accumulated, consumer time preferences guide entrepreneurial action towards projects in alignment with consumer preferences (Manish and Powell 2014).
In the aggregate, extra savings reallocates capital that would have been spent on consumption to loanable-funds markets for investment projects (Garrison 1997). With an increase in the supply of loanable funds, the real interest rate falls and more capital projects are undertaken. Capital-intensive projects are very interest-rate sensitive. Many projects can become economically viable when capital becomes cheaper. When this happens, the structure of production changes to a more lengthy (Hayek 1936) and prolific (Hayek 2008) modus operandi. In the long run, the more productive investment in roundaboutThis term is usually used in capital theory to denote a more capital-intensive method of production. Sometimes Hayek also used “capitalistic methods,” “roundaboutness,” or “roundabout methods of production.” These terms are synonymous (Hayek 2008). methods of production will more than compensate for the fall in consumer prices as a consequence of less short-term consumption (Hayek 1931). When a nation invests in capital projects, its production-possibilities frontier is extended and this extension yields a more solid foundation for future growth (Garrison 2012).
When individuals in a nation have not saved enough such that interest rates in loanable-funds markets fall, external savings (foreign-direct investment) can be another route to sustainable growth (Mises 2006, 75). Foreign investors who have the savings to undertake capital projects can fill in the domestic gap in savings needed to initiate or maintain sustainable growth.
The other way to achieve sustainable growth is with more efficient methods of production and intangible capital (Young 2009a). Technology would certainly mean consuming less resources to produce more output, leading the economy to extend its production-possibilities frontier (Garrison 2012). Productivity can lead to sustainable growth because individuals can produce a larger quantity of output with less input, which ultimately increases individuals’ earnings. It is possible for entrepreneurs to engage in new capital projects while consumption is expanding (Mises 2008, 512–13).
Even if time preferences stay constant, with more productivity more money becomes available for entrepreneurs to engage in more projects, leading to sustainable economic growth (Young 2009a, Engelhardt 2009, Young 2009b). Despite the fact that sustainable growth can be created by increasing productivity, if time preferences are not lowered, entrepreneurial projects will encounter limits. In other words, for a longer and more productive structure of production, individuals’ time preferences will have to be lowered (Salerno 2001, Cochran 2001). Higher productivity increases wealth, which in turn can motivate individuals to lower their time preferences (Block, Barnett, and Salerno 2006). However, it might be the case that individuals can spend all their extra earnings and continue to increase their time preferences. As a result, increased productivity can only lead to a fall in interest rates if individuals, with higher earnings, lower their time preferences. The decision by individuals to lower their time preferences after they become more productive is a function of each individual’s preference, not a fact.
If individuals in a given society do not pursue goals that encourage greater savings and/or lower time preferences, stagnation and slow growth are the results. Changing these variables (savings/time preferences) in the direction that facilitates growth takes time and effort. If government intervenes in the form of shortcuts, the economy can be steered onto an unsustainable path (Garrison 2004). Government interventions can take myriad forms and stifle the economic development of a society (Mises 2011).
In terms of monetary policy, business cycles can be formed when government forces interest rates below their natural market level, stimulating artificial development of capital industries (Mises 2008). In addition, consumption will also be stimulated as individuals are incentivized to spend more and save less. When spending on both capital and consumption goods is stimulated by the government, a tug-of-war competition for scarce resources ensues (Garrison 2001).
The first phase of the cycle is the boom that is a result of the dual-stimulus spending on capital and consumer goods. A euphoria of prosperity will prevail (Mises 2011, 564). The new artificially lower interest rate through credit expansion drives GDP growth. Capital and consumer projects are implemented, with the former being more sensitive to interest-rate manipulation and credit expansion. Thus, capital projects begin growing at a higher rate than consumer projects (Hayek 2008).
Eventually the economy does not have all the resources to complete all the projects that are being simultaneously pursued. On the one hand, qualified labor and land are scarce resources and simultaneous competition for them will lead to rising prices in the factors of production (Garrison 2001, 72). On the other hand, capital is also a scarce resource and, when purchased with newly created money, its price rises quickly as well (Mises 2008, 550).
As a consequence of this process, nominal interest rates eventually rise because of future real losses in the value of bank loans because of inflation.This will necessitate the addition of an inflation premium onto the real interest rate to compensate for the fall in the purchasing power of the currency unit. The sum of the real interest rate plus the inflation premium is the nominal interest rate. The expected result is that capital goods will suffer disproportionately from the early reversal of this process (Mises 2008). In addition, the consumer-goods industry will also suffer from the decrease in the purchasing power of money imposed by inflation. A recession will follow and pessimistic expectations in the market will turn projects once deemed profitable into malinvestments (Rothbard 2009, Holcombe 2017). Banks will then tend to impose greater restrictions on lending because of negative expectations for the economy. The result is stagnation or a fall in credit expansion (Mises 2008, 565).
ABCT is concerned with artificially low interest rates driving not only malinvestment, but overconsumption in the inflationary boom portion of the business cycle (Mises 2008, Rothbard 2000, Hayek 2008). Its essence is the falsification of monetary calculation; it is not an overinvestment (“hydraulic”) theory of business cycles as misunderstood by a pantheon of mainstream macroeconomists from Paul Krugman and Brad DeLong to Tyler Cowen and Bryan Caplan (Salerno 2012).
When the inevitable macroeconomic bust arrives, a return to the old conditions begins through gradual market adjustments. The recession is the “healthy” phase in which the economy begins recovering if the government bows out. If the government does not cease its interventions, the recovery will stall and the recession will continue (Rothbard 2009). In summary, the recession phase is characterized by a fall in prices, a rise in the interest rate, consumer thrift, and slow sales for entrepreneurs.
III. METHODOLOGY Economic cycles occur within a period of time and in a specific geographic region. The recent cycle in Brazil occurred in three distinct phases, covering a period of approximately 13 years (2004–16) from boom to bust. GDP was used to provide a general measure of macroeconomic performance. If ABCT explains the boom and bust caused by a cluster of errors (Hülsmann 1998), then those errors will affect GDP positively and negatively during the business cycle. For that reason, the main criteria for distinguishing the cyclical phases were fluctuations in GDP, interest rates, credit expansion, industrial production of consumer and capital goods, and macroeconomic policy enacted by Brazil’s government.
After identifying the phases of the cycle, the macroeconomic variables of relevance were collated. They are as follows:
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GDP
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interest rate
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money supply
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credit expansion
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savings
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industrial production (higher-order stages)
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industrial production (lower-order stages)
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inflation
GDP of course provides a big picture view of when the crisis unfolded and why the recent cycle was the most severe in Brazil’s more-than-one-hundred years of history. It will be displayed on an annual basis. Obviously, it is expected to grow in the boom phase and fall in the bust phase.
The second variable, the real interest rate, is key for tracing credit expansion and how this expansion lead to an unsustainable boom. The expected results would be a fall in the interest rate during the boom and a rise during the bust. The third variable, Brazilian monetary aggregate M2, will track the changes in the Brazilian money supply.In Brazil, M2 is defined as it is in the U.S.: currency (coins and bills) + demand deposits + traveler’s checks + other checkable deposits + savings deposits + small time deposits + money-market mutual funds + some minor categories (Mankiw 2018, 324). We expect that this variable will grow during the boom and stagnate or decline in the bust. As for credit expansion, the fourth variable, the expected results are an expansion during the boom and a stagnation or decline during the bust.
As for nominal savings (fifth variable), there is no particular expectation about its direction in either the boom or bust phases. If there is an increase in its size during the boom, it must be less than that of artificial credit expansion.
For the sixth and seventh variables, as explained in the previous section, higher-order goods experience a higher rate of growth than lower-order goods during booms. When the bust arrives, higher-order goods production will decline at a higher rate than lower-order goods production. Capital (higher order) goods tend to have more volatile production levels than consumer (lower order) goods. In the nomenclature of statistics, capital-goods production levels have a higher standard deviation from the mean (Rothbard 2009, 19).
Finally, inflation (eighth variable) will tend to rise in the boom phase, since both capital and consumer goods are receiving major stimuli, and this in turn puts pressure on the prices of the factors of production. After first flowing into capital goods, new money raises demand downstream and eventually puts pressure on the prices of consumer goods (Hayek 2008). There must be an eventual reversal of the growth of inflation in the bust phase or a steep fall in it when adjustments instantiate into inflated prices.
Table 1 below is a summary of expected results in the variables during the boom and bust periods. As can be seen in the table, in some cases the theory does not predict any particular result.
Table 1. Expected Results (ABCT)
- No explicit prediction for this was found in ABCT but was deduced from the theory of Garrison (2001) in which it is impossible to have growth in credit markets when savings falls except in the case of government intervention. In later sections of this article, these results predicted by ABCT will be compared to the actual ones from the 2004–16 Brazilian cycle. The methodology used in this study does not involve an empirical test in the sense that hypotheses were formed and-or extraneous economic models were used to test ABCT (Hoppe 2007). The authors only wish to observe whether results consistent with ABCT occurred, assuming that no other exogenous variable(s) significantly influenced these results. Thus if a few of the observed results are not compatible with the theory, it does not necessarily mean that the theory has been refuted but rather that other variables not included in the present study may have affected the results.
Industrial production was disaggregated into specific sectors and how they behaved in the various phases of the cycle. These phases were categorized in light of the structure of production illustrated in Hayek’s triangle (Hayek 2008). The more distant from consumer goods (higher orders), the more capital intensive and time consuming the process becomes. The opposite is also true: businesses closer to consumer goods (lower orders) are less capital intensive and less time consuming. Some industries are not clear cut. For example, the construction sector has characteristics of both orders: it is close to the consumer in some transactions, absorbs significant time and capital to produce certain products in other transactions, and is very interest-rate sensitive. On balance, this sector will be classified as higher order. The data used are from the Brazilian Institute of Geography and Statistics (Instituto Brasileiro de Geografia e Estatística, or IBGE for short) and the Central Bank of Brazil (Banco Central do Brasil, or BCB for short). Both of these institutions in Brazil are (not surprisingly) government agencies. Their classifications were used and then macroeconomic sectors were designated as higher-, intermediary-, or lower-order as shown in Table 2 below.
Table 2. Classification of Brazil’s Industrial-Production Statistical Series* by Their Location in the Brazilian Structure of Production
Source: BCB Industrial Production series 21861–68. * See methodological notes (Brazilian Institute of Geography and Statistics 2004). ** This series became available in January 2012, therefore analysis will be limited. Again, despite the fact that some authors have attempted to empirically test ABCT (e.g., Luther and Cohen 2014), this study will only analyze data in light of ABCT. The authors included changes in savings and interest rates in their criteria for defining the different phases of the cycle (Garrison 2006).
IV. THE BRAZILIAN EXPERIENCE When President Lula took office in 2003, many supporters and opponents of his Workers Party (Partido dos Trabalhadores, or PT for short) were expecting that Lula would implement the agenda that PT had been preaching for several years. Since the 1990s, PT was mainly against “everything that was out there,” advocating market-unfriendly policies (Leitão 2011, 396 [authors’ translation]). With a radical-left mindset, members of the party and Brazilians in general thought that an agenda of economic intervention, such as debt default, would be enacted by the new president (Giambiagi et al. 2016, 198).
Markets were expecting a departure from the economic regime of Lula’s predecessor, Fernando Henrique Cardoso. The Cardoso administration was in compliance with International Monetary Fund (IMF) recommendations and its economic policies were christened the Macroeconomic Tripod. The Tripod, per its name, was based on three major goals: fiscal austerity, inflation control, and a floating exchange rate (Veloso et al. 2013).
However, Lula unexpectedly embraced the Macro Tripod and continued with it in his first term, which ran from 2003 to 2006 (Amorim 2016, 28). Macro-economically, the year 2003 was very turbulent for Brazil because markets were expecting an abandonment of the Tripod. The following year, 2004, is when the first continuous boom of the cycle began.
Suggested proximate causes outside of those specified in ABCT include the following. First, loose money policies in the major world economies allegedly triggered large capital inflows into Brazil. Two BCB officials (Hennings and Mesquita 2008) demonstrate that foreign direct investment (FDI), after reaching a peak of around $40 billion (U.S.) in 2001, fell to about half that in late 2003, then began strongly surging again after mid-2004, reaching around $60 billion (U.S.) in early 2008. Local equity market inflows surged from $5.4 billion (U.S.) in 2005 to $24.6 billion (U.S.) by 2007. In this exact same time interval, gross inflows surged from $32.3 billion (U.S.) to $116.6 billion (U.S.). “[N]et or gross terms, these inflows are unprecedented in the post-World War II Brazilian experience” (Hennings and Mesquita 2008, 107).
Second, BCB increased the money supply in Brazil. Third and last, government fiscal and regulatory policy added more fuel to the boom. One alleged example is a September 2003 executive order (later legislatively approved in December 2003) that authorized banks to offer loans that could be repaid through automatic payroll deductions. A study by Coelho, Mello, and Funchal (2010) found that the new law caused a significant decline in interest rates and significant increase in credit.The authors do not necessarily agree with these purported extra-ABCT causes. A planned follow-up study will explore this issue in greater detail.
Brazil’s economic cycle will be divided into three phases. Phase 1 is the continuance of the Macroeconomic Tripod (T-boom for short) by President Lula throughout his first full term and half of his second term, the years 2004–08 in which the boom began. President Lula’s first year in office was 2003, but that year was removed from this study because, as previously mentioned, it was a period of great instability which clouds the analysis.
The financial crisis in the United States which peaked in September 2008While the initial tremors of the crisis were felt in the bank runs against BNP Paribas (9 August 2007) and Northern Rock (14 September 2007), the apex of the crisis was undoubtedly the collapse of Lehman Brothers on 15 September 2008. with the failure of Lehman Brothers investment bank was the trigger that shifted the Lula administration away from the Macro Tripod. The administration’s new model, later named the New Economic Matrix, was based on five major pillars:
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Aggressive reduction of interest rates.
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Credit expansion to consumers and private enterprises through publicly owned commercial and development banks.
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Government privileges for boosting specific private companies.
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Subsidies and fiscal abnegation for specific sectors to boost the economy.
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State enterprises controlling prices and inflation.This economic plan was gradually being implemented and refined over some years, starting in 2008 and taking full form by 2011. For a timeline of this economic plan and its main pillars, see Roque (2015).
Even though all of the aforementioned interventions played a part in causing the boom and bust, this study will argue that the main causes were artificially low interest rates and accompanying credit expansion and that all other interventions were secondary in nature.
Lula’s shift between economic models will be referred to as “Reset” in this paper, an allusion to the old mindset of PT, which advocates major government interventions to steer Brazil’s economy. This second stage of Lula’s economic program contains the Reset and Economic-Matrix boom or M-boom. In other words, this paper divided the boom periods of the cycle into two parts: T-boom (Phase 1) and Reset plus M-boom (Phase 2).
Finally, the last phase (Phase 3) is the bust. Brazil’s economy shrank for 11 consecutive quarters, producing the worst crisis in the nation’s history. The second leg of the “flight of the chicken” lasted five years (2010–14) before the economy nosedived into the dark waters of deep recession.
In Figure 1 below, the blue bars evince economic growth for 2004–14. The years 2004–08 delivered a mean of 4.81 percent annual growth. The year 2009 represented mainly stagnation for the Brazilian economy. Between 2010 and the beginning of 2013, annual growth was 4.1 percent. While this Matrix-boom average is lower, it is still close to that of the T-boom phase. In the last phase (bust), there was a deep recession with 3.8- and 3.6-percent negative growth in 2015 and 2016, respectively. What is not shown in Figure 1 below is that the recession ended in the first quarter of 2017 with a positive quarterly growth rate in GDP of one percent.
Figure 1. Average Annual Growth Rate in GDP Across Brazil’s 2004-16 Business Cycle
Source: Central Bank of Brazil GDP series 7326. For the purposes of this article, it will be assumed that the Reset began after the peak of the U.S. financial crisis in September 2008 and ended at the end of 2009. The M-boom began in about January 2010 and ended in approximately February 2014. These dates are estimates because it is difficult to pinpoint with great precision when the boom and bust phases began and ended. The great precision that is lost is not relevant for the purposes of this paper. In some cases, only full years will be analyzed—the specific months that characterize each phase will be dismissed. Table 3 below specifies in detail the approximate boundaries of each phase.
Table 3. Components of the Brazilian Business Cycle (2004–16)
V. PHASES 1 AND 2: T-BOOM, RESET, AND M-BOOM One of the most important aspects of ABCT is the manipulation of the interest rate by the central bank. Figure 2 below illustrates real annual interest rates throughout Brazil’s recent cycle. In the first phase of the cycle (2004–08), the real interest rate averaged 9.18 percent per annum. During the second phase—Reset and M-boom—between 2009 and 2013, the mean real interest rate was 3.91 percent.Special System of Liquidation and Custody (Sistema Especial de Liquidação e Custódia, SELIC for short) is the system used by the Central Bank of Brazil (BCB) to implement its interest-rate policy via buying and selling government bonds. This is a difference of 5.27 percentage points, or a fall of about 57 percent. Throughout the bust, the real annual interest rate fell no lower than 4 percent.
Figure 2. Five-Year Average of Annual Real Interest Rates in Brazil (2004-08, 2009-13)
Source: Central Bank of Brazil (BCB). SELIC series 4390. For the real interest rate calculation authors used Fisher equation. For the nominal rate, authors used annualized SELIC rate and for the inflation rate authors used the IPCA 12-month inflation index for each month. The blue bars represent the average for the year. Recall that when the interest rate falls, the demands for both capital goods and consumer goods will be stimulated (Garrison 2001, 72). If the interest rate fell between the first two phases, this would lead us to expect that credit offered to businesses and consumers would enjoy strong and continued growth between the two periods.
It is interesting to note the behavior of M2 surrounding the reduction in the interest rate. Table 4 displays the compound-adjusted growth in M2 in each phase.
Table 4. Compound Average Growth for M1 and M2
Source: Central Bank of Brazil (BCB). M1 and M2 series 27791 and 27819, respectively. It is clear that the boom period had an outstanding growth rate in M2 of 20.83 percent in Phase 1 and 12.98 percent in Phase 2. Before analyzing the results, it is important to make an observation about credit markets in Brazil. Brazil’s credit markets are divided by the Brazilian central bank as follows: government-supported credit policies (code 7524); “free-market” credit for businesses (code 12128), and “free market” credit for consumers (code 12127).If one wants to see the combined series for “free-market” credit (businesses and consumers), the code is 12130. The first category, credit supported by government policies, includes loans through state agencies such as the National Bank for Economic and Social Development (Banco Nacional de Desenvolvimento Econômico e Social, BNDES for short), which offers subsidized or policy-oriented credit to sectors chosen by the government. The second category, “free-market” credit, includes all credit that is offered by banks to businesses and consumers. It should come as no surprise that the entire Brazilian credit market is subject to significant government control. Between 2004 and 2012, the average government share in total credit was 34 percent.For this calculation, the authors used the last month of each year (December) for government credit (code 7524) divided by total credit in the period (the sum of total government credit [code 7524] and “free-market” credit [code 12130]).
Figure 3 shows the growth of credit in the first two phases of the cycle. Displayed in the left panel of Figure 3 is the growth pattern of business credit. It is composed of government and free market credit for businesses. The average annual compound growth rate was 22 and 16 percent for Phases 1 and 2, respectively. Displayed in the right panel of Figure 3 is the growth pattern of credit for individuals. Note that the growth of credit to individuals is even higher than the growth of credit to businesses in Phase 1, reaching 27 percent. In Phase 2, there is an impressive 20 percent rate of continued growth in credit to individuals. Interestingly, the growth rates of credit in Phase 1 for both graphs (22 and 27 percent) are higher than their counterparts in Phase 2 (16 and 20 percent).
As alluded to in the previous section, certain factors unquestionably drove this credit expansion. In terms of alleged causes not specified by ABCT, one suggestion is that loose money policies in the major world economies directed large capital flows into Brazil. No matter how they are measured—net or gross—the inflows were unrivalled in the post-World War II history of Brazil (Hennings and Mesquita 2008, 107). Government fiscal and regulatory policy added more stimulation. One alleged example is an executive order authorizing banks to offer loans repayable through payroll deductions. This “innovation” significantly expanded credit (Coelho, Mello, and Funchal 2010).Again, the authors do not necessarily agree on all of these purported extra-ABCT causes. A planned follow-up study will explore this issue in greater detail.
Figure 3. Credit Expansion for Businesses and Individuals (in billions R$)
Source: Data from BCB (Brazilian Central Bank), elaborated by authors. Business credit series is a result of the sum of government credit policies for business (code 20021) with free market credit for business (code 12128). For individuals, it was calculated by the sum of government credit policies for individuals (code 20020) with free market credit for individuals (code 12127). It used December of each year as a basis for this calculation. For the calculation of compound average growth (CAG) in 2004, it used December 2003 as a starting point. Those series were discontinued and were only available until 2012, which means that the second phase will have a year less. A fall in interest rates would not be a problem per se, provided that it was driven by voluntary savings on the part of individuals (Hayek 1931). When individuals increase their savings, interest rates fall and funds flow to capital goods. When this route is followed, the time preferences of consumers can be synchronized with those of entrepreneurs who want to engage in new projects (Manish and Powell 2014). As a consequence, savings behavior during the recent Brazilian cycle must be analyzed to determine whether Brazil’s massive credit expansion was caused by a natural increase in voluntary savings or artificial state actions.
The next figure, Figure 4, juxtaposes the average growth rate of savings with the interest rate.For the 2004 savings-growth statistic, the authors used the 2003 statistic (15.3 percent of GDP) as the basis (World Bank 2018). In the first phase of the cycle (2004–08), the average annual growth of savings was 2.2 percent of GDP, rising from 15.3 percent (at the end of 2003) to 16.9 percent of GDP. However, the interest rate fell an average of 10.7 percent per annum. Its range was between 11.25 percent and 19.75 percent, with an average of 15.07 percent. In other words, the first phase was characterized by a large reduction in interest rates coupled with a relatively low growth rate in savings, as can be seen in the two bars on the left-hand side of Figure 4 below.
Figure 4. Average Annual Growth of Savings and Interest Rate
Source: World Bank and Brazilian Central Bank data, elaborated by authors. Interest Rate (SELIC) series: 4390. Table 5 below summarizes what happened to interest rates, savings, and monetary and credit expansion in Phase 1 and Phase 2. Phase 1 had a nominal average interest rate of 15.08 percent while Phase 2 had a nominal average rate of 9.77 percent, a fall of 35 percent. The average real interest rate for Phase 1 was 9.18 percent, while for Phase 2 it was 3.91 percent. In terms of savings, Phase 1 had an annual growth rate of 2.2 percent while Phase 2 had an annual growth rate of –0.3 percent.
Table 5. Interest Rates, Money, Credit, and Savings (Consolidated Results)
*Average for Phase 2 (Reset + M-Boom) It is reasonable to conclude that the consistent fall in the interest rate in both phases was not driven by an increase in voluntary savings. In fact, in the second phase, there was a decline in savings. The decline in the interest rate and increase in credit had a huge impact on credit expansion for businesses and individuals, which in turn caused a significant distortion in the structure of production as explained in the next section.
Central-Bank Control of the Interest Rate and Its Impact on Higher and Lower Orders of Production
To analyze the impact on the structure of production, we explored Phase 2 and 3 in greater depth. The structure of production was gradually changing in Phase 1 and started undergoing a complete distortion in Phase 2. As a result, the authors dedicated more analysis to this distortion that occurred in Phases 2 and 3.
The impact of lowering interest rates in the absence of voluntary savings will be different within higher and lower orders of production (Hayek 2008). In the terminology of statistical analysis, higher orders of production have a higher standard deviation in production levels than lower orders of production (Rothbard 2000, 9).
The results are consistent with ABCT. Recall that these results were elucidated earlier in the methodology section of this article for all sectors for which it was possible to obtain industrial-production data: Mineral, Intermediaries, Semi- and Non-durables, etc. Table 6 below displays the standard deviations of these sectors through Phase 2 and Phase 3. Standard deviations and the averages for each sector were then calculated.
Table 6. Industrial-Production Volatility for Phase 2 (Reset and M-Boom) and Phase 3 (Bust)
- All sectors included. To calculate the average standard deviation, two extreme values were eliminated from the data set (Minerals and Capital Goods). The average standard deviation of all sectors is 10.65. Figure 5 below reveals that three sectors of the economy were above average: Construction, Durables, and Capital Goods. These three sectors were clearly the most volatile and received the most impact from central-bank stimuli. They represent 75 percent of the higher-order sectors.
The data for the Construction series became available in January 2012—in the middle of the M-boom—which means that the actual standard deviation could be much greater than the recorded values indicate. This of course would have represented even stronger confirmation of ABCT.
Figure 5. Standard Deviation of Industrial Production Among Sectors for Phases 2 and 3 (Sep. 2008 to Dec. 2016)
Source: Central Bank of Brazil (BCB). One notable exception in the data was the mineral sector, clearly an industry belonging to the higher-order category. In Brazil, this industry has a large portion of its production in two main sub-sectors: iron ore and petroleum and natural gas (and its byproducts). For the iron-ore subsector, it is very well known that one of the most important markets is exports, and for that reason it is very sensitive to international-market conditions. In 2014, about 86 percent of Brazil’s iron-ore production was exported. In 2016, Vale (one of the largest iron-ore producers in the world) achieved a new production record which stood in stark contrast to the contraction witnessed in the other higher-order sectors (Construction, Durables, and Capital Goods) during the recession (Rosas and Machado 2017). Hence, iron ore is not synchronized with the internal Brazilian business cycle and thus of little relevance to this study.
As for petroleum and natural gas, the main supplier of those products is the state-controlled company Petrobras, one of the largest oil companies in the world. This sector is subject to heavy government intervention, thus central planning, not free markets, guides much of its decision making. During the boom, the government prevented the company from raising prices in an attempt to control inflation, even at the cost of significant losses (“Petrobras Approves New Fuel Price Readjustment Policy,” 2013). Such strong state influence muddles the analysis, since the government could accumulate large losses without compromising production.
Taking the long view, the standard deviation, from January 2004 to December 2016, is 10.64. In other words, the standard deviation converges to the average of other sectors. This is not the case for the capital-goods sector which over the same time span had a standard deviation of 18.27: almost identical to the present results. The fact that the petroleum and natural-gas sector is so extensively state controlled makes it almost certain that production decisions were influenced by political considerations rather than sound market fundamentals. This undoubtedly led to distortions in output.
In sum, the results show that Brazil’s higher-order sectors experienced the highest growth in the M-boom and the steepest fall in the bust phase compared to lower-order sectors of production. These results are consistent with ABCT. The Mineral sector is an anomaly because of its atypical export dependence in iron ore. The Petroleum and Natural Gas sector is another outlier because extensive government controls guide its production decisions.
Capital and Consumer Goods: A Closer Look
In Phase 1, industrial production for capital and consumer goods was relatively low in 2003, with index values of 50 and 68 (base year 2012 = 100), respectively. Figure 6 below reveals that both had tremendous growth in subsequent years until this growth was interrupted by the peak of the U.S. financial crisis in September 2008. After this interruption, growth fell precipitously until about the end of the first quarter of 2009. From January 2003 (50.9) to October 2008 (124.8) to February 2009 (73.4), capital goods rose 145 percent to a high and fell 41 percent to a low. From February 2003 (68.1) to October 2008 (110.3) to February 2009 (77.3), consumer goods rose 62 percent to a high and fell 30 percent to a low.
Figure 6. Industrial Production of Capital and Consumer Goods Indices (Base Year 2012 = 100)
Source: Central Bank of Brazil (BCB). Capital-goods series 21863. Consumer goods series 21865. After the Reset, the government began to suppress interest rates with the aim of stimulating the economy, going so far as to even threaten private banks to get on board the program (“On TV, Dilma Raises Tone to Private Banks and Asks Interest Cut,” 2012). The effects of this in terms of greater relative capital-goods volatility can be seen very clearly in Figure 7 below, which shows industrial-production index differences (capital goods minus consumer goods). Where the blue bars in the aforementioned figure indicate negative values, the capital-goods index was less than the consumer-goods index (see scale values on the right vertical axis of Figure 7). The inverse is also true.
Note that in Phase 1 (2004–08), capital-goods production exceeded consumer-goods production for only ten months of the 60-month Phase-1 period. In contrast, during the 2009–13 period (Phase 2), capital-goods production was higher than consumer-goods production for 44 out of 60 months, i.e., for nearly 70 percent of the phase. That fact supports the idea that the structure of production was distorting in Phase 1, however, only in Phase 2 did this distortion reach the point of irreversibility. This is consistent with ABCT, where production of capital goods grows faster than that of consumer goods in the boom phase with this production only to be eventually corrected by market forces during a subsequent bust.
The interest rate is also displayed in the graph, showing a trajectory of successive declines and then a sustained low rate through the T-boom and M-boom (see scale values on the left vertical axis of Figure 7 below).
Figure 7. Interest-Rate Impact on the Structure of Production
Source: Central Bank of Brazil (BCB). SELIC series 4390. VI. PHASE 3: RECESSION In the second quarter of 2014, Brazil’s output began to fall. The next graph shows year-on-year growth in Brazilian GDP on a quarterly basis. GDP shrank for 11 consecutive quarters, resulting in the longest recession in a century.
Figure 8. Quarterly GDP Growth During the M-Boom and Bust Periods 2009-16
Source: Brazilian Institute of Geography and Statistics (IBGE). Quarterly GDP growth series 5932. Credit had a delayed impact on Phase 3 (bust) of the business cycle. Figure 9 shows the long expansion of credit as a percentage of GDP for both businesses and individuals. For 2012, credit grew at a 5.7 percent rate for businesses and a 6 percent rate for individuals. By 2015, the rates had fallen to 2.4 percent for businesses and 3.1 percent for individuals; both forms greatly slowing with business credit falling faster. The following year, 2016, credit expansion entered a clear tailspin, growing at a rate of –13.4 percent for businesses and –1.2 percent for individuals.
Figure 9. Credit Expansion and Contraction as a Proportion of GDP (%)
Source: Central Bank of Brazil (BCB). Business credit/GDP series 20623. Individual credit/GDP series 20624. As can be seen in Figure 9 above, there was no observable contraction in credit at the beginning of the bust. Instead, credit levels fell only in the third year (2016), with businesses cutting back (–13.4 percent) much more than individuals (–1.2 percent) as confirmed in Table 7 below.
Table 7. Business and Individual Credit as a Percentage of GDP (M-Boom to Bust)
Source: Central Bank of Brazil. Business credit/GDP series: 20623. Individual credit/GDP series: 20624. Recession is the healthy part of the recovery process because it is the adjustment of the economy back to its original condition (Rothbard, 2009). Without further state interference, the economy will move back to equilibrium, prices and wages will fall, and unviable businesses will go bankrupt. The recession is the economy’s attempt to adjust to the state of current natural time preferences, utility, and scarcity, which is not necessarily the pre-boom state of affairs because of at least slight changes that could have occurred in these underlying phenomena. This can be observed in the production of capital and consumer goods in Figure 10 below (base year 2012 = 100). Production of capital goods falls steadily between 2014 and 2016, a decline greater than that experienced by consumer goods.
Figure 10. Structure of Production of Capital and Consumer Goods Indices for Phases 2 and 3 (Base Year 2012 = 100)
Source: Central Bank of Brazil (BCB). Capital goods series 21863. Consumer goods series 21865. Despite the visible difference in the two series in the graph, the phenomenon of returning to “the old standards before the crisis” affected industrial production. The authors noted the six months with the highest average value in the boom and the lowest average value in the bust. They also compared the lowest average value during the recession with the six months before the Reset in which similar values could be found. Results will show how many years of performance the economy lost in the bust phase. The reason for searching before the Reset is the Brazilian government’s reaction to the peak of the U.S. financial crisis in September 2008 (which led to muddled data for 2009). The authors used six-month averages to insulate the results from monthly seasonal variations.
For the production of consumer goods, the highest performing six months in the M-boom was the second half of 2013, when the index averaged 106.56. The worst six-month period in the bust was the first half of 2016, with an average of 82.16. The economy then returned to the type of output levels it had in the first six months of 2005 when the index averaged 82.63. That is, consumer-goods production returned to the level of 11 years previous.
For capital goods, the highest level was in the second half of 2011, with the index averaging 115.31. The lowest average in the recession was 66.53, recorded in the first six months of 2016. Capital-goods production fell back to levels not witnessed since the first half of 2004. In other words, this was a decline lasting 12 years.
Table 8 below summarizes the performances of capital and consumer goods in terms of all averages combined among the M-boom and Bust stages.
Table 8. Recession Adjustment Process (Industrial Production)
*half = two consecutive quarters Table 8 shows that capital goods returned to their initial condition in the T-boom phase. This is consistent with ABCT’s prediction that the economy would return to approximate pre-boom levels (Mises 2008). Consumer goods declined to their level of 11 years previous (in the first half of 2005). Capital goods fell even more, falling to their level of 12 years previous (in the first half of 2004). The Brazilian economy returned to its approximate initial conditions when the boom first started in 2004.
VII. INFLATION THROUGHOUT THE BUSINESS CYCLE Brazil’s economic history is full of inflation inanity. Between 1964 and 1994, the nation’s accumulated inflation was more than one quadrillion percent when measured by the IGP–DI index (Leitão 2011, 23). The inflation tsunami was finally brought under control by the 1994 Real Plan, which implemented a new currency and several other important measures. Inflation in the year following the plan was approximately 13 percent. Although this is not a remarkable achievement per se, it is impressive when compared to 1993 when inflation averaged 30 percent per month.
The Central Bank of Brazil (BCB) has an inflation target that guides its interest-rate policy. If inflation is rising or expected to rise, interest rates will rise and the opposite occurs for falling inflation. In addition, BCB sets upper and lower limits of two percent (above and below its inflation goal), which means that inflation must be inside this pre-established range. BCB uses the Broad National Consumer Price Index (Índice Nacional de Preços ao Consumidor Amplo, IPCA for short) as its official measure to guide its interest-rate decisions (Central Bank of Brazil 2016b).
Figure 11. Consumer Inflation
Source: Central Bank of Brazil (BCB). IPCA series 13522. Inflation target series 13521. Figure 11 above shows the performance of consumer inflation during the three phases. The graph is very clear when it comes to BCB inflation-policy effectiveness. The periods in which inflation was mostly outside of BCB’s target range were mainly in the bust phase. However, as further analysis will show, inflation was postponed rather than tamed by BCB interventions.
According to Table 9 below, in 49 months of Phase 1, inflation was within BCB’s target range, a success rate of approximately 88 percent. Inflation averaged about 5.3 percent per annum during this period. Phase 2 had similar results, however, it was the period when government interest-rate interventions became aggressive. Although 82 percent of the months in Phase 2 displayed inflation within BCB’s target range, inflation was artificially suppressed by many state actions. ABCT predicts that consumer inflation will rise in a boom and fall in a bust. However, if government interventions prevent inflation from rising in a boom, it would be rational to expect that a subsequent bust will be hyper-affected by the inflationary forces that were artificially suppressed during the boom.
Sure enough, in the bust, Brazil’s inflation rate was higher than in any other phase. In January 2016, inflation reached a peak of 10.71 percent, the highest level in the previous 13 years. During the bust, inflation was within BCB’s target range for only five months out of 34, giving the central bank a rather unimpressive success rate of 15 percent.
Table 9. Inflation-Goal Performance
For the classification of inside or outside the target range, the inflation range set by BCB was used (Central Bank of Brazil 2018).
How Government Interventions Postponed Economic Recovery
As mentioned above, government interventions in Phase 2 postponed inflation that would have been ordinarily felt during a period of credit expansion. Therefore, higher rates of inflation were experienced only in Phase 3, and still only in a subdued manner.
Inflation as measured by IPCA has two main components: a) “free market” prices; b) government-controlled prices (“Petrobras Approves New Fuel Price Readjustment Policy” 2013). The first component covers all prices that are set by voluntary exchanges in the “free market,” while the latter category covers prices set by government decree via its agencies, companies, and structures. Government-controlled prices are also set at the federal, state, and municipal levels. In May 2016, government-controlled prices represented nearly a quarter of the IPCA (Central Bank of Brazil 2016a) and that proportion is similar to the one that prevailed in earlier years (Solomao 2013). In Brazil, the government uses its discretionary authority to influence prices as measured by IPCA. If the government postpones price increases, the index will be held down artificially.
In Phase 2, government interventions intensified. Table 10 below summarizes many of those decisions which worked to postpone inflation (which should have been felt during the M-boom but was not felt until the bust).
Table 10. Brazilian Government Interventions to Suppress the Inflation Index (Selected Indices)
All the interventions in Phase 2 deferred inflation to the future. The effects were felt only after the M-boom, when most of the artificially low prices could not be sustained. In 2013, there was a 15.65-percent fall in residential electric-power prices as a result of government intervention. However, in 2014 and 2015, prices rose 17.06 percent and 50.99 percent, respectively.Accumulated inflation for each year. Data from BCB series 4453.
The following graph, Figure 12, juxtaposes year-by-year IPCA controlled prices with IPCA free-market prices. The graph shows government-controlled prices sliding way below free-market prices in both boom phases (but especially in the M-boom years of 2011–13) before disproportionately racing ahead of them in the bust years of 2014–15, reaching a peak of 18.07 percent in 2015. At a minimum, the striking divergence between the two series between 2011 and 2015 evokes questions about its cause.
Figure 12. Controlled Prices Compared to Free-Market Prices (Annual Averages)
Source: Central Bank of Brazil (BCB). IPCA series 4449. IPCA free-market series 11428. Controlled prices fell from an annual rate of 5.68 percent in Phase 1 to 3.85 percent in Phase 2, a fall of 32 percent. During the same period, free market prices rose from 5.24 percent to 6.34 percent, a rise of 21 percent. Controlled prices then rose by an annual average of 9.63 percent in Phase 3, a 150.1-percent increase when compared to Phase 2. Free market prices also rose in Phase 3, but the average increase was about 14.4 percent when compared to Phase 2 (see Table 11 below).
Table 11. Annual Inflation: Controlled vs. Free-Market Prices
Without question, Brazil’s government made its recession worse through its manipulation of prices. Instead of leaving prices to fluctuate normally in response to market forces, the government used its power to influence prices as part of its interventionist agenda. Price adjustment, though, cannot be postponed forever. The result was that when the recession finally arrived in 2014, inflation was not able to fall as part of the natural adjustment process. Because of past government interference, prices first had to perversely spike in 2014–15 (the Bust) to compensate for past suppression.
The bust is the start of the recovery process (Rothbard 2009) when prices fall, malinvestments are liquidated, bankruptcies rise, and the high debt ratio for households and companies remains steady or falls (Salerno 2012). However, one main component of the recovery process—prices—was not aligned with the business cycle. Prices had to rise because of government suppression during the boom phases, and this had to occur in the recession. The bust’s increase in inflation combined with negative industrial production was a deadly combination in hindering business profitability.
If the government had not held down prices in the boom it would be realistic to expect that inflation would have fallen in the early months of the bust (2014), and as a consequence, the recovery process would have been faster. Instead, inflation only began falling about two years after the recession began.
VIII. EXPECTED RESULTS AND OBSERVED FACTS The observed facts from the recent Brazilian experience, when compared with ABCT expectations, are not surprising. Table 12 below reveals that 13 out of 15 (87 percent) expected results from ABCT theory were confirmed by the data.
The variables that fell outside expectations were three: savings, inflation, and money supply. Savings actually rose 7.4 percent in the first year of the bust (2014). However, in 2015 it fell 11.3 percent, turning the net effect negative. Individuals did not increase savings in the period. However, for consumption the fall was far greater. As a standalone variable, savings declined but when compared to consumption, it experienced a lower decline.
As for inflation, as discussed in the previous section, Brazil did not experience a sharp fall during the bust. Government intervention prevented controlled prices from rising during the boom, which meant that they had to adjust upwards in the bust. Thus, controlled prices climbed 18 percent in 2015. If the government had not manipulated prices, then prices almost certainly would have fallen in the bust period.
As for the money supply (M2), as Table 4 above indicates, while the average growth rate in M2 was certainly not negative, it was about 35 percent of what it was during the T-boom. M1 was about 29 percent of what it was during the T-boom. The growth rate of both measures of the money supply had declined significantly.
Table 12. ABCT Realized Results
*See CAG for M2 in Table 4 above. While the growth rate of M2 was not negative it was on average a little more than a third of what it was during the T-Boom. IX. CONCLUSIONS This study intended to analyze the 2004–16 Brazilian business cycle through the lens of Austrian Business Cycle Theory (ABCT). From ABCT, 16 expected results were delineated and nearly all of them were empirically confirmed, thus strong supporting evidence in the recent Brazilian experience was found for ABCT. The boom initiated in 2004, the structure of production began to be distorted, and this distortion became more pronounced during the second part of this boom. The Brazilian government continually lowered the interest rate, bringing it low enough to create an artificial boom followed by a severe bust that was not just another typical “flight of the chicken,” but Brazil’s most severe recession in more than a century.
This study’s findings reinforce ABCT’s accuracy in explaining business cycles. In this day and age, it is surprising that mainstream economists still ignore or misinterpret ABCT (Garrison 1999, Evans 2010, Salerno 2012). As for politicians and regulators, there is no way that governments can precisely manage a modern economy through monetary and interest-rate central planning, and it is certainly not possible to do so without temporarily warping an economy’s production structure.
This article aspires to be one of the first scientific studies of the recent macroeconomic crisis in Brazil to utilize the theoretical framework of ABCT. The hope is that it will introduce a fresh perspective in economics for Brazilian economists, business executives, entrepreneurs, academics, and political leaders who can effect social change in Brazil. In a recent survey (Heritage Foundation 2018), Brazil ranked 153 out of 180 nations in terms of having one of the lowest levels of economic freedom in the world. The authors hope that this study will help reverse Brazil’s dismal ranking in economic liberty and bring about lasting changes in Brazil for the economic betterment of its 210 million people.
Is successful value creation through innovation the product of genius? Or, of luck? No, it’s the product of a system, applied with discipline. Utilizing the system can result in repeated success in customer value generation.
Curt Carlson is the world’s leading expert practitioner. He is the founder and CEO of Practice of Innovation, LLC, and was President of SRI International, identified as the most successful innovation company in the world based on its development and introduction of globally important innovations like Siri for the iPhone4 and HDTV. Under Curt’s leadership, SRI grew 3.5X and created tens of billions of dollars of new customer value.
Key Takeways And Indicated Action Curt believes any company can systematically generate new value for customers, and reap the rewards of the market for doing so, when they rigorously apply three fundamental rules:
They have a simple value creation methodology that everyone in the company (and its collaborative partners) can describe, understand and apply every day in every job function. (Curt’s test: ask everyone in the company what the firm’s value creation method is: if they can’t describe it, there isn’t one).They have metrics to define innovation work that is important rather than merely interesting. While subjective value is not quantifiable, there are proxies for measuring importance and market potential.They have a system for active learning. Innovation is a learning science, and active learning is a specific, high speed, high productivity version of learning, applying the best learning science principles. In this week’s podcast, we focus especially on the simple, effective value creation methodology that Curt identifies by the initials N-A-B-C.
N is the identification and quantification of the important customer need. In B2B businesses, it’s possible to monitor financial flows and identify needs based on quantifiable elements — cost savings, time savings, and measurable quality improvements. In consumer businesses, need identification is much harder, and quantification impossible except by proxy, since needs are subjective and individual. Importantly, they are also multi-dimensional, and need identification must encompass all the dimensions.
It’s important to deeply understand human wants, whether it’s for convenience, or higher order wants such as pride and identity. Surveys told Steve Jobs that consumers wanted a “new keyboard” for existing Nokia phones that were hard to use. Jobs’s intuition was that what they really longed for was convenience. The touchscreen on the iPhone provided convenience and opened a doorway to all kinds of additional services.
A is the Approach the entrepreneurial innovator takes to meet the customer need. The approach is the design of an experience that the customer will desire. The Approach mist embrace both the assembly of the right resources into a technical solution, and the business model so that the solution makes money. There’s an iterative back-and-forth between technical solution and business model that can continue for years. Nike’s technical solution for shoes is good but not unique; its business model for sponsoring athletes to inspire aspirational consumers who wanted to “be like Mike” (or, today, like LeBron) elevated their offering from product to experience.
B is Benefits Per Costs. Curt uses this construction to emphasize that there are large buckets of both benefits and of costs. Benefits include not just features and performance and appearance, but also the feelings produced by the experience. Costs are similarly multi-layered: not just dollars, but also the effort required to acquire the product, and perhaps to master its use, the opportunity cost of what is given up, durability, and more. The innovative entrepreneur must look at costs from all of these angles and calculate that the “benefits per costs” for customers are much better than alternatives.
Curt’s rule of thumb is 2X to 10X better. People measure perceived benefits in percentages. 10% better, 50% better, 100% better than the status quo or the alternatives. Transformational innovations are 2X to 10X better.
C is the competition and other alternatives — both today and in the future. What are all the other ways the customer can experience the benefit they seek? What are alternative ways for them to spend their money — perhaps on a different experience that’s not a direct substitute but on which they’ll spend instead of buying our solution. How does your innovation fit into their lives so compellingly as to become preferred over all these alternatives?
N-A-B-C is a simple framework, but it’s not easy to achieve results. It requires iteration at speed among many collaborators (including customers, and possibly investors), all with different and specific talents and tacit knowledge. No individual can command sufficient knowledge, so team learning — active, comparative learning, frequently updated — is critical to the outcome.
The result is transformational: for customers who experience new value, for the firms that facilitate it, and for the individuals who practice the discipline of innovation.
Additional Resources "Curt Carlson's N-A-B-C Innovation" (PDF): Mises.org/E4E_37_PDF
Curt Carlson’s book is Innovation: The Five Disciplines For Creating What Customers Want.
This week, while keeping our eye on our highest value — entrepreneurial success — we raise our focus to the system level and the meta-ideas that sustain entrepreneurial effort and Austrian innovative dynamism.
Key Takeaways and Indicated Action Professor Arthur Diamond has written a wonderful book about nurturing the system in which we entrepreneurs operate. The subtitle of his book is Sustaining Innovative Dynamism. Like all great writers in the Austrian tradition, he recognizes and celebrates the contribution of the entrepreneur to society: to make others’ lives better.
In many ways, this is both an economic and an ethical stance. To quote Jesus Huerta De Soto (in a similarly titled essay, "The Theory of Dynamic Efficiency"):
…the most just society will be the society that most forcefully promotes the entrepreneurial creativity of all the human beings who compose it.De Soto, Jesús Huerta. The Theory of Dynamic Efficiency (Routledge Foundations of the Market Economy) (p. 176). Taylor and Francis. Kindle Edition.
But Professor Diamond is a little bit concerned that the environment for entrepreneurial dynamism is under assault in the US. It’s up to all of us to work hard to sustain the system. Professor Diamond lays out the threats under three headings.
CULTURE The entrepreneurial culture would celebrate the contributions of its entrepreneurs to a better life for all: prosperity, comfort, efficiency, health, personal achievement, and the human augmentation that comes with technology. Our lives are not only more prosperous, but more productive and more enjoyable, longer and healthier, thanks to entrepreneurs.
Often when we do celebrate entrepreneurs, it’s one hand clapping. Bezos, Musk, Gates and Jobs and others are recognized, but also sometimes vilified, and often judged on whether they “give back” — as if there was some guilt about their incredible contributions to human well-being.
And, Professor Diamond points out, a truly entrepreneurial culture would celebrate the lives of meaning and purpose led by entrepreneurs on every scale, from small business to big business.
We can all participate by celebrating the heroic stories of the entrepreneurial life, telling them loud and often.
INSTITUTIONS Under this heading, Professor Diamond focuses on the law, private property and markets.
We can observe our legal institutions turning against entrepreneurs in the form of tort suits and punitive damages. Professor Diamond calls for reform to preclude unreasonable awards of damages, and points to examples where doing so has resulted in unleashing entrepreneurship (such as 7000 new doctor’s practices opened in Texas after a damages cap on malpractice cases was put in place).
Private property protection is fundamental to the economic freedom entrepreneurs exercise to bring the benefits of innovation to society. Government is always tempted to seize private property, and often succumbs to the temptation. We must publicize each instance and protest each time.
Markets are the institution that facilitate the entrepreneur’s presentation of new offerings, and the consumer’s freedom to choose from what’s on offer. We talked about matching venturesome consumers (early adopters) with venturesome entrepreneurs, and removing the barriers that often come between them (for example, in medical innovation markets).
GOVERNANCE At this point, Professor Diamond exhibits amplified animation, recognizing that government regulation is the greatest threat to entrepreneurship and innovative value creation on behalf of others. He’s angry. He discerns two types of anti-entrepreneur regulation. The first is regulation that is sourced in purportedly well-intentioned (but demonstrably wrong-headed) efforts to protect consumers or workers. Here, we must energetically point to the greater benefits that ensue from the exercise of economic freedom than from its constraint.
One particularly important example is medical innovation. Too often, the heroic efforts of medical entrepreneurs to alleviate pain and suffering are thwarted by FDA regulation.
The second kind of regulation is the overtly corrupt protection of industry incumbents and big business, lubricated by lobbying and political quid pro quos. Here, we must all be whistleblowers.
Key Takeaway: Maintain entrepreneurial energy at all times and spread it in all directions.Celebrate heroic stories at every scale. Educate the world on the ethical and moral superiority of the entrepreneurial society, as well as its prosperity and wellbeing. Denounce legal predators, regulation and protectionism. We must contribute to the development of the entrepreneurial culture, institutional framework and governance as much as we do to customer betterment.
Additional Resources "Sustaining Innovative Dynamism" (PDF): Mises.org/E4E_36_PDF
"Entrepreneurial Stories For Young Socialists": Arthur Diamond tells Walt Disney’s story.
"When New Yorkers Cheered The Wright Stuff:: Arthur Diamond tells The Wright Brothers Story.
Openness To Creative Destruction: Sustaining Innovative Dynamism: Arthur Diamond’s book.
Visit Professor Diamond’s personal website (ArtDiamond.com) and blog (ArtDiamondBlog.com), and read his article on Innovation Unbound, which begins: "Inventors and entrepreneurs are key drivers of innovations that result in improvement in human welfare."
Is there a recipe for entrepreneurial success? Chris Wilton has established a successful and growing catering business, and the recipe he developed has some ingredients that every entrepreneur can utilize.
Key Takeaways And Actionable Insights Economists (e.g. Murray Rothbard in Man Economy and State) often talk about the recipe that entrepreneurs develop for business growth and success. They don’t quite mean it literally — a fixed proportion of ingredients combined in the same way and the same sequence every time for the same result — but the analogy is nevertheless useful. Recipes are plans entrepreneurs utilize to advance from one step to the next in pursuing their goals.
A recipe is intellectual property — software if you will. Sometimes it’s opensource, sometimes it’s proprietary. When a chef utilizes a recipe, even one that is well known, both the chef and the customer anticipate something unique: Mary makes the best chocolate cake! Lots of people make chocolate cake, and they might use the same ingredients as Mary, but, in the subjective view of a customer, no one’s result is as good as Mary’s.
To get a result, Mary has to combine hardware with the software, and perhaps there is an edge there. We might call that the capital structure that is perfectly tuned to Mary’s purpose and matches her skills. Perhaps it’s even possible to assemble superior ingredients — a special and better kind of chocolate for example.
Mary might also need collaborators. She certainly needs customers to subjectively evaluate her cake.
We’ve probably tortured the analogy enough at this point. But hopefully, we got you thinking about the role of the entrepreneur in assembling resources in order to produce something that the customer values.
In this week’s podcast, Chris Wilton of Wilton’s Catering gave us his recipe for a successful and growing business. We’ve captured it in the accompanying PDF, linked below.
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Here are some of the headlines:
Start with self-assessment: The one universal attribute of entrepreneurship that everyone seems to agree on is: it’s hard. It requires creativity but also discipline, determination and grit. It’s important to have examined your own disposition before you embark on the entrepreneur’s journey. Passion and drive are mandatory. (There’s a self-assessment tool, and a journey map.)
Identify a market and a customer: Chris Wilton knew his industry, and worked hard to pick the right beachhead customer. The beachhead customer is the first adopter who will be your customer-partner in getting your business off to a good start. Chris chose a nearby university with a highly developed and diverse set of catering needs, where he could develop his unique style of food and service.
Plan, plan, plan: Prior to launch, Chris spent months developing a detailed plan. Working from the customer (what are their needs — identified by multiple, frequent, in-depth customer conversations) backward through on-site service and set-up, delivery, capital equipment, real estate, raw material procurement, recipes, hiring and training and operating manuals. Chris’s time allocation and effort in planning was intensive. And it paid off.
Develop a customer experience, not just a service: Chris is totally focused on delivering a delightful customer experience, which entails a lot of empathic listening to the customer to understand what they expect, and then disciplined and detailed execution at every event and every meal, including the customer experience orientation and training of staff. After the event, always ask and listen for customer reactions. Was the experience good? How could it be better?
Innovate, innovate, innovate: You evaluate so that you can innovate. Innovation is continuous improvement — always looking for something new and better that will create new value for customers. A new or improved recipe, better preparation methods, improved staff training — it’s all innovation when it’s done to elevate the customer experience. One of Chris’s technique’s is sampling events where he can try new things, give away his food for free, and get feedback that he can use to perfect the innovation.
What’s the end-result? For Chris, it’s happiness. He loves and enjoys what he is doing, and he brings happiness to customers, to the attendees at customer events, and to his employees. That’s the great fulfillment of entrepreneurship.
Additional Resource "A Recipe for Entrepreneurial Success" (PDF): Mises.org/E4E_35_PDF
Pricing is fundamental to business success — to generating transactions, to cash flow and to profitable operations. There’s a lot of uncertainty for entrepreneurs in the pricing process, and economics is a good source of clarity. In fact, Peter Klein tells us that economics used to be called price theory, recognizing this fundamental role of pricing in economic exchanges.
Key Takeaways and Actionable Insights Austrian economics offers a special way of thinking about pricing that is helpful for entrepreneurs. Here is a 12-point list of pricing fundamentals.
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Consumers set prices. This insight establishes the right entrepreneurial mindset: the entrepreneur can’t control pricing and shouldn’t try to. It only leads to frustration. Act on the basis of the consumer as the determiner of market prices.
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Consumers don’t set or negotiate the price in every transaction. They are the determiners in the medium and long term. If sufficient numbers of them don’t feel they experience value at the price they’re asked to pay, they won’t buy and the entrepreneur will not be able to generate the revenue that’s called for in their business model. They’ll have to change their price, or their offering or their valued proposition.
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A price holds only for one transaction. Just because it was the right price to get one consumer to transact at one moment in time and one context, does not mean it will hold for the future. Just because it is the sticker price or asking price does not mean the consumer has no alternative but to pay it.
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That’s why Austrian Economics sees pricing as a dynamic and creative discovery process. The entrepreneur is charged with discovering the price the consumer is willing to pay now, in the future, in different circumstances and different contexts.
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Price discovery goes further — to the design of specific packages of product / service and experiences. What will the consumer pay for the product now, with no waiting? What will they pay for same-day delivery? What will they pay for the product / service in a special physical location — is a newly-released movie in a luxury theater valued more than a 3-month old movie on a streaming service? Is a coffee in a cafe where the consumer can sit for a while more valued than a take-away cup?
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The creativity and dynamism of pricing extends to promotions and discounts, including coupons, loyalty bonuses and time-based offers (10% off until midnight!)
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The key to getting this creative and dynamic discovery process right is a deep knowledge of the consumer and their individual preferences. Senior discounts might be effective when they’re offered at a time of day that works for the retired seniors and not for working people. Coupon offers are effective for people with the time and inclination to collect and clip them, but wasted on consumers who feel themselves too busy for such efforts. The smart entrepreneur exercises price segmentation.
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The same principles apply to B2B pricing, although it might not be apparent in the entrepreneur’s subjective experience. The entrepreneur might feel that a retailer or wholesaler or customer to whom he or she is selling makes a take-it-or-leave-it offer on the price they are willing to pay. But the creative dynamism of discovery applies — the entrepreneur experiments with different packages of service levels, contract duration and other variables to find the right value combination that works best for both parties.
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Once prices are discovered, the entrepreneur assembles resources to facilitate a profit at the prevailing price. This process is fundamental to Austrian price theory, yet the opposite of the typical business school scenario of cost-plus pricing. Business schools often get things backwards.
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Entrepreneurs discover many ways to manage costs in the supply chain to meet the price the market dictates. One we talked about was channel management. For example, in the burgeoning Direct To Consumer (DTC) business model, entrepreneurs have eliminated the costs of doing business with physical wholesalers and brick-and-mortar retailers. Often the consumer is willing to pay an unchanged price. Alternatively, the entrepreneur can offer greater value via a lower price, as is the case with Warby Parker in the eyeglasses business, as well as many other innovative DTC brands.
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The key to this process is simply to treat what accounting defines as “costs” as prices that are upstream from the entrepreneur. All prices can be discovered, negotiated or re—channeled. It may not seem that way to the entrepreneur who is buying from a seller with asymmetric negotiating power. But the dynamism, creativity and innovation of the price discovery process is always available and always on the entrepreneur’s side. The only prices we know are historical. All prices in the future are to be discovered and creatively negotiated.
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Sometimes the creative solution is for buyers to organize themselves in a way that brings new negotiating power. Peter Klein used open source software as an example — users who are uncomfortable with the sticker prices of Microsoft or Oracle create an alternative service with an alternative price.
In Summary A price is the outcome of a single transaction — it does not necessarily hold for future transactions.
Prices are determined by the consumer — in the medium to long term.
Ultimately, the consumer also determines prices further up the value chain because all intermediate prices must contribute towards a cost-of-goods that is less than the price the consumer is willing to pay.
Entrepreneurs take control when they consider pricing as a dynamic, creative discovery process. Creativity spans pricing segmentation (different prices for different customers on different occasions in different contexts), pricing objectives (one transaction, multiple transactions, long term loyalty, etc.) and product-service-price repackaging.
In all cases, deep knowledge and understanding of customers and vendors yields the understanding that informs effective creativity and discovery, and experimentation yields new knowledge.
Additional Resource "The Process of Pricing Discovery" (PDF): Mises.org/E4E_34_PDF
ABSTRACT: There is an avoidable tension in a recently presented argument against the income effect from the perspective of Austrian or causal-realist price theory. The argument holds that a constant purchasing power of money is a necessary assumption for constructing an individual demand curve for a specific good, and hence that price changes along the demand curve are by definition incapable of exerting a “purchasing power effect,” that is, an income effect in standard neoclassical terminology. Price changes are, however, never neutral to the purchasing power of money. We show that the necessary assumption for the construction of a demand curve for a specific good is not the constant purchasing power of money as such, but rather constant opportunity costs of expending money on the good in question. On this basis we show that it is possible to derive a type of income effect in causal-realist price theory. Yet, it might be more appropriate to call it a “wealth effect.” Regardless of important and undeniable differences, the gulf between neoclassical and Austrian microeconomics on this point is thus smaller than it has been made to be.
KEYWORDS: income effect, wealth effect, causal-realist tradition, price theory, demand theory JEL CLASSIFICATION: B53, D11 Karl-Friedrich Israel (Kf_israel@gmx.de) is lecturer at the Institute for Economic Policy at Leipzig University, Germany.
Quarterly Journal of Austrian Economics 21, no. 4 (Winter 2018) full issue, click here.
- INTRODUCTION In a recent publication, Salerno (2018) argues that the income effect is an illusion of neoclassical microeconomics. He demonstrates his claim on the basis of causal-realist price theory in the tradition of Menger, Böhm-Bawerk, Mises, Robbins, Wicksteed, and Rothbard. He thereby picks up a long-standing debate that emerged with Friedman (1949, 1954), who questioned the Hicksian interpretation of the Marshallian demand curve that became the standard view in modern microeconomic demand theory.
Moreover, Salerno rebuts a critique raised by Caplan (1999) against Rothbard (2009 [1962]). The latter was accused of contradicting himself when he rejected the idea of the income effect, while still considering backward-bending labor supply curves to be possible. In fact, Salerno demonstrates that a backward-bending labor supply curve can be derived simply from the law of marginal utility and a given value scale on which leisure is ranked against money balances. Hence, the backward-bending labor supply curve is in principle independent of the income effect as explained in standard neoclassical micro.
While the gist of Salerno’s argument is sound, there is a certain tension related to the ceteris paribus assumptions he invokes. A slight adjustment of the assumptions, however, suggests that there is a type of income effect to be identified in causal-realist price theory. A more appropriate label might be “wealth-effect,” since what matters in causal-realist demand and price theory are stocks of goods that individuals possess and demand at any given moment, rather than flows of goods, which are a derivative of exchanges, as Salerno convincingly argues.
We will first summarize Salerno’s argument in the next section before the tension caused by his stated assumptions is highlighted. We will then proceed to conduct a similar analysis with an adjusted set of assumptions. Finally, the income or “wealth” effect that emerges is illustrated by means of a numerical example.
- THE CAUSAL-REALIST ARGUMENT AGAINST THE INCOME EFFECT Standard neoclassical microeconomics separates the effect of price changes along a given demand curve into substitution and income effects. This analysis was introduced by Hicks (1946 [1939]). The underlying assumptions for the construction of the demand curve for a certain good are that the actor’s tastes and preferences, their monetary income, as well as the money prices of all other goods remain constant. Hence, a change of the money price for the good under consideration along the demand curve has an impact on real income and the corresponding budget constraint.
Since then, the income effect has enjoyed a long-lasting but scattered debate in neoclassical microeconomics as summarized by Salerno (2018, pp. 27–30). He argues that Friedman and his followers were adopting a specific set of assumptions for positivist reasons. These assumptions would rule out an income effect.These assumptions include that real income remains constant, that is, a price change along the demand curve for the good under consideration goes hand in hand with offsetting price changes for other goods (Friedman, 1949, pp. 465–466). The Friedmanite income-compensated demand curve would facilitate the formulation of empirically testable predictions. Salerno thus closely follows Yeager’s (1960) review of the Methodenstreit over demand curves.
In contrast, the causal-realist rejection of the neoclassical income effect is not based on these positivist considerations that motivated Chicago School economists. Salerno attempts to show that the causal-realist rejection is at least implicitly contained, for example, in the writings of Wicksteed (1933), Mises (1998 [1949]) and Rothbard (2009 [1962]) (see also Salerno 2011, p. 14), and that it can be logically justified as an implication of the existence of value scales and the law of diminishing marginal utility.Salin (1996) has previously presented a similar critique of the neoclassical income effect. He concluded that it is a “myth” and since he regarded it as a necessary condition for a backward-bending labor supply curve, he drew the erroneous conclusion that the latter is impossible. Salerno (2018, pp. 37–43) demonstrates why this conclusion is false.
Demand curves in that tradition are taken to be pedagogical tools used to illustrate the inverse relationship between the money price of any good and the quantity demanded, which is an essential part of the process of market price formation. Demand curves are thus not seen to be “real” or anything measurable and observable in the external world. They are abstractions from subjective ordinal preference rankings, which are more fundamental and in an important sense “real,” as they partly reveal themselves in every action and choice: “Without the concept of a scale of values, it would be impossible to even describe an acting being or speculate meaningfully about the subjective processes that give rise to purposeful behavior” (Salerno 2018, p. 31).
Different individual value scales in combination with the existing stocks of goods owned by those individuals determine the equilibrium structure of quantities and prices of goods exchanged on the market. As Salerno (2018, p. 31) puts it: “This momentary equilibrium position denotes a state in which all consumers allocate expenditures across goods so that the marginal utility of the last unit of each good purchased just exceeds the marginal utility of the sum of money expended for its price.” Demand and supply curves are just means to facilitate the grasp of that mechanism.
One fundamental distinction from the standard neoclassical view that can be drawn directly from this statement is that money itself is treated as a valuable good in causal-realist analysis. It is not simply taken to be a measure of value, or a numeraire. Another important difference is that income as a flow of money plays only a secondary role. In fact, income is the result of market exchanges at certain money prices that one seeks to explain, but “[a]t the moment before any set of exchanges is consummated all that objectively exists are given individual stocks of goods and money” (p. 32).
Salerno does not deny the indirect impact that expected future income may have on the subjective value of existing cash balances in the present. However, for actual monetary exchanges occurring on the market, it is precisely the latter that is crucial: the subjective valuation of cash balances at the moment immediately before the exchanges are realized.Salerno (2018, p. 32) explains the special role of the concept of income in economic theory as follows:The notion of (net) income as a “flow” is the outcome of the individual entrepreneur’s judgment of a recorded sequence of concrete transactions during a definite period of the past; or it may refer to his summary appraisement of quantities of goods or money that will accrue from discrete acts of exchange expected to take place during a relevant future time period. In either case, it is the product of a subjective judgment, because income in economic theory exists on a different plane of abstraction from realized prices and present stocks of goods and money. The concept of a stock of goods or a realized price is a first-order abstraction of an observable phenomenon referring to an objective result of valuation and action. The twin concepts of income and capital are, in contrast, derived abstractions referring to unobservable mental categories used by the actor in calculating the costs and returns of alternative uses of the objective means of action. These categories are employed in the intellectual process of economic calculation to establish a quantitative distinction that enables capitalist-entrepreneurs and factor owners to net out the consumable product from the gross revenues of their productive activities and to thereby maintain intact the capital value of their resources and their level of consumption in the future.
In order to derive a demand schedule, certain ceteris paribus assumptions are necessary. According to Salerno (2018, p. 32),
[b]ecause it seeks to explain prices as the outcome of a unitary valuation process that includes money, causal-realist price theory holds the following data constant in deriving the individual demand curve: 1. the buyer’s value scale; 2. his money balances; 3. all other prices; and 4. the (anticipated) purchasing power of money.
Thus, in Salerno’s (2018, p. 34) presentation of the argument, in order to be able to rank units of money along with various units of other goods on an ordinal unitary value scale a given purchasing power of money must be presupposed:
In the causal-realist derivation of the individual demand curve, then, units of various goods and of money are ranked and compared with one another by the individual. But in order to intermingle units of money with units of goods on a unitary value scale and judge their relative utilities, a pre-existing purchasing power of money must be assumed.
This assumption is deemed necessary by Salerno, because one has to “abstract from the complexities of the value scale […] to trace out a curve that isolates the relationship between the price and quantity demanded of a single good” (p. 35). Hence, if variations in the purchasing power are not permissible, when constructing demand curves, there can be no such thing as an “income effect,” which relies on changes in the purchasing power of money. This is why Salerno calls it more appropriately “purchasing power effect.” He summarizes his argument as follows:
Put another way, the demand curve is based on a person’s overall economic position and his expectations prevailing in the moment preceding action […] If this were not the case, if the demand curve did not refer to a period temporally and logically antecedent to action, it would be impossible for individuals to formulate a coherent value scale, because the purchasing power of money would be unknown and units of money could not be meaningfully ranked against units of goods. The very existence of money prices thus logically implies the absence of an income effect or, more properly, a “purchasing power effect.” That is, in causal-realist analysis, the individual’s ex ante real money stock cannot vary with movements along the demand curve, because the curve can only be derived based on an already existing and “known”—or rather, definitely anticipated—purchasing power of money. (Salerno 2018, p. 36)
The effect emerging from a price change along a given demand curve would then have to be interpreted entirely as a substitution effect (Salerno 2018, pp. 36-37).
- THE TENSION IN THE ARGUMENT The problem with the argument presented by Salerno (2018) lies in the ceteris paribus assumptions that hold all other prices (3) as well as the purchasing power of money (4) constant, while the price of the good under consideration is allowed to change along the demand curve. If the assumption of a constant purchasing power is really necessary to construct the demand curve in the first place, then an obvious tension emerges once we allow the money price for the good to vary along that curve. Changes of the money price of a good are inextricably linked to the purchasing power of money.
The purchasing power of money corresponds to the array of goods that can be exchanged against a given sum of money on the market. Hence, whenever some money price is allowed to change ceteris paribus, it has a direct effect on the purchasing power of money. When a money price increases along the demand curve, then the exchange value of money and hence its purchasing power decrease, and vice versa. If, however, the demand curve for a specific good is itself contingent on the purchasing power of money, a price change along a given demand curve is contradictory as it destroys the underlying assumption on which the demand curve is based. In other words, a price change along the demand curve affects the demand curve itself as it changes the purchasing power of money. There could thus be no price change along the demand curve.
Salerno (2018, p. 34) himself is aware of the problem to a certain degree, but he seems to be convinced that it is sufficiently mitigated by invoking the time element:
The marginal utilities of goods today are derived directly from the varying importance of the wants they are expected to satisfy today. However, judging the subjective marginal utility of money today necessarily entails knowing yesterday’s objective purchasing power of money, that is, the inverse of the structure of money prices in all their particularity. This means that before an individual can formulate his value scale in anticipation of today’s exchanges, he must refer back to the purchasing power of money that emerged in the immediately previous round of exchanges. In other words, an individual’s value rankings and marginal utilities of goods and money, which are operative in determining today’s structure of prices, are based on today’s valuations of goods and money. But the valuation of money today must refer back to yesterday’s purchasing power of money, because it is the only means by which its prospective purchasing power in today’s market can be anticipated and its marginal utility set. If money did not have a pre-existing purchasing power — that is, if money never exchanged against goods in the past — market participants would lack the knowledge needed to assign a value ranking to it and, consequently, no one would accept it in exchange for goods today. […] Every money price therefore always contains a time component. […]
There is, therefore, no contradiction in assuming that the purchasing power of money is constant and that the price of the good whose demand curve is being analyzed is permitted to vary. For the purchasing power of money that is held constant and on the basis of which the individual establishes his demand curve today is the purchasing power of money expected to prevail today, which refers back to yesterday’s structure of prices as the starting point for the forecast.
This is unconvincing, since the purpose of the whole exercise is to illustrate and “explain the formation of ´realized prices’,” as Salerno (2018, p. 32) pointed out earlier in his article, that is, in other words, the purpose of the exercise is to explain the purchasing power of money, at least partly, with respect to a certain good. If the demand curve derived rests on the assumption that the purchasing power of money remains constant, then it does not give us what it is supposed to, namely, the isolated relationship between the price and quantity demanded of a single good and hence an illustration of an essential part of the price formation process on the market that in turn explains changes in the purchasing power of money.
There is no question about the necessity of ceteris paribus assumptions in order to derive a demand curve from a hypothetical subjective value scale. We obviously have to keep that value scale constant, but the assumptions cannot extend to the phenomena we seek to explain. Fortunately, the problem is easily solved with a slight adjustment of the assumptions.
The demand curve is supposed to give us the quantities of a good that an individual would purchase at different prices. The trade-off that the individual faces is thus between the marginal value of units of money versus the marginal value of units of the good in question. The marginal value of units of money are essentially given by the opportunity costs of expending a given sum of money in exchange for the good in question. These opportunity costs are indeed closely related to the purchasing power of money. More precisely, however, it is the purchasing power of money with respect to other goods that the person values and might want to acquire. There are other factors that might come into play, such as the expectations about the future development of the purchasing power of money, future monetary income etc. Whatever it may be, the important assumption for the construction of a demand curve from an ordinal value scale is that the subjective value of money does not vary relative to the subjective value of the good in question.
Hence, what is needed in order to derive an individual demand curve for a good is simply a fixed ordinal preference ranking of units of money and units of the good. Since, that ranking is subjective and the relative importance of the factors that influence it ultimately is subjective too, we cannot boil this assumption further down. Taking for granted that the only purpose of money is to be exchanged and that its subjective value derives essentially from its purchasing power, we could reformulate the assumption in very much the same way as Hicks did, namely, that money prices for all other goods would have to remain unchanged. Hence, with respect to Salerno’s stated assumptions, there is only a minor adjustment needed. One has to hold constant: 1. the buyer’s value scale; 2. his money balances; 3. all other prices; and 4. the (anticipated) purchasing power of money with respect to other goods.Only the italics at the end have been added to Salerno’s original list of assumptions. Given our notion of the purchasing power of money defined as the array of money prices for various goods, it has to be noted that point 4 is already implied in point 3. However, strictly speaking, what has to be held constant for the construction of the demand schedule are the opportunity costs of expending a given sum of money on the good in question, whatever the influencing factors of this subjective notion may be.
It is important to realize that for the derivation of a demand schedule we cannot use a fixed preference ranking for units of all conceivable goods on a unitary scale, since such a ranking is indeed dependent on the price structure and would be altered by price changes along the demand curve as Salerno (2018, pp. 36–37) explains. Whether or not an agent would rather have the first unit of good A than the first unit of good B depends on the opportunity costs of acquiring them. The latter are most notably determined by their money prices. Hence, starting from a fixed unitary value scale that ranks units of multiple goods as well as money, we cannot derive the demand curve that we set out to construct, namely, one that allows for analyzing price changes along the curve, because again, price changes along the curve would jeopardize the underlying assumption of the fixed unitary preference ranking that was used to construct the curve in the first place.
Instead, we simply need a fixed preference ranking for units of money and units of the one good that we wish to analyze. No other goods appear in the ranking. On such a scale, the changes in the relative ranks of units of the good with respect to units of other goods remain implicit—hidden behind the units of money actually ranked. In fact, this way we could not illustrate substitution effects between different specific goods directly. We can, however, illustrate substitution effects between the one good under consideration and money.
This point deserves emphasis: deriving the demand curve for a good requires fixing its ranks on a unitary value scale. However, changing the money price of the good along the demand curve is not neutral to that ranking, unless the only good against which it is ranked is money. The necessary assumption for such a fixed ranking is that the opportunity costs of expending any given amount of money on the acquisition of the good as well as the subjective value of the good itself remain constant. We can thus analyze the substitution effect between that good and money. The substitution effects with other goods that the latter entails remain implicit. Moreover, it becomes easy to also illustrate a type of income effect, which might rather be referred to as a “wealth effect.”
In fact, as we will show below, the wealth effect is, in a sense, the more fundamental of the two. It is a direct consequence of any price change along the demand curve. A substitution effect only emerges for price changes along a segment of the curve for which the quantity actually changes, and it effectively adds to the wealth effect only in cases where demand is price-elastic.
- ILLUSTRATION OF THE “WEALTH EFFECT” IN CAUSAL-REALIST PRICE THEORY The best way to illustrate the above point is to construct a concrete example. We thus imagine a Bavarian farmer who visits the Oktoberfest in Munich, Germany, in order to consume beer.The example is obviously absurd. A Bavarian farmer would much rather stay at his local pub to drink beer than go to the touristy Oktoberfest, since the quality of the Festbier is relatively low and its price is heavily inflated. Teaching experience shows, however, that absurd and even annoying examples stick in the mind much better. He holds a cash balance of €200. The quantity of one-liter units of beer (a Masskrug in German)6 that the farmer consumes, depends on its money price, his subjective valuation of beer, as well as his subjective opportunity costs of expending a given sum of money on beer consumption. All of these factors that we assume for the following analysis to remain constant are captured in the farmer’s ordinal value scale given in Table 1.
Table 1: Ordinal Value Scale of Bavarian Farmer Holding a Cash Balance of €200 [[{"fid":"82854","view_mode":"image_no_caption","fields":{"format":"image_no_caption","alignment":"","field_file_image_alt_text[und][0][value]":false,"field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""},"type":"media","field_deltas":{"1":{"format":"image_no_caption","alignment":"","field_file_image_alt_text[und][0][value]":false,"field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""}},"attributes":{"style":"width: 450px; height: 433px;","class":"media-element file-image-no-caption","data-delta":"1"}}]]
This representation of the value scale follows the notation used in Rothbard (2009 [1962]), where the units of the good to be acquired are put in brackets and are ranked amongst the amount of money to be given up in exchange for one unit. From the ranking in Table 1, we can infer that the farmer will always hold on to at least €100 of his initial cash balance of €200, before he consumes the first Masskrug. His reservation price for the first unit of beer is €100. At any price above that threshold, he would abstain from beer consumption entirely. At any price below, he would at least consume one Masskrug. Moreover, he would buy a second unit of beer only at a price below or equal to €40. From the ordinal value scale in Table 1, we can thus derive his entire demand schedule as summarized in Table 2.
Table 2: Bavarian Farmer’s Demand Schedule for Beer Derived From His Ordinal Value Scale [[{"fid":"82855","view_mode":"image_no_caption","fields":{"format":"image_no_caption","alignment":"","field_file_image_alt_text[und][0][value]":false,"field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""},"type":"media","field_deltas":{"2":{"format":"image_no_caption","alignment":"","field_file_image_alt_text[und][0][value]":false,"field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""}},"attributes":{"style":"width: 450px; height: 203px;","class":"media-element file-image-no-caption","data-delta":"2"}}]]
Figure 1: Bavarian Farmer’s Demand Curve for Beer [[{"fid":"82856","view_mode":"image_no_caption","fields":{"format":"image_no_caption","alignment":"","field_file_image_alt_text[und][0][value]":false,"field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""},"type":"media","field_deltas":{"3":{"format":"image_no_caption","alignment":"","field_file_image_alt_text[und][0][value]":false,"field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""}},"attributes":{"style":"width: 450px; height: 242px;","class":"media-element file-image-no-caption","data-delta":"3"}}]]
The corresponding demand curve is plotted in Figure 1. As the farmer decides to consume discrete units of beer, his demand curve is a downward-sloping step function.For the sake of simplicity and brevity, we abstract from the possibility of purchasing half a Masskrug here, which would be an insult to Bavarian culture anyway, as far as a Northerner can tell.
Every price-quantity combination along the demand curve for beer corresponds to a certain amount of money that the farmer retains in his cash balance, that is, his retention demand for money. In our analysis, the sum of money retained corresponds to the farmer’s ability to satisfy other wants than his thirst for beer. This includes his demand for other goods that he might also want to consume, such as a roasted chicken, a potato salad, and a good Caribbean cigar, or it might indeed reflect his demand for money as such. The more money he retains, the better he can satisfy his demand for other goods.
At a price above €100 per Masskrug of beer, the farmer retains his entire cash balance of €200 as his opportunity costs of purchasing beer at the Oktoberfest would be too high. If the price falls below €100, he starts to spend money on beer consumption. He retains 200-P*Q(P) units of money, where P corresponds to the unit price of beer and Q(P) to the quantity of beer demanded at that price. His retention demand for money is plotted in Figure 2. Due to the discrete changes in the quantity of beer consumed, the retention demand for money follows a zigzag pattern.
Figure 2: The Farmer’s Demand for Beer and His Retention Demand for Money as a Function of the Money Price Per Unit of Beer [[{"fid":"82857","view_mode":"image_no_caption","fields":{"format":"image_no_caption","alignment":"","field_file_image_alt_text[und][0][value]":false,"field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""},"type":"media","field_deltas":{"4":{"format":"image_no_caption","alignment":"","field_file_image_alt_text[und][0][value]":false,"field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""}},"attributes":{"style":"width: 450px; height: 242px;","class":"media-element file-image-no-caption","data-delta":"4"}}]]
Overall, the retention demand for money increases back to €200 as the price falls from €100 to zero. The zigzag movements of the curve correspond to substitutions between beer and money in the farmer’s cash balance, that is, between beer and any other conceivable good that he might want to acquire with the money retained. When the price falls below a certain threshold, he lowers his retention demand for money in order to increase his demand for beer. For example, as the price falls below €40, the farmer demands a second Masskrug of beer and lowers his cash balance accordingly. He foregoes other ends he might want to pursue with the money in order to consume a larger quantity of beer.
However, the overall trend towards a bigger cash balance retained (over the relevant segment of the curve) as the price for beer decreases, captured in the right panel of Figure 2, also encapsulates a change that can be interpreted as a wealth effect. This wealth effect with respect to the cash balance becomes obvious over any segment of the demand curve for which the discrete quantity of beer consumed remains constant, that is, a segment of the curve for which the price-elasticity of demand is perfectly inelastic. For any such segment, there is nothing but an increase in the cash balance retained as the price for beer decreases and the quantity consumed remains the same. This means that the farmer’s ability to purchase other goods increases while his consumption of beer stays constant. In that sense he becomes wealthier due to decreases of the price for beer along his demand curve.
Figure 3 illustrates this wealth effect with respect to the cash balance as the price per Masskrug of beer decreases from €10.50 to €6.50. The farmer demands four units of beer for any of the two prices, but his cash balance increases from €158 to €174, leaving him better off, that is, wealthier, ceteris paribus, however he decides to use the additional units of money retained.
Figure 3: Illustration of the Wealth Effect with Respect to the Cash Balance as the Price Per Unit of Beer Drops From €10.50 to €6.50 [[{"fid":"82858","view_mode":"image_no_caption","fields":{"format":"image_no_caption","alignment":"","field_file_image_alt_text[und][0][value]":false,"field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""},"type":"media","field_deltas":{"5":{"format":"image_no_caption","alignment":"","field_file_image_alt_text[und][0][value]":false,"field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""}},"attributes":{"style":"width: 450px; height: 242px;","class":"media-element file-image-no-caption","data-delta":"5"}}]]
A critic of the above analysis might argue that the example captured in Figure 3 is merely a special case, since the quantity of beer consumed remains constant for the price change under consideration.This has in fact been pointed out by an anonymous reviewer of an earlier version of this paper. This is certainly true. The example as such does not suffice to show that something akin to the income effect exists in causal-realist price theory. Yet, it already conveys the basic idea. The example can easily be extended to a case where the price-elasticity of demand is not perfectly inelastic and that includes both wealth and substitution effects with respect to the cash balance and their translation into changes in the quantity of beer demanded.
We simply assume a price change from €10.50 to €4.00 as illustrated in Figure 4. Again, at the initial selling price the farmer consumes 4 units of beer and his retained cash balance is €158. At a selling price of €4 per unit he consumes 5 units of beer and the retained cash balance is €180. Both his cash balance and beer consumption have increased. In that sense, he is obviously wealthier than before. There clearly is a wealth effect. Yet, there is also a substitution effect.
The two effects can be separated from each other in the following way. In a first step, we hold beer consumption constant at 4 units. The farmer thus saves €26 because of the price change (4*[10.50 – 4]). His cash balance as a function of the price of beer at constant beer consumption of 4 units is given by the dashed line in Figure 4. It is simply the prolongation of the first segment of the retention demand for money at point (176, 6) under unchanged beer consumption.
Figure 4: Illustration of Wealth and Substitution Effects with Respect to the Retained Cash Balance as the Price Per Unit of Beer Drops from €10.50 to €4.00 [[{"fid":"82859","view_mode":"image_no_caption","fields":{"format":"image_no_caption","alignment":"","field_file_image_alt_text[und][0][value]":false,"field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""},"type":"media","field_deltas":{"6":{"format":"image_no_caption","alignment":"","field_file_image_alt_text[und][0][value]":false,"field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""}},"attributes":{"style":"width: 450px; height: 242px;","class":"media-element file-image-no-caption","data-delta":"6"}}]]
In a second step, we adjust the quantity consumed. The cash balance would be €184 without such an adjustment. However, given the value scale of the farmer, we notice that due to the increased cash balance, the marginal value of money has fallen to the point that the farmer would rather substitute another €4 for the fifth unit of beer. This is the substitution effect.
The net effect on the retained quantity of money is an increase by €22, from initially €158 to €180. Solely with regard to the farmer’s retained cash balance the overall effect of the price change along his demand curve for beer consists of a wealth effect of 26€ and a substitution effect of -€4. The substitution can thus be financed entirely out of the farmer’s wealth improvement in terms of his increased cash balance.
In the above example the overall sum of money spent on beer consumption is lower at a unit price of €4 than at a unit price of €10.50. This means that the farmer’s demand for beer is still inelastic, albeit not perfectly inelastic, between the two points considered. However, the same decomposition can be applied to other points on the schedule between which demand is price-elastic, that is, for which the substitution effect outweighs the wealth effect as described above.
Figure 5: Illustration of Wealth and Substitution Effects with Respect to the Retained Cash Balance as the Price Per Unit of Beer Drops from €6.50 to €5.90 [[{"fid":"82860","view_mode":"image_no_caption","fields":{"format":"image_no_caption","alignment":"","field_file_image_alt_text[und][0][value]":false,"field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""},"type":"media","field_deltas":{"7":{"format":"image_no_caption","alignment":"","field_file_image_alt_text[und][0][value]":false,"field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""}},"attributes":{"style":"height: 242px; width: 450px;","class":"media-element file-image-no-caption","data-delta":"7"}}]]
Take, for example, an initial price of €6.50 and an exogenous price drop to €5.90. Analogously to the above case, the wealth effect this time would amount to €2.40 (4*[6.50-5.90]). Without an adjustment of beer consumption, the retained cash balance would thus increase from €174 to €176.40. This would lower the marginal value of money sufficiently to make a substitution of €5.90 for a fifth unit of beer beneficial. The net effect on the farmer’s cash balance is then -€3.50. He ultimately holds a cash balance of €170.50. This case is illustrated in Figure 5.
Only in this last example, for which the demand for beer is price-elastic, that is, the substitution effect outweighs the wealth effect, a net substitution between beer and money occurs. In other words, the increase in beer consumption cannot be financed entirely out of the wealth effect.
In the previous case, shown in Figures 4, the demand for beer is price-inelastic. Hence, there is no sacrifice to be made in terms of a lower cash balance, as compared to the cash balance retained at the initial price, in order to increase beer consumption. There is no net substitution. At the lower price for beer the farmer can increase his beer consumption by one unit and also demand larger quantities of whatever goods happen to have the highest marginal value for him—be that money itself, or any other good he wants to consume. The adjustment in the farmer’s consumption decisions is better interpreted as a pure wealth effect.
In the last example, there is a net substitution. Expansion of beer consumption by one unit as the price falls from €6.50 to €5.90 requires the sacrifice of a diminished cash balance as compared to the cash balance that would have been retained at the higher price. The change in consumption can thus partly be interpreted as a net substitution effect. This, however, does not mean that there is no wealth effect at all. There always is a wealth improvement when the price of one good falls, ceteris paribus, because any basket of goods that could have been acquired without the price change can also be acquired with the price change. Any net substitution must then correspond to a wealth improvement that goes even beyond the wealth effect with respect to the cash balance as described above.
Focusing on the cash balance allows us to express both wealth and substitution effect quantitatively. Only in the case where the substitution effect outweighs the wealth effect, as in Figure 5, a net substitution or sacrifice in terms of a diminished cash balance is necessary to expand the consumption of beer. This means that only a part of the substitution can be financed out of the wealth improvement due to the wealth effect. The remainder of the substitution requires a decrease in the quantity of money retainedOne should always keep in mind that the decrease referred to in this discussion occurs with respect to the cash balance that would have been retained at the higher price. and hence diminishes the farmer’s capacity to acquire other goods.
It is the net substitution with respect to the cash balance that can be interpreted as a genuine (or net) substitution effect with respect to the quantity of beer consumed. The other part, as it is financed out of the wealth effect with respect to the cash balance, can be interpreted as a wealth effect akin to the income effect in standard neoclassical price theory.
Both effects can be expressed in relative terms. The wealth effect in Figure 5 is €2.40. Hence, 40.68 percent of the increase in beer consumption from the fourth to the fifth unit at a unit price of €5.90 are financed out of the wealth effect, while 59.32 percent of the increase require a net substitution. The net substitution of €3.50 translates into the substitution effect with respect to the quantity of beer. This is illustrated in Figure 6.
Figure 6: Illustration of Wealth and Substitution Effects with Respect to the Quantity of Beer Consumed as the Price Per Unit of Beer Drops from €6.50 to €5.90 and Beer Consumption Increases from Four to Five Units [[{"fid":"82861","view_mode":"image_no_caption","fields":{"format":"image_no_caption","alignment":"","field_file_image_alt_text[und][0][value]":false,"field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""},"type":"media","field_deltas":{"8":{"format":"image_no_caption","alignment":"","field_file_image_alt_text[und][0][value]":false,"field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""}},"attributes":{"style":"width: 450px; height: 242px;","class":"media-element file-image-no-caption","data-delta":"8"}}]]
The proposed decomposition has the following implications. First of all, it allows to quantify the substitution and wealth effects with respect to the retained cash balance in all conceivable cases of an exogenous price change.
When, as a result of a lower unit price, the consumption of beer increases but is price-inelastic (Figure 4), the entire increase in consumption is interpreted as a wealth effect. Since there is no net substitution in such a case, there is no substitution effect with respect to the increased quantity of beer. This is because the cash balance that would have been retained at the higher price is taken to be the relevant benchmark and it is smaller than the cash balance retained at the lower price. Hence, the increase in beer consumption can be financed entirely out of the wealth improvement with respect to the cash balance.
In the case of price-elasticity (Figure 5), there is a net substitution. The cash balance retained at the lower price is smaller than the cash balance that would have been retained at the higher price. Only a part of the increase in beer consumption can be financed out of the wealth effect with respect to the cash balance. This part translates into the wealth effect with respect to beer consumption. The remainder is interpreted as the substitution effect.
The other goods that the farmer might want to acquire remain implicit in the above examples. If we wanted to exemplify the substitution and wealth effects further, we would have to set up a second value scale on which money is ranked against other goods than beer that the farmer wants to purchase at the Oktoberfest.
In order to set up the second value scale, the money prices for these goods have to be held constant.For this extended exemplification of the wealth and substitution effects we thus have to adopt the standard Hicksian assumption of constant money prices for all other goods. From that scale, we could then in very much the same way as above derive the farmer’s demand for other goods as a function of the sum of money he retains after beer consumption. Table 3 contains such a mapping.
Table 3: Bavarian Farmer’s Demand for Other Goods as a Function of the Sum of Money Retained After Beer Consumption Given a Fixed Price Structure for Other Goods (€12 roasted chicken, €6 potato salad, €6 cigar) [[{"fid":"82862","view_mode":"image_no_caption","fields":{"format":"image_no_caption","alignment":"","field_file_image_alt_text[und][0][value]":false,"field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""},"type":"media","field_deltas":{"9":{"format":"image_no_caption","alignment":"","field_file_image_alt_text[und][0][value]":false,"field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""}},"attributes":{"style":"width: 450px; height: 231px;","class":"media-element file-image-no-caption","data-delta":"9"}}]]
We assume a fixed price structure for the other goods. As the money price for a Masskrug changes along the farmer’s demand schedule for beer, we can now trace the wealth and substitution effects in terms of real consumption decisions. At a price of €10.50 per unit of beer, the farmer retains €158 after beer consumption. However, he decides to also purchase a roasted chicken at €12 and a potato salad at €6, thus reducing his cash balance further to €140. As the price per unit of beer decreases to €6.50, the farmer does not change the quantity of beer consumed, but instead buys an additional supplement rounding up the evening, that is, a cigar for €6. Even though his real consumption increases, his final cash balance is even higher, namely €150, due to the strong decrease in the unit price of beer.
If the unit price was to fall even further to only €3, the farmer would expand his consumption of beer and cigars by one unit each, and still end up with a higher cash balance of €152 at the end. Again, there is no net substitution required.
We can exemplify a net substitution in Table 3 as we imagine again a price change per unit of beer from €6.50 to €5.90. At €6.50, the farmer demands 4 Masskrug and enjoys 1 cigar as a supplement. He holds a final cash balance of €150. At €5.90, however, he would rather drink the fifth Masskrug of beer and forego the enjoyment of the cigar. He would hold a final cash balance of €152.50. He foregoes the consumption of the cigar because the opportunity costs are too high, that is, he prefers to hold a cash balance of at least €146.50 over the consumption of the first cigar. Hence, he substitutes the fifth Masskrug and a slight increase of his cash balance by €2.50 for the first cigar.
We want to emphasize again that there is also a wealth effect associated with the price change from €6.50 to €5.90 per Masskrug of beer. The farmer saves 60 cents on the first four beers he consumes, adding up to an amount of €2.40. This is, taken as such, undoubtedly a wealth improvement. The above approach that takes account of the cash balance allows to give a quantitative expression of the wealth effect. It goes without saying that it does not provide us with an exact measure of the wealth improvement in terms of subjective utility that results from a lower price per unit of beer.
- CONCLUSION Salerno (2018) argues that the neoclassical income effect is a theoretical illusion. However, as our analysis has shown, there is a kind of income effect, or rather “wealth effect,” to be identified in causal-realist price theory that plays essentially the same role as the income effect in standard microeconomics. Salerno’s conclusion that everything that emerges from a price change along the demand curve for a specific good are substitution effects, must be regarded as too strong a claim. Salerno is misled by his assumption that the purchasing power of money needs to be held constant in order to derive the demand curve for a certain good.
As seen above, not the purchasing power as such, but the opportunity costs of expending any given amount of money on the good in question need to be held constant. These opportunity costs are undoubtedly related to the purchasing power of money, but it is the purchasing power with respect to all other goods that matters here. If we regard the latter as the only relevant factor, then our assumption for the derivation of the demand curve essentially boils down to Hicks’s original assumption, namely, that the money prices for all other goods have to remain constant. The actual gulf between the standard neoclassical view and the causal-realist or Austrian take on substitution and income effects thus becomes much less pronounced.
However, there are two important points of divergence. First, in the causal-realist tradition, money is treated as an actual good that is valued as such and that is demanded or retained. It is not simply a numeraire. It is through the ordinal ranking of units of money against units of a specific good on a unitary value scale that we can derive the individual demand curve for that good. Second, income plays only an indirect role. The relevant magnitude is the cash balance of an economic actor immediately before exchanges take place. Expected future income may indirectly affect how these cash balances are valued in the present. But the present valuation of the cash balance is decisive, whatever the influencing factors are. Hence, the effect we have illustrated above is more appropriately called wealth effect. It can be given a quantitative expression in terms of changes in the cash balance retained that translates directly into the actor’s capacity to acquire additional goods.
The presented approach provides an easy and direct illustration of a very real phenomenon that most people intuitively understand, namely, that consumers are made better off when a given good can be acquired at a lower money price. The wealth improvement with respect to the cash balance may be used to finance an increase in the quantity of the good demanded. This is the wealth effect. Only the remainder, in case of a price-elastic demand schedule, requires a net substitution. This is the substitution effect.
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.
[Chapter 11 from Human Action.]
- The Gradation of the Means2. The Barter-Fiction of the Elementary Theory of Value and Prices3. The Problem of Economic Calculation4. Economic Calculation and the Market
- The Gradation of the Means Acting man transfers the valuation of ends he aims at to the means. Other things being equal, he assigns to the total amount of the various means the same value he attaches to the end which they are fit to bring about. For the moment we may disregard the time needed for production of the end and its influence upon the relation between the value of the ends and that of the means.
The gradation of the means is, like that of the ends, a process of preferring a to b. It is preferring and setting aside. It is manifestation of a judgment that a is more intensely desired than is b. It opens a field for application of ordinal numbers, but it is not open to application of cardinal numbers and arithmetical operations based on them. If somebody gives me the choice among three tickets entitling one to attend the operas Aïda, Falstaff, and Traviata and I take, if I can only take one of them, Aïda, and if I can take one more, Falstaff also, I have made a choice. That means: under given conditions I prefer Aïda and Falstaff to Traviata; if I could only choose one of them, I would prefer Aïda and renounce Falstaff. If I call the admission to Aïda a, that to Falstaff b and that to Traviata c, I can say: I prefer a to b and b to c.
The immediate goal of acting is frequently the acquisition of countable and measurable supplies of tangible things. Then acting man has to choose between countable quantities; he prefers, for example, 15 r to 7 p; but if he had to choose between 15 r and 8 p, he might prefer 8 p. We can express this state of affairs by declaring that he values 15 r less than 8 p, but higher than 7 p. This is tantamount to the statement that he prefers a to b and b to c. The substitution of 8 p for a, of 15 r for b and of 7 p for c changes neither the meaning of the statement nor the fact that it describes. It certainly does not render reckoning with cardinal numbers possible. It does not open a field for economic calculation and the mental operations based upon such calculation.
- The Barter-Fiction of the Elementary Theory of Value and Prices The elaboration of economic theory is heuristically dependent on the logical processes of reckoning to such an extent that the economists failed to realize the fundamental problem involved in the methods of economic calculation. They were prone to take economic calculation as a matter of course; they did not see that it is not an ultimate given, but a derivative requiring reduction to more elementary phenomena. They misconstrued economic calculation. They took it for a category of all human action and ignored the fact that it is only a category inherent in acting under special conditions. They were fully aware of the fact that interpersonal exchange, and consequently market exchange effected by the intermediary of a common medium of exchange — money, and therefore prices, are special features of a certain state of society's economic organization which did not exist in primitive civilizations and could possibly disappear in the further course of historical change.The German Historical School expressed this by asserting that private ownership of the means of production, market exchange, and money are "historical categories." But they did not comprehend that money prices are the only vehicle of economic calculation. Thus most of their studies are of little use. Even the writings of the most eminent economists are vitiated to some extent by the fallacies implied in their ideas about economic calculation.
The modern theory of value and prices shows how the choices of individuals, their preferring of some things and setting aside of other things, result, in the sphere of interpersonal exchange, in the emergence of market prices.Cf. especially Eugen von Böhm-Bawerk, Kapital and Kapitalzins, Pt. II, Bk. III These masterful expositions are unsatisfactory in some minor points and disfigured by unsuitable expressions. But they are essentially irrefutable. As far as they need to be amended, it must be done by a consistent elaboration of the fundamental thoughts of their authors rather than by a refutation of their reasoning.
In order to trace back the phenomena of the market to the universal category of preferring a to b, the elementary theory of value and prices is bound to use some imaginary constructions. The use of imaginary constructions to which nothing corresponds in reality is an indispensable tool of thinking. No other method would have contributed anything to the interpretation of reality. But one of the most important problems of science is to avoid the fallacies which ill-considered employment of such constructions can entail.
The elementary theory of value and prices employs, apart from other imaginary constructions to be dealt with later,See below, pp. 237-257. the construction of a market in which all transactions are performed in direct exchange. There is no money; goods and services are directly bartered against other goods and services. This imaginary construction is necessary. One must disregard the intermediary role played by money in order to realize that what is ultimately exchanged is always economic goods of the first order against other such goods. Money is nothing but a medium of interpersonal exchange. But one must carefully guard oneself against the delusions which this construction of a market with direct exchange can easily engender.
A serious blunder that owes its origin and its tenacity to a misinterpretation of this imaginary construction was the assumption that the medium of exchange is a neutral factor only. According to this opinion the only difference between direct and indirect exchange was that only in the latter was a medium of exchange used. The interpolation of money into the transaction, it was asserted, did not affect the main features of the business. One did not ignore the fact that, in the course of history, tremendous alterations in the purchasing power of money have occurred and that these fluctuations often convulsed the whole system of exchange. But it was believed that such events were exceptional facts caused by inappropriate policies. Only "bad" money can bring about such disarrangements. In addition people misunderstood the causes and effects of these disturbances. They tacitly assumed that changes in purchasing power occur with regard to all goods and services at the same time and to the same extent. This is, of course, what the fable of money's neutrality implies. The whole theory of catallactics, it was held, can be elaborated under the assumption that there is direct exchange only. If this is once achieved, the only thing to be added is the "simple" insertion of money terms into the complex of theorems concerning direct exchange. However, this final completion of the catallactic system was considered of minor importance only. It was not believed that it could alter anything essential in the structure of economic teachings. The main task of economics was study of direct exchange. What remained to be done besides this was at best only a scrutiny of the problems of "bad" money.
Complying with this opinion economists neglected to lay due stress upon the problems of indirect exchange. Their treatment of monetary problems was superficial; it was only loosely connected with the main body of their scrutiny of the market process. About the turn of the nineteenth and twentieth centuries, the problems of indirect exchange were by and large relegated to a subordinate place. There were treatises on catallactics which dealt only incidentally and cursorily with monetary matters, and there were books on currency and banking which did not even attempt to integrate their subject into the structure of a catallactic system. At the universities of the Anglo-Saxon countries there were separate chairs for economics and for currency and banking, and at most of the German universities monetary problems were almost entirely disregarded.Neglect of the problems of indirect exchange was certainly influenced by political prepossessions. People did not want to give up the thesis according to which economic depressions are an evil inherent in the capitalist mode of production and are in no way caused by attempts to lower the rate of interest by credit expansion. Fashionable teachers of economics deemed it "unscientific" to explain depressions as a phenomenon originating "only" out of events in the sphere of money and credit. There were even surveys of the history of business cycle theory which omitted any discussion of the monetary thesis. Cf., e.g., Eugen von Bergmann, Geschichte der nationalökonomischen Krisentheorien (Stuttgart, 1895). Only later economists realized that some of the most important and most intricate problems of catallactics are to be found in the field of indirect exchange and that an economic theory which does not pay full regard to them is lamentably defective. The coming into vogue of investigations concerning the relation between the "natural rate of interest" and the "money rate of interest," the ascendancy of the monetary theory of the trade cycle, and the entire demolition of the doctrine of the simultaneousness and evenness of the changes in the purchasing power of money were marks of the new tenor of economic thought. Of course, these new ideas were essentially a continuation of the work gloriously begun by David Hume, the British Currency School, John Stuart Mill and Cairnes.
Still more detrimental was a second error which emerged from the careless use of the imaginary construction of a market with direct exchange.
An inveterate fallacy asserted that things and services exchanged are of equal value. Value was considered as objective, as an intrinsic quality inherent in things and not merely as the expression of various people's eagerness to acquire them. People, it was assumed, first established the magnitude of value proper to goods and services by an act of measurement and then proceeded to barter them against quantities of goods and services of the same amount of value. This fallacy frustrated Aristotle's approach to economic problems and, for almost two thousand years, the reasoning of all those for whom Aristotle's opinions were authoritative. It seriously vitiated the marvelous achievements of the classical economists and rendered the writings of their epigones, especially those of Marx and the Marxian school, entirely futile. The basis of modern economics is the cognition that it is precisely the disparity in the value attached to the objects exchanged that results in their being exchanged. People buy and sell only because they appraise the things given up less than those received. Thus the notion of a measurement of value is vain. An act of exchange is neither preceded nor accompanied by any process which could be called a measuring of value. An individual may attach the same value to two things; but then no exchange can result. But if there is a diversity in valuation, all that can be asserted with regard to it is that one a is valued higher, that it is preferred to one b. Values and valuations are intensive quantities and not extensive quantities. They are not susceptible to mental grasp by the application of cardinal numbers.
However, the spurious idea that values are measurable and are really measured in the conduct of economic transactions was so deeply rooted that even eminent economists fell victim to the fallacy implied. Even Friedrich von Wieser and Irving Fisher took it for granted that there must be something like measurement of value and that economics must be able to indicate and to explain the method by which such measurement is effected.For a critical analysis and refutation of Fisher's argument, cf. Mises, The Theory of Money and Credit, trans. by H. E. Batson (London, 1934), pp. 42-44; for the same with regard to Wieser's argument, Mises, Nationalökonomie (Geneva, 1940), pp. 192-194. Most of the lesser economists simply maintained that money serves "as a measure of values."
Now, we must realize that valuing means to prefer a to b. There is — logically, epistemologically, psychologically, and praxeologically — only one pattern of preferring. It does not matter whether a lover prefers one girl to other girls, a man one friend to other people, an amateur one painting to other paintings, or a consumer a loaf of bread to a piece of candy. Preferring always means to love or to desire a more than b. Just as there is no standard and no measurement of sexual love, of friendship and sympathy, and of aesthetic enjoyment, so there is no measurement of the value of commodities. If a man exchanges two pounds of butter for a shirt, all that we can assert with regard to this transaction is that he — at the instant of the transaction and under the conditions which this instant offers to him — prefers one shirt to two pounds of butter. It is certain that every act of preferring is characterized by a definite psychic intensity of the feelings it implies. There are grades in the intensity of the desire to attain a definite goal and this intensity determines the psychic profit which the successful action brings to the acting individual. But psychic quantities can only be felt. They are entirely personal, and there is no semantic means to express their intensity and to convey information about them to other people.
There is no method available to construct a unit of value. Let us remember that two units of a homogeneous supply are necessarily valued differently. The value attached to the nth unit is lower than that attached to the (n-1)th unit.
In the market society there are money prices. Economic calculation is calculation in terms of money prices. The various quantities of goods and services enter into this calculation with the amount of money for which they are bought and sold on the market or for which they could prospectively be bought and sold. It is a fictitious assumption that an isolated self-sufficient individual or the general manager of a socialist system, i.e., a system in which there is no market for means of production, could calculate. There is no way which could lead one from the money computation of a market economy to any kind of computation in a nonmarket system.
The Theory of Value and Socialism
Socialists, Institutionalists and the Historical School have blamed economists for having employed the imaginary construction of an isolated individual's thinking and acting. This Robinson Crusoe pattern, it is asserted, is of no use for the study of the conditions of a market economy. The rebuke is somewhat justified. Imaginary constructions of an isolated individual and of a planned economy without market exchange become utilizable only through the implication of the fictitious assumption, self-contradictory in thought and contrary to reality, that economic calculation is possible also within a system without a market for the means of production.
It was certainly a serious blunder that economists did not become aware of this difference between the conditions of a market economy and a non-market economy. Yet the socialists had little reason for criticizing this fault. For it consisted precisely in the fact that the economists tacitly implied the assumption that a socialist order of society could also resort to economic calculation and that they thus asserted the possibility of the realization of the socialist plans.
The classical economists and their epigones could not, of course, recognize the problems involved. If it were true that the value of things is determined by the quantity of labor required for their production or reproduction, then there is no further problem of economic calculation. The supporters of the labor theory of value cannot be blamed for having misconstrued the problems of a socialist system. Their fateful failure was their untenable doctrine of value. That some of them were ready to consider the imaginary construction of a socialist economy as a useful and realizable pattern for a thorough reform of social organization did not contradict the essential content of their theoretical analysis. But it was different with subjective catallactics. It was unpardonable for the modern economists to have failed to recognize the problems involved.
Wieser was right when he once declared that many economists have unwittingly dealt with the value theory of communism and have on that account neglected to elaborate that of the present state of society.Cf. Friedrich von Wieser, Der natürliche Wert (Vienna, 1889),p. 60, n. 3. It is tragic that he himself did not avoid this failure.
The illusion that a rational order of economic management is possible in a society based on public ownership of the means of production owed its origin to the value theory of the classical economists and its tenacity to the failure of many modern economists to think through consistently to its ultimate conclusions the fundamental theorem of the subjectivist theory. Thus the socialist utopias were generated and preserved by the shortcomings of those schools of thought which the Marxians reject as "an ideological disguise of the selfish class interest of the exploiting bourgeoisie." In truth it was the errors of these schools that made the socialist ideas thrive. This fact clearly demonstrates the emptiness of the Marxian teachings concerning "ideologies" and its modern offshoot, the sociology of knowledge.
- The Problem of Economic Calculation Acting man uses knowledge provided by the natural sciences for the elaboration of technology, the applied science of action possible in the field of external events. Technology shows what could be achieved if one wanted to achieve it, and how it could be achieved provided people were prepared to employ the means indicated. With the progress of the natural sciences, technology progressed too; many would prefer to say that the desire to improve technological methods prompted the progress of the natural sciences. The quantification of the natural sciences made technology quantitative. Modern technology is essentially the applied art of quantitative prediction of the outcome of possible action. One calculates with a reasonable degree of precision the outcome of planned actions, and one calculates in order to arrange an action in such a way that a definite result emerges.
However, the mere information conveyed by technology would suffice for the performance of calculation only if all means of production — both material and human — could be perfectly substituted for one another according to definite ratios, or if they all were absolutely specific. In the former case, all means of production would be fit, although according to different ratios, for the attainment of all ends whatever; things would be as if only one kind of means — one kind of economic good of a higher order existed. In the latter case each means could be employed for the attainment of one end only; one would attach to each group of complementary factors of production the value attached to the respective good of the first order. (Here again we disregard provisionally the modifications brought about by the time factor.) Neither of these two conditions is present in the universe in which man acts. The means can only be substituted for one another within narrow limits; they are more or less specific means for the attainment of various ends. But, on the other hand, most means are not absolutely specific; most of them are fit for various purposes.
The facts that there are different classes of means, that most of the means are better suited for the realization of some ends, less suited for the attainment of some other ends and absolutely useless for the production of a third group of ends, and that therefore the various means allow for various uses, set man the tasks of allocating them to those employments in which they can render the best service. Here computation in kind as applied by technology is of no avail. Technology operates with countable and measurable quantities of external things and effects; it knows causal relations between them, but it is foreign to their relevance to human wants and desires. Its field is that of objective use-value only. It judges all problems from the disinterested point of view of a neutral observer of physical, chemical, and biological events. For the notion of subjective use-value, for the specifically human angle, and for the dilemmas of acting man, there is no room in the teachings of technology. It ignores the economic problem: to employ the available means in such a way that no want more urgently felt should remain unsatisfied because the means suitable for its attainment were employed — wasted — for the attainment of a want less urgently felt.
For the solution of such problems technology and its methods of counting and measuring are unfit. Technology tells how a given end could be attained by the employment of various means which can be used together in various combinations, or how various available means could be employed for certain purposes. But it is at a loss to tell man which procedures he should choose out of the infinite variety of imaginable and possible modes of production. What acting man wants to know is how he must employ the available means for the best possible — the most economic — removal of felt uneasiness. But technology provides him with nothing more than statements about causal relations between external things. It tells, for example, 7 a + 3 b + 5 c + … xn are liable to bring about 8 P. But although it knows the value attached by acting man to the various goods of the first order, it cannot decide whether this precept or any other out of the infinite multitude of similarly constructed precepts best serves the attainment of the ends sought by acting man.
The art of engineering can establish how a bridge must be built in order to span a river at a given point and to carry definite loads. But it cannot answer the question whether or not the construction of such a bridge would withdraw material factors of production and labor from an employment in which they could satisfy needs more urgently felt. It cannot tell whether or not the bridge should be built at all, where it should be built, what capacity for bearing burdens it should have, and which of the many possibilities for its construction should be chosen. Technological computation can establish relations between various classes of means only to the extent that they can be substituted for one another in the attempts to attain a definite goal. But action is bound to discover relations among all means, however dissimilar they may be, without any regard to the question whether or not they can replace one another in performing the same services.
Technology and the considerations derived from it would be of little use for acting man if it were impossible to introduce into their schemes the money prices of goods and services. The projects and designs of engineers would be purely academic if they could not compare input and output on a common basis. The lofty theorist in the seclusion of his laboratory does not bother about such trifling things; what he is searching for is causal relations between various elements of the universe. But the practical man, eager to improve human conditions by removing uneasiness as far as possible, must know whether, under given conditions, what he is planning is the best method, or even a method, to make people less uneasy. He must know whether what he wants to achieve will be an improvement when compared with the present state of affairs and with the advantages to be expected from the execution of other technically realizable projects which cannot be put into execution if the project he has in mind absorbs the available means. Such comparisons can only be made by the use of money prices.
Thus money becomes the vehicle of economic calculation. This is not a separate function of money. Money is the universally used medium of exchange, nothing else. Only because money is the common medium of exchange, because most goods and services can be sold and bought on the market against money, and only as far as this is the case, can men use money prices in reckoning. The exchange ratios between money and the various goods and services as established on the market of the past and as expected to be established on the market of the future are the mental tools of economic planning. Where there are no money prices, there are no such things as economic quantities. There are only various quantitative relations between various causes and effects in the external world. There is no means for man to find out what kind of action would best serve his endeavors to remove uneasiness as far as possible.
There is no need to dwell upon the primitive conditions of the household economy of self-sufficient farmers. These people performed only very simple processes of production. For them no calculation was needed, as they could directly compare input and output. If they wanted shirts, they grew hemp, they spun, wove, and sewed. They could, without any calculation, easily make up their minds whether or not the toil and trouble expended were compensated by the product. But for civilized mankind a return to such a life is out of the question.
- Economic Calculation and the Market The quantitative treatment of economic problems must not be confused with the quantitative methods applied in dealing with the problems of the external universe of physical and chemical events. The distinctive mark of economic calculation is that it is neither based upon nor related to anything which could be characterized as measurement.
A process of measurement consists in the establishment of the numerical relation of an object with regard to another object, viz., the unit of the measurement. The ultimate source of measurement is that of spatial dimensions. With the aid of the unit defined in reference to extension one measures energy and potentiality, the power of a thing to bring about changes in other things and relations, and the passing of time. A pointer-reading is directly indicative of a spatial relation and only indirectly of other quantities. The assumption underlying measurement is the immutability of the unit. The unit of length is the rock upon which all measurement is based. It is assumed that man cannot help considering it immutable.
The last decades have witnessed a revolution in the traditional epistemological setting of physics, chemistry, and mathematics. We are on the eve of innovations whose scope cannot be foreseen. It may be that the coming generations of physicists will have to face problems in some way similar to those with which praxeology must deal. Perhaps they will be forced to drop the idea that there is something unaffected by cosmic changes which the observer can use as a standard of measurement. But however that may come, the logical structure of the measurement of earthly entities in the macroscopic or molar field of physics will not alter. Measurement in the orbit of microscopic physics too is made with meter scales, micrometers, spectrographs-ultimately with the gross sense organs of man, the observer and experimenter, who himself is molar.Cf. A. Eddington, The Philosophy of Physical Science, pp. 7-79, 168-169. It cannot free itself from Euclidian geometry and from the notion of an unchangeable standard.
There are monetary units and there are measurable physical units of various economic goods and of many — but not of all — services bought and sold. But the exchange ratios which we have to deal with are permanently fluctuating. There is nothing constant and invariable in them. They defy any attempt to measure them. They are not facts in the sense in which a physicist calls the establishment of the weight of a quantity of copper a fact. They are historical events, expressive of what happened once at a definite instant and under definite circumstances. The same numerical exchange ratio may appear again, but it is by no means certain whether this will really happen and, if it happens, the question is open whether this identical result was the outcome of preservation of the same circumstances or of a return to them rather than the outcome of the interplay of a very different constellation of price-determining factors. Numbers applied by acting man in economic calculation do not refer to quantities measured but to exchange ratios as they are expected — on the basis of understanding — to be realized on the markets of the future to which alone all acting is directed and which alone counts for acting man.
We are not dealing at this point of our investigation with the problem of a "quantitative science of economics," but with the analysis of the mental processes performed by acting man in applying quantitative distinctions when planning conduct. As action is always directed toward influencing a future state of affairs, economic calculation always deals with the future. As far as it takes past events and exchange ratios of the past into consideration, it does so only for the sake of an arrangement of future action.
The task which acting man wants to achieve by economic calculation is to establish the outcome of acting by contrasting input and output. Economic calculation is either an estimate of the expected outcome of future action or the establishment of the outcome of past action. But the latter does not serve merely historical and didactic aims. Its practical meaning is to show how much one is free to consume without impairing the future capacity to produce. It is with regard to this problem that the fundamental notions of economic calculation — capital and income, profit and loss, spending and saving, cost and yield — are developed. The practical employment of these notions and of all notions derived from them is inseparably linked with the operation of a market in which goods and services of all orders are exchanged against a universally used medium of exchange, viz., money. They would be merely academic, without any relevance for acting within a world with a different structure of action.
Quarterly Journal of Austrian Economics 20, no. 2 (Summer 2017) ABSTRACT: The aim of this paper is to examine the non-price effects of monetary inflation. An increase in the money supply may lead to price inflation, but it may also affect the non-price parameters of goods and services, such as quality or the quantity enclosed in packaging. Based on our analysis, we claim that an expansionary monetary policy may cause a decline in quality (quantity) of produced goods and services if the rise in costs prompts the entrepreneurs not to increase nominal prices of their product but to decrease their product’s quality (quantity), increasing its effective price—price adjusted for quality (quantity). In this way, the increase in money supply may have, ceteris paribus, a negative impact on innovativeness of entrepreneurs who, instead of improving the quality of products they offer, may in fact take the opposite action in order to avoid evident nominal price increases of their products.
KEYWORDS: monetary inflation, non-price parameters of goods and services, non-price effects of monetary inflation, pricing strategy, product quality JEL CLASSIFICATION: B53, D40, E31, E51, L11 1. Introduction The influence of monetary inflationOriginally the term “inflation” stood for increase of the money supply, though nowadays this term is identified with the effects of this phenomenon: the increase of prices. Therefore, the term “monetary inflation” is used in this work and it stands for increase of money supply. “Price inflation” stands for increase of prices (Mises, 1998 [1949], pp. 419–421). on price changes has been subject to many research studies (e.g., Cantillon, 1959) [1975]; Mises, 1953 [1912]; Hayek 2008], Friedman and Schwartz, 1963). However, less attention has been paid to the analysis of the relation between monetary inflation and the changes in remaining parameters of goods and services, such as quantity (actual volume enclosed in packaging), quality, or the type and the date of delivery, etc.There is a question whether goods of different quality are still the same goods. Therefore, economists investigate the impact of monetary inflation on prices taking into account the ceteris paribus clause. However, we believe that focus on the factors economists usually abstract from can be helpful in better understanding the inflationary process and the behavior of entrepreneurs confronted with monetary inflation. There is plentiful anecdotal evidence on quality or quantity adjustments (e.g., Martin, 2008), but the academic literature on the subject is modest.
Armstrong and Chen (2009) argued that producers may use non-price (rather than price) adjustment mechanisms, if they have more information than consumers about goods’ attributes, while Snir and Levy (2011) found that producers are more likely to decrease quantities than increase nominal prices when consumers are more price attentive than quantity attentive, especially in periods of high inflation and in markets where producers face strong competition.
Imai and Watanabe (2013) examined the extent to which product downsizing occurred in Japan in 2000–2010. They found that one pricing strategy adopted among firms reluctant to raise nominal prices was to reduce the size or the weight of a product while leaving the nominal price practically unchanged, thereby raising the effective price. Importantly, the number of product downsizings has been particularly high since 2007, when firms faced substantial cost increases due to the rise in the price of oil and other imported raw materials.
Cakir, Balagtas, and Okrent (2013) analyzed the effects of package downsizing in the United States on household food-at-home consumption and expenditure in 2004–2010, while Cakir and Balagtas (2012) examined package downsizing in the Chicago ice cream market. Both studies found that producers use downsizing to implicitly increase prices in order to pass through increases in production costs.
These mainstream articles, although interesting, do not mention explicitly the link between monetary inflation and the changes in the non-price parameters of goods and services. They also tend to focus only on the package downsizing, omitting the changes in product quality.
Although Austrian economists analyze thoroughly the harmful consequences of rising money supply under the fiat monetary system and fractional-reserve banking, they are not interested in the problem of non-price effects of monetary inflation either. The only two exceptions known to us are Rothbard (2005) and Hülsmann (2008). The former (Rothbard, 2005, p. 53) assumed that consumers are more price sensitive than quality sensitive and wrote:
The general atmosphere of a “sellers’ market” will lead to a decline in the quality of goods and of service to consumers, since consumers often resist price increases less when they occur in the form of downgrading of quality.
The latter (Hülsmann, 2008, pp. 187–88) was a bit less laconic:
Then there is the fact that perennial inflation tends to deteriorate product quality. Every seller knows that it is difficult to sell the same physical product at higher prices than in previous years. But increasing money prices are unavoidable when the money supply is subject to relentless growth. So what do sellers do? In many cases the rescue comes through technological innovation, which allows a cheaper production of the product, thus neutralizing or even overcompensating the countervailing influence of inflation. This is for example the case with personal computers and other products made with large inputs of information technology. But in other industries, technological progress plays a much smaller role. Here the sellers confront the above-mentioned problem. They then fabricate an inferior product and sell it under the same name, along with the euphemisms that have become customary in commercial marketing. For example, they might offer their customers “light” coffee and “non-spicy” vegetables—which translates into thin coffee and vegetables that have lost any trace of flavor. Similar product deterioration can be observed in the construction business. Countries plagued by perennial inflation seem to have a greater share of houses and streets that are in constant need of repair than other countries.
However, neither Rothbard nor Hülsmann analyzed the above-mentioned problem in a systematic way, in contrast to our article. This limited interest in the literature is puzzling for three reasons. First, researchers have already shown that other goods’ attributes can also change depending on market conditions. Price is one of several elements that matters for consumers. Actually, in many marketplaces, adjustments in non-price attributes of products may be more important than changes in price. Thus, entrepreneurs may also compete on service quality, product quality, size or weight of a product, methods of distribution, delivery time, and so on. The non-price competition is well established in the literature (Blinder et al., 1998). Carlton (1987) even claims that markets may clear in terms of other factors than price—for example, delivery lags (Carlton, 1983). Therefore, the assumption that entrepreneurs always increase nominal prices in response to monetary inflation and rises in costs is not true.
Second, the growth of consumer prices resulting from monetary inflation is not automatic and deterministic, but depends on autonomous decisions made by entrepreneurs who, dealing with higher expenses, may or may not raise the prices of their products. Austrian economists always criticized the deterministic approaches of mainstream economics, particularly the hydraulic interpretations of the quantity theory of money, which postulate that a given increase in the money supply would lead to a proportional and mechanistic rise in the general price level (e.g., Mises, 1998 [1949], pp. 398–416). Although they are aware that increases in the money supply do not need to be revealed in increases in the consumer price level (e.g., Shostak, 2002), Austrians hardly analyze the impact of monetary inflation on non-price parameters of products.
Third, historically, until the implementation and distribution of banknotes in use, monetary inflation occurred in fact as a coin debasement—that is, a reduction in the weight or a deterioration in the quality (fineness) of coins, without changing the nominal value (Hülsmann, 2008, pp. 89–91). Therefore, economists should be aware that increases in money supply may be reflected in changes in non-price parameters of products, such as quality or weight (size).
The aim of this article is to fill the gap in the literature and thoroughly examine how the increases in money supply influence the non-price parameters of goods and services, especially how it affects the actual volume enclosed in packaging and the quality of the products. In other words, our goal is to draw a connection between monetary inflation and the non-price adjustments. Hence, we develop a theory of inflation and changes in the non-price parameters of goods and services. It turns out that neither are entrepreneurs greedy individuals who want to cheat consumers all the time, nor are downsizing and reduction in product quality always the optimal market outcome and beneficial for consumers. Our conjecture is that an expansionary monetary policy may, ceteris paribus, cause a decline in quality (quantity) of produced goods and services if the rise in costs prompts the entrepreneurs to not increase nominal prices of their products, but to decrease the products’ quality (quantity), raising rather their effective prices—prices adjusted for the volume or quality. In this way, the increase in money supply may have a negative impact on innovativeness of entrepreneurs who, instead of improving the quality of products they offer, may in fact take the opposite action in order to avoid explicit nominal price increases of their products.
The remainder of the paper is organized as follows. Section 2 analyzes the link between monetary inflation and non-price changes of goods and services. Section 3 focuses on the downsizing, and section 4 on decreasing quality. Section 5 examines the indirect effects of monetary inflation on quality of goods. Section 6 concludes.
- Monetary Inflation and Non-price Changes of the Goods and Services The starting point for our analysis is the Cantillon effect, a distributional effect and price effect resulting from the uneven increase in the money supply (Cantillon, 1959 [1755]). The new money is not evenly distributed in the economy but only runs through specific channels (Sieroń, 2015). This implies that only some entrepreneurs observe the increase in monetary demand for their products (or they observe it earlier than others). Other market actors will be confronted with a relative increase in the price of the factors of production used by them in the production process. The increase will be particularly widespread if the new money entered the economy through credit expansion (Huerta de Soto, 2006), which would lower the interest rates and, as a consequence, increase the monetary demand for raw materials and producer goods.
The rise in commodity prices was particularly strong in the 2000s (Trostle et al., 2011), when the annual percentage changes in the producer price index (PPI) were usually bigger than changes in the consumer price index (CPI), as one can see in the chart below.However, the percentage changes in the PPI were often smaller than changes in the CPI in other decades. This chart shows that producers faced significantly rising costs at that time, which could prompt them to reduce either quality or quantity of products, without adjusting nominal prices. Hence, focusing on the CPI is not sufficient in order to understand the inflationary process taking place in the economy. It cannot be ruled out that the greater increases in the PPI in the 2000s could partially have resulted from the fact that producers of consumer goods changed either the quantity or the quality of their products (and these changes were not properly reflected in statistics).
Figure 1: The percentage change from a year before in the PPI (blue line) and CPI (red line) in the 2000s
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Entrepreneurs facing the increase in costs may raise their nominal prices. However, such a solution is not always an optimal one. If the demand for a good is elastic, then an increase in price causes a decrease in revenues.It is worth mentioning that entrepreneurs always try to establish the price on the level maximizing profit, so any raising of price above the optimum value may lead to a decrease of revenue. Therefore it is not true that entrepreneurs can smoothly pass the rise in costs on to their consumers (Rothbard, 2009). Moreover, a few articles show that consumers are more sensitive to price than non-price changes due to lack of appropriate knowledge about non-price parameters or cognitive costs associated with processing information about both products’ prices and non-price parameters (Gourville and Koehler, 2004; Snir and Levy, 2011).On the other hand, Imai and Watanabe (2013) did not agree that consumers are sensitive to price changes but not to size/weight changes. Moreover, some consumers may be completely aware of an increase in an effective price (price per unit) but focus more on the nominal (absolute) price due to being short on cash.
What is more, sometimes entrepreneurs are not permitted to freely change prices. Price controls implemented by governments to keep inflation in check force them directly to change non-price attributes of products and, for example, reduce the quality or lengthen the delivery time during inflation (Carron and MacAvoy, 1981).Under the communist system, inflation was repressed. The increase in money supply led to shortages and non-price rationing—for example, in terms in time spent in lines (Kolodko and McMahon, 1987). For these reasons, entrepreneurs are forced to adjust non-price parameters of products in order to sustain their level of profitability.A similar example may be a minimum wage. The increase in the minimum wage may prompt employers to reduce fringe benefits or worsen the working conditions (Wessels, 1987).
There are many ways to deal with the rising costs. In certain sectors and at a certain point in a company’s development, the technological process plays the most important role (Hülsmann, 2008, p. 187).Please note that these efforts to deal with monetary inflation decrease the officially reported consumer inflation rate due to hedonic adjustments. However, the role and the rate of technological progress vary from one sector to another (Castellacci, 2004). For that reason, some entrepreneurs, operating in industries when the technological progress plays a much smaller role, may try to implement one of the two following major strategies (or both of them at the same time):
a) curtailing the amount of product, but keeping the nominal price unchanged (i.e., downsizing); orb) reducing costs through offering products of inferior quality.The difference between them is often very subtle as producers may use cheaper substitutes reducing quality and, for example, add water to foodstuffs in order to reduce the quantity of the primary nutrient used in the production of given goods. It seems however that it is worth distinguishing between these two methods, as the first one does not influence the quality of the products per se.
Surely, entrepreneurs may also adopt other solutions in response to monetary inflation and a surge in costs. However, we focus on the above-mentioned strategies because quantity and quality are the most important (and most general) non-price parameters of products. In particular, entrepreneurs can also increase the costs of shipping, reduce customer service, or move production to cheaper locations. They can also lower product variety because an increase in costs resulting from monetary inflation may reduce their companies’ profitability, which may lead to a narrowing of product range only to those products with the highest margin (instead of hiking prices). This is important because the literature shows that product variety enhances customers’ welfare (Dong, 2010).It is worth noting that non-price changes of a product may cause the relative underestimation of the CPI. We write about “relative” underestimation because it is difficult to determine whether there is absolutely positive or negative measurement bias in the CPI (Rossiter, 2005). However, goods substitution in the basket does not cover the loss of usability resulting from replacing more expensive goods of high quality by cheaper ones with lower quality. On the contrary, economists generally believe that substitution bias overstates the CPI.
- Downsizing Downsizing means decreasing the quantity of a product sold at the same nominal price. It seems to be a relatively new strategy, and can be either illegal or legal. The illegal one consists in placing less of the product in the packaging than was mentioned on the label, while the legal one consists in explicitly reducing the net content,The number of items or units in the packaging may also decrease, which is not easy to identify—for example, in the case of toilet paper sheets. often in a way unnoticeable for consumers, however. Although sellers are obliged to present unit price as well—that is, price per unit of weight or per product unit—the studies show that consumers are far more sensitive to changes in nominal prices than to the quantitative changes even if they both lead to the same change in effective price (Gourville, Koehler, 2004; Snir and Levy, 2011).Although this fact seems to prove that consumers do not always act rationally, it is worth mentioning that comparing both prices and quantity of different products involves additional costs in the form of time and effort (Snir and Levy, 2011). It should also be noted that unit prices are not always given, and even if they are, they are usually written with small characters. Therefore, consumers comparing only nominal prices can be considered rationally ignorant.
The nature of this phenomenon is complex. On the one hand, some argue that the above-mentioned actions show how greedy producers are and that the actions may be perceived as examples of fraud, or at least misleading packaging practices (Lawrynowicz, 2012). On the other hand, one can claim that producers almost always inform consumers about the actual quantity of the product in the packaging and indicate the unit price, whereas the consumers voluntarily make decisions on the purchase. It may also be true that some of the changes in the packaging may have an innovative character and may be an attempt to meet consumers’ needs.For example, beverages sold in tiny cans are often far more convenient though much more expensive in comparison with bigger containers when adjusted for per-unit volume.
However, it may be that downsizing is only an attempt to ensure profitability by companies facing rising costs and price-sensitive clients. This is not due to the entrepreneurs’ greed, but due to inflationary monetary policy. Because of inflation, entrepreneurs devote their time, energy, and scarce resources to producing smaller packaging in an unobvious way instead of offering products in the most appropriate form of packaging from the consumers’ point of view.
- Reduction of Quality of Goods and Services ("Cantillon Defect") Although the phenomenon of decrease in quality of some goods is a subject of research, nevertheless economists generally do not relate it to inflation policy. In this paper, we consider the reducing of quality of goods and services while keeping the same nominal price as a second non-price strategy for enterprises to adjust to monetary inflation and an increase in price of the means of production.
Reducing quality while keeping a stable nominal price, just like decreasing the quantity of the product, may turn out to be an attractive strategy aiming at increasing the effective price of goods or services as it is a parameter substantially harder to measure than price.
Two basic ways of lowering the quality are as follows: reducing durability or modifying components.Deterioration of durability may be the result of modifying components used to produce given goods. However, not every modification of components reduces durability, which is why these methods shall be discussed separately. Reducing durability of the products can be achieved mainly through the use of cheaper components of lower quality. It was recognized in the literature long ago (Swan, 1972; Gregory, 1947; Goering, 1993), but it seems this phenomenon, at least in general perception, has taken on more significance in the last several years.
The modification of components has a particular meaning in the case of non-durables, especially food. Contrary to durables, modifying components of given foodstuffs may rely on extending their durability to the detriment of nutritional values. This phenomenon is based on decreasing the content of the primary component in the product in the face of rising prices of raw materials. It may occur through replacing it with cheaper substitutesAn example of this problem is the European horse-meat affair, as the horse meat used for bovine hamburgers was cheaper (Wikipedia, 2013). (including diluting it with water), using raw materials of lower quality, or adding chemical substances (and applying production methods) that make the product more tasty or durable but harm health.One research area of particular interest is the coexistence of unprecedented monetary inflation since the 1970s (as a result of President Nixon’s definitive break from the gold standard in 1971) and the development of the world obesity epidemic, which in OECD countries dates to the 1980s (OECD, 2010; NIDDK, 2012). There are some indications that low-quality components used for production of foodstuffs, which may partly result from cheaper methods of production adopted by entrepreneurs in the inflationary environment, cause increase of obesity (Schoonover and Muller, 2006). Wiggins and Keats (2015) found that in high-income countries over the last thirty years, the cost of healthy items in the diet has risen more than that of less healthy options, thereby encouraging unhealthy diets. The reason may be that it is more difficult to cut costs associated with production of fruits and vegetables than with production of processed foods.
t is very difficult to evaluate the strategy of reducing the quality of products while keeping the same nominal price. Some will try to find reason for this in entrepreneurs’ willingness to increase sales and profits by all means, though some will defend this phenomenon and claim that clients purchase these products voluntarily. However, it should be noted that the voluntary nature of a transaction does not preclude that consumers’ utility could be higher if they were offered goods and services of better quality. Public monopoly is an example of such a situation. Clients purchase products voluntarily from the public monopoly, but their situation would be better if there were more competitors on the market.
Analyzing this phenomenon is difficult also because decreasing the quality of goods may result from many reasons, not only from expansionary monetary policy. First, it may result from monopolization of the market (Bulow, 1986). Second, government regulationWe refer in particular to price regulations, which often apply to the so-called public utility companies. Changes in the quality of services offered by public utilities due to the monetary inflation may have particular significance (Troxel, 1949). Carron and MacAvoy (1981) researched the quality of services of public utilities in the United States in the 1970s. As regulators did not give their consent to increasing prices, the quality of services and the volume of investment expen-diture decreased, while delays in delivery appeared. may influence the quality of the products. Third, the literature on the subject points to asymmetric information (Grout and Park, 2005). Finally, decreasing quality may correspond with real consumer needs. Market actors may prefer less durable goods because of lower prices, changing trends in fashion, or rapid pace of technological developments.It should also be noted that “quality” is a wider notion than “durability.” Some goods may be characterized by shorter durability, but, for example, extra conve-nience and functionality. It can therefore be reasonably concluded that though some goods were once of the higher quality, only the wealthiest people could afford them. Nowadays, thanks to lower prices, but lower quality as well, these goods are available for a wider range of consumers. From this view point, decreasing quality allows most consumers to purchase desired goods at low price. Simultaneously, there are goods of high quality on the market offered for more demanding and richer consumers.
It is notable, however, that consumers, ceteris paribus, prefer more durable goods as they “render more total service” (Rothbard, 2009, p. 16). As Reisman (1990, pp. 214–216) proved, if higher costs of producing more durable goods on the free market are less than proportionate to the product’s longer life, entrepreneurs have incentives to produce more durable products. Thus, it seems that the decreasing quality—including durability—of some goods and services may result from different government interventions, including monetary inflation, that impose higher costs on companies. Monetary inflation decreases innovation of companies, which may choose methods of production not necessarily the most innovative and favorable for consumers but that guarantee the highest rate of return in an inflationary environment.We can argue that inflation, in a sense, forces innovation by producers in cutting costs and investments that allow them to reduce the use of raw materials whose prices increase. However, it should be noted that such an allocation of resources does not have to coincide with a counterfactual free market allocation of resources. Therefore, we can state that though the inflation may, in a sense, cause innovative behavior, it would be innovation going in the wrong direction in comparison to the one that would have occurred in a reality deprived of monetary inflation.
Hence, we call the decline in quality due to monetary inflation “Cantillon defects,” as it occurs because the new money supply does not distribute itself evenly through the economy, but runs only through specific channels. Therefore, if new money enters the economy through the capital-goods and commodity sectors, entrepreneurs producing consumer goods may face rising costs that could prompt them to adjust non-price parameters of products they sell.
- Indirect Effects of Monetary Inflation on Quality of Goods and Services It is worth pointing out that reduction of the quality of goods and services offered does not have to follow directly the increase of costs of production and be the direct aim of entrepreneurs. The reduction may be only relative and occur with a delay as a result of restricting investment expenditures, including spending on research and development, in the face of inflation (Able, 1980). Moreover, monetary inflation reduces the supply of savings and increases uncertainty, negatively affecting the volume of investments (Horwitz, 2003, p. 78).
The reduction of the quality of goods and services may also result from other indirect effects of monetary inflation. First, monetary inflation decreases the real value of borrowings and thus discourages saving and prompts debtors, including consumers, to buy goods on credit. Consumers in such a situation, instead of saving for goods of higher quality, which would serve their functions for several years, may prefer to buy cheaper goods of shorter durability on credit.Encouraging borrowing would be enhanced if monetary inflation took place through credit expansion, which lowers (ceteris paribus) interest rates. The credit expansion (especially if recurrent) does not only cause a market rate below the natural level resulting from time preference, but can also lead to an increase in time preference, which encourages consumption. In other words, “easy money” policy, which leads to higher prices and higher time preference, may prompt consumers to buy cheaper, less durable goods. Consumers in such economic conditions may prefer lower expenditures in the present day, even if over the years their decision will mean higher total costs for purchasing specific goods (because of their frequent replacement). It happens so because they pay less attention to the future. Such an attitude may be supported through the possibility of buying new products thanks to reduced-interest loans. In this context, it is worth pointing out that the relatively loose monetary policy run by the Federal Reserve System contributed to the development of consumer credit in the 1920s and after the Second World War (Eichengreen and Mitchener, 2003, pp. 36–42; Huerta de Soto, 2006, pp. 487–493).
Second, monetary inflation leads to disturbances in a correctly functioning price mechanism (Horwitz, 2003). Increases in prices resulting from a higher money supply disrupt information conferred through prices, which can unbalance the structure of consumption and the allocation of production factors between goods of higher and lower quality. High price for consumers often stands for high quality (Leavitt, 1954). Therefore, consumers may interpret higher prices resulting from monetary inflation in an incorrect way as an indication of high quality. In fact, they may buy more expensive products of lower quality, which can negatively affect the profitability of companies producing goods of high quality and in this way reduce the supply of high-quality goods.
Third, an increase in prices along with lower variety and lower quality of products may stimulate individuals to self-production. What we can currently observe is the growing popularity of the movement called do-it-yourself (Wolf and McQuitty, 2011). Such a movement reduces innovation as it decreases the division of labor as well as efficiency of production.
- Conclusions In this article, we have challenged the common view that monetary inflation automatically leads to increases in prices of consumer products. Changes in prices are always a result of conscious actions of entrepreneurs who, in response to the rising prices of means of production—and according to the Cantillon effect, an increase in money supply does not affect all prices uniformly and simultaneously—may apply other strategies, consisting in decreasing the quantity of product or reducing its quality, keeping the nominal prices unchanged.
Thus, monetary inflation is a factor passed over in the literature that may be partially responsible for downsizing and decreasing quality of some products. From this perspective, the above-mentioned actions taken by entrepreneurs do not have to result from their ill will or inherent greed, but from their effort to remain in business in inflationary and competitive environment. Therefore, it seems that the Austrian theory of inflation should be extended to incorporate non-price effects of monetary inflation.
The non-price effects of increases in the money supply clearly show that the impact of monetary inflation on innovation is negative. Instead of promoting products of higher quality, entrepreneurs spend scarce resources to hide the increase in an effective price through changing packaging or reducing quality, which is detrimental to innovation. That impact does not have to be direct, but can result from cutting costs through limiting expenditures on investments.
This paper does not exhaust the subject, but it contributes to further research, perhaps of a quantitative nature. We believe that the presented considerations on non-price effects of monetary inflation have a solid foundation and contribute to the literature on inflation and business strategies adopted in an inflationary environment.
Quarterly Journal of Austrian Economics 20, no. 1 (Spring 2017)
ABSTRACT: The aim of this article is to demonstrate how monetary disorder spawns asset price inflation. This is re-interpreted here according to modern usage as meaning an empowerment of irrational forces in asset markets. The author blends insights from behavioral finance research and from Austrian business cycle theory to develop a hypothesis about how mental flaws of investors become inflamed by monetary influences and how these contribute to episodes of widespread mal-investment. Identifying two types of asset price inflation—boom type and depression type—this article draws on the last century of history to illustrate both through several stages, accompanied by a variable intensity of inflation symptoms in the goods markets.
KEYWORDS: asset price inflation, Austrian business cycle theory, carry trade, hunt for yield, irrational exuberanceJEL CLASSIFICATION: B53, E14, E31, E32, E42, E43, E44, E58, F45, G02, G12, N12, N14
Competition as a social price policyThe political organization and legal institutions of all nations, in their treatment of private property and the rights of citizens, involve various social price policies. The term "social price policies" is used here in contradistinction to the individual price policies of private enterprisers. Our own economic order known as capitalism, with its complex system of laws, traditions, and business practices, assumes the policy of competition as the general rule. Competition is rivalry, the seeking of the same desired end by two or more living beings. Even plants compete for their places in the sun and a chance to live. Competition may be contrasted with co-operation, which is the seeking of the same end or two or more creatures working together without rivalry but with the intention of sharing the fruits of their efforts. All gregarious animals, even wolves which hunt in packs, co-operate in some degree among themselves at the same time that they compete against other groups of animals. In human society men both co-operate in their various group activities and compete as individuals or as groups in other activities.
Economic competition, in particular, is the process by which men, individually and in groups, are given the opportunity to earn their living by producing desirable things and performing useful services, and by selling them for what others will pay. More and better goods, lower prices made possible by the steady march of science and technological invention, material progress constantly shared by the masses of the people — these are the ideal social purposes of competition.
In the main, Anglo-Saxon institutions, as they developed through the centuries out of feudalism, not only permitted but more and more encouraged free competition in the choice of occupations, in the exchange of goods and services, and in the management of private business. This general trend continued till near the end of the nineteenth century. However, social price policies always have been and still are a mixture of competition and other features more or less monopolistic and restrictive of free market relations. Let us consider first the competitive aspect.
Economic conditions for effective competitionIn order that economic competition may be effective, three essential conditions must be united in some degree at certain times and places: (1) ability, (2) choice, and (3) freedom.
Ability on the part of a seller to compete means the capacity to perform the service, or to produce or procure the goods that are to be sold. On the part of a buyer it means the possession of sufficient purchasing power. One who cannot play a musical instrument cannot effectively compete for a place in an orchestra, nor can a blacksmith effectively compete for a watchmaker's job. An enterpriser's ability depends on his possessing proper personal and technical qualifications — physical strength, intelligence, education, practice, experience, prestige, character — the necessary material equipment of various kinds, and sufficient financial means.
Combined with ability must be choice, or willingness to do, in order that there shall be effective competition. Many a man is better able to do a certain kind of work than are those whom he employs to do it for him, but he prefers to do something else — or nothing. Many a merchant could perform the duties of janitor, bookkeeper, sales clerk, or delivery man as well as or better than his employees do, but he can hire them for less than his services are worth for managing the business. If one who has the ability to compete chooses not to do so, it shows that his alternative valuation (the opportunity cost considered in the last chapter) of his own services and capital is greater in some other occupation. The explanation of this situation in the special case of international trade is known as the doctrine of comparative advantage.
Ability and choice to compete are the two essential economic conditions to competition, but in order that competition may be effective another condition is necessary which is primarily political, in character — freedom to compete.
Custom and caste as restrictions on freedom to competeIn human society the individual is free to act only within more or less definite limits set by his fellow men. Individual action is restricted partly by formal law and partly by numerous other subtle influences of custom, caste, status, tradition, training, beliefs, superstition, religion, and individual and class interests. In most savage tribes certain kinds of goods and some offices and occupations are tabu or forbidden to all but privileged members of the tribe. Rules and institutions are maintained and enforced by public opinion with penalties of social disapproval; the extreme is social and economic ostracism, banishment, and sometimes death for the offender. As was the case in many ancient highly-developed societies, so in India today many occupations are the hereditary monopolies of certain castes. Even now in some advanced countries of Europe the conception of social status is such that a talented individual can only with great difficulty rise above the station in life to which he was born.
Modern extralegal restrictions on freedom to competeEven in our society, limitations of a similar sort are temporarily and deliberately created by some groups for their own purposes. These groups foster prejudices and hatreds against competing persons and groups of workers or of employers, and coerce them by epithets, social ostracism, picketing, and boycotts. Driven further by passion as the mob spirit grows, as, for example, during strikes by laborers, various groups frequently embroil the whole community and disturb all civic relations by threats and by violence to property and to persons. The modern "racketeers" in American cities, sometimes disguised as leaders of organized labor, sometimes merely criminal gangsters, have levied tribute on all honest citizens. In degrees varying from the least to the greatest, such conditions restrict the economic freedom of men to compete. Those who act in this way create a sort of State within the State, usurp and for a time exercise the normal political powers of government, justifying their conduct on the ground of necessity. It is plain, however, that under these conditions free and therefore effective competition is impossible.
Competition legally regulated in the public interestThe basic function of government is to prevent competition by brute force, and in this connection it should be remembered that economic competition is only one of many species of competition between men. Organized government places restrictions upon competition in many legal and orderly ways: by the common law, by statute laws, by executive agencies of enforcement, and by courts which interpret the statutory and common law.
Governmental action in relation to competition is of two distinct types. The first merely determines the scope, methods, and kinds of competition that the community desires, leaving prices to be adjusted by competition. The second directly fixes or manipulates prices, instead of leaving the forces of legalized competition to operate.
The extent to which economic competition is regulated by government is rarely recognized. We hear much loose talk about laissez faire as a policy of keeping hands off competition; but no government has ever followed such a policy to its extreme. Governments are constantly seeking to limit economic competition to honest and peaceful efforts in producing and selling goods. The whole body of business law regulating contracts; much of the criminal law punishing crimes against persons, and preventing fraud, embezzlement and gambling; and all laws punishing crimes against property are designed to eliminate certain sorts of competition deemed to be uneconomic and to retain only those peaceful activities which are deemed to be economically beneficial to the community.
The nature of fair competitionOf recent years the term "fair competition" has been increasingly used to designate the economic competition that is limited to actions in accord with prevailing standards of integrity and legality. Fair competition is the only kind that society desires because it is the only kind that confines rivalry in business to acts which tend toward greater production and service. Bribing a competitor's employees to betray his business secrets, hiring ruffians to dynamite a competitor's factory, and a thousand other such reprehensible or downright criminal acts, are not fair economic competition. Criminal injury of competitors and unfair competition are not economic competition, as is often assumed; rather they make it impossible. The purpose and nature of such behavior is usually monopolistic, that is, it prevents capable and willing competitors from competing. These have been among the most telling methods by which the present monopolistic organization of industry has been brought about.
Fair competition has been too narrowly understood as applying to the behavior of competitors toward each other, rather than toward the buying public. Such a view of competition, however, stresses the means or the methods of economic activity rather than its main purpose — the furthering of the public welfare. There is some tendency for the courts to broaden the meaning of fair competition, and it is to be hoped that they will do so. In the discussion of the N.R.A. in the years 1933–1935, the term "unfair competition" was often curiously twisted to mean any competition that tended to lower prices against the will of the dominant monopolistic interests.
The nature of monopoly; limited monopolyThe root meaning of monopoly is unified selling, and the term is applied to a person or group of persons acting in unison in the sale of all the units of an important class of goods offered in a market. Such a single seller could withhold a part of the supply and thus greatly enhance price. But such a complete, or absolute, monopoly is an extremely rare condition. The far more frequent case is partial, or limited, monopoly. The limitation may be in respect to the proportion of the whole supply under a single control. Or it may be in respect to place, time, kinds, and qualities of goods, urgency of desires, and the possibility of meeting these desires by the substitution of other goods. The theory of monopoly has to explain how monopolistic power, however limited, may operate to raise prices above the level that would result from effective competition.
A single seller controlling a small portion of the total stock of goods in a free market could often for a brief time cause the price of his goods to rise by refusing to sell. But only his competitors would profit by this, while the withholder forfeits his usual profit on the unsold goods and the unused capacity of his enterprise. However, one seller or a unified group of sellers may control such a large fraction of all the goods of a certain kind produced in a single market, that he or they will gain more by raising prices than will be lost through limiting production. If by the use of any of the devices of collusive, criminal, and unfair competition sellers are able to force others to limit their production, the total monopolistic gain may be much greater than otherwise would be the case. In some instances monopoly is inclusive. This is the case when there are agreements and common action to restrict sales. In other instances monopoly is exclusive in that it compels others to restrict their sales partially or completely.
Monopoly may be defined as follows: It is unified control by sellers over such a proportion of the whole supply of certain goods or classes of goods in a market that a net gain may result by withholding or excluding from sale some goods that would be offered for sale if ownership were not unified. A similar unification on the side of demanders, a comparatively rare occurrence, is often called buyers' monopoly.For this type of monopoly the name of monopsony has been suggested as being in accord with the meaning of the Greek roots.
Demand and supply in monopoly priceWhen the conditions determining sellers' valuations were considered in the preceding chapter, it was seen that all sellers competitive as well as monopolistic, charge what the traffic will bear. The true contrast between competitive and monopolistic valuations is that where competition is effective, the traffic usually will not bear so much as under monopolistic conditions. It is misleading to say that the contrast lies in the fact that monopoly prices are fixed or determined solely by demand, whereas competitive prices are fixed by the equilibrium of demand and supply. The essential contrast is this: In the case of exercised monopoly power, the supply is restricted by common action below what would result from independent competitive action. When monopolistic sellers find that they can get more by restricting supply, they raise their reserve valuations accordingly. Monopoly price is determined by the equilibrium of demand and supply. But while demand is competitively unrestricted, supply is artificially restricted.
Monopolistic sellers may effect the restriction in several ways. They may by collusion reduce their own sales, or they may use either rewards or punishments to induce competitors to reduce their sales in whole or in part, or they may persuade some public authority to limit or exclude possible competitors. In all these ways and by numberless devices, supply is more or less manipulated in many industries today, according to favoring conditions.
Crude monopoly priceA distinction may be made between crude and net monopoly prices. Crude monopoly price is that which yields the maximum receipts (units sold times unit price) rather than, necessarily, the greatest net gain. The aim is to obtain the maximum receipts when goods are either costless (as might be the case with some agents of production) or are perishable, as are some foods in the markets on Saturday night or before a holiday, or where for temporary gain some part of the existing stocks of goods is destroyed without regard to first costs or to replacement valuations.
Suppose that at various prices the supply of and demand for certain goods correspond with the latent valuations as set forth in the following table:
At the true competitive market price of $5, there will be 50 units sold and the receipts will be $250. If, however, all the sellers unite and restrict production to 45 units, price will rise to $6 and receipts to $270, which is the maximum possible, Further restriction of supply to 35 units would raise unit price to $7 but receipts would fall to $245. This is shown in Figure XVII.
Elasticity of demand and supplyElasticity of demand means the extent to which changes in price initiated by active changes of supply are followed by passive inverse changes in demand. This is usually expressed as a ratio of the rate per cent of the demand change to the rate of price change, the two rates having opposite signs, plus or minus. For example, if the price falls 10 per cent and as a result the demand rises 10 per cent, the rate of elasticity of demand at that point is unity. But if a fall of price from 10 to 9 (10 per cent) is followed by a rise of demand only from 100 units to 105 (5 per cent), the rate of elasticity is .50.
Figure XVII. Crude, Uniform Monopoly PriceElasticity of supply is similar in nature to elasticity in demand but varies directly with price changes, supply rising passively as prices rise and falling as prices fall.See Chap. XVIII on passive and active changes in latent valuations.
Drawn on the same scale, a graph of more elastic demand (or supply) is more nearly horizontal, and one of less elastic demand (or supply) is more nearly vertical.
Inelastic demand makes monopoly easierConsider a situation, as in Table VIII, in which the latent demand at higher prices is somewhat less elastic than in Table VII, for example:
Under these conditions, if the monopolistic group has 50 units on hand which will sell for only $5 if all are offered, it will pay them to destroy 20 units, if that is necessary to make sure that the remainder may be sold at $10 per unit. This sort of waste and destruction of goods has often been practiced, as for example, when East Indian spices were sunk in European ports— a case made famous by Adam Smith — and when certain foodstuffs were occasionally dumped into the waters of New York harbor.
Figure XVIII. Monopoly Uniform Price with Less Elastic DemandThe foregoing examples involve the assumption (1) that the monopolist controls the whole supply; (2) that the monopoly price is uniform to all buyers without discrimination, and (3) that actual costs and alternative valuations are disregarded. Let us consider how a difference in each of these conditions might influence the result.
Limited monopoly; influence of partial competitionIf a considerable fraction of the supply remains outside of the monopolistic agreement, the control of price is more difficult. If competitors (in Table VIII) supply 10 units at the competitive price, and the monopoly group supplies 40 and then cuts down its supply by 10 units, the monopoly group would be selling 30 units, and its competitors 10 at a price of $7. Its receipts at the competitive price would be $200 (40 X 5); at the $7 price they would be $210. There is therefore a gain of $10 for the monopoly if it restricts production and obtains the $7 price. But if the monopoly restricts its output by 20 units to raise the price to $10, it would then sell only 20 units, and its receipts would be only $200.
Tendency of monopoly to overreach. — Theory and abundant practical experience unite to show that under such conditions the other competitors would be likely to increase their outputs, while new forces would be set into operation by the higher prices, causing substitution of goods, stimulation of new competitors near and far, and the discovery of new methods. In all cases of limited monopoly the long-time gains of restrictions are certain to be smaller than they appear in the short-time view, and large immediate gains sometimes turn ultimately into large losses.
The history of monopoly is full of evidence that it usually overreaches itself in the exercise of newly acquired powers over prices. Notable recent examples are the British policy of restricting rubber production by which the price of rubber was driven up to about $1.50 a pound, to fall later to 5 cents a pound; the copper monopoly which drove copper up to 24 cents a pound, to see the price collapse to 5 cents, the lowest in all history; and the efforts since 1933 to fix American cotton prices, which have stimulated competition in cotton growing in many parts of the world where it threatens to continue even at prices lower than those at present, with disastrous results to our Southern farmers.
But this is not to say that the problem of monopoly always solves itself, or that monopoly power is always temporary, or that it usually is unprofitable to the monopolists, or that no one is injured by its exercise, or that the public may safely follow a policy of laissez faire toward the monopoly problem.
Discriminatory monopoly pricesIn practice, uniform monopoly price is unusual and theory makes it clear why this must be so. Except when demand is highly inelastic, the gain from uniform monopoly prices is likely to be limited. It has been observed that with rare exceptions monopoly power is not complete but is partial and limited. The most general limitation of monopoly power is the newly aroused competition which it has to meet at each successive higher level of prices. To meet such competition by a uniform lowering of its price would compel the monopoly to give up some of the monopolistic gains derived from those buyers that are already fully within its power. But if monopoly can find a way to classify the buyers, even roughly, and make those in each class pay a price approximating their reserve valuations, it can gain much more than it can from a uniform price.
Price discrimination is nonuniform treatment of customers by making a difference in the price of goods without a corresponding difference in quality, service, or conditions in the terms of sale. When the monopoly discriminates against such buyers as are within its power by charging them higher prices while it sells at lower prices where competition must be met, it succeeds in accomplishing the proverbially impossible — "it eats its cake and has it too."
The price discriminations practiced by a monopoly are often at certain geographical points or market area boundaries. Or again they are found in certain grades and kinds of goods and services. Or they may be seen in the methods of making sales to certain persons. The monopoly may undercut certain competitors' prices while continuing to charge its other customers monopolistic prices. So discrimination takes manifold forms, but it always means nonuniformity in the prices exacted from buyers by the sellers.
Monopoly gains from discrimination. — In Table IX total receipts at a uniform price of $7 would be only $245; but they may be increased to $330 by discriminating prices down to the normal competitive price of $5, as follows:
Table IX
Price Units Salable at Various Discriminatory Prices Receipts
$7 35 $245 6 10 additional 60 additional 5 5 additional 25 additional __________ ____________Total 50 $330
In a similar manner the effect of further discrimination by creating a higher price class would be as follows:
Table X
Price Units Salable at Various Discriminatory Prices Receipts
$10 30 $300 7 10 additional 70 additional 6 5 additional 30 additional 5 5 additional 25 additional __________ ____________Total 50 $425
Cutthroat discriminationDiscrimination in prices, while it wears the guise of competition, is, in fact, the most potent instrument of monopoly. A strong combination or monopolistic association, when discriminating by lowering prices, need not stop at a truly competitive price level which yields a normal profit. It can and often does go lower, even accepting a loss, for the purpose of warning, disciplining, forcing into the monopolistic group, or driving into bankruptcy any smaller competitor who is interfering with the price plans of the monopoly. This is cutthroat competition in the proper sense of that often misused term. It is much more agreeable and profitable to a monopoly if competitors can be made to restrict their production than for the monopolists, by cutthroat means, to do it themselves. In that way, a monopoly gets all the gain and the would-be competitors bear the losses along with the consumers.
The practice of cutthroat competition is much easier for a financially powerful corporation than it is for a smaller competitor. It is particularly easy for a large combination owning a number of plants in various geographical areas and turning out a large variety of products. It can cut prices on some products by the use of "fighting brands," and in some localities by the use of "fighting mills," while continuing to charge higher prices and to earn ample profits from its other products and plants. On the other hand, it is financially impossible for a comparatively small independent enterprise with a single plant, no matter how efficient it may be technically or how able to meet fair competition, to compete against its large competitors by the use of cutthroat prices. It can only cut its own throat in that way.
Without a clear understanding of discriminatory prices there is no hope: for effective public control of monopoly.
Monopoly profit above costs; net monopoly pricesCases of crude monopoly price are comparatively rare. Much more frequently the aim of a going concern is to get the maximum price over the costs of replacement — the greatest net monopoly price. In the continuous production and sale of goods, costs have to be considered — that is, the alternative valuations of indirect agents. Normal competitive prices of goods contain an element of profit both on fixed and variable costs necessary to attract and to keep enterprisers in the business. The normal competitive price contains no additional profit above this: costs and prices are, or tend to be, just equal. Assume the competitive price to be $5 (as in Table VIII; the fixed costs (including a fair profit) to be $150; and the variable costs (also including a fair profit) to be $100 (receipts $250, costs $250). Under these conditions costs, prices, and normal profits would be in equilibrium, as shown in Figure XIX.
Figure XIX. Costs and Competitive Price Showing Also Possible Additional Pure Monopoly Profits Through DiscriminationNow if the monopoly reduces its production from 50 to 30 units, fixed costs would be unchanged at $150; variable costs would be $60 (3/5 of $100); and total costs (including normal competitive profit) would be $210. As the receipts are $300, there is a pure monopoly profit of $90 over and above the normal profit which investment would give under competitive conditions. These figures are illustrative of the fact that a monopolistic increase of competitive prices increases the profits of monopoly in greater proportion than it does the total receipts. This is shown in Figure XX.
Figure XX. Pure Monopoly Profit Above Costs, With Uniform PriceExpressed generally net monopoly price: is that price which maximizes the remainder left after subtracting from the total receipts the costs of production. The many complexities in the calculation of costs according to whether they are constant, increasing, or decreasing per unit, or total, go beyond the scope of our treatment.
Public or legalized monopoliesThe innumerable and varied monopolistic controls over prices in modern business may be broadly classified as public and private. Public monopoly is that which is legalized, including direct public ownership and operation of enterprises. Monopoly power is also exercised by private persons, organizations, and industries acting under authority of patents, copyrights, charters, and statutes which confer special or exclusive privileges on them.
The professed public motive in all these legalized forms of monopoly is to advance the general welfare, but frequently they are determined by the private and class interests of "pressure groups" acting upon legislators and executive or judicial officials. Organized groups of citizens are constantly seeking the authorization and grant of monopolistic powers for themselves with the plea that this is the best way to help the public. The "bootstrap doctrine" of economic welfare became known as mercantilism from its wide exercise by governments on behalf of the merchant class in the seventeenth century. It has been followed in the United States through extensive grants and subsidies to railroads, water carriers, and other industries, and in tariffs to favored groups of manufacturers, farmers, and owners of natural resources such as coal, iron, lumber, oil, copper. In these and many other ways, the power of taxation exercised by local, state, and Federal authorities has been diverted from its primary purpose of raising public revenues to promote the general welfare, to that of making gifts to private citizens, on the apparent assumption that somehow these gifts will filter through their pockets back to the taxpayers, magnified by some magic power in the process.
Restrictive tariffs and monopolyA peculiar case of monopoly by public action is presented by so-called protective tariffs on imports, more accurately called restrictive tariffs. The purpose of such protective tariffs is not to raise revenue for the government but to restrict imports and thereby to raise the prices which domestic producers may receive from domestic users. Inasmuch as domestic producers are thus relieved practically or wholly from the competition of foreign products with their own, this is a monopolistic measure. This is true even though domestic producers are not thereby authorized to unite in monopolistic selling but are expected to compete actively with each other. If they do so compete, they may reduce the rate of profits in their industries to the general level of other industries. Nevertheless prices almost certainly will remain higher than they would be with free importation (with the possible exception of bona fide infant industries). The higher domestic prices due to restrictive tariffs are in many cases reflected back to the natural resources involved in the manufacture of the product. These natural resources would often be much less valuable if imports were free. Tariffs are thus the source of large private fortunes. Though it is extreme to say that "the tariff is the mother of trusts," it can hardly be doubted that the exclusion of foreign goods facilitates the formation of domestic monopolistic agreements. Moreover, domestic monopolistic industries such as oil, lumber, copper, and cement have been able to exert a peculiarly strong pressure to procure higher tariffs on their products.
Public utility monopoliesThe enterprises known as public utilities present a special problem of monopoly. The chief enterprises of this type have appeared somewhat in this historical order: ferries, toll turnpikes and bridges in private hands, water- and gasworks, railroads, streetcar lines and interurban trolleys, electric power and light, and telegraph and telephone companies. A public utility, as the name indicates, is an industry which, with the progress of society, is deemed necessary to the public welfare. But so are many other industries that have developed in the last century and a half. In contrast with industries supplying such products as textiles, iron and steel, cement, gasoline, or automobiles, the really distinctive character of a public utility lies in technical conditions which call for the extension of physical lines of rails, pipes, poles, wires, and other apparatus into the particular locality, and usually into each home or factory, to be served. It is impossible for this to be done unless these industries are granted (by charter or franchise) special legal privileges not accorded to citizens generally. These usually include the right to occupy, cross, excavate, and use the public highways for their rails, pipes, conduits, wires, and other equipment, and the power to exercise the right of eminent domain. By this right a public utility can compel others to sell their property at an appraised valuation, even against their will. Hence such enterprises are quasi-public, for they enjoy not merely the ordinary rights of private business but become in some respects public agencies exercising public rights.
Experience soon showed that it was physically impossible and financially wasteful to multiply the physical equipment of rails, pipes, wires, poles, and so on, in each locality so that the buyers of services could choose and shift back and forth among competing bidders. Under these conditions local monopolies were inevitable, however limited they might be on the geographical margins and by substitution of goods such as candles and kerosene for gas or electricity. The term "natural monopolies," often used loosely, may with some reason be rightly applied to such industries. The public did not, as is sometimes assumed, purposely create them as monopolies. But it soon discovered that they inevitably had become monopolies. Therefore the public undertook by regulation to keep their prices down to what prices supposedly would be if competition were possible. The purpose of regulating such industries is not to create monopoly, but to remove the clement of extortion. Public utility rates, as fixed by commissions, are attempted copies, or estimates, of competitive rates. Thus far, however, they have been pretty crude imitations of the real thing.
Private industrial and commercial monopoliesMany of the monopolistic forces in our present economy are not derived from, or sanctioned by, public authority, as are those described in the preceding sections. The commodities and services sold by most commercial and industrial enterprises, unlike those of public utilities, can be distributed to every part of the land by the aid of common carriers. Thus they may come into continual competition in many localities and in many ways with the commodities of other enterprises. Buyers may shift at any moment from one seller to another, under the inducement of lower prices. As long as production and distribution were much decentralized and shared by large numbers of small enterprises (a condition continuing substantially until after 1865 in this country), competition and uniform prices to buyers at each mill or market were the general rule. But since that time there has been a steady trend toward larger production in single plants, and greater centralization of industries at certain localities. In the process many neighborhood factories have disappeared.
Concentration of control facilitating monopolyMuch more important in facilitating monopoly has been the concentration of ownership of factories and stores in the same industry, sometimes in the same locality, sometimes widely distributed geographically. This great unification of ownership ensures complete unification of price policies of formerly competing companies, and often gives a dominating position in matters of price policy over the remaining so-called independents. In many great industries such as steel, other metals, cement, machinery and implements, the principal kinds of building materials, and in many tariff-protected industries, some one great corporation or friendly group of smaller corporations has become known as the market leader. In industries where concentration had not proceeded so far, trade associations have been organized in great numbers since 1912 ostensibly to deal with unfair competitive practices between independent enterprises but chiefly to make possible collusive agreement on more or less monopolistic prices and practices. Under these conditions monopolistic influences have penetrated into nearly every corner of the price system.
The foregoing brief discussion of monopoly theory suggests the devices by which prices can be monopolistically controlled and also the methods by which such practices could be prevented and corrected. A growing body of evidence indicates that the capitalistic system, whose basic assumption is free markets and a free price system, cannot continue to work with an ever-widening range of prices fixed by monopolies.
Rigid and flexible pricesWhenever monopoly by agreement is possible in periods of normal business, it becomes effective in boom times. When all producers are well booked up with orders, and buyers' reserve valuations are unusually high, it is easier than at any other time to get competitors to agree to restrict production in order to raise prices. But it is more difficult to maintain such price agreements when business falls off and factories are running below capacity. Then the enterprisers that are in greatest need of orders are tempted to break away and reduce prices, and this precipitates fierce retaliation by the dominant corporation or group in the industry. In any industry, but especially in one that has been pegging its prices at a high level, price reductions serve to stimulate orders to increase production, and to give employment to more workers, and thus somewhat to alleviate the depression.
Rigid monopoly prices in depression periodsIn recent decades, spontaneous, competitive lowering of prices in depression periods has not occurred promptly nor in many industries. This tends to throw the price system further out of equilibrium. Competitive industries reduce their prices, while industries that are monopolistically organized peg their prices. The whole burden of readjustment in getting production, employment, and exchange started again is thrown upon those industries and occupations in which prices and wages are already most deflated. In the world depression beginning in 1929, this contrast between rigid and flexible prices (or sticky and fluid prices) has been more noticeable than ever before. Rigid, or inflexible, prices are pretty closely correlated with monopoly, partly because of the increasing number of prices fixed on static principles by public authority (as public utility commission rates), and partly by the multiplying controls of private monopoly of various kinds over wages and commodity prices. There is much reason to believe that this rigidity tends first to induce depressions, and then to prolong and to increase their severity by keeping excess capacity unused and by aggravating unemployment. If only a few industries peg their prices, in defiance of the ordinary competitive motives to reduce prices when there is unused capacity and unemployed labor, they may gain at the expense of the rest of the community, which behaves differently. But as price fixing during a depression becomes more and more the general practice, even the monopolists lose more in the end than they gain. The remedy for monopoly is not more monopoly but the policy of competition impartially applied.
Figure XXI. Comparison of the Behavior of Prices and Production in Agriculture (Competitive) and Industry (Now Largely Monopolistic) in the Depression Period 1929–1934. While Employment in Industry Greatly Decreased, the Number of Farm Operators Actually Increased by More Than 500,000.Overhead costs and rigid pricesApologists for monopoly, while not denying the growing practice of artificial price rigidity in many industries regardless of changes in demand, have lately sought to justify it as the necessary result of overhead costs because of the heavy investment of capital in durable plants. They say that the prices of the products must provide a fair return on invested capital, including any interest on bonded debt (an actual cost); also a return on stockholders' actual investment at the rate the management expected to get; and finally a return at the same rate on watered stock issued as promoters' profits in forming combinations and reorganizations. These together constitute a heavy burden of so-called overhead costs, which, it is said, the industries are justified in shifting to the public in the form of higher prices, regardless of the general collapse of business conditions. This argument assumes the validity of the erroneous theory that cost prices of indirect agents cause and determine product prices, instead of the reverse.
Those who argue that rigid prices are the normal and justifiable result of overhead costs admit that overhead costs did not so dominate industry in the past. But they maintain that this was because such costs are essentially a new feature in modern industry. In fact, however, overhead costs are at least as old as the practice of expressing the capital value of the investment in durable agents such as machines, buildings, and lands. Every farmer has a large burden of overhead costs, yet the products of agricultural industry (except for recent public measures) are usually sold under competitive conditions at flexible prices.
It is monopoly power, not overhead costs, which make it possible today for some industries to maintain their prices at monopolistic levels regardless of changes in competitive conditions. Industries without monopoly power (such as most kinds of agriculture) have to forget overhead costs, and they continue to produce and sell at any price they can get that covers their actual out-of-pocket outlays. A price system of rigid, or monopoly, prices is not truly a system, for it is out of balance and cannot easily recover. It is the function of market price changes to restore demand and supply to equilibrium, and only a competitive price system can do this.
Summary and conclusionsThis chapter carries the study of the price system further into the region of reality where free exchange between individuals in accordance with their own valuations is so often and in manifold ways restricted and controlled either by some public authority or by private monopoly.
The true nature of fair competition in business must be carefully studied to determine what limitations must be placed upon it to ensure the general welfare. Monopoly is essentially unified action by sellers to restrict production artificially and thereby to cause buyers to bid up prices above the competitive norm. Discrimination by monopolistic sellers, that is, charging different classes of buyers nonuniform prices, enables monopoly still further to evade marginal competition and to increase prices and profits above the competitive level.
Grave questions of public policy are involved in the artificial control of prices by public ownership and by special public favors to private industries in various ways, as by means of restrictive tariffs to some, and by special franchises to other industries known as public utilities. Another outstanding present problem is industrial monopoly, which is not legally authorized but is definitely outlawed, yet which in defiance: of law has been steadily growing in power. The influence of monopoly in making prices more rigid, especially in periods of business depression, throws a disproportionate burden upon those other classes of citizens who are competing in their occupations. Monopoly even threatens to undermine the existing system of free industry and private property.
The student should, at this point, try to get a clear and consistent picture of the price system as a whole, by retracing the line of thought running from first to last through these four chapters. The starting point in the explanation of prices is in the differing choice and valuations of individuals. Exchange of goods, beginning in the simplest forms of barter and developing into a complex system of markets and agencies of trade, widens the range of individual choice and increases the wealth of the community. Market prices are mutually related through many ties. Monopoly gains involve the injury of others. A free price system is the essential condition of economic freedom. A true theory of price under actual conditions of mingled competition and monopoly is a necessary prerequisite to the shaping of sound, social price policies.
Suggested ReadingsBerle, Adolph A., Jr. and Means, Gardiner C. The Modern Corporation and Private Property. The Macmillan Co. New York. 1933. Reissue, Pp. xiii, 396.
Chamberlin, Edward H. The Theory of Monopolistic Competition. Harvard University Press. Cambridge, Mass. 1933. Pp. x, 213.Fetter, Frank A. The Masquerade of Monopoly. Harcourt, Brace and Co. New York. 1931. Pp. xii, 464.
——. "Big Business and the Nation." Facing the Facts. (James G. Smith, ed.) G.P. Putnam's Sons. New York. 1932. Pp. xvi, 372. See especially Chap. VII.
Keezer, Dexter M. and May, Stacey. The Public Control of Business. Harper and Brothers Publishers. New York. 1930. Pp. xi, 267. A clear view of the real nature of industrial monopoly.
Laidler, Harry W. Concentration of Control in American Industry. Thomas Y. Crowell and Co. New York. 1031. Pp. xvi, 501. The facts regarding concentration.
Means, Gardiner C. "Growth in the Relative Importance of the Large Corporation in American Economic Life." The American Economic Review. March 1931. Vol. XXI. Pp. 10–42. Factual account.
Mund, Vernon A. "Prices Under Competition and Monopoly: Some Concrete Examples." The Quarterly Journal of Economics. February, 1934. Vol. 48. Pp. 288–303.
Viner, Jacob. "Objective Tests of Competition Applied to the Cement Industry." The Journal of Political Economy. February, 1925. Vol. 33. Pp. 107–111.
Wormser, I.M. Frankenstein, Incorporated. McGraw-Hill Book Co., Inc. New York. 1931. Pp. ix, 242. A lawyer's analysis of ominous corporate abuses.
Questions and Problems1. What general social price policy is assumed in our political and legal institutions?
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What is competition? Co-operation? For effective competition what three essential conditions are necessary? Explain.
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What two types of action in relation to competition may the government take?
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Give some examples of unfair competition. Can you suggest ways to eliminate such acts or practices?
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What is the root meaning and definition of the word "monopoly"? Distinguish between absolute and limited monopoly; between inclusive and exclusive monopoly.
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What is the essential difference in the determination of monopoly price as compared with the determination of competitive price? Explain.
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Explain the way in which monopoly may be used to obtain higher prices from purchasers.
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What is the nature of crude monopoly price? Under what conditions would a monopolist charge this type of price?
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What is meant by discrimination in prices? Do monopolists usually practice discrimination? Why or why not?
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Define cutthroat competition. Why, and by whom, is it usually practiced?
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How would you characterize net monopoly price? Under what conditions does a monopolist aim at this type of price?
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Give examples of public (Iegalized) monopolies. Are public monopolies in the United States more prevalent than private monopolies?
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Why does private monopoly always involve a restriction of supply? What are other economic results of private monopoly?
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How does monopoly tend toward rigidity of prices?
The roundabout or technological process"Production" is the general term for the natural and artificial processes by which indirect goods (or uses) are combined and advanced one or more stages toward ripeness or readiness for direct use by men.See Chaps. V, X, and especially the section on "direct and indirect uses" in Chap. 17. In the processes of production, goods are changed in various ways in their stuff, form, place, time, or ownership. Nature is the great primary producer. The amount of labor employed in the various processes of production — whether measured in time, trouble, effort, or price — varies from an almost negligible amount to a great deal. Man's part often might be likened to the mere pulling of a gun trigger to set off a load of natural forces, or to the unlocking of a door to release the imprisoned uses in indirect goods. Production under human guidance has been called "the roundabout process,'' because the end sought — the direct enjoyable goods — is attained by a succession of indirect steps. The adjective "technological," implying the action of one thing upon another, is also used in place of roundabout.
Technological changes are usually accompanied by increasing valuations of the goods, and it is this desired result which motivates men to produce. The increment of valuation belongs to the responsible owner of the products after all the legal claims of others who supplied part of the indirect goods have been satisfied by the payment of wages, rents, purchase prices, and claims of all sorts. The erroneous notion that the increased valuation is caused solely by the labor used in the process of production is known as "the labor theory of value."
Men often have to choose between the direct and the indirect uses of concrete goods. For example, should a piece of wood be used for fuel, or as material to build a house, or to make some implement such as a fence or a hoe handle? These choices depend on the owner's differing valuations of present and of future uses, and durative and of consumptive uses, contained in same agents. One kind of use may be had only at the price of the other kind, as discussed further below in connection with alternative costs, or alternative valuations.
The enterpriser's functionThe enterpriser, or entrepreneur, as pointed out in Chapters V and XI, is the middleman who undertakes the financial responsibility of carrying on some roundabout process one step further for the next group of buyers, and eventually for the final users. He is a self-appointed agent of the proximate and ultimate buyers. On his judgment of the probable difference between his outlays and his sales he risks his own time and services together with whatever capital he has embarked in the enterprise — that is, the financial fund embodied in his money, credit, lands, houses, tools, and so on.
The outcome of large or of small profits depends partly on mere chance and accidents beyond any human control or prediction, such as earthquakes, floods, fires, wars, and fashions, which are the incalcuable risks of any enterprise. Other profits may result from unfair, fraudulent, and criminal conduct or from monopoly and special governmental favors. Under more normal conditions, however, profits depend mainly on the comparative skill with which the enterpriser chooses his investment and operates his business, combining the agents in the right proportions to obtain product that may be sold at profitable prices.
The current prices at which indirect agents can be bought is rather narrowly fixed in free markets, and one enterpriser usually has little advantage over another in this regard. Except when he has some monopolistic power, he must take the system of prices for his necessary agents pretty much as he finds it. The success of the competitive enterpriser in making profits depends the agents far more after on good judgment in selecting and in proportioning the agents after he buys them, than on buying them at less than current prices.
Optimum size of an enterpriseIt may be recalled that the point was made in Chapter XI that the first question the enterpriser must decide regarding his plant is that of external proportion: How big a plant should he build? For how large an output? There is an ideal, or at optimum, proportion between plant capacity and the demand at a profitable price within the market area of the plant. An excess of consumptible agents such as coal and raw materials can be used up in a short time with little loss. The greater chance of error is determining the capacity of the durable plant; if it is too small it frequently can be enlarged as output increases, only at disproportionate expense. Therefore it may seem better to provide for the future by purposely building some parts of the plant larger than is needed at the time, in the hope that the present cost (recurring interest on investment) may be defrayed from future profits.
If the plant is built too large, the unused capacity, whether land, floor space, power plant, or machines, represents an outlay useless for present and near-future needs. A question of theory and of practice arises: Should a normal return on either an intentional or a mistaken original outlay for unused plant be treated as part of the "costs" of the actual smaller output?
Overhead costsCosts for unused capacity which is already paid for are merely that part of the capital outlay on which an estimated fair annual return is expected. Often such costs are represented by outstanding bonds calling for regular interest payments. These costs for unused capacity, whether they be estimated or actually incurred, and a number of other costs which do not vary with the size of the output — executives' salaries, taxes, and depreciation charges — are known as overhead costs.
When overhead costs are included in the costs of the actual output, what happens if the output increases in response to an enlarged demand? As the external proportionality of plant to market moves during this time toward the optimum, total costs increase slowly, unit costs decrease, and profit increases. This period, during which a former mistake in the size of a durable plant is being point has corrected, is a stage of decreasing costs. After the optimum point has been passed, unit costs in the enterprise, calculated in the same way, will again increase because of lack of proper proportionality in the use of the agents of production. This is the stage of increasing costs.
This use of the terms "decreasing" and "increasing costs" as applied to a single enterprise is often confused with the very different problems of diminishing physical returnsSee Chaps. V and VI. to an entire national industry. An example is agriculture, where increasing population and the more intensive utilization of a limited ares of land results in diminishing physical returns.
Optimum internal proportion of agentsAs the optimum size of a plant in relation to its market area is a problem of external proportion, so the optimum amount of each factor of production within the single plant presents a problem of internal proportion. Land, buildings, power plant, machines and tools of various kinds, and labor of all grades should be bought in just the right amounts and kinds in view of their relative prices. The two conditions are not entirely distinct, but they mutually affect each other. An unwise external proportioning of capacity of a whole plant to market demand upsets the right internal economic proportion within the plant. When the investment in durable plant is too great, the excess investment would yield a larger profit either in making other products or in other enterprises.
The internal proportion of variable agents within the plant may also be mistaken when the capacity of the plant as a whole is not out of line. Even in a small enterprise, many choices of agents must constantly he made, choices involving a comparison of costs at the prevailing prices with the expected addition to the prices of the products. At one time it is better to hire another laborer or another skilled worker; at another time it is better to buy more tools or better machines, or to use more materials of certain kinds. So far as these choices are wisely made, they serve both to ensure a profit to the single enterprise and to maintain the equilibrium in the general system of prices. As a result of the differing judgments of enterprisers, costs in various competing enterprises within the same industry may differ widely in their items and in their total amount. There is no common standard cost in this sense for an entire industry; each enterprise has its differing outlay costs.
The empirical law of costsThe total of the prices (costs) of the agents used in an enterprise tends to correspond pretty closely in amount with the total price of the products. It is assumed in this statement that costs include a "fair profit" to the enterpriser on his invested capital, as measured by the opportunity costs as explained later. If, however, profits were defined as the remainder left after deducting costs from receipts, then the wording of the principle would be that cost plus a fair profit tend to be equal to the price of products. Total costs and total price of products, divided by the number of units of product, gives unit cost and unit price of product.
This tendency of costs and product prices to come into agreement is the empirical law of costs. It is called empirical to denote that it is a simple fact of observation and not an assertion regarding causal relationship. As such it must be accepted by all economists as true, subject to various frictions and lags in practical experience.
Question of the causal order of costs and product-pricesDifferences of opinion, however, have arisen among economists in their attempts to state a causal order of cost and price. Thus some have maintained that the business costs in each industry determine, set, fix, or regulate the prices in that industry — in other words, that the causal order runs from the costs in an enterprise or industry to its prices. Few have seriously attempted to oppose this view with its direct opposite, that is, to maintain that the prices in any one industry (or enterprise) determine the costs in that one industry. But seeing that costs and product prices are merely two sets of prices in the same industry, the question arises as to whether either set necessarily is the cause of the other. May not these two sets of prices in the same industry be the effect of a common cause, be merely parts of the larger system of prices determined by forces and conditions lying outside any single enterprise or even the wholeindustry? Let us try to find the answer to this question.
Technological adjustment of costs to higher product-pricesIt is through the action of middlemen that the empirical law of costs operates. With no such purpose in view they are constantly bringing costs and product-prices into accord; they do so merely through seeking to make a better profit by buying indirect agents more freely when their cost is low compared with the product-prices, and vice versa. If but a single kind and grade of goods is produced, as cement in a cement mill, the estimation of unit costs is simplest, and yet even here there is no problem of estimating and distributing overhead costs fairly. When a variety of by-products is produced, as in a flour mill or in a meat-packing house, nearly all items of variable costs are spread over two or more products, and, like overhead costs, are joint costs. Under such conditions the problem of relating costs to prices becomes complex.
What happens when it becomes known that an industry generally, or some plants in certain neighborhoods, are making profits higher than "normal." The output of some plants will be. increased, some plants will be enlarged, new plants will be started, and goods will be shipped into that territory from greater distances. The increasing supply will decrease the product-price or at least retard its rise, and at the same time the cost-price of the more limited agents (labor, local materials, and the like) will be bid up somewhat. The result is a new relationship, a tendency toward a new equilibrium between cost-prices and product-prices in such plant and in the entire industry.
Technological adjustment of costs to lower product-pricesThe whole process is reversed when product-prices and profits are abnormally low. Output is curtailed by those so situated that they cannot male a profit in that area; some marginal producers go out of business entirely; some shift a part or all the capicity of their plants to the making of other products, and the industrial equipment that wears out or is otherwise destroyed goes unreplaced so long as normal profits cannot be made on the cost of upkeep. The effect of deceasing supply is to raise product-prices (or at least to check further tendency to fall), whereas the decreased demand in that market for the more limited cost goods reduces their prices until again there results a new equilibrium of product-prices and costs.
AII such methods of bringing costs and product-prices into accord by physical changes in plant capacity and in the amount of products may he grouped under the general description of the technical, or technological, adjustment of costs and product-prices.
Friction and lag in adjustmentsSolely by such technological methods the equilibrium between costs and product-prices might eventually be brought about but here is much friction and lag in the process. To explain these facts the doctrine of quasi rents, with its contrast between the long- and the short-time relationship of costs and prices, was developed by the English economist, Alfred Marshall. In this view of the cost and adjustment process, it is assumed that original investment has the same capital value as long as the physical agents last, and that the "fair" rate of return on this investment may be accounted as parted of the costs of present products.
Adjustment of costs by resaleBut this is not all. A certain flour mill which cost originally $100,000 continued for years to earn the expected annual return on that investment. Fifty years later it was still in good repair and usable, yet no one was willing to pay more than $10,000 for it, and that only because of the water power. Why so? Because that region no longer produced wheat, the chief raw material of the mill, and no buycr could be found who thought the present and prospective net income (rental value) of the mill would justify his paying that much for it.See the capitalization theory in the chapter on Interest. On the other hand an old business may sell for more than its original cost as a result of various changes in economic conditions.
This illustration of the mill is no imaginary case, and there have been thousands like it. That particular mill is now entirely abandoned. If someone did buy it for $10,000, implying that he estimated its net earning power (rental value) at about $500 or $600 a year, neither he nor anyone else could assume that a fair allowance for annual overhead costs would be $5,000 (say 5 per cent of the original cost). Was that, then, a fair estimate of costs by the former owner up to the moment of sale? Can or ought nothing change the fair estimate of overhead costs, based on original capital investment until the property changes hands?
Adjustment of costs by recapitalizationOriginal investment cost is merely the price paid by the investor at the moment he buys the business, at a valuation reflecting his forecast and hopes of its future earning power (rental value). Experience must tell whether that valuation (capitalization) was right. If he discovers by the end of the first, or any later, year that he has made a mistake, the original cost figure merely records that error.
In the price system economic agents are worth what they will earn, not what they cost, and the capital value of agents with future uses is the present worth of their expected incomes. Frequently, present worth is much greater than past cost, a fact which business men are rarely slow to recognize by reappraising their assets upward. In other cases present worth is less than past cost.See the chapter on Interest. Past costs are ancient history, and if an enterpriser continues to carry his original capital costs and inventory unchanged on his books, and to use these figures as the basis for "fair" prices based on costs, he is, to say the least, a laggard accountant. If he is in a competitive enterprise, his error will cost him dearly, but if he has sufficient monopoly power, it will cost the public dearly.
The cost-of-reproduction doctrineIf present and estimated future earning power is the logical and practical basis for the present "capital value of business agents for a new owner, why was it not likewise so for the old owner before the sale? Once one departs from original investment price (less depreciation) as the standard of costs, even in the case of resale at a lower or a higher price, it is hard to find any logical stopping place in modifying the theory that past costs determine the just and fair basis of present prices.
Recognizing this, some economists,For example, Francis A. Walker, as early as 1880. seeking a way out of the difficulty, many years ago adopted the view that present "cost of reproduction," not past cost of production, is what determines product-prices. If, as is clearly implied by this doctrine, the present cost of indirect agents is not determined by their past cost, what does determine it? To this no direct answer is given by the cost-of-reproduction theory, although the thought is near that costs somehow are shifted up or down with current prices of products.
In one text which professes to accept the cost-of-production theory, the doctrine is developed that future costs of production determine present prices. Whatever else that may mean, it is something very different from the older cost-of-production doctrine.
Actual costs versus costs from past investmentIf all costs in an enterprise were actual current outlays, and all products were sold within a single year, it would be comparatively easy to calculate costs and profits. The real conditions, however, as to the time and form of costs and sales are usually such that any statement of the amount of costs and profits is largely the result of somebody's conjecture rather than the outcome of completed business transactions. Note a few of the difficulties.
Besides the agents bought and used at once (or within a single year), there are usually some stocks of consumable things such as coal, oil, lumber, cotton, grain left over from previous years; and in turn some such things bought this year may not be all used up. The current prices of these stocks at the time they are used is usually either more or less than their actual cost, and the longer the lapse of time the more the two figures are likely to diverge. Even greater changes occur in the costs of durable agents such as land, buildings, and machinery, and of intangible rights such as patents, charters, good will, and the like, acquired in the past for a price, but the benefits of which continue over a series of years. Of the total original monetary costs of such durable agents and rights, evidently only that fraction of separable uses that goes into the making of one year's output could reasonably be counted in the current costs.
Guesswork in calculations of annual cost itemsThe amount of cost allotted to the making of one year's output is decided only by somebody's valuation. There is, first, an estimate of the "fair" capital value of the durable agents, and, second, an estimate of the "fair" annual rate of return upon that capital value (as say $100,000 at 10 per cent, giving $10,000 as one year's cost). The question has been raised above whether the original cost of the durable plant should remain unchanged through the years, regardless of changed conditions which have revealed such facts as that the location was a mistake, or that the plant has become obsolete and nearly worthless, or that there is no longer a market demand for the output. Or the conditions might seem to call for an increase in the valuation of the present worth.
Then a further question arises. Whatever be the capital value, is the rate at which the investor merely hoped to profit to be taken now as the "fair" rate regardless of whether it is the rate which new investors now expect to earn? Evidently such cost figures are merely personal estimates and contain a large element of guesswork. Calculations of cost made by sellers for the purpose of convincing the public that their prices afford them only a "reasonable" profit over costs of production are peculiarly open to suspicion of biased judgment.
Opportunity costsUnder our system of private property and enterprise a producer is entitled to decide whether to continue in business at all or to continue making any specific product. He may get out of his business at once by selling it outright; or he may gradually reduce its scope, neglect repairs, and finally sell the rest at its salvage value; or he may choose not to rebuild after a fire; or he may shift its uses to products of another industry (sewing machines to bicycles, phonographs to radios, and so on). Whatever he does in this way tends to reduce the supply of the products and thus to raise or to check the fall of their prices as already described. The reverse process occurs when profits are temptingly high.
Any of these things may happen even if the enterpriser owns his entire plant without indebtedness and even if he and his family do all the labor so that his actual cash outlays are very small. His leaving the business would be evidence that his valuation of his fund of economic agents (lands, buildings, tools, working capital in the form of cash, his own labor and that of his family) is greater for some other uses than it is for this particular business. This is true, even if he loses a large part of his original investment in making the change. The estimate of the return which can be obtained from economic agents in an alternative use has been called an opportunity cost, which is merely an alternative valuation. If in any given employment the use of an agent will not yield as great a return as its valuation in another use, the agent will tend to be shifted to the other use. It is plain that opportunity cost is not an actual cost but an estimate or personal valuation. The costs in every business in which the enterpriser owns and supplies a part of the economic agents are partly actual costs and partly the owner's personal valuations of alternative applications.
Personal preferences in alternative valuationsSuch valuations are often made by the residual method of comparison. As a simple example, suppose a small manufacturer calculates that he is making an average annual income of $9,000, this being both for his investment and for his own services. He can get a salary of $5,000 in another business, and thinks he can sell the business for $100,000 and invest the proceeds safely at 5 per cent and get an income of $5,000. His total alternative valuation in money incomes is therefore $10,000, as against $9,000 which he is now getting. Under these circumstances he might sell, but again for purely personal reasons — habits, sentiments, hopes, and so on — he might not. Or he might shift the factory to other products in which he believes he could earn a net income of $12,000. He might make this shift, or he might not if he prefers the business he is in. There are factors of psychic income in all such personal decisions; estimates of incomes and opportunity costs merely in terms of dollars are not alone decisive, The example shows, too, that the marginal producers, those most likely to come into or go out of the production, are not necessarily the least efficient. When price falls, those who drop out may be among the most efficient as measured by their monetary costs of production and by profits, but they may have other better alternatives, and may be influenced by psychic factors such as prestige, social ambition, health, temperament, aesthetic and personal tastes, and other considerations.
Price relationship implicit in demandIn all their transactions in search of profits, entrepreneurs and other middlemen operate within an all-embracing system of prices which no one of them makes, but which each has to take as he finds it. Let us consider further how the price system takes form, and how it influences the demands and supplies of individual enterprisers. Recall here some elementary truths of valuation. Every individual valuation is the numerical expression of the importance to that person of one thing in terms of another. The quantity of any valuation is finite, because purchasing power is limited in amount. If more money is given for a commodity having a direct use to its owner, the marginal valuation to him of his remaining money rises in terms of that commodity.
The market demand at a certain price is merely the sum of individual demands. It is the number of units of a given commodity for which buyers are willing to pay the total price called for (unit price times units bought, say 100,000 bushels of wheat at ninety cents a bushel, or $90,000). Buyers will buy to that point because, individually and collectively, they value that amount of wheat more than any assortment of other goods they could buy at the time for that sum of money. Beyond that point further (extramarginal) units of wheat have not so great a valuation as the marginal units of the remaining purchasing power.
And what is the source of the value of purchasing power in terms of money? It is merely the reflected value to its possessor of the other desirable things which money can buy. Whatever be the actual demand for any specific commodity in a market, each and every buyer is choosing it in preference to every other good which could be bought for the same price. Of course, lack of vision, impulse and various accidents cause many mistaken choices which later may be recognized as such. Every personal and family budget is a system of valuations, linked through exchange with the existing system of prices.
Middlemen and final buyersThe market demand for a commodity is a cumulation of the demands of many individuals who have many different uses for the goods and many motives for their demands at various prices. Two classes of buyers particularly may be distinguished here: The first class consists of final or ultimate buyers, whose valuations are based on their own uses; the second class consists of intermediate buyers, or middlemen, who buy not with any purpose of using the goods for their own enjoyment but only to sell again. Such resale may be of goods in nearly unchanged form (as in merchandising), or after fabrication (as in manufacturing), or after their use as agents in various other sorts of enterprise (as seed and fertilizer in agriculture, or fuel for power in transportation). Middlemen may sell either to buyers for personal use or to other middlemen who, in turn, sell either to other middlemen or to final users. But in any case, the analysis finally gets to the starting point of all valuations, namely, valuation for direct use. All intermediate market-demand valuations are but reflections, or forecasts, or estimates, of the prices which ultimate users of goods may be expected to pay for them.
Middlemen's supply and demand reserve valuationsIn only a comparatively small number of trades, mostly retail, have many of the buyers direct-use valuations for the things they are buying. Even more rarely is this true of the sellers. In our developed system of exchange, raw materials and fabricated products pass through numerous hands before coming in completed form to the final users. Therefore, in the markets for most goods, both demand and supply are determined immediately, though not ultimately, by businessmen's valuations. In viewing the ordinary diagram of demand and supply, we must not think that demand is determined immediately by final users and that only supply is determined by businessmen's estimates. In most business deals, both the buying and selling groups are made up of businessmen and middlemen, and, to repeat, their estimates determine immediately both demand and supply. But what is the basis, or the final criterion, of their valuations?
Business demand and ultimate buyers' demandFollow this process step by step, starting from the valuation of the direct commodity by the final users. The commodity being scarce and valuable (say bread), enterprisers in stage one (bakers) undertake to produce more of the commodity by combining other indirect things. The limit which they dare pay (their total costs) for these means is fixed by the valuations of the direct users of bread, and this limit will be approached under competitive conditions. In turn, the millers purchase wheat and advance it one step further toward completion (flour). Their demand for wheat is fixed by the amount which bakers will pay for flour. Continuing, the original step in roundabout production will be the ultimate factors of natural resources and human labor; the demand for them, too, is at valuations determined from the valuations of the direct users, not of one final product only (bread), but of the various products for which any part of these original factors are used.
The valuation in each of these possible uses is an opportunity cost, or alternative valuation, for each of the other uses. Such original factors as land and labor have no prior, or original money cost: their price is derived from the price of the final products.In and old country, however, present owners may have bought natural agents directly or indirectly from the first owners, at prices determined by the bidding of the whole community for these useful and scarce indirect economic agents. In such cases these agents have a monetary price constantly readjusted the same as that of any other agents in the price system.
Supply valuation determined by ultimate buyers' demandThe answer to the question: "What is the ultimate source of middlemen's supply valuations?" is suggested in what has just been said of middlemen's demand valuations. Every enterpriser is operating in the midst of a system of prices. All business costs at each stage of the roundabout process are incurred in the expectation of selling the product for enough above costs to allow a profit. The enterpriser buys each agent up to the point where his marginal valuation of it is just equal to that of any other factor which he can buy with the same amount of money. The costs include the prices not only of the physical materials — textiles, lumber, metals, grains, and the like — but rents, wages and salaries, advertising, freights, taxes, and many minor outlays. Why are the agents which are an enterpriser buys worth what he pays for them, or worth any amount whatever? Evidently it is because each enterpriser in turn expects, or hopes, to sell the products for more than they cost him, selling always in the direction of the ultimate buyers. Any one middleman may not need to consider the source of demand beyond the sale of his own product, and usually he does not try to. He bids for and buys the indirect agents needed by him on the basis of the prices for which he in turn hopes to sell his products. And this goes on in every stage of production until the final user of the finished goods is reached. A middleman has no independent buying or selling valuations for agents, outside the system of prices in which he operates. In final analysis, therefore, all middlemen's buying valuations are traceable to, or derives from the value of goods to final direct users.
The moment a middleman has paid a price for any factor of production it becomes a cost of production to him. Product-prices and costs are both prices within the price system, the former for more nearly direct uses, the later for less direct uses or goods at each stage of production. There is, however, no antecedent price for scarce natural agents at the very first stage of production in the roundabout process. Their price is, so to speak, the auction price which competing ultimate users pay for these agents through the medium of middlemen competing at each stage of production. Business costs of indirect goods are reflections of the prices of the final direct goods of all kinds with which they are connected in the whole system of prices.
Various conditions of the theoretical price equilibriumThe various prices constituting a system of prices at a certain time in a community are not the result of separate accidents, and they are not arrived at independently. As the very word "system" implies, they are related by some principle in a more or less orderly way. That principle is the marginal valuation of both direct and indirect goods.
First, the final buyers of direct goods apportion their purchasing power (money and other salable goods in their possession, including their labor power) among the various direct goods so that to each user the direct-use valuations are brought into equilibrium. Then each middleman apportions his purchasing power among the various indirect agents at this stage of production so that in his business the marginal valuations of the indirect uses are in equilibrium. When this condition is attained, there is, for the moment at least, no motive for anyone to rearrange his budget either of personal and family expenditures or of business outlays. Each budget is for the moment at its optimum proportionality. The outside limit of middlemen's valuations, either in buying or selling indirect goods, lies in his estimation of the valuations and demands of the buyers of his products, and so on to the final buyers. Under these conditions of equilibrium of individual valuations, demand and supply for each king of goods also tend to be brought into equilibrium, thus forming a system of prices which for the moment is also in approximate equilibrium.
A perfect equilibrium of valuations and of prices is a theoretical ideal, an abstraction never fully realized. It is an end toward which the forces of human desire and choice at each moment are always tending without every fully attaining. There is a lag and friction in choice and in the processes of production; in the meantime changes occur in desires as well as in the material conditions of plenty and scarcity of goods — weather, plagues, crops, accidents, discoveries, sickness and health, peace and war, a thousand vicissitudes. Each new total set of conditions involves a new theoretically correct equilibrium. Despite the ceaseless flow of the tides toward adjustment with the forces of gravitation, the oceans never come to rest.
Prices under static and dynamic conditionsThere is no need of two distinct price theories, a static thenry, concerned only with a condition of rest and equilibrium, and a quite different dynamic theory to explain the behavior of contemporary prices when new forces violently disturb such an equilibrium. The function of price theory is to give a rational explanation of the choices and actions of men which tend to bring about an equilibrium of valuations and prices, rather than to study and explain a mere motionless equilibrium itself. The most static human society of which we have any knowledge, one with the least progress in the technical arts and with population stationary during long periods, is yet full of much internal movement and fluctuation. Children are born, grow to maturity, are well or ill, suffer accidents, grow old and finally die and are replaced in the population by other individuals. Education must be constantly repeated; the young must chose and master their occupations. There is the constant round of the seasons, changes of weather, heat, cold, floods, drought, insect pests, plant blights, scanty or bountiful harvests, for years, lean years, pestilence, plague, famine, and war.
A price theory which serves to explain how an equilibrium of contemporary prices tends to be constantly re-established in these conditions merely needs to be extended — speeded up, as it were — to apply in more dynamic conditions of society where there is rapid population growth, revolutionary progress in science and in the practical arts, and striking changes in manners, tastes, education and culture, with accompanying changes in human tastes and desires and in the kinds and amounts of goods and services. We have not undertaken to treat the special dynamic problems of price changes during the successive time phases of the business cycle — the sudden disruptions, the marked inequalities between the price changes of the various commodities and industries, and the differing lags in their recovery. However, numerous passages in chapter and the next one are not without bearing upon those questions.
Summary and conclusionsIn this chapter our attention now returns to man's part in the process of production. The purpose is to consider particularly the part played in the determination of prices by middlemen who have no use-valuations of their own for the goods they buy or sell, but only exchange-valuations.
The roundabout process in production is directed by enterprisers who, if successful, thereby obtain profits on their investments and for their efforts. To obtain profits it is essential that the enterpriser keep his outlays (costs) below the receipts frm the sale of his products.
The observed tendency is for the product-prices and costs (including normal profits) of the various industries and separate enterprises to come into accord, through with frequent lags and imperfect adjustment. This statement is called the empirical law of costs. Business costs are merely one sort of prices in the price system. The theory of price has to explain the relationship of two sets of prices in the price system, those of direct final goods and those of indirect or intermediary goods, or agents of production. The motives which lead businessmen to pay any amount whatever for the agents of production (that is, to incur costs) is the hope of reselling the goods (further fabricated) in the direction of the final users.
The enterpriser's "costs" are in business language understood to include not only actual cash outlays for a specific agent, but also estimated (opportunity) costs of various kinds. Costs of both kinds are traceable immediately to the marginal valuations of the purchasers of the products of each stage of production and ultimately to buyers' demand for final direct goods.
The price system as a whole is made up of a number of sets of prices, each of which is constantly tending toward internal and external equilibrium. These various equilibria are constantly being upset by new forces. When the disturbance is gradual and moderate, the condition is called relatively state; if rapid and extensive, it is spoken of a dynamic.
Suggested ReadingsBöhm-Bawerk, Eugen von. The Positive Theory of Capital. D.E. Stechert and Co. New York. 1923. Reprint. Pp. 428.
Carter, Thomas N. The Distribution of Wealth. The Macmillan Co. New York. 1904. Pps. xvi, 290. Chap. 2 contains a statement of the principle of proportionality.
Clark, John M. Studies in the Economics of Overhead Costs. The University of Chicago Press. Chicago. 1923. Pp. xiii, 502.
Davenport, Herbert J. The Economics of Enterprise. The Macmillan Co. New York. 1913. Pp. xvi, 544. An analysis of opportunity costs is found in Chaps. 6 and 8.
——. Value and Distribution. The University of Chicago Press. Chicago. 1908. Pp. xi, 582.
Fetter, Frank A. Economic Principles. The Century Co. New York. 1915. Pp. x, 523. Chap. 28 contains an analysis of the relation of cost to price. In Chaps. 12 and 31 will be found additional data on the internal and external proportioning of the productive agents.
Green, D.I. "Pain-cost and Opportunity-cost." The Quarterly Journal of Economics. 1894. Vol. 8. Pp. 218–229.
Mund, Vernon A. "The Financial Adjustment in the Empirical Law of Cost." The American Economic Review. March, 1936. Vol. 36. Pp. 74–80.
Robinson, E.A.G. The Structure of Competitive Industry. Harcourt, Brace and Co. New York. 1932. Pps. viii, 184. A consideration of the optimum size of an enterprise.
Questions and Problems1. How would you characterize an enterpriser? What is the function of the enterpriser?
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Distinguish between the optimum external and the optimum internal proportion of the agents in productive activity.
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What is the "empirical law of costs"? What individuals bring about the operation of the law?
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By what methods or adjustments is the correspondence of cost and price effected? Explain fully.
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When is the price of a good "normal"?
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How is market price determined by the interplay of demand and supply?
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Distinguish between actual (contractual) costs and estimated costs. Give examples of each.
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What are "opportunity costs"? Give examples of conditions in which agents have an opportunity cost; of conditions in which they do not have an opportunity cost.
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Show by means of an illustration the way in which opportunity costs influence the use made of economic agents.
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How would you characterize the "marginal" producer? Give an example. In what sense is he the weakest? In what sense not?
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What is the basis for ultimate buyer's valuations of direct use goods? For intermediate buyers' or middlemen's buying valuations?
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What is the basis for the selling valuations of middlemen?
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Trace the process of making valuations in each principal stage involved in the making of a wool dress or suit. In your answer show how product-prices become cost prices.
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What is the final source of demand for goods of any degree of indirectness?
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A business executive recently said: "Over a period of years, from 1925 to 1934, the steel industry averaged only 2 1/2 per cent return on its aggregate investment. In the best of those years, it showed a return of only a little more than 9 per cent and in the four years, 1925 to 1928 inclusive, the industry averaged less than 4 per cent return after all charges but before dividends." How was the "aggregate investment" of the whole industry determined, and by whom?
Primitive forms of tradeTrading is so familiar a sight to us today that it is hard to realize how recently it began in human history. Adam Smith declared that men had "a natural propensity to truck and barter," but all observation of the more primitive peoples shows that before the visits of explorers and travelers "truck and barter" of any developed sort was unknown. The primitive families and groups produced for themselves all the goods that they consumed. Within the groups duties and goods were apportioned by custom and authority, and trade was unknown. The earliest exchange of goods took the form of gift-giving from which very slowly more regular trading, as we understand it, seems to have developed. Perhaps a visitor gave the savage chief a present when he expressed a desire for it, whereupon the chief gave a present in return. Or strangers left goods at the border of the tribal territory, and members of the tribe, if pleased with them, left something else in return. The primitive code of gift-giving called for a fair equivalence between the goods; at least each party must like what he got more than what he gave, or he stopped giving. In this way tribes near the ocean developed a crude form of barter with forest tribes in the interior. Salt and fish were traded for ivory and pelts; and flint, copper, and iron weapons were traded by successive stages thousands of miles from the few places where they were first found. The earliest trade was with foreign and distant peoples rather within the tribes and among near neighbors."Value-in-use" and "value-in-exchange"Value-in-use is the quality of importance attributed by a person to a thing intended for use (direct or indirect) by himself or those to whom he gives it. Value-in-exchange is a reflection of somebody else's value-in-use, that is, it is the importance a thing has to its present owner by virtue of the fact that someone else is willing to give something else for it. Following the matter further, step by step through the successive exchanges, one comes at last to the final buyer and direct user of the commodity to whom it has value-in-use. Most goods which have use-value to their owner also have exchange-value to him, because others will give him something for them. The two values are not always exactly equal to a person; indeed, they often may be different. Sometimes one, sometimes the other, is the greater at a certain time and place, and the owner of a good may choose between these two values. If the use-value is the greater, he keeps the thing for his own; if not, he trades it for something else more desirable. A merchant or other middleman may have only exchange-valuations both for what he sells and for what he receives; only ultimately will he get goods with use-values by the spending of this profits.Priority of values-in-useThe only kind of value which goods can have to a wholly self-sufficing individual or group is value-in-use. Today in our highly organized society, where goods are mostly made to be sold, the typical producer or merchant considers mainly the exchange-value of the goods he handles. Their value to him is the reflect value of the other goods (or of general purchasing power) which he hopes to get for them. He may hardly think of the fact that he can sell the goods only because they have use-value to ultimate buyers, that is, to those who finally buy not to sell again but to use after the goods may have passed through the hands of a whole series of middlemen. Today in our highly organized society, the largest part of men's incomes accrues in the form of money received for what they sell — as wages, salaries, and fees for their services, as rent for the uses of agents they own, as profits and dividends on investments, as interest for their loan capital. But it is well never to lose sight of the fact that use-values were prior in historical origin to exchange-values and that they are still the basis and course of all exchange value to their owner only i and when they are expected finally to have use-value to someone else. Values-in-use are primary; and values-in-exchange are secondary, being always derived ultimately from values-in-use. The priority of values-in-use is fact deserving emphasis because it is one we are prone to overlook.Isolated barterConsider how two men would trade after the earlier stage of mutual gift-giving is past and the custom or propensity to trade has developed and become fixed. How would they behave? Every economic subject has, as we have seen, his system of valuations at any moment, resulting from his existing desires and from the amounts of goods, including human services, at his command. The meeting of two such persons apart from others offers the opportunity for isolated barter, the direct trading of one kind of goods for another without the use of money. Each person has opened to him new choices through trade whenever his set of valuations of all kinds of goods is not exactly the same as that of the other person. If the state of desires and possessions of the two men thus differ, the relatively surplus goods of the one may meet the most urgent wants of the other, and vice versa. The hunter with many furs and pelts but without food meets the fisherman needing furs and leather. Each might part with some of his more abundant goods (having, therefore, small use-value) in exchange for some of the things which he most lacks (having large use-value).Marginal valuation in tradingRarely, however, would either trader part with all of his stock of any good that has use-value to him, because, for example, as the fisherman's stock of fish shrinks, the valuation per unit of the remainder in terms of furs, increases; and as he gets more furs their valuation per unit decreases in terms of fish. And so it is, conversely, with the hunter. Each party will stop trading at the point where his valuation of the goods he can get is no more than his valuation of the goods he has to give in return. This would be marginal trade, and the last or least urgent uses to which any of the like units of goods were put would be the marginal uses. Observe, however, that each of the units of like goods in a person's possession at a moment have then the same value as every other unit. The term "marginal valuation" always implies the equal valuation of a number of like things at the same time. Evidently, there is marginal valuation both of the sale good (the thing the buyers is acquiring) and the price-good (his purchasing power); but during the trade the two valuations move in opposition directions, one down and the other up, both for the buyer and for the seller, until the two valuations come to equilibrium at some ratio.
Figure X. Marginal Valuations in Trading
Let it be assumed that the fisherman before meeting the hunter had 20 fish and no pelts and the hunter 7 pelts and no fish, and that the latent valuations of each party for successive marginal units of pelts in terms of fish were as shown in the graph. It follows that, rather than not trade at all, the fisherman would have been willing in a single trade to give a total of 5 fish for 1 pelt. 8 for 2 pelts, or 9 for 3 pelts; likewise, the hunter would have been willing to accept a total of 1 fish for 1 pelt, 3 for 2 pelts, or 9 for 3 pelts. If only one pelt were traded, the fisherman would have continued to value pelts higher than did the hunter, and the hunter to value pelts lower than did the fisherman. But if 9 fish are traded for 3 pelts, the marginal valuations (pelts in terms of fish) of both parties are brought close to equilibrium. Observe that exchange alters the use-valuation (pelts in terms of ish) of both parties, and brings use-valuation to each party is 1 pelt = 3 fish. This is the ratio of exchange toward which the trading would tend, and the goods would then be distributed thus: the fisherman would have 11 fish and 3 pelts; the hunter would have 9 fish and 4 pelts. However (as discussed in the section on higgling), this situation might not be exactly arrived at in isolated trade.
Higgling in isolated tradeIn trade that takes place between two persons far removed from any other persons or opportunities to trade, the ratio of exchange many vary widely. In such a situation there is no competition on either side, on the side of the buyer or of the seller (see below p. 523 on competition). The least advantageous ratio of exchange that could induce a buyer or a seller, respectively, to trade one or more units of goods is called reserve valuation with respect to that specific number. Each party may be much in the dark regarding the needs, purchasing power, and reserve valuations of the other party; or one may be much better informed, or more able to wait, or have other means of getting what he wants. After much time spent in "dickering" or "chaffering" or "higgling," the trade may be made at a ratio which leaves barely any gain in valuation (motive to trade) to one party, while making it very advantageous to the other. Every isolated trade presents the condition of this sort of monopolistic power and of its exercise, especially when the two parties are not equally matched in their information and in the strength of their economic resources. But probably more often a medium ratio is agreed upon which makes the trade very desirable to both parties.
Latent competition in isolated tradeEven if there is no actual competition in isolated trade at a certain place and time, it can rarely happen that a certain amount of latent, or potential, competition is entirely lacking. Back in the thought of either of the two parties, or of both of them, may be the knowledge that another neighbor is willing to trade, or that like goods can be bought or sold on better terms the next market day in the neighboring town. Thus the valuations of each trader have elastic limits determined usually not by desperate need but by somewhat vague alternative valuations in exchange, varying according to his willingness to wait, his ability to travel to market, and his chance of getting substitute goods more or less suitable. Thus in many trades which appear to be purely isolated, a sort of latent, invisible competition is present to moderate the ratio of exchange arrived at, and to keep it from diverging very for from a fair medium, which "splits the difference" between the first and perhaps extremer demands of each party.
At this point it may be helpful to define the word "price" which has already appeared in our discussion. Price is the amount of goods which a buyer gives for the sale-good. In simple barter, price may be any sort of goods the seller will take; but where money is in general use, price, unless otherwise specified, is always understood to mean a certain sum of money or valuable things expressed in terms of money (monetary price). Price may mean either the whole amount of money given in a trade (total price) or more commonly the amount given per unit of sale-good (unit price). These meanings arc usually indicated clearly by the context.
Simple auctions with competitive biddingThe range left for higgling over price in a trade is narrowed by actual competition on one side or other of the trade. The simplest case is presented by an auction at which a single unit of a good is offered for sale where several persons are present to bid for it. This is one-sided competition, namely, on the side of the buyers. The reserve valuation of each bidder may have been fixed by a friend or a customer for whom the bidder is acting. In other cases it is more or less definitely decided in advance by the bidder himself, subject to change on new information and often increased under the spur of rivalry or the persuasive arts of the auctioneer. Under the hypnotism of the crowd a bidder may be led to buy a "white elephant" which his cooler judgment tells him he really does not want at all, or to pay prices higher than those at which the goods can easily be bought elsewhere. Many purchases in more developed markets often show similar results. An auction which advertises that all goods are to be sold to the highest bidder is called an auction sale without reserve. Such an announcement helps to attract more bidders to attend the auction, for they hope to buy cheap; and the sellers on their part hope in this way to make a quick sale at a fairly satisfactory price. In sales without reserve the buyers still have reserve valuations, and in competition they usually fix the price within pretty narrow limits. However, it often happens that the auctioneer has confederates in the crowd, known as "cappers," who deceive the outside public by making higher bids and even by bidding-in articles that otherwise would be sold at real bargain prices. This is a fake auction.
Auction price of a single articleSuppose five persons come to an auction, each hoping to buy a table at a bargain price although having higher reserve valuations which they would pay rather than go away without buying. Let us put in tabular form the reserve valuations of person A along with those of four other weaker or less eager bidders, B, C, D, and E.
A's reserve valuation is $10B's reserve valuation is $ 9C's reserve valuation is $ 8D's reserve valuation is $ 7E's reserve valuation is $ 6
Figure XI Auction Price Determined by Competing Buyers' Bids
Evidently the weaker bidders, B, C, D, and E, would have no chance in the end to get the table. For if the bidding starts at, say, $5 or $6, the weaker bidders are forced to drop out one after the other, finally leaving A as the successful bidder. But at what price? Assuming that bids may be advanced at not less than ten cents at a time, the answer is: either $9.00 or $9.10; for if A happens to bid $9.00 before B does, B would not outbid him, and the sale will be at that price; but if B first bids $9.00, then A can outbid him and buy at $9.10. Similarly, if bids must be advanced $1.00 at a time, the price at which the article is sold might be either $9.00 or $10.00. The general rule is that the range of uncertainty of competitive price is limited to the smallest permissible advance in bids, the lower limit being the bid of the second most eager bidder, the upper limit being one unit bid higher. The valuation of the bidder excluded last evidently does help to fix the price, for if in this case B were absent, the price would be $8.00 or $8.10.
Auction price of two or more like goodsIf two tables (just alike and in equally good condition) are to be sold as advertised, A and B acting independently, without collusion, may each buy a table for $8.10 (or $8.00), just enough to eliminate C provided they size up the situation correctly. Either A or B would drop out when bids on the first table reached $8.00 or $8.10, enough to outbid C, each knowing that C would not pay more than that for the remaining table. So, if there are three tables for sale, they might all be sold at $7.00; and so on, in due order of the reserve valuations. It may happen, however, that one or all of the more eager bidders may miscalculate and either drop out too soon or go on bidding too long. For example A and B may both guess wrong, and may hold back, letting C take the first table at $8.00, and then A would have to bid up the one remaining table to $9.00 to keep B from getting it. Often in this way at auctions a unit put up for sale later sells for either more or less than the earlier units. The perfect theoretical result is possible in practice only where there is perfect knowledge of conditions by those who are to be successful in buying. However, it is true in very large measure that the order of bidding and the point at which various bidders drop out, along with other circumstances, pretty well reveal the real situation in a genuine auction.
Buyers' competition in informal marketsThe essential conditions of competitive bidding for a single article or for the sale-goods of a single seller are presented in every neighborhood without a formal auction. It is so whenever a person having something to sell lets it be publicly known, gets from several persons their best offers, and finally accepts the highest if it is not less than his own reserve valuation for the good. In this way thousands of houses, building lots, forms, factories, horses, wagons, automobiles, pianos, all kinds of new and old furniture, and innumerable other goods are constantly being sold, The advertising columns of the newspapers assist greatly in this process. Thus every neighborhood is an informal, loosely organized competitive market for the sale of goods to the highest bidder, a sort of perpetual auction. It works more or less imperfectly for lack of full information, and often a person is heard to say: "I wish I had known that article was for sale; I would gladly have given far more for it than the price at which it sold." In that case the seller regrets his selling too hastily.
Two-sided competition in informal marketsWe have been speaking only of the competition between buyers, but it is evident that what has just been said is equally true if the words "seller" and "sale" be substituted for "buyer" and "purchase." For, while in many cases several buyers are competing with each other to acquire a certain sale-good from a single seller, at the same time several sellers may be competing to sell to a single buyer. Whenever a person lets it be known by telling his neighbors, by advertising in the papers, by going to an agent, or in any other way, that he wishes to buy a certain article, say a house, those having a house for sale offer it at a certain price. The buyer weighs these offers against each other, making due allowance according to his own needs and his scale of valuation for differences in location, size, construction, artistic design, condition, and conveniences, and finally makes a purchase at what he deems to be the lowest price, all things considered. Sometimes the difference between the best offer and the next best is very small, and one or the other seller may reduce his offer or modify the terms. Many such transactions may be going on separately at the same time, and they tend to merge into a continuous system of trades where both buyers and sellers respectively are competing. The individuals of each group are thus enabled to get the prevailing price, more favorable for most of them than their own extreme reserve valuations (buying or selling respectively) to which they might be forced in an isolated trade.
The retail districts of towns and cities afford countless examples of this sort of perpetual, informal auction markets, where customers are constantly comparing goods and prices, through reading advertisements, "window shopping," or making sample purchases. And on their part, merchants are seeking with all the arts of salesmanship each to convince as many buyers as possible that all things considered, his goods are the best and the cheapest. The very considerable differences, real or apparent, in retail prices will be commented upon later.
Regular markets with two-sided competitionNow let us consider a somewhat more formally organized market where there is two-sided competition. In the Middle Ages the regional fairs, held once or oftener each year in many parts of Europe, were well-conducted markets to which merchants and buyers came from great distances. Regular markets also were held weekly or oftener in many market towns, where the products of the neighborhood fields and shops were offered for sale.A further description of medieval fairs and markets may be found in the reading references for this chapter. In many rural villages and county seat towns in the United States, and even in some large cities, farmers' markets still are of considerable importance. Fully organized and regulated markets are maintained in many cities of the world for the sale of such staple products as wheat, corn, cotton, furs, the rarer metals, and many other commodities, either at wholesale or retail; and exchanges or bourses are organized for the marketing of investment securities.
Demand in regular marketsIn regular markets each trader (or the trader's broker or agent) has a buyer's or a seller's reserve valuations. Buyers must have acceptable purchasing power with which they are trying to get some of the sale-goods and sellers must have goods with which they are seeking to get the buyers' purchasing power. Demand is not mere desire; rather it is the quantity of goods desired at a certain price by some one or more persons who have the necessary means of payment. The hungry boy outside the baker's window does not represent demand unless he has a nickel. Observe that the buyers' reserve valuations are the highest prices which they might be induced to pay for each marginal unit; and every is of course willing to buy for anything less, down to zero. The total number of units which buyers collectively stand ready to buy at any particular price is the market demand at that price. Thus if only one unit is for sale and the highest reserve valuation is 10, the demand at that price is only one, and this outbids the next highest valuation of 9 and all lower ones. If successively more units are offered for sale at the same time, other bidders are able to buy within their reserve valuations. The total demand at any price may come from buyers some of whom are ready to take several units at that price. The total number of units that any one buyer will take at a certain price is his individual demand, and the sum of all individual demands is the market demand at that price. But at any one moment there is only one actual price and one actual demand (the number of units which will be taken at that price). All other demands are merely latent (potential or hypothetical); they are the amounts that might be taken under different conditions. The general rule, or law, of demand is: Individual latent valuations for specific kinds and amounts of goods remaining the same, the market demand for them is greater when the price at which they can he bought is lower, and less when the price is higher. This is shown in Figure Xll for the valuations in the auction problem, with the addition of other bidders at prices 5.5, 5, and 4, respectively.
Figure XII Graph of Additional Latent Demand and Increasing Cumulative Demand at Each Lower Price
Supply at various pricesThe explanations given in the last section regarding the market demand all apply to the market supply with such changes of wording ("supply" for "demand," "seller" for "buyer," and so on) as are necessary to fit the reversed conditions. The owner of goods in a market may be assumed to have, in respect to each margin use of his goods, a seller's reserve valuation. Some of these valuations may be as low as zero or even negative — the nuisance valuations of surplus goods — whereas after most of his stock had been sold he might have a very high valuation on the remaining units. These differing valuations for like units of goods are merely latent and do not exist at the same time as actual valuations. (It matters not for our present purpose how supply valuations are determined or caused; that will be discussed in the following chapter.) A seller's reserve valuations are not the most that he would like to get, but merely the least he will take for each successive marginal unit. He will always take a higher price if he can get it — and at the same time he will mark up his valuation of all the intramarginal units. The price for which a buyer can buy, or a seller can sell, becomes for each then and there his exchange valuation.
Figure XIII Graph Showing Latent Supply at Various Prices When Sellers' Valuations Range from Price $2 to $7, as Indicated in the Figure
Conditions determining sellers' valuationsMany influences enter into the determination of sellers' valuations under the actual conditions in the market at any specific time. The first and most general is their estimate of how much the buyers are willing, or may be induced, to pay. Apart from charity and friendship, sellers will not take less than they can get buyers to pay. Even under conditions of keen competition, sellers usually try to get "all the traffic will bear," a statement often assumed to be true only under conditions of monopoly in varying degrees. The true contrast is this: when and where sellers must meet real competition, the traffic will not bear so much, for at the competitive price level the goods will be supplied by other competitors.
Under any conditions the sellers, in their estimate of what they can get, take account of the amount of goods of the specific commodity which will be coming upon the market at various prices, of the ability and willingness of buyers to postpone demand for a time, and of the amounts, prices, and qualities of substitute goods to which demand will shift at certain price levels. After considering their estimate of the most they can hope to get from buyers, sellers will also consider their own need for money, what they intend to do with it, and their own ability to hold out for a higher price.
Finally sellers must weigh their alternative valuations of these goods if sold elsewhere or later, and also (in a going business and not merely in a distress sale) the alternative opportunities for investing and employing their own services and their capital in making other products or even in shifting to an entirely different industry and occupation. These alternative valuations of their own goods are described more fully in the next chapter which deals with business costs.
How demand and supply are equalized by priceWhen we were looking at the demand curve and were assuming that the goods were to be sold without reserve, we saw that the price would follow the demand curve down step by step, with the increasing supply of goods. Now we are looking at the supply curve (which is made by connecting the points representing the height of the reserve valuations) and we sec that as more and more units are demanded, they will be supplied only at higher and higher sellers' marginal valuations. As the sellers' marginal valuations increase, the number of buyers who can pay that price decreases, until at some level of price supply and demand are just equal.
The result of this adjustment may he seen in Figure XIV — where the latent demand and supply curves are superimposed on each other. Latent valuations being as here assumed, demand would be 9 units at a price of 4, and at that price a supply of only 5 units would be forthcoming. What happens? There being four more buyers than sellers at a price of 4, some of them will fail to obtain any goods, and it may be those buyers with the higher latent valuations unless they become more active bidders. So they compete with higher bids. At a price of 4.5 one buyer drops out and one seller comes in; the disparity of demand (8) and supply (6) is reduced to 2. The bids rise to 5, at which price another buyer drops out and another seller comes in, making demand and supply just equal, 7 units purchased and 7 units sold at $5 per unit.
Or suppose that the market starts with a price of $7, at which price demand will be 4 units and supply will be 9, a disparity of 5 units. Then competition among sellers would reduce the price successively to $6, and then to $5, at which price there would be 7 units to exchange with no further competition among sellers to lower the price or among buyers to raise the price. The price of $5 (under the assumed latent valuations) is therefore the true equilibrium price in such a market situation. Such a price may also be called the theoretically correct price in that state of demand and supply in a free market.
Figure XIV Demand and Supply Equalized at the Competitive Price
Passive and active changes in latent valuationsIn any state of latent valuations, actual demand and supply and price may be said to be functions of each other in the mathematical sense, because a change in any one causes a change in the others and a resultant new equilibrium. But changes begin with either demand or supply, and price is merely the passive result, as we have just seen. Change on the side of demand and of supply may occur one at a time, or both together and, in the latter case, may be in the same direction or in opposite directions.
We may distinguish between an initial, or active, change in demand, and resultant, or passive change of supply and vice versa. An active change in demand or in supply is always the result of a change in latent valuations. For example, referring to Figure XV, if the intensity of latent desire for successive units of the commodity as shown on curve DD falls d1d1 without any change in the supply curve, the theoretical price would fall from $5 to $4, and the actual supply from 7 to 5 units, moving along the curve of latent supply. An increase of latent demand valuations to d2d2, on the other hand, would move the equilibrium price to $6 and cause the latent supply of S units to become actual at that price. This is shown in Figure XV. Similarly, active change may be initiated on the side of supply valuations, to be followed by the passive adjustment of demand and of price to a new equilibrium. (See Chapter XX on elasticity of demand.)
Figure XV Showing How Active Changes in Demand Result in Passive Changes in Supply, to Equalize Supply with Demand at the New Price
Features of a free market priceA true price in a free market, where a considerable number of traders are together, is marked by certain distinctive features:
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It is a price uniform to all buyers, that is, all buyers pay the same price at the market place, and all sellers get the same net realized price on sales at the same time.
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It is a uniform price prevailing at the place of sale and does not include transportation charges to or from other places, so-called "absorption of freight," which causes the net realized prices of the sellers to be nonuniform.
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It is a price that permits the greatest number of goods to be traded — a number greater than is possible at any other price. A higher price will reduce the number of units to be bought, and a lower price will reduce the number of units for sale.
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It is a price which benefits both parties in every trade, there being always the best balance between supply and demand set by the difference between the latent reserve and the actual exchange-valuation.
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It has other advantages, both of an economic and of a moral nature. Being public and uniform, a free market price saves the time and the energy of both buyers and sellers, who would otherwise market and shop around to buy; it reduces the temptations to unfair treatment in isolated trade; and it tends to make the process of trade more open and honorable.
In a market that is not free — that is where various forces prevent the individual traders from trading freely according to their own valuations — the price which results is lacking in some or all of the features here listed. This appears in the later discussion of monopoly, but certain explanations are in order here.
Apparent nonuniformity of market pricesThe principle of uniform price in a true market may appear under actual conditions to be subject to many exceptions. But let us examine them more closely. Frequently when actual prices really are not uniform, the conditions of a true free market are not present, because through custom, force, graft, authority (taxes, tariffs, special public privileges, monopoly, and so on) some traders, either buyers or sellers, are prevented from approaching the market freely and freely trading in it. Other apparent cases of nonuniform prices result from friendship and special favor, where, therefore, they are not truly prices but in the nature of private gifts. Again many "special low prices" and "bargain sales" of various kinds are largely a pretense. Often what is called a market is not a unit but is broken up into such subdivisions as retail trade, wholesale trade, large jobbers and small, manufacturers, and their customers, and the like to each of which different groups of traders belong through custom and business practice. One trader may belong in turn to different markets, as, for example, a merchant buying at wholesale and selling at retail.
Nonuniformity of retail pricesThe most striking apparent deviations from the principle of uniform prices appear in retail trade. At stores not far apart different prices are paid for what appear to be the same kinds of goods. A good many of these cases are the result no doubt of the imperfect knowledge of buyers as to prices and qualities; but in many other cases the explanation is a very different one. The physical commodities such as clothes, furniture, flowers, and drugs, are not all that the customers are buying; they are also buying services, attention, and conveniences (psychic incomes) of various kinds. Physical goods bought under different conditions are not just the same goods; the prices are nonuniform, it is true, but so are the goods nonuniform. Various conditions make some buyers willing to pay more and enable some merchants to sell for more than others. The reputation for high and consistent quality of merchandise is valued more highly by customers having deep pocketbooks. Convenience of location either on the main street or in the neighborhood, thus saving time, makes some buyers willing to pay more. On the other hand, some buyers, but not all, are willing to walk down a side street, or go to a less accessible location for a small concession in price which the merchant can afford to make.
Influence of quality of services in sellingA better quality of clerical services, corresponding with higher salaries and better treatment of employees by some merchants, makes some stores more pleasant places in which to buy, a difference especially values by those who do not have to weigh the price so carefully. A very evident difference of service exists between stores granting credit along with free delivery of goods to buyers' homes and stores conducted on the "cash and carry" plan without even the convenience of telephone orders. The attractive displays of some stores, the lavish variety of styles, and the extensive entertainments, attract some buyers more than the lowest prices to. Really informative advertising tells the public where they will find what they want and thus saves them time and trouble; and much other advertising creates prestige for certain stores or for certain brands of goods which builds into the minds of the public a "good will" to buy without higgling over the pennies.
In such ways the retail market considered as a whole is broken up into a variety of submarkets, where goods of the same, or nearly the same, physical quality, are sold at different prices. But when account is taken of the numerous differences of taste, and of the valuations in accompanying services and conveniences, the differences in price may prove to be apparent rather than real. The price paid is a complex of the price for the bare physical commodity plus the prices of accompanying services. It often happens that when a customer buys he knows full well that he could get the article for less if he were willing to wait or to take the added trouble, and when he has more time he may seek the market with the lower price. Substantial differences in retail prices in the same community cannot persist without some such differences in the conditions of sale.
Mutual influence of pricesThus far we have spoken of the market prices of distinct commodities as if they were determined independently, one at a time. The explanation of the prices of each separate kind of goods would be very incomplete if it stopped at this point. In many ways the demand, the supply, and the current price of each kind of goods are related to those of other goods in the same and in other markets. This mutual influence of prices exists not merely among goods of the same specific kind or of the same general kind, but frequently among goods very unlike in physical conditions and in uses. Price is the numerical expression of the market valuation not merely of one sales-good but, indirectly, of many others. For example, if one cow is exchanged for ten sheep (by barter) this links the exchange-valuation of sheep with that of any other goods for which a cow may be exchanged. When, as generally, price is expressed in terms of money, the general medium of exchange of each separate price is still more easily related numerically with all other market valuations at that time and place. When the price of a bushel of wheat is one dollar and that of a ton of coal is four dollars, a ton of coal is worth four bushels of wheat and anything else for which four bushels will exchange.
The price systemAll prices are constantly being compared and constitute an interrelated system of prices in the market place and in the minds of individuals. It was seen in the last chapter that each individual's valuations form something of a system. So too in a market, in a larger way the various contemporary prices are systematically related. This was implied though not explicitly discussed in all the preceding account of the nature of demand and supply. Every system of present prices is also more or less related to those of future periods. Further, the system of prices in one market is more or less related to the present and future systems of prices in all other contemporary markets with which dealings are carried on, and to any from which goods are shipped.
The understanding of what a system of prices means is essential to the solution of many of the problems of commerce and public price policy. In the following chapter will be shown further the way in which the demand and the supply schedules of single commodities are related to those of other commodities in the individual budgets and in the valuations of all traders in the markets. In concluding this chapter, let us indicate briefly how the price system at any one place is linked in a larger geographical system with the prices of other localities.
Markets and market areasThe location of goods in relation to the place where they are desired is a fact which obviously affects their valuation. The trouble and expenses of all sorts (freights, commissions, fees, profits) for moving them from one place to another are expressed in terms of price as the costs of commerce. Costs of this kind are incurred in moving things from the places where they are produced to a central market to be sold and, after they are sold, again in taking them away from that place to the places where they are desired for final use. The movement of goods from numerous decentralized sources of production (such as farms, mines, small shops, and so on) to be sold in a central market may be called centripetal (seeking a center). The movement of goods sold and bought to be shipped outward in various directions toward their final destinations is centrifugal (fleeing, or moving away from a center). The whole geographical region from which things are sent centripetally to market is that market's buying market area; and that to which the goods are shipped centrifugally from a market is its selling market area. These two areas, in relation to a certain market, may more or less overlap (goods bought from one class of customers being sold to another class in the same territory) as when, for instance, butter and eggs and other produce bought by merchants from farmers and sold to local consumers. Often, however, in more distant trade the two areas are largely mutually exclusive. For example, Chicago as a wheat market buys mostly from the area west of it and ships eastward almost solely.
Any area which regularly ships certain products only outward (as food from the agricultural states) is a surplus area; and an area to which certain goods are regularly brought for use (as grain to New England and other eastern states), is a deficit area, in respect to those goods. Inasmuch as trade is reciprocal giving or exchange, every deficit area for one product must regularly or finally be a surplus area for other goods or services which it sells to obtain purchasing power to pay for the goods it buys. In other words, the total valuation of exports must in the long run equal the total valuation of imports — a simple fact generally overlooked in much popular discussion of tariffs and trade.
Market prices and delivered pricesThe net realized price at the point of production (that is, the "form price" of agricultural products or the mill price of factory products) is less than the delivered price by the amount of the costs of transportation. In turn the delivered price to the buyer from a centrifugal market is greater by the costs of transportation than the uniform market price resulting from competition. A delivered price is really the sum of two prices, one, that of the commodity, the other that of the transportation. The net realized price at point of origin, the market price, and the so-called delivered price at final destination must be carefully distinguished to escape confusion in the discussion of prices.
Whenever the prices of certain goods in two or more markets differ by more than transportation costs, there is a motive for shipment and (subject to friction and lag) intermarket shipments will occur. This is regularly the case in trade between regions, either domestic or foreign which differ much in climate, natural resources, skilled labor, wealth, or industrial technique. The market prices in different markets under these conditions are thus kept from diverging from each other for more than brief periods by more than intermarket costs of transportation. The prices in the several markets differ, but they form a geographical system of prices. A clear understanding of this principle is helpful in studying not only market prices, but also the location of industries, the direction of commerce, the operation of import tariffs and export bounties, tax policies in general, and other problems.
Price competition on the geographical marginIf the prevailing prices of like goods in two geographically separate free markets are either the same or differ by less than the costs of transportation, no regular shipments from one market to the other can occur without loss to the shipper. However, the prices in the two markets are not without mutual influence in the intermediate territory. The prices in adjoining market areas are related in intimate and interesting ways, creating certain zones of competition and determining with mathematical accuracy sales in relation to prices and transportation costs. Consider the case of industrial products produced at two centrifugal markets and shipped to surrounding territories. When all buyers in the intermediate area are free to buy in either market at uniform market prices, they will buy where they incur the lower delivered cost. This, as has been observed, is the sum of two prices, the market (base) price at place of sale plus the transportation costs. The area from which buyers come to market A (Figure XVI) is its tributary market area, bounded by a line of indifference where delivered costs are equal from the two markets, beyond which, in the direction of market B, the delivered cost from B is lower than from A. If base prices are the same at both markets and freight rates are proportional to distance, the market areas of the two markets are delimited by a line perpendicular to the straight line connecting them. The enterprises in neither market can sell beyond that line unless their uniform market price is reduced below that of the other market.
Figure XVI The Relation of Market Base Prices, Freight Charges, and Normal Market Areas — in Other Words, the Economic Law of Market Areas
Assuming that the market price in A is $10 and in B is $12, and that freights are proportional to distance, being $4 between the two markets: then the delivered cost of C and E is $14, and at D (on a line between the two Markets) is $13. It is equal from both markets that every point in the hyperbolic curve CE. The areas between two competitive markets are naturally delimited in this way, but under monopolistic arrangements for selling by a formula, as by the basing point plan, geographical relations are distorted. This plan first became known as Pittsburgh Plus in the sale of steel, but has since been adopted in numerous industries.
The economic law of market areasAny temporary change of local conditions, or certain lasting advantages in materials and methods, may easily establish a brief or permanent price differential between the price on one market as compared with that of the other. But until the difference in base price equals or exceeds the total cost of transportation from A to B, regular shipments cannot profitably be made all the way from A to B, and some area is left tributary to B, the market with the higher base price. Smaller decentralized enterprises have thus a chance to survive against the competition of larger producers unless the latter reduce their uniform base price by as much as the whole cost of transportation between the two competing enterprises, or unless they make a discriminating price by cutting below their regular price in more distant sales (a problem of monopoly touched upon in a later chapter).
The economic law of market areas is a statement of the mathematical relationship of the price differential between two locally separate markets with the area in which it can sell (or from which it can buy). Assuming freight rates to be proportional to distance in every direction in straight lines, the boundary between the market areas of two geographically competing markets is a hyperbolic curve; the difference of freight from the two markets respectively to each point on this curve being just equal to the difference in the prices of the goods in the two markets. The selling market with the lower price and the buying market with the higher price attract traders from greater distances. For example, if the base price at A is five dollars less per unit than that at B, then A can sell in everydirection toward B to the points where the freight charge from A begins to exceed that from B by more than five dollars.
Summary and conclusionsThe aim of this chapter is to show further how the exchange of goods, and finally a whole system of prices, develops out of individual valuations and serves to bring them into closer accord.
Trade opens up new opportunities for choice and the reapportionment of the goods in a man's possession to meet his desires. Trade is the social aspect of choice. Alongside of value-in-use appears value-in-exchange, as a new sort of importance felt in goods. It is, however, derived from the value-in-use that some other person attaches to the good which makes him willing to part with other goods to obtain it.
The simplest form of trade, barter between two isolated individuals, depends on the marginal principle of valuation. In the simple auction the competition between two or more traders on one side of the bidding narrows the range of higgling and uncertainty as to price. The essential conditions of an auction are present in every informal grouping of traders in a community, but they are more completely developed in highly organized markets.
Demand and supply, the quantities of goods ready to be traded at certain prices, are the results of individual valuations and are brought into equilibrium by the agreement of traders (for the moment) upon a market price. The main features of markets are described, and real or apparent departures from uniform market prices are considered.
Prices, like individual valuations, are mutually influenced, and the prices of particular goods tend to unite into a larger system of prices that are mutually related in many ways. The geographical relationships of competitive markets and prices are summed up in the economic law of market areas.
The study of exchange valuation and prices from the angle of use-values of consumers has prepared the ground for the consideration in the next chapter of the ways in which middlemen's market valuations arise on the side of supply.
Suggested ReadingsBöhm-Bawerk, Eugen von. The Positive Theory of Capital. D.E. Stechert and Co. New York. 1923. Reprint. Pp. 428.
Fetter, Frank A. "The Economic Law of Market Areas." The Quarterly Journal of Economics. May, 1924. Vol. 38. Pp. 520–529.
——. Economic Principles. The Century Co. New York. 1915. Pp. x, 523. See especially Chaps. 5–8.
——. The Masquerade of Monopoly. Harcourt, Brace and Co. New York. 1931. Pp. xii, 464. See especially Chap. 20.
Grierson, P.J. Hamilton. The Silent Trade. W. Green and Sons. Edinburgh. 1903. Pp. x, 112.
Schultz, Henry. Statistical Laws of Demand and Supply. The University of Chicago Press. Chicago. 1928. Pp. xix, 228.
Questions and Problems1. Distinguish between the nature and origin of "value in use" and "value in exchange." What concrete things can you name which have both of these qualities? Which have only the one quality?
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How can trade be advantageous to both parties if it is fair?
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Explain the phrases: "individual market demand" and "collective market demand."
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Give illustrations of the difference between desire and demand.
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What is meant by the law of demand? How do you explain this rule of buyers' valuations?
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Explain the phrases: "individual market supply" and "collective market supply." Why does the supply curve slope upward to the right?
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Explain the phrase "higgling area."
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Why does market price tend to settle at the point at which demand and supply are equal?
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Summarize the distinctive features of market price under conditions of competition.
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What examples can you cite of nonuniform retail prices? How do you account for such nonuniformity?
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Explain the meaning of the phrase, "the price system."
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What examples can you find in your community of a "centripetal market," a "centrifugal market"?
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Distinguish between the "market" and the "market area." What factors govern the size of the market area of any enterprise?
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Explain and illustrate the economic law of market areas. Does this law apply to centripetal markets as well as to centrifugal markets?
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Explain the price relationships which prevail in a centrifugal market; in a centripetal market.
[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.
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.
In response to recent claims by the Obama administration and others that “millions of jobs” have recently been created, I examined the data here at mises.org to see if the claims were true. It turns out that job growth since the 2008 recession has actually been quite weak, and hardly something to boast about.
Nevertheless, our conclusions from these analyses tend to rest on the idea that job growth is synonymous with gains in wealth and economic prosperity.
But is that a good assumption?
In an unhampered market, the answer would be no, for several reasons.
First of all, as worker productivity increases, workers would need to work fewer hours to maintain their standard of living.
Second, as goods become less expensive (as a result of rising productivity) it would also be necessary to work fewer hours to maintain the same standard of living.
This need for fewer man-hours could translate into shorter work weeks and shorter days, but it could also manifest itself at the household level in the form of changes from two-income households to one-income households. Or, people may retire earlier, thus leaving the work force.
In other words, in a well-functioning economy over time, less human labor will be necessary to maintain standards of living, all things being equal. (If consumers wish to constantly increase their standard of living of course, they will choose more labor over more leisure for the sake of more consumption.)
Historical Trends in Work HoursEven in our hampered and un-free economy, we can still see this basic trend at work. The number of work hours necessary to maintain the standard of living our grandparents enjoyed, for example, is less today than it was in 1950.
If middle-class consumers were satisfied with a two-bedroom residence in an unstylish neighborhood, one car, a single phone line, no air conditioning, and no internet access, many of them would require far fewer work hours than is necessary to maintain a common middle-class standard of living today.
In the 1950s for example, my mother shared a bedroom with three brothers in a two bedroom house in central Los Angeles. She went to a private Catholic school where there were 50 students to a classroom. For her family, there were certainly no European vacations or airline travel to seaside resorts.
And yet, no one would have described this lifestyle as “impoverished” or “lower class.” It was a middle-class lifestyle, but this lifestyle could only be maintained by far more than 40 hours of work at the family business each week, where both parents labored regularly.
This experience was not atypical.
In spite of increases in the standard of living since then, working hours have actually decreased. Indeed, according to Robert Fogel in The Fourth Great Awakening and the Future of Egalitarianism, from 1880 to 1995 the number of hours spent on work during an average day for a male head of household decreased from 8.5 hours to 4.7 hours. Meanwhile, leisure time increased from 1.8 hours to 5.8 hours.
In a separate study by Thomas Juster and Frank Stafford, it was found that from 1965 to 1981 in the United States, “market work” hours per week fell from 51.6 hours to 44 hours for men. For women, market work rose from 18.9 hours to 23.9 hours. We would expect an increase for women over this period as women began to take on “market work” at higher rates than before. This was for wage work only, though, and if we include “housework” we find that “total work” for women during this time period fell from 60.9 hours to 54.4 hours. Women exchanged some housework for market work over this period, but overall, the work hours decreased. Total work for men decreased also, from 63.1 hours to 57.8 hours. (Housework increased for men over this period.)
In yet another study by Mary Coleman and John Pencavel, average weekly hours worked fell for white men from 44.1 hours in 1940 to 42.9 hours in 1988. It fell for white women from 40.6 hours to 35.5 hours over the same period.
The typical standard of living increased over these periods, as the square footage of housing units increased, automobiles became more common, and amenities like telephones, washing machines, personal computers, and climate control became more common. The work itself also became less hazardous over this time period.
The Invention of “Retirement”Even as work hours were falling, productivity was rising enough to allow large numbers of workers to leave the work force early in the form of a new-fangled concept known as “retirement.” As explained by W. Andrew Achenbaum in The Wilson Quarterly, working well into one’s so-called golden years was common in the 19th century and before. Prosperous farmers who owned land could afford to significantly cut back hours as they aged, but common laborers generally needed to work as long as possible or face penury.
It was only during the late 19th century, as worker productivity rapidly accelerated, that workers could withdraw from the workforce at an increasing rate. Many became obsolete whether they liked it or not, however. Achenbaum writes:
The obsolescence of the older worker is one reason the period around 1890 marks the beginning of the long-term trend toward the withdrawal of the elderly from the work force. In that year, about two-thirds of men aged 65 and older were still in the labor force — roughly the same proportion found today in developing countries such as Brazil and Mexico. By 1920, that number had dropped to 56 percent, and by 1940 it was down to 42 percent. Today it is 27 percent.
In the bad old days of subsistence wages, workers could labor for decades without many opportunities to accumulate capital, and thus “retirement” was just another word for poverty. As worker productivity and capital accumulation rose, however, private firms could afford to create a new thing called “pension funds” which accelerated the retirement trend.
The advent of government pensions accelerated the trend as well, with large transfers of wealth from current workers to past workers. The fact that these wealth transfers did not reduce the current workers to subsistence levels themselves was also due to the productivity gains of the new industrialized and mechanized workplace. Essentially, workers were now supporting both themselves and current pensioners, while still experiencing perceptible increases in the standard of living. Such a situation would never have been politically feasible in an earlier age when workers would likely have revolted against a new tax that would have impoverished them for the sake of retired workers. This new world in which workers could support their families, plus some strangers they never met, was a triumph of markets that ironically allowed governments to get away with higher taxes.
So, Is Job Growth Progress?Once upon a time, we measured economic progress in terms of the ability of households to feed themselves and sleep in a warm bed. We still do this in the developing world where “extreme poverty” is a real problem.
In the industrialized world, however, “extreme poverty” does not exist, and 78 percent of “the poor” have air conditioning, and a majority have cell phones. The lifestyle enjoyed by my mother in the 1940s would today be deemed “overcrowded” and “substandard” by federal agencies. At the time, such conditions were considered to be quite middle class. But, as Ludwig von Mises once remarked, “the luxury of today is the necessity of tomorrow.”
Apparently, if we were to measure necessary work in terms of the need to fund basic food and shelter, the number of work hours needed today would hardly constitute a full-time work schedule.
This is why over decades, we find that the amount of labor done by human beings has declined over time. Machines now do the work that many people once did, and more economically.
This is why the US now has more industrial production today than in the past, even though fewer people are employed in manufacturing. This is why our grandparents worked more hours than our parents, even though standards of living are higher now than they were in the 1960s.
So, over the long term, we cannot say that more jobs equals more prosperity. In fact, one could just as easily argue that fewer jobs, fewer work hours, and fewer workers illustrates gains in prosperity. Child laborers, for example, are no longer essential to maintaining a family’s standard of living. All those jobs are long gone.
So, how should we respond when politicians claim to have “created millions of jobs”? Should we assume this is a measure of economic improvement?
Over the short term, this may yet be a useful metric. We must ask ourselves if the economy changed fundamentally over the past ten years that would lead far fewer people to need employment. More importantly, we must consider if the price of goods and services has decreased significantly. Are more people voluntarily electing to adopt a lower standard of living for the sake of more leisure or to pursue non-market work?
These are all questions that should be considered when we speak of jobs and economic improvements. Really, the only measure that matters is real household wages and wealth, and what can be acquired with it. Anything else is groping for answers with tangential data, and the whole endeavor illustrates the limits of aggregated economic data.
Nevertheless, there’s nothing wrong with skeptically picking apart government claims about economic successes, especially when it makes Washington look bad.
Quarterly Journal of Austrian Economics 18, no. 4 (Winter 2015): 378–408
ABSTRACT: Although commonly misconstrued as a statement concerning the “correctness” of prices, the Efficient Market Hypothesis (EMH) is a statement about their informational content. The aftermath of the recent recession has brought renewed skepticism to EMH, even leading some to redefine it as the “inefficient” market hypothesis. We demonstrate that such a course of action is misguided, as it changes the nature of the input (i.e., the market) but not the truth value of the statement (i.e., whether markets are efficient). We outline further several logical fallacies of the Hypothesis which negate its usefulness. We conclude by showing that the EMH was never a hypothesis and as such is best considered a conjecture. As a conjecture, it is increasingly difficult to reconcile with market behavior in both theory and practice.
KEYWORDS: efficient markets, informational efficiency, EMH, equity returnsJEL CLASSIFICATION: B53, G14
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.
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.
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.”
Free Prices Now! begins by asking why the human race is still so poor. How can it be that billions still lack even enough to eat? It then provides the answer. A prosperous society is a cooperative society. Cooperation in turn depends on trust. And trust requires honesty.
The most reliable barometer of economic honesty is to be found in prices. Honest prices, neither manipulated nor controlled, provide both investors and consumers with reliable economic signals. They are the foundation for a successful economy.
A corrupt economic system does not want honest prices, honest information, or honest results. The truth may be unprofitable for powerful government leaders, private interests allied with them, or economic “experts” whose careers have been devoted to price manipulations and controls.
The US Federal Reserve and other central banks have created a system of “liar loans” and false prices. Other parts of government have contributed as well. In effect, the regulators on whom we depend have become dis-regulators.
Can it really be this simple, that economic prosperity and job growth depend on allowing economic prices to tell the truth, free from the self-dealing and self-interested theories of powerful special interests?
Yes.
Although Lewis takes us inside the complexities of the national economy and the Federal Reserve, his lively and transparently clear writing style makes it easy for anyone to follow him.
“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.
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.
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
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.”
On Tuesday, Vermont Senator Bernie Sanders stood up on the stage of a Democratic Party presidential debate and proudly proclaimed himself a “democratic socialist” to an adoring crowd. Spurred on by myths about the success of socialism in countries like Sweden and Norway, the horrors of a centrally planned economy have never been more popular in American politics. As Mises President Jeff Deist highlighted in Thursday’s Mises Daily:
These ideas, and the people who hold them, are not outliers in America. There are millions … who believe exactly as Bernie believes. They may prefer to vote for Hillary Clinton purely as a tactical matter because they are unsure the country is “ready” for full socialism … but average progressives and Democrats agree with Bernie Sanders across the board …
Ninety-five years after Ludwig von Mises published his indispensable essay Economic Calculation in the Socialist Commonwealth, it is as critical to stand up to the tyranny of statism — on any scale — now as ever before.
The devastating consequences of government intervention into healthcare markets is the topic of this week’s episode of Mises Weekends. Charles Hugh Smith joins Jeff to discuss how Washington’s desire to eliminate markets from medicine has led to the industry being captured both by incompetent government regulators and insurance lobbyists.
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:
Charles Murray's Tepid Radicalism by David GordonWhat "Progressive" Corporate Welfare Looks Like by Andrew SyriosThe Dirty Business of Government Trash Collection by Allen MendenhallSanders and His Followers Are Not Outliers by Jeff DeistHow Modern Sweden Profits from the Success of Its Free-Market History by Yonathan AmselemGeorge Akerlof, Meet Oliver Williamson by Peter KleinAngus Deaton and Modern Economics by Peter KleinThe Mistake of Only Comparing US Murder Rates to "Developed" Countries by Ryan McMakenThe Fed’s Quadral Mandate and Impossible Balancing Act by Jonathan NewmanRothbard on Economic Ignorance by Matt McCaffreyTrue Money Supply: August Money Supply Growth Remains Way Down from 2012 Levels by Ryan McMakenDonald's Remarks on the Bubble and the Fed Are on the Money by Joseph SalernoNo way, Norway! by Carmen Elena Dorobăț
I moved to Auburn, Alabama, in January 2013. I love Auburn.
It's been nearly ten years since The Wall Street Journal profiled the Mises Institute and claimed that Auburn was an ideal spot for studying libertarian ideas and the Austrian tradition. I don't know how much has changed since then, but I arrived in Auburn expecting a free-market sanctuary, a veritable haven where the ideas of Menger and Mises and Hayek were in the air and imbibed by the majority of people who weren't members of the Auburn faculty, and even by some who were.
Once settled in Auburn, I realized I'd been quixotic and naïve. Even before national media picked up the story about the officer who spoke out against his department's ticket and arrest quotas, even before the city of Auburn squeezed out Uber with severe licensing regulations, even before Mark Thornton highlighted the Skyscraper Curse in town, there was the matter of my trash bin.
I bought my house from a relocation company, the previous owner having been assigned a new position in another city. He was, this owner, in a hurry to move. Before he left town, he and his family rolled their trash bin to the side of the home, away from the street, where the garbage collector refused to retrieve it. They had stuffed the bin with garbage: food, paper, cardboard boxes, dirty diapers, and other junk. There was so much trash in the bin that the lid wouldn't fully close. It looked like a yawning mouth. The house was on the market for approximately eight months before I purchased it, and I assume the bin had been sitting there, at the side of the house, the entire time. Naturally it had rained during the last eight months, so, with its half-open lid, the bin was flooded with soupy garbage and untold parasites. And it reeked.
The City enjoys a virtual monopoly on garbage collection; it tacks its fees onto the City's water and sewage bill. The few private garbage-collection companies in town service mostly restaurants and businesses: entities that simply cannot wait a week for garbage pickup and need a service provider capable of emptying whole dumpsters full of trash. The City does allow residents to opt out of their collection services, but this only masks soft coercion with an illusion of consumer choice.
Government opt-out clauses are malicious precisely because of the impression that they're harmless if not generous. Contract law is premised on the principles of mutual assent and voluntary agreement. Government opt-out clauses, however, deprive consumers of volition and bargaining power. They distort the natural contracting relationship by investing one party, the government, with power that the other party cannot enjoy. Not contracting for services is not an option, and government is the default service provider that sets the bargaining rules; the deck is stacked against the consumer before negotiating can begin.
The onus, moreover, is on the consumer to undo a contract that he's been forced into, rather than on the government to provide high-quality services at competitive rates in order to keep the consumer's business. Opt-out clauses make it difficult for the consumer to end his relationship with the government provider, and they force potential competitors to operate at a position of manifest disadvantage.
My wife and I took turns calling the City to ask about getting a new trash bin. No amount of cleaning and sterilization could rid the current bin of its stench. We couldn't keep the bin inside our garage because of the oppressive odor. We left voicemails with different people in different departments at the City, begging for a new bin and explaining our situation, but our calls weren't returned. There was no customer service of the kind a private company would have. After all, there was little danger of losing our business: the City was the service provider for nearly every neighborhood in town because of the difficulty private companies had breaking into a market controlled by government. We were, for now, stuck with the City’s inefficiencies and unresponsiveness. With much persistence my wife was eventually able to speak to an employee of the City. She was informed, however, that we could not get a new trash bin unless ours was broken or stolen. That stunk.
I learned in time about other drawbacks to our government-provided garbage service. During the holidays, collection schedules changed. When my wife and I lived in Atlanta and used a privately owned garbage company, our collection schedules never changed. Our collections were always on time. Our garbage collectors were kind and reliable because, if they weren't, I could hire new collectors who would materialize in my driveway the next morning with shining smiles on their faces.
It's simple enough to follow an altered holiday schedule, so that's what we did in Auburn, only the collectors declined to follow that schedule themselves. After Thanksgiving, when trash tends to pile up, we placed our trash bin out on the street according to schedule. So did our neighbors. Yet nobody picked up our trash. Our entire street tried again the next week, on the appointed day, and once again nobody picked up the trash. A concerned neighbor called the City, and we were able to remedy the now-messy situation, but not without spending time and energy that could have been channeled toward better things.
When I was a child my brother and I were tasked each year with clearing trees, weeds, and shrubs that were growing along the pond in our backyard. We would pile sticks and sawed-up tree trunks and other debris on the curb of our driveway, along with bags of grass clippings, and our garbage collectors, who worked for a private company, would always pick up these items without question or complaint. We were so grateful that sometimes we'd leave them envelopes with extra cash to express our thanks.
In Auburn, however, I was once unable to squeeze an additional garbage bag into our trash bin, which was full, so I rolled the bin to the street and placed the additional bag beside it. I then lumbered inside for my morning coffee, when all of a sudden the garbage collector drove up and parked beside my bin. I watched from the window as he descended from his truck, shook his head, climbed back into his truck, picked up a pad and paper, and began scribbling with his pen. The next thing I knew he was issuing a yellow citation for an alleged infraction. It turned out to be a mere warning, but it indicated, right there in bold letters, that the next time we did something so egregious as putting our trash out for collection without using the bin, some repercussion — I forget what — would visit us.
When I think about the things the garbage collectors would remove from our driveway in Atlanta — an old door, a broken toilet, a malfunctioning lawnmower — I marvel that the City requires you to purchase tags at the Revenue Office if you wish to place things like dryers, water heaters, refrigerators, or microwaves on the street for garbage collection. Yet I remain optimistic, and not only because Joseph Salerno is coming to town to hold the newly endowed John V. Denson II chair in the Department of Economics at Auburn University.
I’m optimistic because I see some positive change. We recently organized a garage sale and came to discover, two days before the big day, that the City required a permit for such events. This time when we called the City to ask about the mandatory permit for garage sales, we received good news: those permits were no longer required as long as we conducted the sale in our own driveway. However minor, that’s progress. Perhaps it'll spill over into other sectors of our little local community. Until then, War Eagle!
Being a government means never having to say you’re sorry. And it also means you get to blame everyone else for all the problems you’ve caused.
This week at mises.org, we explored how deeply indebted governments blame the ones who lend them money, while government prosecutors blame entrepreneurs, businesses, and “white collar crime” for other problems in the economy. And surges in drug prices, we’re told, have nothing to do with government control of the drug market.
Lackluster new jobs data and continued surges in home price inflation confirm that the distortions of the Fed-induced boom continue to add up.
But even with all the bad news, the miracles of the market place point toward a brighter future. This week on Mises Weekends, Rod Martin, a co-founder of PayPal and world renown philosopher-capitalist, joins Jeff for a wide-ranging interview covering such topics as the refugee situation in Europe, unrest in the Middle East, and why some cultures are more prosperous than others. Martin contrasts the difficulties world governments have in confronting global macro-crises with the hope and resilience of technological innovation and entrepreneurship.
Indeed, Ludwig von Mises would have easily understood how market innovations outpace government innovations, since Mises, whose birthday we celebrated this week, pioneered our understanding of how government intervention cannot achieve the goals it tries to achieve. Be sure to see this never-before-published essay by Bettina Bien Greaves, and this newly-discovered recording of a Mises lecture from 1962.
In case you missed any of this week’s Mises Daily and Mises Wire articles, take a second look:
The Reality Behind the Numbers in China's Boom-Bust Economy by Yonathan AmselemDrug Shortages, Price Gouging, and Our Broken Health Care System by Michel AccadThe Coming Corporate "Crime Wave" by William L. AndersonLuwig von Mises, Genius? by Bettina Bien GreavesGovernments Turn to the UN to Avoid Paying Their Debts by Nicolás CachanoskyThe Military Gravy Train: Full Speed Ahead by Andrew SyriosThe Silent, Slow, Stubborn Revolution Carmen Elena DorobățCollege Athletics: Public Institutions Are the Real Sham By Jonathan NewmanThe Real Estate Crisis in North Dakota's Man Camps by Mark Thornton
The shaming campaign that followed last week’s news of two generic drug prices somersaulting into the stratosphere after being acquired by private companies is not too surprising. The idea that a drug which cost $13.50 one day can cost $750 the next, seemingly on the whim of greedy Wall Street investors and pharma start-ups, is fodder for the outrage machine.
But what the outrage machine does not realize is the extent to which the generic healthcare supplies are constantly on the brink of shortage.
Every week I get a “drug shortage report” by email from my hospital. It lists the various items in short supply. Some drugs (for the most part generic ones) may even be absent from the shelves. And every week, the email also reminds me that there is a national shortage of normal saline.
Normal saline, for heaven’s sake!
What’s going on? Is our productive capacity in such a shamble that we can’t have the wherewithal to mix sterile salt and water and put it into a bag? Let’s go back to the basics.
Remember that in order for any product to be available in a sustainable way, there must be a supplier willing to make it and a buyer willing to pay for it at the price the supplier expects. Multiple buyers bid the price up, multiple suppliers bid it down.
It seems that for something as commodified as normal saline, making plenty of it should not be too much of a problem. After all, there is no shortage of #2 pencils, even if the profit margin on pencils is minuscule.
Welcome to our glorious world of regulated health economics.
On the buyer side, you have hospital administrators which have been trained to operate under the reality of fixed payments and onerous oversights. Every expense is a cost that cannot be passed on to the ultimate “consumer” of the good. Therefore, the lower the price of supplies, the better.
On the supply side, the regulatory apparatus overseeing the making of medical products is not known for its flexibility. The last thing bureaucrats want is any intimation that they are not tough enough on bugs and safety. Manufacturers must follow rules which have no regard for market realities and for how much the intended customer will be willing to spend for the product. For something like normal saline, profit margins become dangerously thin and may even be negative.
In such an environment, the tendency is for consolidation and bureaucratization. Manufacturers with disappearing profit margins merge. Indeed, we are left with a handful of mega-suppliers of hospital commodities. Purchasers also consolidate into large hospital chains or pool their buying resources into purchasing cooperatives.
These impersonal buyers and sellers, who are further and further removed from the ultimate use of the product, bundle purchases of commodities in large bulks. Normal saline is now bought and sold as a package deal with all sorts of other sundries, like toilet paper, tooth paste, and plastic tubs.
With the bundling of commodities, the system is prone to miscalculate supply and demand predictions. Demand predictions cannot be made with great accuracy because of the more centralized nature of the enterprise. And if a mismatch were to occur, no one would be held accountable. “There’s a shortage!” administrators on either side would say fatalistically.
Now, if we’re teetering on the brink of a shortage with something as widely needed and as easily produced as normal saline, it’s only to be expected that we would face actual shortages of generic drugs for rare diseases.
For the drug maker, the regulatory costs are unchangeable, whether the drug is used by many or by few. At the other end of the transaction, buyers are third-party payers whose interests and willingness to pay do not reflect the needs of the ultimate consumer. Producing generic drugs in such conditions offers no great hope of sustainability.
Under normal circumstances, if the economics of a product are such that it cannot be manufactured in the country except at a loss, an extremely effective safety valve is provided by the importation market. Lower foreign manufacturing costs can ensure an additional source of supply for the good.
Not so in healthcare, not so.
Our wise legislators, encouraged by the pharmaceutical industry and supported by the entrenched regulatory bureaucracy, have decided that importing medications from the outside is a big no-no. “It wouldn’t be safe!” they claim.
Not safe when we can produce plenty, perhaps. But safer than an actual shortage? Ergo, an opportunity for the “price gouger” about whom we should also add a few words.
First of all, to the extent that some patients are able to obtain access to the treatment after the price hike, the price gouger provides at least a modicum of service. In her absence, there may be no drug available at all.
Second, “price gouging” is a loose term that has no real economic meaning. There is no particular price increase that defines it. Nowhere in the press will we find what the “break-even” price might be for making cycloserine or pyrimethamine, to inform us of the magnitude of the expected profit.
As a matter a fact, the break-even price of any product can only be guesstimated, and the only one effectively willing to make that guess is the entrepreneur who engages and risks her assets. We must keep in mind that every entrepreneurial activity, however obnoxious it may seem to us, involves incommensurable risk or uncertainty.
It is not in the realm of the impossible, for example, that a price gouger could find himself losing money, even with a 5,000 percent initial price increase: under such conditions, patients and doctors may figure out alternative modes of treatment with existing drugs or (a happy outcome!), deregulation could allow the importation of these drugs from outside, thus evaporating the expected profit.
Third, to the extent that she wakes us up from our stupor, the price-gouger serves as a very effective signaling mechanism, telling us of a gaping unmet need she has managed to find a temporary solution for — however unpleasant and expensive her pill may be to swallow. She thus necessarily invites competitors to follow suit, or prompt us to re-examine the particular economic and regulatory environment that has fostered the shortage in question.
In a certain sense, then, the character assassination directed at the price gouger is akin to shooting the messenger pointing to the brokenness of our healthcare system. Perhaps it is to that system that the shaming should be directed.
And we may wish to do that fast. Normal saline could be the next vital supply to dry up.
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
The term “managed care” entered the common lexicon in the 1990s, when contracted arrangements between physicians and hospitals on the one hand, and insurance entities on the other, became standard means to try to control healthcare expenditures. The origin of the concept is frequently credited to Dr. Paul Ellwood and his influential Jackson Hole Group, who introduced the idea in the early 1970s.
But in my 2-part series on the economic history of American medicine, I examined how healthcare has been “managed” from its inception in the late 1910s, when the Flexnerian reforms and the ensuing medical licensing laws began to influence (and limit) the type of medical care Americans could choose to receive.
Since that time, an ever-growing managerial class of academics, industry leaders, technocrats, and private foundation believers in “systems” and in a “scientific” approach to organizing society has been guiding the various government interventions which have shaped American healthcare as we know it today.
And if we take the Flexnerian reforms of the mid-1910s to be the very first set of interventions giving birth to the system, then the history of American healthcare as it subsequently unfolded is a stark illustration of what economist Ludwig von Mises described in his 1950 essay “Middle-of-the-Road Policy Leads to Socialism.”
In that essay, Mises argued that when the government hopes to avoid the extremes of pure capitalism and pure socialism, and chooses instead to selectively intervene in a sector of the economy to address a “market failure,” it will either fall short of its intended goal or generate new, unanticipated difficulties that are invariably greater than the ones initially confronted. The reason for the failure has to do with an intrinsic deficiency in knowledge, as proposed by Hayek and Mises, to the inability of government to assume entrepreneurial risk, and to other relevant factors as well (political incentives and bureaucratic inertia, for example).
By the time the failures and unintended consequences of the government intervention are recognized, many interests have become vested in keeping the status quo. As a result, the intervention is almost never reversed, but additional government measures are proposed instead. As these generate their own unexpected problems, repeated cycles of intervention in due time bring the sector more and more under the control of government.
That scenario seems to have played out in healthcare over the last 100 years, and the history of our medical system could reasonably be described as a “Misesian” tragedy in five acts as follows:
Act One was the institution of licensing laws favoring the AMA-led “scientific” care, ostensibly to improve the quality of medical education. Consequent to these laws were an acute shortage of physicians, an incentivization for more aggressive medical care, an unprecedented increase in medical prices, and a worsening of healthcare access inequalities.
Act Two took place after the Great Depression deflated that first healthcare bubble. A set of legal interventions was engineered to facilitate the establishment of health insurance and “rescue” the medical institutions which had invested in excess hospital capacity during the boom years. Consequent to these legal measures was a second wave of medical price inflation due principally to an underestimation of “moral hazard.” With this increase in prices, health access inequalities separating those holding health insurance from those without it increased.
Act Three was the establishment of government insurance programs to provide coverage for those most disenfranchised by the rapid expansion of employer-based health insurance, namely the elderly and the poor.
Consequent to the government provision of insurance was an astronomical rise in medical prices, again due to moral hazard among an elderly population naturally more prone to utilizing medical resources. This tremendous price inflation affected all aspects of the economy, but harmed the federal budget in particular and caused an ever increasing portion of GDP to be devoted to healthcare.
Act Four was the enactment of various legislations, from the Health Maintenance Organization Act signed under Nixon in 1973 to the HITECH Act of 2009, aimed at controlling costs by fixing prices and reducing utilization of healthcare by a variety of bureaucratic measures.
Consequent to that legislative spree, a consolidation of the healthcare industry occurred, with hospitals, private health insurers, and physician practices each merging into ever larger entities. As a result, the attempts at price controls were wholly ineffective, but the trend of consolidation also made the healthcare system much less responsive to the needs of patients. Patient discontent grew, and professional dissatisfaction among doctors and health professionals also emerged.
Act Five is being played out as we speak. To address the medical price inflation crisis, the Affordable Care Act of 2010 is forcibly extending health insurance to the entire population and introducing a number of provisions to try to control costs. To deal with a notable deterioration in healthcare quality (traced back, at least in part, to a variety of systemic disruptions in care), physicians are spurred into becoming employees of “accountable care organizations” or other large administrative entities that can mirror or adapt to the bureaucratic demands of the government.
Meanwhile, the private insurance industry is reduced to a small oligarchy which, given important new restrictions imposed on its business model, may not survive in the same capacity in the next few years.
Admittedly, the outcome that will follow the current stage of evolution remains to be seen. Will it really lead to total government control (Mises’s essay did not deem that to be inevitable), or will a private healthcare sector remain in operation? Will there be an unexpected good ending, or will the system collapse under the weight of its debt?
Only time will tell, but we may be reminded that according to historian Andrew Feffer, the notion that social and political affairs ought to be managed with “scientific” rigor and systemic planning is actually a hallmark of the American Progressive movement at the turn of the last century.
In that case, and to the extent that some of the country’s brightest managerial talent are to this day seduced into concocting for us policy “solutions” to the problems at hand, it may be appropriate to view the American healthcare system, at least as it stands today, not only as a tragedy, but as a real triumph of Progressivism.
Mainstream historians and economists tend to see the period from about 1900 to 1920 as a glorious time for the Progressive agenda. In 1913 alone, the government headed by Progressive Woodrow Wilson created the Federal Reserve System, direct election of US Senators via voters (and not state legislators), and the federal income tax. The rise of regulatory agencies such as the Food and Drug Administration, the Interstate Commerce Commission, the Federal Trade Commission, and the Federal Communications Commission further directed the US economy away from “destructive” laissez-faire and toward a more “rational” model. Likewise, the US government at this time aggressively pursued anti-trust policies that sought to break up or prevent the creation of private monopolies, supposedly protecting the very heart of the American free enterprise system: competition.
Not surprisingly, upon further inspection, we find that the reality was different than the vision historians have produced. As economic historians such as Robert Higgs in Crisis and Leviathan, have documented, the economic regulation imposed by American Progressives actually formed monopolies where none had existed and Progressive policies created new and harmful barriers to entry that blocked whole groups out of occupational lines in the name of creating a better society.
Progressives and Race: Spoiling the PictureIf there were dark clouds in this otherwise “bright” period of “progress,” they were World War I, the most destructive and murderous international conflict ever in which the USA inevitably was drawn, and the rise of institutional racism, otherwise known as Jim Crow. World War I, while admittedly a disastrous event of one sort, did serve to further uproot the conservative and regressive monarchies of Europe. Thus, from the Progressive perspective, there was a small but important “silver lining” in the dark cloud of war.
Jim Crow laws were another matter altogether, but Progressive historians had a ready-made explanation for what clearly were the implementation of policies that exacerbated inequality at a time when intellectuals, journalists, and politicians were beating the drums of equality. The Progressive advocates of Jim Crow, write historians such as C. Vann Woodward and David W. Southern, simply suffered under a “blind spot” of racism. While their intentions were good, and while the economic policies they advocated ultimately would advance the cause of African-Americans, the practitioners and creators of Jim Crow were blind not only to the needs of blacks, along with their basic humanity, but also were unable to understand that they unwittingly were helping the very people they claimed to hate.
There is another way to view Progressive policies, however, one that does away with the so-called blind-spot-of-racism narrative and replaces it with a viewpoint that recognizes that the very economic and social “reforms” that Progressives championed and for which they receive ubiquitous praise actually were intended to harm blacks and other minorities that found themselves out of favor with American Progressives.
In 2013, David Kiriazis and I published an article in The Independent Review in which we openly challenge the “blind spot” thesis and claim that Progressives wanted to harm black Americans and that their reforms were the tools which they employed to carry out their goals. Far from making economic life “fairer” and more open via the regulatory process, we argue that the Progressive Era regulatory machine did what government regulations always do: create economic winners and losers through the creation of barriers to entry, raised business costs (which favored the larger business enterprises that also were politically-connected) and in the process created government-sponsored economic rents.
In an eye-opening paper, Thomas Leonard of Princeton University lays out how Progressives embraced the faux science of eugenics in an attempt to “weed out” ethnic groups that Progressives considered to be vastly inferior to educated whites. Blacks were among those groups that Progressives believed needed to be subjugated to white rule and pushed into the margins of society, with the tools being economic “reforms” and the implementation of the minimum wage.
Some quotes from intellectuals of that day simply are shocking. Margaret Sanger, the founder of Planned Parenthood and an icon of Progressivism spoke of the need to “exterminate the Negro population” through a program of birth control and sterilization. Economists such as Irving Fisher, Frank Fetter, Simon Patten, and Edward A. Ross saw the presence of blacks and immigrants from Eastern Europe as destructive to American society and believed that the implementation not only of eugenics, but also imposing a minimum wage would help “purify” the country by keeping the “unemployables” out of the workplace.
Likewise, the most passionate economic “reformers” of the early Progressive Era, such as US Senator “Pitchfork” Ben Tillman of South Carolina, also were the most vocal racists and based their campaigns on going after established businesses and blacks. (Woodward could not reconcile himself to what he saw as the inconsistency of Tillman’s political and economic Progressivism with his racism.)
Leonard points out that the Progressives saw the increased unemployment caused by the minimum wage to be a net social benefit, which went against the standard neoclassical viewpoint of economists like Alfred Marshall, A.C. Pigou, and Phillip Wicksteed, who saw job losses via the minimum wage as imposing a social cost. If one promotes the viewpoint today that increasing the minimum wage will create higher levels of unemployment, especially among blacks, then that person is a racist, according to socialist Harold Myerson, who writes for the Washington Post.
Regulation and RacismFew people understand the impact of the regulatory process on the modern economy. For example, Democratic party presidential candidates Hillary Clinton and Bernie Sanders both have attacked the popularity of ride-share companies like Uber and Lyft, along with Airbnb, which permits people in high-cost cities like San Francisco and New York to turn their apartments into a bed and breakfast. Both Sanders and Clinton claim that these entities are “unregulated,” which, in their view, places consumers in danger and prevents authorities from overseeing their operations and offering protection to their users.
Likewise, New York Mayor Bill de Blasio attacks Uber supposedly for its lack of regulations when, in fact, de Blasio is representing the interests of the taxicab industry, which does not want competition and which gave the mayor large campaign contributions. Like his fellow politicians, de Blasio and his supporters want us to believe that economic regulation creates a lower-cost, “orderly” market that “protects” consumers and actually results in lower prices (because government regulators set cab fares).
Far from making economic life low-cost and orderly, government regulation creates economic rents that accrue to people who are politically-connected, shutting out people who are shunted to the back of the line, and reducing economic opportunities and, in the end, reducing the supply of goods and services in the marketplace. This last point is important, for even Paul Krugman supposedly understands that if in a market the government reduces the supply of a good, its price will rise, ceteris paribus (all other things held equal). Government cannot regulate an increasing supply of goods into existence, period; it only can reduce that supply because regulation adds costs to production and the distribution of goods.
Progressive Policy as an Extension of Jim CrowSo, where does Progressivism and Jim Crow fit into this picture? The answer is disarmingly simple, yet rejected even by modern black Progressives who seemingly have embraced the very economic doctrines that help hold back African-American economic progress.
Regulation by government by definition restricts economic output, thus creating economic rents that are distributed, at least in part, on a political basis. Thus, people who are best politically-connected will be at the head of the line and those not connected will be at the back. It is that simple. The history of Progressive labor laws, especially those from earlier in the twentieth century, are a history of blatant attempts by powerful white labor unions to legislate black workers out of the workplace altogether.
One example is the National Recovery Act, the 1933 New Deal law that sought the cartelization of nearly every industry in the USA. (The thinking behind the Franklin Roosevelt-inspired legislation was that if government could increase prices of goods, it would increase revenues and profits for businesses, thus keeping them from going under and creating even higher unemployment. For obvious reasons, the attempt to fight unemployment by reducing economic output did not cure the nation’s economic ills.)
Given that black Americans already labored under infamous Jim Crow laws, it did not take long for the NRA to manifest itself in racist ways. Blacks called the law the “Negro Removal Act,” “Negroes Rarely Allowed,” and “Negroes Robbed Again.” Likewise, the Progressives touted the minimum wage not as a tool to lift black workers out of poverty (as modern Progressives claim will happen), but rather as a device to keep black workers from competing with whites.
Another example involves the taxi industry, which is scrutinized in Walter Williams’s book, The State Against Blacks, in which Williams documents how government policies often force black workers to the back of the line. The taxi industry in New York City (the same government-chartered monopoly that Mayor de Blasio favors), Williams writes, has legally-imposed high barriers to entry which effectively shut out blacks who might wish to drive cabs
The Progressive-inspired Flexner Report of 1910, which recommended the closure of a large number of small medical schools that trained African-American doctors, ultimately resulted in blacks being shut out of many professional jobs in medical care. While Flexner did not primarily aim to damage black individuals pursuing medical careers, he did understand that implementation of his recommendations (America, he said, needed “fewer and better doctors”) would effectively shut out most African-Americans from medical professions.
Blacks, Whites, and Unemployment RatesWhile few modern Progressives are willing to acknowledge their movement’s racist past, even fewer Progressives are willing to admit that the very policies they demand be implemented have a strong negative impact upon black Americans. What may be most ironic is that the proof of the failure of Progressivism can be seen in numbers on black unemployment even while both white and black Progressives demand more of the same.
If the cause of high rates of black unemployment were simply caused by white racism, then one would expect the employment “gap” between blacks and whites was greater before the 1940s when whites pretty much were free to act on their own racial prejudices than was the “gap” after World War II. However, that is not the case, according to the Pew Research Center:
The black-white unemployment gap appears to have emerged in the 1940s, according to a 1999 analysis of Census data. Although labor economists, sociologists and other researchers have offered many explanations for the persistent 2-to-1 gap — from the differing industrial distribution of black and white workers to a “skills gap” between them — there’s no consensus on causes. One 2011 working paper, after reviewing existing research on wage and unemployment differentials among blacks and whites, concluded that “none of the existing models of race discrimination in the labor market explains the major empirical regularities.”
According to Pew Research, black rates of unemployment have been roughly double that of white joblessness since the 1950s. Today, the rate of black unemployment is almost twice what it is for whites, but the gap exploded only after Progressive economic policies became permanently embedded in the US economy. If the reason for this employment gap is not racism (and American racial policies have changed drastically in the past sixty years), then why would we see these kinds of numbers?
I believe that the biggest reason has been the tendency of African-Americans — and especially African-American political leaders — to fully embrace the Progressive agenda. While it might seem strange that blacks would give full support to an economic and political ideology that caused blacks to be shunted onto the margins, one must remember that the educated classes, both black and white, embrace Progressivism religiously.
Furthermore, modern Progressivism is an urban-based, secular religion and most African-Americans tend to live in cities. It should not be surprising that when the dominant urban intellectual culture is anti-enterprise, people most exposed to the steady drumbeat of hatred for private enterprise are not going to support it. Indeed, most large American cities with large black populations are dominated politically by coalitions of wealthy, anti-enterprise whites and African-Americans.
Take Baltimore, for example. As I pointed out during the Baltimore riots last April, Baltimore is dominated by the Progressive white-black coalition that is friendly to the kind of “economic development” that is high-profile, subsidized by governments, and carried out by politically-connected whites and benefits mostly affluent whites. However, real-live entrepreneurs that wish to involve the local black population are given the back-of-the-hand by the Progressive establishment. Progressives might like “investment” in subsidized stadiums and high-profile shopping centers that have little positive effects for local black populations, but are not going to support the ordinary businesses that help keep communities together.
Lest one thinks I exaggerate, the recent quote from former Baltimore mayor Martin O’Malley, who also has been governor of Maryland and now is running for president of the United States, sums up the Progressive view toward private enterprise:
“It is not true that regulation holds poor people down, or regulation keeps middle class from advancing,” O’Malley, the former governor of Maryland, said Monday in an interview with NPR’s Steve Inskeep. “That's kind of patently bulls---.”
Yet, we know the history of economic regulation and we know its effect upon black Americans. Progressives knew what they were doing when they built regulatory structures that pushed African-Americans to the back of the line in the struggle for the government-created economic rents. The results have become doubly tragic because blacks now fully embrace the very political philosophies that made their lives so difficult during the Jim Crow era.
“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)The present volume, prepared as a Ph.D. dissertation, is the only known work of Chi-Yuen Wu, a Chinese scholar contemporary with Ludwig von Mises. In 1939 Wu completed his doctorate at LSE under Lionel Robbins, and then returned to China at Southwest Associated Universities. Since nothing is known of his career after this time, we are left wondering if he kept writing, or how he coped with the rise of the communist regime in his native country. Nevertheless, the achievements of the present work are even greater for this reason. An Outline of International Price Theories was singlehandedly able to keep Wu on the radar of economic research for almost a century, a testimony to his acumen and mastery of his topic.
The book is an overview of the historical development of international price theories.
In late June of this year, President Obama signed an executive order and presidential directive clarifying the administration’s hostage policy. Afterward he gave a statement to the press, in which he condemned threats of prosecution against families trying to pay ransom: “the last thing we should ever do is add to a family’s pain with threats like that.”
This follows a review into the government’s treatment of overseas hostages, which found that the family of James Foley, the freelance journalist beheaded by ISIS in August 2014, had been told that they would be taken to court if they tried to negotiate with the terrorist group.
Following the review’s publication, the president was faced with three choices:
(1) A policy of no-concession, whereby the government not only refuses to pay ransom, but continues to threaten the prosecution of private citizens who negotiate;
(2) A policy of laissez-faire, whereby the government does nothing — it neither pays ransom, nor interferes with the negotiations of private citizens; and
(3) A policy of concession, whereby the government foots the ransom bill.
The president’s statement indicates his administration’s support for policy number 2. This article compares said policy — of laissez-faire —with its rivals, policy 1 and policy 3, both of which have recently found public proponents.
No-Concession: Coercing the Victims of CoercionAdvocates of no-concession (e.g., House Speaker John Boehner) argue that if families are allowed to bargain for the release of their loved ones, it will send a message to rogues overseas that American hostages fetch a price. The number of kidnappings will increase as a consequence.
This argument fails on its own terms. While it assumes hostage-takers are rational, self-interested actors who respond to incentives, it does not afford American travelers the same courtesy, instead assuming that they would not act any differently in light of the heightened threat to life and limb. In fact, if the risk of visiting lawless, unstable regions has increased appreciably, then marginal visitors (e.g., amateur journalists) can be expected to cancel their excursions; more serious trippers, on the other hand, will spend more on security provisions.
There are now two forces acting, each in the opposite direction: rogues are increasingly on the prowl for victims, but trippers are fewer in number and more vigilant. Whether the number of kidnappings should fall or rise with the payment of ransom by families, then, is a matter of some ambiguity.
But don’t ransom payments enable hostage-taking groups the material resources necessary to kidnap more frequently in the future? This objection is vulnerable to the same counterargument: as rogues militarize, some American visitors will armor up, while others will cancel their trips. Just as the lynx population cannot expand indefinitely at the expense of the snowshoe hare’s, the hostage-takers face constraints — as they become stronger and more numerous, they will find the pickings less plentiful, because their prey has in turn become stronger or has simply stayed at home.
In short, a policy of no-concession asks that we tolerate the addition of government coercion to an already coercive situation; that we strip hostages and their families of their best hope for conflict resolution. And yet, in return, it does not even give us reason to believe that the total number of kidnappings should certainly drop. A sorry trade-off indeed!
Uncle Sam’s Deep PocketsThere are currently over thirty American hostages held abroad, and, quite understandably, it is their families who form the dominant lobby for a policy of government-paid ransom. How might we expect a policy of concession, practiced in some form by every country but America and Britain, to affect the number of kidnappings?
First, we should note that governments do not face the same budget constraints as private individuals, meaning kidnappers could expect to extract a far higher ransom. And even if the government-paid ransom were capped, it would still stimulate kidnappings by rewarding rogues with income security. By contrast, under the policy of laissez-faire which Obama has endorsed, hostage-takers enjoy no such certainty — they may find, after outlawing themselves and expending labor in the process of kidnapping, that their victim hasn’t the means to pay.
Furthermore, under a policy of government-paid ransom, Americans could be expected to visit dangerous regions in greater numbers, and to become less vigilant while doing so. It would, of course, still be unpleasant to be kidnapped, but it would be made less onerous if one knew one’s house needn’t be re-mortgaged to buy freedom. That is, government guarantee of ransom creates moral hazard, partly removing the incentive to guard against risk. Other things being equal, a policy of concession stimulates the kidnapping industry, providing it with more opportunities and a stable, generous bounty per head.
However, all other things are not equal between countries: that is the reason why, in spite of its government’s consistent refusal to pay ransom, the US had the second highest number of citizens held hostage in 2013.This source reports that America had nine citizens in the hands of hostage-takers in 2013. However, the U.S. government reported in 2015 that over thirty Americans are currently being held. In the interim, IntelCenter reports that only two hostages were taken: 0 in 2013, 1 in 2014 and 1 so far in 2015 (data on yearly kidnappings here. This demonstrates the difficulty of finding consistent data on American hostage-takings. It is government policy not to publicize hostages, so as to deny their kidnappers limelight and bargaining power. America’s foreign policy has made political targets of its citizens, with many being kidnapped and killed to influence military decisions. That is not, however, to discount the importance of government ransom policy; the country that beat America in 2013 was France — the French have intervened in places such as Mali and Libya, while at the same time paying out more in ransoms than any other nation since 2008. And that shows in the hostage nationality data.
ConclusionAllowing families to negotiate without fear of prosecution provides some hope for those seized overseas; at the same time, the moral hazard associated with government-paid ransom is avoided. In short, it is a humane and level-headed response to the lengthening list of American abductees.
However, until such a day as American spears are beat into pruning hooks, citizens will remain in disproportionate danger of abduction while abroad. John Boehner, in response to Obama’s recent change in hostage policy, lamented, “... you could be endangering more Americans here and overseas.” If, like Boehner, one is truly concerned with the safety of citizens at home and overseas, one must consider the crucial role played by American military intervention and political subversion in creating hatred for the homeland and her people.
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.
Due to Obamacare, my health plan has become something other than insurance. It is now, for the most part, nothing other than a wealth transfer scheme to benefit the politically connected over others.
In order to identify the difference between health insurance and government-mandated health care coverage, we can look to Human Action, in which Ludwig von Mises splits probability into class probability and case probability:
Class probability means: We know or assume to know, with regard to the problem concerned, everything about the behavior of a whole class of events or phenomena; but about the actual singular events or phenomena we know nothing but that they are elements of this class.
Case probability means: We know, with regard to a particular event, some of the factors which determine its outcome; but there are other determining factors about which we know nothing.
David Howden explains that events such as football matches and wars are events that fall under case probability. But those events do not lend themselves to insurance.
Indeed, Mises claims that only risk associated with class probability can be remediated by insurance. This is true because the number of payoffs is relatively predictable within a class, allowing premiums to be set that benefit both the insurer and the insured.
This is the way in which life insurance works, for example, as Howden explains:
Life insurance works because insurance companies can play the averages. Some people who own a life insurance policy will die before the insurance company earns enough money on the premiums to pay the death benefit. In this case the company loses money. It offsets these losses with the gains it makes on those who die long past the point where they have broken even on the premiums they have paid relative to the death benefit they will receive.
Discrimination in the life insurance market is not only a fact of life; it is fair. Every policy holder pays according to his odds of death. People are free to undertake risky activities, but they must pay the price. People who choose to live less risky lives — that is to say, avoiding those activities that increase one’s probability of death such as skydiving or smoking — lose out on the enjoyment these activities may provide, but they gain by paying less for life insurance.
Broken arms and certain diseases would also fall under class probability, and would also lend themselves toward being profitably insured in a functioning market.
But, due to changes resulting from Obamacare (as well as decades of government meddling), distortions in the market have thrown the health insurance market out of whack, and my health plan, and the plans of many others, now have high deductibles for “class probability” events such as broken arms, while providing “free” access to goodies that are only unpredictable in so far as I may or may not choose to use them, such as a “free” annual physical, birth control, and more.
As Mises knew, “insurance” that covers an event such as a voluntary checkup, bears little resemblance to what we would consider to be insurance in the proper sense. Nevertheless, the freebies (i.e., “insured” events) are numerous, not because insurance companies can calculate a way to profitably insure them, but because they are mandated, thanks to interest groups with access to legislators.
The Politics Behind MandatesNevertheless, because the distributed costs are minimal and unseen, while the benefits are concentrated and substantial, little opposition arises from voters to fight such transfers of wealth.
As an example, I pay an extra, say, $1 in monthly premiums so that someone else can reap $50 in benefits per month. Stack up those $1 premium increases among all payers and we begin talking real money. However, I have neither the time nor energy to oppose each $1 increase.
This process becomes obvious when, because of my high deductible, the infrequent and unpredictable accident that falls under class probability — my son breaks an arm — costs me thousands out of pocket, without any monetary benefit from my plan, while others celebrate access to goodies they should be purchasing on their own as uninsurable events.
It is as if, because of government interventions, my car insurance pays for upgrades to Sirius Satellite Radio (which I do not have), but, because of high deductibles, only pays a few thousand dollars should I have an accident that totals my car.
Insurance does still exist with regard to life, home, and auto. But it does not exist with regard to health in our present regulated economy. Health plans are wealth transfers that bestow known and predicable benefits on the few while leaving all at risk of the vagaries of life. So, let’s not claim that our system of government-regulated health care system is insurance.
Presented at Mises Boot Camp, a one-day seminar for anyone seeking to learn the fundamentals of the Austrian school. Download the Syllabus.
Recorded at the Mises Institute in Auburn, Alabama, on 25 July 2015.
Many investors still view gold as a safe-haven investment, but there remains much confusion regarding the extent to which the gold market is vulnerable to manipulation through short-term rigged market trades, and long-arm central bank interventions. First, it remains unclear whether or not much of the gold that is being sold as shares and in certificates actually exists. Second, paper gold can theoretically be printed into infinity just like regular currency — although private-sector paper-gold sellers have considerably less leeway in this regard than central banks. Third, new electronic gold pricing — replacing, as of this past February, the traditional five-bank phone-call of the London Gold Fix in place since 1919 — has not necessarily proved a more trustworthy model. Fourth, there looms the specter of the central bank, particularly in the form of volume trading discounts that commodity exchanges offer them.
The Complex World of Gold InvestmentsThe question of rigging has been brought to media attention in the past few months when ten banks came under investigation by the US Commodity Futures Trading Commission (CFTC) and the US Department of Justice in price-manipulation probes. Also around that time, the Swiss regulator FINMA settled a currency manipulation case in which UBS was accused of trading ahead of silver-fix orders. Then, the UK Financial Conduct Authority, which regulates derivatives, ordered Barclays to pay close to $45 million in fines against a trader who artificially suppressed the price of gold in 2012 to avoid payouts to clients. Such manipulations are not limited to the precious-metals market: in November of last year, major banks had to pay several billion dollars in fines related to the rigging of foreign-exchange benchmarks, including LIBOR and other interest-rate benchmarks.
These cases followed on the heels of a set of lawsuits in May 2014 filed in New York City in which twenty-five plaintiffs consisting of hedge funds, private citizens, and public investors (such as pension funds) sued HSBC, Barclays, Deutsche Bank, Bank Scotia, and Société Génerale (the five traditional banks of the former London Gold Fix) on charges of rigging the precious-metals and foreign-exchange markets. "A lot of conspiracy theories have turned out to be conspiracy fact," said Kevin Maher, a former gold trader in New York who filed one of the lawsuits that May, told The New York Times.
Central Banks at the Center of Gold MarketsThe lawsuits were given more prominence with the introduction of the London Bullion Market Association (LBMA) on February 20, 2015. The new price-fixing body was established with seven banks: Goldman Sachs, J.P. Morgan, UBS, HSBC, Barclays, Bank Scotia and Société Génerale. (On June 16, the Bank of China announced, after months of speculation, that it would join.)
While some economists have deemed the new electronic fix a good move in contrast to behind-closed-door, phoned-in price-fixing, others beg to differ. Last year, the commodities exchange CME Group came under scrutiny for allowing volume trading discounts to central banks, raising the question of how "open" electronic pricing really is. Then, too, the LBMA is itself not a commodities exchange but an Over-The-Counter (OTC) market, and does not publish — does not have to publish — comprehensive data as to the amount of metal that is traded in the London market.
According to Ms. Ruth Crowell, the chairman of LBMA, writing in a report to that group: "Post-trade reporting is the material barrier preventing greater transparency on the bullion market." In the same report, Crowell states: "It is worth noting that the role of the central banks in the bullion market may preclude 'total' transparency, at least at the public level." To its credit, the secretive London Gold Fix (1919–2015) featured on its website tracking data of the daily net volume of bars traded and the history of gold trades, unlike current available information from the LBMA as one may see here (please scroll down for charts).
The Problem with Paper GoldThere is further the problem of what is being sold as "paper" gold. At first glance, that option seems a good one. Gold exchange-traded funds (ETFs), registered with The New York Stock Exchange, have done very well over the past decade and many cite this as proof that paper gold, rather than bars in hand, is just as sure an investment. The dollar price of gold rose more than 15.4 percent a year between 1999 and December 2012 and during that time, gold ETFs generated an annual return of 14 percent (while equities registered a loss).
As paper claims on trusts that hold gold in bank vaults, ETFs are for many, preferable to physical gold. Gold coins, for instance, can be easily faked, will lose value when scratched, and dealers take high premiums on their sale. The assaying of gold bars, meanwhile, with transport and delivery costs, is easy for banking institutions to handle, but less so for individuals. Many see them as trustworthy: ETF Securities, for example, one of the largest operators of commodity ETFs with $21 billion in assets, stores their gold in Zurich, rather than in London or Toronto. These last two cities, according to one official from that company, "could not be trusted not to go along with a confiscation order like that by Roosevelt in 1933."
Furthermore, shares in these entities represent only an indirect claim on a pile of gold. "Unless you are a big brokerage firm," writes economist William Baldwin, "you cannot take shares to a teller and get metal in exchange." ETF custodians usually consist of the likes of J.P. Morgan and UBS who are players on the wholesale market, says Baldwin, thus implying a possible conflict of interest.
Government and Gold After 1944: A Love-Hate RelationshipStill more complicated is the love-hate relationship between governments and gold. As independent gold analyst Christopher Powell put it in an address to a symposium on that metal in Sydney, October 2013: "It is because gold is a competitive national currency that, if allowed to function in a free market, will determine the value of other currencies, the level of interest rates and the value of government bonds." He continued: "Hence, central banks fight gold to defend their currencies and their bonds."
It is a relationship that has had a turbulent history since the foundation of the Bretton Woods system in 1944 and up through August 1971, when President Nixon declared the convertibility of the dollar to gold suspended. During those intervening decades, gold lived a kind of strange dual existence as a half state-controlled, half free market-driven money-commodity, a situation that Nobel Prize economist Milton Friedman called a "real versus pseudo gold standard."
The origin of this cumbersome duality was the post-war two-tiered system of gold pricing. On the one hand, there was a new monetary system that fixed gold at $35 an ounce. On the other, there was still a free market for gold. The $35 official price was ridiculously low compared to its free market variant, resulting in a situation in which IMF rules against dealing in gold at "free" prices were circumvented by banks that surreptitiously purchased gold from the London market.
The artificial gold price held steady until the end of the sixties, when the metal's price started to "deny compliance" with the dollar. Still, monetary doctrine sought to keep the price fixed and, at the same time, to influence pricing on the free market. These attempts were failures. Finally, in March 1968, the US lost more than half its reserves, falling from 25,000 to 8,100 tons. The price of other precious metals was allowed to move freely.
Gold Retreats Into the ShadowsMeawhile, private hoarding of gold was underway. According to The Financial Times of May 21, 1966, gold production was rising, but it was not going to official gold stocks. This situation, in turn, fundamentally affected the gold clauses of the IMF concerning repayments in currency only in equal value to the gold value of such at the time of borrowing. This led to a rise in "paper gold planning" as a substitution for further increases in IMF quotas. (Please see "The Paper Gold Planners — Alchemists or Conjurers?" in The Financial Analysts Journal, Nov–Dec 1966.)
By the late 1960s, Vietnam, poverty, the rise in crime and inflation were piling high atop one another. The Fed got to work doing what it does best: "Since April [1969]," wrote lawyer and economist C. Austin Barker in a January 1969 article, "The US Money Crisis," "the Fed has continually created new money at an unusually rapid rate." Economists implored the IMF to allow for a free market for gold but also to set the official price to at least $70 an ounce. What was the upshot of this silly system? That by 1969 Americans were paying for both higher taxes and inflation. The rest, as they might say, is the history of the present.
Today, there is no “official” price for gold, nor any “gold-exchange standard” competing with a semi-underground free gold market. There is, however, a material legacy of “real versus pseudo” gold that remains a terrible menace. Buyer beware of the pivotal difference between the two.
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.
Last month, the United States Supreme Court declined to take up a case involving Arizona’s and Kansas’s attempts to require proof of citizenship to vote in federal elections. The two states sought SCOTUS review in an attempt to overturn a prohibition imposed by lower federal courts. Had the two states been allowed to impose more stringent citizenship requirements, the effect on the voting population would have likely been small, but the overall legal effect of the court’s decision is significant.
The refusal of the Supreme Court to hear the case yet again sends a message to state and local governments that the federal government shall continue to centrally direct election and immigration law. As noted in The Hill:
“This is a very big deal,” Rick Hasen, a University of California Irvine law professor, wrote on his election law blog. “Kobach had the potential to shift more power away from the federal government in administering elections toward the states.”
Centrally Planning Immigration PolicyThe Arizona and Kansas voting restrictions had been efforts to affect national immigration policy via state laws. But, as has been the trend over the past century, the federal government has repeatedly asserted itself as the last word in policymaking in citizenship and immigration matters.
Indeed, the Federal Courts explicitly declared the states powerless to attempt to control immigration within their own borders when Federal Judge Mariana Pfaelzer struck down California’s voter-approved Proposition 187 in 1994 and wrote:
California is powerless to enact its own legislative scheme to regulate immigration. It is likewise powerless to enact its own legislative scheme to regulate alien access to public benefits.
Naturally, this decision sent the message nationwide that states should not bother to limit access to taxpayer-funded amenities (with public education being a central issue) because the federal government will simply declare such efforts illegal.
Thus, through these cases, federal courts have made it clear that no state (or anyone other than the feds) can meaningfully prevent participation by non-citizens in political activities such as elections, nor can the states limit the ways in which immigrants can access government benefits, even when those benefits are locally-funded.
The net effect is an imposition of a migrant subsidy scheme across all states regardless of the local economic and demographic realities, while ignoring the fact that residents of certain states bear a greater tax burden in subsidizing migrants.
The Answer Is Not More Government InterventionAt this point, it is important to note that the antidote to government subsidies (i.e., government intervention) is not more intervention. If the federal government insists that the taxpayers subsidize the immigrant population, then the proper response is to simply eliminate the subsidy. This is exactly what voters had attempted to do with Proposition 187 (and Arizona Proposition 200).
This correct approach is to be contrasted with the draconian methods employed by other states which have centered on punishing employers and landlords (and the immigrants themselves, of course) for engaging in private contracts and non-violent market transactions.
Such efforts only expand the size and scope of government, and they ultimately involve federal agents raiding private establishments and combing through lease agreements and payroll documentation to make sure that workers and renters bear an arbitrarily-assigned status as “legal” immigrants.
When states turn to these methods, we end up with the worst of both worlds, since not surprisingly, federal courts have been relatively tolerant of state and local efforts to punish local businesses and employers while at the same time remaining steadfast in opposition to efforts to limit the scope of government programs.
The Answer Is Decentralization and Smaller GovernmentThus, while states and local government are given a small space to act around the edges of immigration policy, all regions and states are tethered to a single national policy on citizenship and immigration. However, we can guess that, if they were given greater leeway to do so, states would offer a very diverse array of immigration-related policies.
In research conducted by Huyen Pham and Pham Hoang Van, the authors attempt to measure the legal “climate” for immigrants for all fifty states by evaluating state and local legislative and legal efforts to limit (or encourage) immigrant activity in each state. The authors unfortunately do not distinguish between efforts that restrict private property (i.e., employment restrictions) and efforts that restrict government growth (i.e., limiting health care benefits). In the following chart, we find Pham’s and Van’s rankings:
Source: Immigrant Climate Index from “Measuring the Climate for Immigrants: A State by State Analysis,” by Huyen Pham and Pham Hoang Van The legislative and legal climates differ broadly, and this suggests that ideology, economics, and demographics produce some areas (i.e., California and Illinois) that tend to favor and subsidize immigration while other areas (i.e., Arizona and Virginia) would thoroughly limit subsidies.
If we took this a step further and gave states and localities the power to determine all eligibility to both state and federal benefits, such measures by themselves (assuming benefits were not transferrable across state lines) would serve to place the burdens of subsidized immigration onto the states that mandate it.
And, of course, there’s nothing to say that the state level is the optimal level of decentralization. As with any truly laissez-faire proposal, the ultimate goal is complete privatization of immigration policy. That is, the ability of immigrants to relocate to a community would be dependent on the dispersed and individual decisions of employers and other property owners who can decide on their own to employ or house migrants in the community. This is, of course, the democracy of the marketplace described by Mises in which individual persons — by making decisions about whom to employ or sell property to — collectively determine who is a member of each community. Any employer who wished to fully staff his operation with so-called illegal immigrants would be legally free to do so, and his decision would be subject to approval or veto by his customers, not by arbitrary government fiat.
But even in the absence of this ideal, movement toward more locally-focused immigration policy gives existing residents greater choice in where to reside and place their property. Without decentralization, the taxpayers (many of whom will want to live in jurisdictions with laissez-faire attitudes toward conducting business with migrants) are powerless to make meaningful choices in this matter without completely uprooting his life and leaving the country.
The Problem with Imposing Top-Down PolicyThe goal of laissez-faire immigration policy is to both diminish the availability to taxpayer-funded programs for immigrants (on the way to eliminating these programs overall) while also avoiding anti-private-property regulations that prohibit owners from freely contracting with immigrants in general.
As we have seen, there is no technological or practical barrier to decentralizing this effort immediately. As is so often the case, however, there is significant ideological and legal opposition.
Among those who insist on a single nationwide policy are those who assert that the best way to ensure the protection of property rights (for both property owners and migrants) is to impose it from above.
Unfortunately, we’ve seen this movie before on other issues ranging from eminent domain to drug policy. In each case, however, the more practical, enduring, and least-risky solutions come from decentralization.
Following the Supreme Court’s Kelo decision in 2005, for example, many advocates for free markets condemned the court for not issuing a top-down prohibition on certain types of eminent domain. As Lew Rockwell pointed out, however, Kelo was one of the few cases in which the court was actually correct in deferring to local control. Even when the central government agrees with us, political decentralization remains the prudent choice:
We are … opposed to top-down political control over wide geographic regions, even when they are instituted in the name of liberty.
Hence it would be no victory for your liberty if, for example, the Chinese government assumed jurisdiction over your downtown streets in order to liberate them from zoning ordinances. Zoning violates property rights, but imperialism violates the right of a people to govern themselves. The Chinese government lacks both jurisdiction and moral standing to intervene. What goes for the Chinese government goes for any distant government that presumes control over government closer to home ...
There are several reasons for [this position].
First, under decentralization, jurisdictions must compete for residents and capital, which provides some incentive for greater degrees of freedom, if only because local despotism is neither popular nor productive. If despots insist on ruling anyway, people and capital will find a way to leave. If there is only one will and one actor, you cannot escape ...
This is certainly true in the case of immigration policy. Those states that turn to raiding employers and fining landlords as “solutions” to perceived problems with immigrants will lose their most productive citizens and property owners to states that shy away from such interventionism. Moreover, those states that choose to heavily subsidize immigration will also suffer the loss of many of their taxpayers.
In such a system, would some states still indulge in massive redistribution schemes and other unsustainable public policies? There is no doubt that would occur, but it’s best to limit the damage to a handful of states than to impose the same fate on everyone nationwide.
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.
Those of us leaning in the Austrian direction see bubbles and malinvestments around every corner and assume, wrongly as it turns out, the market will right these wrongs lickety-split. But, for the moment a rational market is no match for cheap money. “Any college that is thinking about capital expansion, now is a very good time,” Robert Murray, an economist at Dodge Data told the Wall Street Journal. “Several years down the road, the climate might not be as good.”
Now being a good time because stock market gains have pumped up endowments, “and low interest rates have created a favorable environment for colleges to build,” writes Constance Mitchell Ford. The campus building boom marches on.
In 2014 colleges and universities commenced construction on $11.4 billion worth of projects, a 13 percent increase from the previous year. It’s the largest dollar value of construction starts since the heady days of 2008.
Ms. Ford’s piece highlights a $2 billion project at Cornell and sixteen new buildings at Columbia worth $6 billion. But here in Auburn, Alabama the campus has been a construction zone since 2008 when I arrived. Multiple new dorms, a basketball arena, a fancy student center, and various new classroom buildings have been constructed at a time when funding from the state has been cut back. What’s now underway is the largest scoreboard in college football, with a plan to expand the stadium next.
Back in the 1985–86 school year, full time tuition at Auburn for a non-resident was $2,585. Thirty years later it is now $28,040. That’s a compounded annual growth rate of 8.27 percent.
According to Bloomberg, college tuition and fees have increased 1,120 percent since records began in 1978, and the rate of increase in college costs has been “four times faster than the increase in the consumer price index.”
Tuiton at state schools is rising even faster says Peter Cappelli, professor of management at the Wharton School of the University of Pennsylvania. He told Becky Quick on CNBC’s “Squawk Box” the cost of an education has risen 50 percent faster at state schools versus private in roughly the last decade.
Cappelli said a critical question is whether students will graduate in the first place, noting that only 40 percent of full-time students earn a degree within four years, and 30 million — and perhaps as many as 35 million — young adults do not finish their studies.
Unfinished college is as useful as an unfinished building.
College degrees are similar to what Austrians call higher-order goods. It’s believed a student will gain knowledge and seasoning in college, making him or her more productive and a candidate for a high-paying career. The investment of time and money in knowledge are undertaken for the payoff of higher productivity and a high future income. Higher education is the higher-order means to a successful career.
The assumption is those high-pay jobs, (A) will require a college degree, and (B) they will be plentiful when the student graduates. Borrowing $100,000 to earn a law degree is a malinvestment if the student ends up writing briefs for $15 per hour. A recent graduate of the Charlotte School of Law put fliers on cars announcing that he or she had borrowed $200,000 to attend school and is now working at Walmart for $35,000 a year.
A post on the “Above The Law” blog revealed, “As of the 2013–2014 academic year, the total cost of a three-year J.D. degree from Charlotte Law was $123,792.00, while the median loan debt per graduate was $159,208.00. Just 34 percent of the class of 2014 was employed in full-time, long-term jobs where bar passage was required. ...”
“More college graduates are working in second jobs that don’t require college degrees,” writes Hannah Seligson in the New York Times, “part of a phenomenon called ‘mal-employment.’ In short, many baby-sitters, sales clerks, telemarketers and bartenders are overqualified for their jobs.”
Ludwig von Mises wrote in Human Action,
The whole entrepreneurial class is, as it were, in the position of a master builder whose task it is to erect a building out of a limited supply of building materials. If this man overestimates the quantity of the available supply, he drafts a plan for the execution of which the means at his disposal are not sufficient. He oversizes the groundwork and the foundations and only discovers later in the progress of the construction that he lacks the material needed for the completion of the structure. It is obvious that our master builder’s fault was not overinvestment, but an inappropriate employment of the means at his disposal.
As it is now, parents and students still have the belief that college is the way to, if not riches, at least a well-paying career. In a 2011 piece for mises.org with what turned out to be the hasty title of “The Higher-Education Bubble Has Popped” I quoted PayPal founder and early Facebook investor Peter Thiel, who questioned the value of higher education. He told TechCrunch,
A true bubble is when something is overvalued and intensely believed. Education may be the only thing people still believe in in the United States. To question education is really dangerous. It is the absolute taboo. It’s like telling the world there’s no Santa Claus.
Like most bubbles this one is being fueled by debt. USA Today reports, 40 million borrowers owe $29,000 each, totaling $1.2 trillion outstanding. Student loan debt is easy to get, but hard to get rid of. It’s hard to pay back without a high salary, nor can it be bankrupted away. “Government either guarantees or owns most of the student loans and has the power to sue and to garnish wages, tax refunds, and federal benefits like Social Security when borrowers default,” Kelley Holland writes.
Defaults are plentiful. In the third quarter of last year, the three-year default rate was roughly 13.7 percent, with the average amount in default per borrower just over $14,000.
These debtors “are postponing marriage, childbearing and home purchases, and ... pretty evidently limiting the percentage of young people who start a business or try to do something entrepreneurial,” says Mitch Daniels, president of Purdue University
I administer funds for a small scholarship for graduating high school seniors in my old home town. This year, for the first time, an applicant wrote that he needed financial help for college because his father, a veterinarian, can’t help his children because he’s struggling to make payments on his own student debt.
The college boom is not just on campus. Student housing developers have been riding the college boom as well. Two years ago in a piece for The Freeman, I wrote about developers cashing in building dorms. These developers have even found Auburn, with its population of only 50,000. A project called 160 Ross has long-time residents in an uproar with its high density. But as much as locals don’t like it, students have snapped up units at $599 a bed.
That rack rate has large student housing developers coming to town and CV Ventures is ready to break ground for a six-story mixed-used project on just one acre featuring 456 beds, stumbling distance from the college bars, with a Waffle House across the street.
Meanwhile, everyday we hear about how online courses being the death knell for brick-and-mortar institutions. For the moment traditional colleges seem safe. “Because traditional campuses offer peer and teacher interaction,” writes Ron Kennedy, “as well as a plethora of other important benefits often sought by traditional, college-aged students, there will remain a need for traditional education.”
More importantly, Kennedy continues, “Research has shown that students who interact face-to-face with their instructors and other students tend to be more academically balanced than their online counterparts. This is one reason why most employers still prefer students who have attended traditional campuses.”
Trees don’t grow to the sky and neither will tuition. However, it’s doubtful young people will suddenly stay home with their parents and work toward degrees taking online classes. Parents who can afford it want to relive their college days vicariously through their kids.
The higher education bubble continues to inflate.
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.
Austrians oppose the whole notion of trying to accurately measure “inflation” which mainstream economists see as a general rise in prices. (Austrians view inflation as a politically engineered increase in the money supply.)
A few years ago, mainstream economists like Paul Krugman chastised the Austrians for the lack of anticipated price inflation in the economy. However, their mistake was a fixation on the Consumer Price Index (CPI). If you looked around at other prices in the economy you could see higher prices in just about every other market, such as commodities, oil, gold, producer goods, real estate, and stocks.
More recently, mainstream economists have returned to fears about there not being enough inflation, and their outsized fear of deflation. For them, their fear justifies Zero Interest Rate Policy (ZIRP) and Quantitative Easing (QE), but they fail to explain why we must have rising prices. When it comes to the cost of living, most people prefer falling prices to rising prices, a condition that typically characterizes a true free market economy.
The Futility of Price-Inflation MeasurementsThe practical problems with price indexes such as the CPI are the issues of which prices are to be measured and what “weights” will be assigned to what goods. Another problem is deciding what to do about changes in quality. For example, what do you do when Apple introduces a new and improved iPhone at the same price as the previous version?
To deal with this, government statisticians systematically increase the weights for goods that are going down in price and reduce the weights of things are going up in price. If the quality of a good goes up, the statisticians “hedonically” reduce the price of the good.
Those sorts of adjustments do not seem fair to most normal people. If you are eating more ramen noodles and fewer lamb chops you can take little comfort in the fact that that the CPI is staying inside the Fed’s target range. Moreover, under the system of hedonic adjustments, every time entrepreneurs and engineers come up with better products for consumers at lower prices, the Fed takes credit for keeping inflation under control.
A Debate Over Alternative MeasuresOne economist that takes exception to these adjustments is John Williams, owner of ShadowStats.com. Williams offers alternative measures of government statistics based on older methodologies where the goods, weightings, and quality adjustments play less of a role. His measure of CPI, for example, shows price inflation much higher than government statistics. Whether Williams’s calculations are more accurate than the government statistics is hard to say, however, because both are constructed on the same inherently flawed foundations.
One recent critique of Williams’s statistics comes from Ed Dolan. He criticizes Williams not for his belief that CPI understates the impact of the Fed on the cost of living, but for the way he calculates his alternative measure:
No one really denies that the CPI, as presently calculated, understates the rate of inflation compared to a measure based on a fixed basket of unchanged goods. Rather, what many economists, myself included, find hard to accept is Williams’s estimate of the degree of understatement.
This friendly dispute does not solve the problems of calculating the cost of living or price inflation, but only serves to underscore the futility of such an undertaking, a point first established by Ludwig von Mises.
Furthermore, the whole discussion obscures the real impact of the central bank’s “monetary policy.” In the absence of a central bank, it is generally assumed that the supply of money would grow slowly because real resources have to be expended to create gold and/or silver (or anything else, including Bitcoin) to serve as the monetary base.
In an expanding market economy, improvements in technology, efficiency, and productivity means that you would experience real economic growth per capita of at least 2–4 percent per year. If the supply of money is increasing slower than production, then the economy will experience price deflation and a stronger currency.
What Would the CPI Be With a Fixed Money Supply?The full impact of the central bank’s monetary policy is better described by adding consumer price inflation (higher prices) and the foregone price deflation together. The combined amount shows a truer picture of the negative impact the Fed’s monetary policy has on the typical wage or salary earner. Economist Mark Brandly provides an estimate of this damage to an economy that consists largely of workers on fixed wages.
He calculates what the CPI would have been between 1959 and 2005 if the money supply had been fixed. Using data on the actual money supply and actual CPI, he calculates that the actual CPI in 2005 was 6.7 times higher than the CPI in 1959. In the absence of increases in the money supply, however, he calculates that CPI would have fallen by 80 percent so that the actual CPI was thirty-four times larger than what the CPI would have been in the absence of the Fed.
What would this mean for the common man? Brandly provides a few estimates about what this world would look like in terms of the prices of goods the consumer would face today:
Let’s put this in everyday terms. Suppose these estimates represent the changes in the prices of goods such as hamburgers, cars, and housing. According to these numbers, a hamburger that cost 60¢ in 1959 would have cost $4 in 2005. If the money supply had been fixed, however, that hamburger would only cost 12¢ today. Similarly, a $20,000 car in 2005 would have cost slightly less than $3,000 in 1959. Again, without the monetary effect on prices, that car would only cost $600 today. The price of a $45,000 house in 1959 would have increased to $300,000 in 2005. With a fixed money supply, that house would cost $9,000 today.
Ultimately, however, “fixing” the CPI would accomplish little. The Fed would continue to do significant harm to the working class and enrich the wealthy and the political class. The Fed has destroyed the incentive to save and turned financial markets into crony casinos. Meanwhile, economic inequality is the worst in American history. The Fed has blown up enormous economic bubbles and they are stuck with seven years of ZIRP and are too afraid to change course for fear of blowing up the world economy. Tinkering with the CPI won’t solve these problems.
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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
Recently, the Polish economy experienced its first price deflation since the 1980s, which sparked in the country deflationphobia (or, as Mark Thornton calls it, apoplithorismosphobia).
Media sources and many economists focus on price inflation and price deflation as the source of various economic ills, but, contrary to much of the rhetoric, price inflation and price deflation are always “optimal” in the economic sense. At first, such a claim may seem controversial, since virtually all economists have something negative to say about either inflation or deflation. This concerns almost all schools of economic thought, mainstream and heterodox, including the Austrians.
Yet in some very important sense, one can make a reasonable argument that price inflation and price deflation are optimal in one specific sense. If we notice that prices are formed by choices of market participants, we see that modifications to price levels are executed in order to “correct” the markets. Always.
Price Inflation and Price Deflation Are a Solution to a ProblemTake the case of very high price inflation. In some circumstances we may see prices suddenly rising rapidly. What this means is that private owners, selling their property, have noticed an advantage in re-pricing goods they own. Even if it happens in a very chaotic manner, they try to economize their resources to the best extent possible. Price fixing, on the other hand, would not be a solution to the problem, since it would lead to shortages.
We discover a similar situation with price deflation. Imagine that lots of sellers have to drastically lower the prices for goods and services which they offer in the market. Apparently it is their way of attracting customers and making sure that someone makes a purchase. Fixing prices would not solve the problem, since it would cause surpluses.
With both price deflation and price inflation we see adjustments to changing circumstances. The adjustments themselves are necessary, because some underlying economic conditions have changed. When we hear various economists criticizing either price inflation, or price deflation, they usually have in mind some underlying variable that causes prices to change. It is not really the adjustment of prices that they wish to attack, but really it is some underlying cause of the price adjustment that is the issue.
When 100-percent-banking Austrians criticize price inflation, they criticize expansions of the money supply, which lead to price inflation (or sometimes lack of price deflation, to be precise). They are not really criticizing private owners, who adjust their prices to shifts in conditions. That is why the Austrians are quite specific in their approach and define inflation as an expansion of the money supply, because price adjustments in themselves are not a problem. Indeed, price changes are a solution to the problem.
Similarly, when some economists of the monetarist tradition focus on price deflations, they may have in mind criticism of the banking sector, which collapses and leads to shrinking money supply, causing many businesses to go bankrupt. When price deflation happens, because banks are falling, adjusted prices are not problems. Again, they are a solution to the problem, which is a collapsing banking sector (or actually some previously-inflated sector of the economy). If banks fall, along with the money supply, prices had better adjust! The adjustment may be painful, but it is optimal under the circumstances, just as it is optimal for prices of wheat to go up when there is a drought.
This is also the case with economists in the fractional-reserve free banking tradition. When they focus on negative aspects of price deflation, they usually mean they have a problem with a lack of deposit expansion on the part of the banks, when people decide to decrease the so called “velocity” of money. When people spend less, they exercise influence on sellers to decrease the prices. If nothing additional occurs, then prices are supposed to fall, and there is nothing inefficient about it. Prices falling is what should happen. What the fractional-reserve free bankers are saying is that under conditions of people decreasing their spending, it is beneficial for banks to expand the money supply.
Prices Have a Job To DoPrices have a job to do: adjust to conditions, no matter what they are. That is why price inflation and price deflation are always optimal — because they are the sign that market actors are ready to adjust their actions to shifts in economic variables in order to economize on their property. There is nothing inefficient about it, since this is how the market system works.
One may ask a sensible question: why make this seemingly trivial point? It is good to remind ourselves of this because economists of various traditions sometimes divert their arguments from the underlying causes of price adjustments, and instead focus on results of the problems they have identified. Such an approach can lead to obscuring the nature of economic problems and to distortion of proper macroeconomic analysis. Instead of discussing the end results (i.e., the final pricing structure) it is much better to discuss the variables which lead to the creation of that price structure in the first place. The next time we’re tempted to discuss whether or not price levels are optimal, let us discuss whether forces resulting in those price levels were optimal, instead.
In a market economy a major service that money provides is that of the medium of exchange. Producers exchange their goods for money and then exchange money for other goods.
As production of goods and services increase this results in a greater demand for the services of the medium of exchange (the service that money provides).
Conversely, as economic activity slows down, the demand for the services of money follows suit.
Prices and the Demand for MoneyThe demand for the services of the medium of exchange is also affected by changes in prices. An increase in the prices of goods and services leads to an increase in the demand for the medium of exchange.
People now demand more money to facilitate more expensive goods and services. A fall in the prices of goods and services results in a decline in the demand for the medium of exchange.
Now, take the example where an increase in the supply of money for a given state of economic activity (i.e., production) has taken place. Since there wasn’t any change in the demand for the services of the medium of exchange, this means that people now have a surplus of money or an increase in monetary liquidity.
No individual wants to hold more money than is required, and an individual can get rid of surplus cash by exchanging the money for goods.
All the individuals as a group, however, cannot get rid of the surplus of money just like that. They can only shift money from one individual to another individual.
The mechanism that generates the elimination of the surplus of cash is the increase in the prices of goods. Once individuals start to employ the surplus cash in acquiring goods, it pushes prices higher.
As a result the demand for the services of money increases. All this in turn works toward the elimination of the monetary surplus.
Note that what has triggered increases in the prices of goods in various markets is the increase in the monetary surplus or monetary liquidity in response to the increase in the money supply.
Price Deflation and the Money SupplyWhile increases in the money supply result in a monetary surplus, a fall in the money supply for a given level of economic activity leads to a monetary deficit.
Individuals still demand the same amount of services from the medium of exchange. To accommodate this they will start selling goods, thus pushing their prices down.
At lower prices the demand for the services of the medium of exchange declines and this in turn works toward the elimination of the monetary deficit.
A change in liquidity, or the monetary surplus, can also take place in response to changes in economic activity and changes in prices.
For instance, an increase in liquidity can emerge for a given stock of money and a decline in economic activity.
A fall in economic activity means that fewer goods are now produced. This means that fewer goods are going to be exchanged, implying a decline in the demand for the services of money.
Once, however, a surplus of money emerges, it produces exactly the same outcome with respect to the prices of goods and services as the increase in the money supply does. That is, it pushes prices higher.
An increase in prices in turn works toward the elimination of the surplus of money — the elimination of monetary liquidity.
Conversely an increase in economic activity while the stock of money stays unchanged produces a monetary deficit.
This in turn sets in motion the selling of goods thereby depressing their prices. The fall in prices in turn works toward the elimination of the monetary deficit.
These dynamics can affect a wide variety of markets unequally, but one market in which we can see the relationship between prices and money supply is the stock market.
A Time Lag Between Peak Liquidity and Peak Stocks?There is a time lag between changes in liquidity, i.e., a monetary surplus, and changes in asset prices such as the prices of stocks.
(The reason for the lag is because when money is injected it doesn’t affect all individuals and hence all markets instantly. There are earlier and later recipients of money.)
For instance, there could be a long time lag between the peak in liquidity and the peak in the stock market.
The effect of previously rising liquidity can continue to overshadow the effect of currently falling liquidity for some period of time. Hence the peak in the stock market emerges once declining liquidity starts to dominate the scene.
Historical Examples: 1927 to 2009For instance, the yearly rate of growth of liquidity topped in November 1927 at 10.2 percent — after a time lag of 22 months the S&P 500 responded by peaking in August 1929 at 31.71. (Note liquidity is the yearly percent changes in AMS minus yearly percent changes in the CPI and industrial production.) In 1987 the time lag between a peak in liquidity and a peak in the stock market was much shorter — the yearly rate of growth of liquidity topped in January 1987 at 15.1 percent. The S&P 500 responded to this by peaking eight months later at 329.9 in September of that year.
According to historical data the yearly rate of growth of liquidity bottomed at minus 16.6 percent in May 1929. Yet it took a long time before the S&P 500 responded to this. It took over three years after the bottom in liquidity was reached before the S&P 500 started to recover. The stock price index bottomed in June 1932 at 4.43. The time lag between the bottom in liquidity and the bottom in the stock market has been shorter in more recent history. Thus the yearly rate of growth of liquidity had bottomed at minus 5.7 percent in September 2000. It took twenty-five months before the S&P 500 bottomed at 815.28 in September 2002.
Another example is the yearly rate of growth of our monetary measure AMS which stood at 4.5 percent in May 1975. The yearly rate of growth of the consumer price index stood at 9.5 percent while the yearly rate of growth of industrial production closed at minus 12.4 percent. As a result, our measure of liquidity reached a high of 7.4 percent. In response to this the S&P 500 peaked at 107.5 in December 1976. Now, our measure of liquidity hit bottom at minus 10.4 percent in May 1976. The S&P 500 reached its bottom at 87.04 in February 1978 — a fall of 19 percent from the peak.
The S&P 500 closed at 1,549.30 in October 2007 before a large decline took place bringing the stock index to 735.1 by February 2009 — a fall of 52.3 percent. The yearly rate of growth of liquidity peaked at 7.1 percent in June 2003 (see chart). Note that the bottom in the stock price index at 735.1 reached in February 2009 was preceded by a bottom in liquidity at minus 6 percent in November 2007.
Where Are We Now?We suggest that a major threat to the S&P 500 is a fall in liquidity from 30.6 percent in June 2009 to minus 7.4 percent by June 2010. (Note again that the time lag between a peak in liquidity and a peak in the S&P 500 is variable.)
Now if we were to assume a time lag of around six years, then we can suggest that based on the peak in liquidity in June 2009 the level of the S&P 500 of 2,061 reached so far in March this year could be not far from the top.
Image source: iStockphoto
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.
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In recent years, some economists, contrary to long-established and widely-accepted economic theory, have been claiming that increases in the minimum wage do not increase unemployment. But both logic and the data say otherwise, writes Andrew Syrios.
This audio Mises Daily is narrated by Robert Hale.
Raising the minimum wage has become the cause célèbre for many on the progressive left. Most notably, Seattle has passed a $15 per hour minimum wage. In addition, California lawmakers are trying to pass a state-wide $13 per hour minimum wage and President Obama is supporting the increase of the federal minimum wage from $7.25 to $10.10.
The general public has generally been pretty ignorant regarding economics, so it’s understandable that many would fall for hollow populist appeals. However, a series of new studies on the minimum wage purport to show a low or non-existent impact on unemployment. Seventy-five notable economists even signed a petition to President Obama to raise the minimum wage.
This would seem at odds with basic economic theory. After all, demand curves are downward sloping, aren’t they? At some point, an increase in the minimum wage has got to cost jobs. If the minimum wage was increased to $100 per hour, obviously that would cost a lot of jobs. No one would disagree with this. So in that case, why wouldn’t increasing it to $10.10 per hour cost some jobs, right?
Revisionist Studies Before the latest wave of revisionist studies, the idea that minimum wage hikes don’t cause unemployment received a substantial boost in 1994 from a study of New Jersey-Pennsylvania fast food workers. However, David Neumark and William Wascher re-evaluated the evidence and found that the “New Jersey minimum wage increase led to a 4.6 percent decrease in employment in New Jersey relative to the Pennsylvania group.”
More recently, the old consensus was challenged again. Robert Murphy summarizes these economists approach as follows,
If we include regional-specific trends indexed by time period, the influence of the minimum wage begins to disappear and, in particular, using their preferred control group method (of contiguous county pairs) completely obliterates the textbook finding. The minimum wage may even have a positive impact on employment.
However, as Murphy notes, these adjustments “might mask the policy’s true effect.” As a recent working paper from Jonathan Meer and Jeremy West finds,
Using three separate state panels of administrative employment data, we find that the minimum wage reduces net job growth, primarily through its effect on job creation by expanding establishments.Jonathan Meer and Jeremy West, "Effects of the Minimum Wage on Employment Dynamics," December 2013, pg. 1.
In essence, minimum wage increases make it more likely that firms won’t hire new people than that they will fire current employees. For example, movie theaters have stopped employing ushers almost entirely. And many companies are moving toward more automation, at least partly because of minimum wage increases.
Furthermore, there is another major problem as Robert Murphy’s points out,
… careful analysts will often summarize the new research in a nuanced way, saying “modest” increases in the minimum wage appear to have little impact on employment. But the proposed increase from $7.25 to $10.10 an hour is a 39-percent increase, which can hardly be characterized as “modest.” Such an increase, therefore, could well destroy teenagers’ jobs, notwithstanding the revisionist studies.
It should also be noted that according to the Bureau of Labor Statistics, only “4.3 percent of all hourly paid workers” work at or below the minimum wage and “… workers under the age of 25 … made up about half of those paid the federal minimum wage or less.”Bureau of Labor Statistics, Characteristics of Minimum Wage Workers, 2013, March 2014, pg. 1. Studies focusing on modest increases in the minimum wage are of course not going to show much of a difference. However, even with only modest increases in the minimum wage, effects can be found. As a review of the literature by David Neumark and William Wascher describes,
Our review indicates that there is a wide range of existing estimates and, accordingly, a lack of consensus about the overall effects on low-wage employment of an increase in the minimum wage. However, the oft-stated assertion that recent research fails to support the traditional view that the minimum wage reduces the employment of low-wage workers is clearly incorrect. A sizable majority of the studies surveyed in this monograph give a relatively consistent (although not always statistically significant) indication of negative employment effects of minimum wages. In addition, among the papers we view as providing the most credible evidence, almost all point to negative employment effects, both for the United States as well as for many other countries.David Neumark and William Wascher, "Minimum Wage And Employment: A Review of Evidence From the New Minimum Wage Research," November 2006, pg. 2.
Indeed, even the Congressional Budget Office estimates that increasing the minimum wage to $10.10 per hour will cost 500,000 jobs.
Hurting Those It’s Meant to Help The minimum wage is constantly sold as good for workers, or minorities or women. In truth, it hurts the most vulnerable and those its well-intentioned sponsors intend to help.
A study by Jeffrey Clemens and Michael Wither evaluated the effect of minimum wage increases on low-skilled workers during the recession and found that minimum wage increases between December 2006 and December 2012 “… reduced the national employment-population ratio by 0.7 percentage points.”Jeffrey Clemens and Michael Wither, "The Minimum Wage and the Great Recession: Evidence on the Employment and Income Trajectories of Low-Skilled Workers," November 24, 2014, pg. 36. That amounts to about 1.4 million jobs. And more noteworthy, that “… binding minimum wage increases significantly reduced the likelihood that low-skilled workers rose to what we characterize as lower middle class earnings.”
Yes, it’s hard to make ends meet with a minimum wage job and such jobs certainly aren’t enviable. That being said, cutting out the bottom rung from people just makes it all the harder to get by. A bad job is better than no job and it is often the first step to something better. This is further shown by an illustrative chart provided by economist Mark Perry comparing the minimum wage with teenage unemployment. The two are almost perfectly correlated.
And while the large majority of those pushing for an increase in the minimum wage have good intentions, this has certainly not always been the case. Much like rent controls, increasing the minimum wage reduces the price of discrimination by creating a surplus of laborers for employers to choose from. Whereas many have noted the odd alliance of “Bootleggers and Baptists” when it came to Prohibition, another odd alliance of “Populists and the Prejudiced” could just as easily be applied to the minimum wage.
When Apartheid was collapsing in South Africa, the economist Walter Williams did a study of South African labor markets and found that many white unions were seeking to increase the minimum wage. He quotes one such union leader as saying “… I support the rate for the job (minimum wages) as the second best way of protecting white artisans.” By pricing out less educated black laborers with a minimum wage, white unions were able to insulate themselves from competition.
Indeed, the Davis-Bacon Act, which demands that private employers pay “prevailing wages” for any government contracts, was explicitly passed as a Jim Crow law in order to protect white jobs from cheaper black competitors. And while the minimum wage is supported with much more pleasant rhetoric these days, the effects on black employment, particularly black teenage employment, have been devastating. As Thomas Sowell observes,
In 1948 … the unemployment rate among black 16-year-olds and 17-year-olds was 9.4 percent, slightly lower than that for white kids the same ages, which was 10.2 percent. Over the decades since then, we have gotten used to unemployment rates among black teenagers being over 30 percent, 40 percent or in some years even 50 percent.
It’s hard to imagine that black unemployment was actually less than that of whites. But that is the effect minimum wage laws can have.In 1948 there was a minimum wage, but because of a high inflation during that decade, it was so low as to be irrelevant.
Ending poverty and giving people additional income are praiseworthy goals, but there are no free lunches in this world. And trying to force prosperity through a minimum wage simply creates a whole host of negative and unintended consequences especially for those who are the most vulnerable.
Image source: iStockphoto.
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.
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.
Image Source: iStockphoto.
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
When the central bank meets to decide on the level of interest rates, most people care about only one thing: are my home loan, car, and credit card repayments going up, down, or staying the same? Although this is no trivial concern given the importance of managing a household budget, such a limited view does scant justice to the broad, critical, and complex role interest rates play in an economy.
What Soda Prices Tell Us About Interest RatesThe usual narrative is that low rates are good and high rates are bad. But the real problem is not “high” interest rates, but wrong interest rates. You see, interest rates are like prices. Like the price of a soda drink is agreed between seller and buyer, so interest rates are the price of loans agreed between lender and borrower.
Suppose the government forced the price of sodas to half their market level, jailing anyone caught selling them at any price above this new level. What happens? Soda lovers flock to the stores to buy soda. Soda makers, by contrast, take heavy losses and either close down or find some way to make cheap and less tasty soda for half the original cost. The supply of soda plummets, while the quality of good soda free falls.
Paradoxically, setting a price artificially low makes a product easy to buy for a while, but eventually leads to shortages. Interest rates in most modern economies work in a similar way. The central bank forces this price (the interest rate) to a desired level through extensive regulatory control over the banking system, relying on the fact that the money it creates is the only legally permissible money used in trade. When the central bank forces interest rates too low, borrowers think life is great. Houses, cars, and furniture seem cheap and starting a business with a loan is easy. Except that discerning lenders don’t see much point in lending anymore, because they are no longer adequately compensated for their costs and risk. Not only do loans from these lenders dry up, but the quality of remaining loans falls.
Make Lots of Cheap, Low-Quality LoansHow does the quality of loans fall? Just like the soda makers who sourced cheap and less tasty products, so credit providers (banks) move away from sourcing funds from discerning investors who would charge more, and rely instead on getting cheap money directly from the central bank, which prints it out of thin air and lends it to the bank at the cheap rate.
With this cheap funding, and with the ability to resell the loans to governmental and quasi-governmental organizations like Fannie Mae, the banks don’t have to be nearly as careful who they lend to and can happily accept lower interest repayments from borrowers. And, if things go wrong, the banking system can also appeal to the Fed and the US treasury for bailouts.
Risky borrowers who were unable to pay the rate of interest discerning lenders demanded can now access cheap loans. Simultaneously, even prime borrowers are misled by the reduced interest rate into projects that turn out to be malinvestments.
Furthermore, because the loans created out of thin air look exactly like the money in the hands of discerning lenders, this poor quality is veiled and people are fooled into thinking that discerning lenders are supplying loans, when in fact they’re running for the hills. (But even the discerning lenders are fooled in the initial phases of the boom as the new money makes borrowers look more stable and profitable than they really are.)
Consuming More Than We ProduceThis ends in disaster. Borrowers get into too much debt and the money loaned out of thin air floods into the economy. New money in people’s hands causes the economy to consume more than it produces and the result is a gaping and unsustainable trade deficit. The new flood of money pushes prices up and causes the currency to weaken.
After initially feeling flush, people realize they are not as well off as they thought as price increases eat into their real living standards. Forced to rein in inflation before it destroys everyone’s living standards, the central bank hikes interest rates to entice the discerning lenders to do more lending. Businesses addicted to cheap loans find their input and funding costs rising unexpectedly, damaging profitability.
The return of discerning funding is critical for sustainable economic growth, because it funds productive capital investments that yield the highest return, creating jobs and quality, affordable products. Meanwhile, higher interest rates punish those who gorged on artificially cheap credit, restoring the economy to healthy reality and balance.
The next time the central bank meets to decide on the level of interest rates, don’t just ask how much your home loan payments are going to cost next month. Also ask: are interest rates at the right level to foster sustainable economic progress, and might I be living an illusion?
Image source: iStockphoto.
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.
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.
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.
Friday marks the thirtieth anniversary of the fall of the Berlin Wall. Like most historical events that are commemorated as if they took place on a single day, the fall of the Berlin Wall on November 9, 1989, was just one of many interrelated events that led to the end of the system of Soviet client states in Eastern Europe, and the end of the Soviet Union itself, in December of 1991.
With the fall of the Berlin Wall, East Germans, who had lived under severe restrictions on travel and emigration, were able to freely travel to West Berlin, which continued a chain of events already begun earlier that year in which many anti-Soviet dissidents throughout Eastern Europe became emboldened and met with unprecedented success. Meanwhile, East Germans flooded into neighboring countries by the thousands, seeking refuge from Soviet-sponsored oppression in Austria and West Germany.
Why It Was Different in 1989 Throughout the mid-twentieth century, Eastern Europe was home to numerous anti-Soviet revolts and acts of civil disobedience. In Hungary in 1956, Prague in 1968, and especially in Poland throughout the 1970s and 1980s, resistance flared up, but was reliably crushed with Soviet-sponsored martial law and outright military intervention.
But in the summer of 1989, the Poles held an election that essentially overthrew the Soviet-approved regime in Poland. This, time, however, instead of sending tanks to crush the Polish agitators, the USSR did nothing.
By November of that year, dissidents had become emboldened by Soviet inaction. Hungary and Czechoslovakia haphazardly opened their borders, allowing East Germans to stream into Austria and on to West Germany. East Berliners began to demand free passage to the West. The “fall” of the wall, soon followed.
Americans today, and especially American conservatives, like to claim that the end of the Soviet bloc and the Soviet Union was America’s doing; that the Soviet oligarchs feared American military might, and simply decided to give up and vote themselves out of existence, as they did two years later. This tale makes for nice domestic propaganda in America, but the fact that regimes virtually never just “give up” without firing a shot when faced with a threatening foreign power makes it rather unlikely.
We are far more likely to find an answer if we ask ourselves not why the American state was so strong in the 1980s, but why the Soviet state was so weak. If the Soviets were more than capable of maintaining “order” in Eastern Europe during the 50s, 60s, and 70s, why was it unable or unwilling to do the same in the 1980s?
An inquiry along these lines quickly leads us to find that by the 1980s, the soviet economy, and most of the economies of Eastern Europe were economic basket cases. Housing was in disrepair. Vehicles and appliances were incredibly old-fashioned and unreliable. The standard of living was a fraction of what it was in the “West.” Basic items like soap and women’s pantyhose were often luxuries.
In other words, the centrally-planned economies of the Soviet bloc produced little actual wealth, and as the regimes siphoned off more and more of what little wealth was being produced, the people, as well as the regimes, became poorer and poorer.
This economic weakness meant not only that the legitimacy of the regime was imperiled, but that the Soviets no longer enjoyed a military “surplus” with which they could simply roll into every rebellious neighborhood and re-establish order.
In other words, the USSR was too poor to pay the political bills.
Mises and the Calculation Problem None of this would have surprised Ludwig von Mises. Decades before, Mises had shown that a socialist economy (by which he meant a centrally planned economy) could not possibly know what to produce, when to produce it, or for whom to produce. In explaining this, Mises proved that the Soviet Union, regardless of any victories it might have in remolding human nature, was economically impossible. Rothbard explains:
Before Ludwig von Mises raised the calculation problem in his celebrated article in 1920, everyone, socialists and non-socialists alike, had long realized that socialism suffered from an incentive problem. If, for example, everyone under socialism were to receive an equal income, or, in another variant, everyone was supposed to produce “according to his ability” but receive “according to his needs,” then, to sum it up in the famous question: Who, under socialism, will take out the garbage? That is, what will be the incentive to do the grubby jobs, and, furthermore, to do them well? ...
But the uniqueness and the crucial importance of Mises’s challenge to socialism is that it was totally unrelated to the well-known incentive problem. Mises in effect said: All right, suppose that the socialists have been able to create a mighty army of citizens all eager to do the bidding of their masters, the socialist planners. What exactly would those planners tell this army to do? How would they know what products to order their eager slaves to produce, at what stage of production, how much of the product at each stage, what techniques or raw materials to use in that production and how much of each, and where specifically to locate all this production? How would they know their costs, or what process of production is or is not efficient?
Mises demonstrated that, in any economy more complex than the Crusoe or primitive family level, the socialist planning board would simply not know what to do, or how to answer any of these vital questions. Developing the momentous concept of calculation, Mises pointed out that the planning board could not answer these questions because socialism would lack the indispensable tool that private entrepreneurs use to appraise and calculate: the existence of a market in the means of production, a market that brings about money prices based on genuine profit-seeking exchanges by private owners of these means of production. Since the very essence of socialism is collective ownership of the means of production, the planning board would not be able to plan, or to make any sort of rational economic decisions. Its decisions would necessarily be completely arbitrary and chaotic, and therefore the existence of a socialist planned economy is literally “impossible” (to use a term long ridiculed by Mises’s critics).
The Soviet central planners never had an answer to this critique. Indeed, their “answer” only came in 1991 when the USSR finally shut itself down. And even up to the end, American Keynesians never figured it out either, and Paul Samuelson still claiming in 1989 that a “socialist command economy can function and even thrive.”
Why Did it Take So Long? In response to Mises’s claim of the impossibility of central planning, some then ask “well, if central planning was impossible, why did it last so long?”
The answer can be found in the fact that even in a centrally planned state, capital does not simply vanish overnight. The soviet planners were not starting with nothing. They had the accumulated capital of centuries of savings and investment by Russians, Ukrainians, Germans, Poles, and others under their control.
True, it was not possible for them to correctly plan or determine non-arbitrarily what goods should be produced. But they nevertheless had large amounts of capital at their disposal, and even if the centrally planned state produced zero wealth (which was not true since even the Soviet state produced some things people wanted), the state still had plenty of wealth to redistribute until it was all gone.
This is all the more true for regimes that are only partly centrally planned, as in the case of Venezuela, on which Nicolás Cachanosky observed:
[I]f one of the wealthiest and developed countries in the world were to adopt Cuban or North Korean institutions overnight ... [t]he wealth and capital does not vanish in 24 hours. The country would shift from capital accumulation to capital consumption and it might take years or even decades to drain the coffers of previously accumulated wealth. In the meantime, the government has the resources to ... enjoy the wealth, highways, electrical infrastructure, and communication networks that were the result of the more free-market institutional realities of the past.
Eventually, though, the “reserve fund,” as Mises called it, is used up:
An essential point in the social philosophy of interventionism is the existence of an inexhaustible fund which can be squeezed forever. The whole system of interventionism collapses when this fountain is drained off: The Santa Claus principle liquidates itself.
In addition to this, the Soviets made money for the regime by selling oil (and other goods) in international markets, and high oil prices in the 1970s propped up the regime so well, that had it not been for Soviet oil sales, it’s quite possible the regime would have collapsed a decade earlier.
Conclusion As the mainstream news outlets cover the anniversary of the Berlin Wall’s fall this year, they will surely spend much time discussing the role of various American politicians, and military programs, and international relations. It is quite possible that all of these things had an effect on the regimes of Eastern Europe that were non-trivial. Nonetheless, such analysis ignores the huge elephant in the room which is the inevitable failure of regimes that are built on central planning and wealth re-distribution. Without markets and prices, there can be no planning, and without planning, no wealth creation, and ultimately, no political durability. The rebels and demonstrators of Eastern Europe deserve immense credit for courageously standing up to the state. But in the end, those who were successful were helped immensely by good timing and bad economics.
[Editor's Note: This article was first published in 2014 to mark the 25th anniversary of the fall of the Berlin Wall. It has been slightly updated for the 30th anniversary.]
Price changes are the solution to a problem, not the problem itself. We should focus on what causes the price changes in the first place, writes Mateusz Machaj. This audio Mises Daily is narrated by Robert Hale.
The Patient Protection and Affordable Care Act focused the attention of Americans on government regulation as few issues have. However, they should have paid attention decades earlier because states have been eating away like termites at freedom in the healthcare insurance market for decades. The PPACA adds little to existing state regulations. States began dictating to insurance companies what to cover, whom to cover, when to cover them and how much they could charge in the 1950s. Massachusetts, home of Romneycare, the template for Obamacare, enacted the first state mandate in 1956 requiring insurers to cover mentally and physically handicapped children.Jensen, G. A., and M. A. Morrisey. 1999. ‘‘Employer-Sponsored Health Insurance and Mandated Benefit Laws.’’ Milbank Quarterly 77 (4): 425–59.
States have mandated coverage in four areas: benefits, providers, populations, and rates. Benefit mandates decree types of care, such as mammograms, well-child care, drug and alcohol abuse treatment, but also acupuncture and wigs for cancer patients. Provider mandates ordain payments to healthcare providers such as chiropractors, podiatrists, social workers and massage therapists. Population mandates increase the number of people covered under a policy, such as extending coverage to non-custodial children and grand children. Rate mandates prevent insurance companies from charging premiums that reflect risk, in effect using low risk policy holders to subsidize high risk members.
Through the 1960s, state legislatures focused on commanding insurance companies to cover more people. In the1970s, states began to require that insurance policies cover non-physician practitioners, such as psychologists, podiatrists, and dentists. States expanded coverage to high-risk individuals who had been turned down for coverage by one or more insurers in the 1980s.
The decade of the 1990s ignited the war between managed care plans and their subscribers. State legislators entered the war on the subscriber’s side, launching a fusillade of new mandates dealing with the types of coverage offered. Among the many laws were minimums for hospital lengths-of-stay and coverage for hospital care following procedures such as normal childbirth, cesarean delivery, and mastectomy.
In addition, states enacted any-willing-provider (AWP) laws, forcing managed care firms to admit any provider willing to abide by the terms of the network contract. Freedom-of-choice (FOC) laws required that managed care plans allow subscribers to visit any licensed provider they desired as long as the subscriber paid a larger out-of-pocket fee when they used a provider from outside the network. Direct access mandates allowed subscribers to visit specialists, such as OB/GYNs, dermatologists, ophthalmologists, psychiatrists, chiropractors, etc., without first getting approval of the subscriber’s primary care physician (PCP). Managed care plans had tried to limit the rapid growth in medical care expenses by requiring the approval of a PCP before subscribers visited costly specialists.
The new millennium continued the onslaught of state regulations aimed at healthcare insurers. Between 1950 and 2000, states had enacted an average of 22 laws per year, with the average for the last decade rising to 57 per year. The first 11 years of the twenty-first century saw the average climb to 61 mandates per year.This data and the data in the chart are compiled from The Council for Affordable Health Insurance, Policy Trends, “Trends in State Mandated Benefits, 2011,” March 2011, and Miriam J. Laugesen, Rebecca R. Paul, Harold S. Luft, Wade Aubry, and Theodore G. Ganiats, “A Comparative Analysis of Mandated Benefit Laws, 1949–2002,” Health Research and Educational Trust, p. 1082. The chart below depicts the growth in state mandated laws over the past six decades. As of 2011, the total number of laws controlling insurance coverage amounted to 2,262 according to the Council for Affordable Healthcare Insurance (CAHI).CAHI, 2011. The numbers that make up the graph will add up to 1,910 because of differing definitions of mandates between the organizations providing the data.
Figure 1: Mandated Benefit LawsThe most popular new mandates cover autism, diabetes, oral and infusion chemotherapy, diabetes and screenings. As the number of news diagnoses of autism has exploded, so have the mandates. “To date, 29 states have passed autism mandates and the amount of proposed legislation grows each year. Advances in diagnosis (including a new rapid test to screen for autism) and treatment, along with a well organized national advocacy movement, guarantees autism mandates will remain high on legislative priority lists”Ibid. according the CAHI.
Oral and infusion chemotherapy is a regimen in cancer treatment that can be administered at home instead of a clinic or hospital. At least 15 states have passed such mandates. Diabetes is growing rapidly in the US as a result of the obesity epidemic. A 2009 University of Chicago study concluded that the number of diabetics will double in the following 25 years. As a result, 41 states have mandated coverage of diabetes.Ibid.
Mandates to pay for screening have increased in part because “most legislators and policymakers believe all preventive care saves lives and money. Recent studies reported in the Journal of the American Medical Association and elsewhere, however, are casting doubt on this idea. A number of screening tests have been shown to produce ‘false positive’ results, leading to expensive and unnecessary treatments.”Ibid.
The least-discussed mandates are those applying to what companies can charge for premiums. Rate mandates are a form of state price controls. Before one can appreciate the impact of price controls, one needs to understand how normal insurance works, such as car or house insurance, and prices premiums. Insurance companies hire actuaries to establish rates using probability theory, statistics and risk theory. Greater risks result in higher premiums. Things that affect risk in healthcare include geography, demographics (age and gender), and health status.
Consumers grasp these concepts easily with home and car insurance. For example, a house located in a flood plain will cause the owner to pay higher insurance premiums. Home owners in the southern plains states pay higher premiums than those on the west coast because of the frequency of hail in thunderstorms on the plains. Car insurance for teenage boys costs much more than the same coverage for girls or for older married men. These are examples of higher risks that cause higher premiums. The same should be true of healthcare insurance, but it is not.
Some states impose rate bands on insurance premiums. Rate bands set upper and lower limits on how much premiums can vary from the average due to risk factors such as gender, age, or health status. Many states allow the insurer to vary premiums by no more than 50 percent from the average. For example, if the average premium is $1,200 per month, the company can charge no more than $1,800 and no less than $600, which produces a 3:1 ratio of highest to lowest premiums. Other states allow no more than a 2:1 ratio. Such rate bands force young, healthy subscribers to subsidize the premiums of older, sicker ones.
The managed care provider I work for had a hemophiliac as a subscriber for many years who regularly cost the company over $1 million per year in medical bills. Oklahoma enforces rate bands on premiums, so the company could not charge that member any more than other subscribers whose medical expenses totaled less than 10 percent of his. Fortunately for our company, his employer chose another health care insurer.
So far we have looked at state mandates only, but the federal government has not remained unconcerned about health care insurance. The federal government issued the Pregnancy Discrimination Act in 1978, the Consolidated Omnibus Budget Reconciliation Act of 1985 (COBRA), the 1996 Health Insurance Portability and Accountability Act (HIPAA), the 1996 Mental Health Parity Act, and the 1996 Newborns and Mothers Health Protection Act (NMHPA).
The Pregnancy Discrimination Act requires health plans to provide benefits for prenatal and maternity services comparable to the coverage for other conditions. COBRA requires companies with 20 or more workers to continue providing the group insurance to former employees who have been separated, though the former employee and not the company pays the premiums. The premium cannot exceed 102 percent of the group premium.
HIPAA limits preexisting-condition clauses to one year before enrollment. In addition, the insurer must waive such clauses for subscribers who change plans if they have satisfied the waiting period for coverage under the previous plan. Plans cannot consider pregnancy a preexisting condition nor subject newborns or adopted children who are insured within 30 days of birth or adoption to the plan’s preexisting-condition clause. Under the Mental Health Parity Act, plans that include coverage for mental health care must provide the same annual and lifetime reimbursement ceilings for such care that they offer for other non-mental health related ailments.
Unintended ConsequencesIn a 2007 review of the literature about the effects of state mandates on insurance premiums, the authors concluded “Despite exhaustive research, little compelling evidence exists that state health insurance mandates do, in fact, have a significant impact on these outcomes.”Alan C. Monheit, Jasmine Rizzo, “Mandated Health Insurance Benefits: A Critical Review of Literature,” State of New Jersey, Department of Human Services, 2007. Is it really possible such massive state interventions in the insurance market, most of which create higher demand, have no impact on prices?
CAHI says it just ain’t so: “Health insurance actuaries have warned that virtually all mandates increase the cost of coverage by increasing utilization over time (referred to as “frequency of use”). Why is this so? Mandates require insurers to pay for care that consumers previously funded out of their own pockets, if they purchased it at all. Changing the dynamics of payment creates more frequent use of the service and a resultant increase in premium costs to all health insurance beneficiaries.”CAHI, 2011.
CAHI estimates that mandates can boost premiums from 10 percent to 50 percent depending on the state, number of mandates, and the type of policies.
Jensen and Morrissy found in 1990 that some benefits boost premiums significantly. Adding chemical dependency treatment lifted premiums 9 percent on average. Psychiatric hospital stays raised premiums 13 percent. Visits to psychologist increased them by 12 percent and routine dental services by 15 percent.Jensen and Morrissey, 1999.
James Bailey, an economist at Temple University, discovered results similar to those of CAHI: “When a mandate is passed, more medical spending is channeled through insurers, rather than being paid directly out-of-pocket by consumers. This partly explains the long-term shift away from out-of-pocket spending in the US health care market. ... As more medical spending is done using insurance, health insurance costs and premiums will rise.”James Bailey, “The Effect of Health Insurance Benefit Mandates on Premiums,” Temple University, Department of Economics, p. 2. The graph in figure 2 below depicting the source of healthcare spending appeared in Bailey’s paper.
Bailey conducted regression analyses on changes in mandates and premiums from 2008 to 2010 and found that each added mandate during that period increases annual premiums on average $35. He concluded “Given the total increase in average premiums of $545 from 2008 to 2010, these results imply that mandates were responsible for 25–45 percent of premium increases.”Ibid., p. 6. Average annual premiums for individual coverage in 2010 were $4,952.
Why is it so difficult to determine the price effect of state mandates on insurance premiums? The answer is that all people do not respond in the same way to price changes. Insurance companies try not to raise premiums if possible because in most states they compete for customers on the basis of premium prices. Most groups offer more than one insurance provider to their employees. Healthier employees will switch to cheaper plans, so insurance companies may choose to increase out-of-pocket expenses instead of raising premiums. Or they may reduce non-mandated benefits.
Figure 2: Source of Funds for US Healthcare Spending 1960–2008If an insurer raises premiums, companies paying the premiums for employees may opt for reduced benefits, switch insurers, have employees pay a larger share of the premium, or abandon company-paid insurance completely. The cost of mandates may be masked by the rising number of uninsured. Finally, companies may choose to become self-insured, in which case they are exempt from state mandates but must follow federal mandates. Self-insured plans cover over 57 percent of privately insured people.Ibid., p. 7.
Whatever the cause, insurance premiums have risen fast according to Milliman, an independent actuarial and consulting firm. The Milliman Index estimated that premiums for a family of four have doubled in less than nine years, from $9,235 per year in 2002 to $19,393 in 2011.[13] Milliman Research Report, “2011 Milliman Medical Index,” 2011.
ConclusionLiberty-loving people are right to be appalled by the power grab and destruction of freedom found in the Patient Protection and Affordable Care Act. However, just about every evil in the legislation has already been inflicted on the market through 50 years of state destruction of the healthcare market. Even the requirement that everyone have insurance was pioneered by Mitt Romney in Massachusetts. PPACA does little more than federalize earlier state abuses of power. For businesses in healthcare, especially insurance companies, there is nothing new here.
Image source: iStockphoto.
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.
President Barack Obama signed the Agricultural Act of 2014 into law on February 7, 2014.H.R. 2642: Agricultural Act of 2014. Bill Summary & Status. 113th Congress, 2013–2014. The Library of Congress. The legislation becomes law later than anticipated given the usual timing for farm bills, which typically work their way through the Congress every five years.Bernstein, Jonathan: “Farm Bill Proves Politics Isn’t Dead. Yet.” Bloomberg. January 29, 2014. The last major farm bill was passed in May 2008,H.R. 2419: Food Conservation, and Energy Act of 2008. Bill Summary & Status. 110th Congress, 2007–2008. The Library of Congress. and key provisions of that bill were at the center of discussions of the federal “fiscal cliff” in late 2012.Rogers, David. “Fiscal cliff deal includes farm bill extension.” Politico. January 1, 2013. Of the $956 billion spent in this massive bill,“2014 Farm Bill Breakdown.” Nebraska Farm Bureau. February 26, 2014. about 80 percent is earmarked for nutritional assistance programming, with the balance going to various types of agriculture spending.Morton, Joseph. “Farm bill refigures agriculture funding, but money still flowing to aid farmers.” Omaha World-Herald. February 23, 2014.
Within the agriculture spending provisions, the bill phases out some programs that provided direct payments to farmersIbid. originally designed to wean crop producers off of old-fashioned price guarantees for crops including wheat, corn, sorghum, barley, oats, cotton, rice, soybeans, minor oilseeds, and peanuts.Edwards, Chris. “Agricultural Subsidies.” Cato Institute. June 2009. Although the farm bill rolls back these direct payment programs, it also creates two new commodity programs to replace them: Price Loss Coverage (PLC) and Agriculture Risk Coverage (ARC).
Taxpayer-Subsidized Crop InsuranceUnder PLC, which originated in the House version of the bill, national reference prices are set and payments to farmers would be triggered if the average market price for the crop year falls below the reference price level.Ellis, Stu. “Which is For You: PLC or ARC?” Ag Professional. January 31, 2014. Participation in PLC also makes the farmer eligible for additional subsidized crop insurance coverage under the newly created Supplemental Coverage Option.Morton The ARC program is a Senate idea perceived as more advantageous for Corn Belt states like Nebraska, a fact evidenced by the active support lent to the proposal by the National Corn Growers Association.Rogers, David. “Corn popping in farm bill talks.” Politico. November 19, 2013. ARC provides payments “when actual crop revenue is below the ARC guarantee for the crop year, and that guarantee is 86% of a county-based yield formula multiplied by a national average price.”Ibid. Participating farmers will have to make the one-time decision to opt for one program or the other for each crop, with the default choice being PLC if no election is made. Farmers can also opt for an individual farm version of ARC instead of the county-level version.Ibid.
The farm bill also expands taxpayer-subsidized crop insurance to include other crops for which subsidized insurance has not previously been available, namely fruits, vegetables, and other “specialty crops.”Steinhauer, Jennifer. “Farm Bill Reflects Shifting American Menu and a Senator’s Persistent Tilling.” New York Times. March 8, 2014. When combined with the new Supplemental Coverage Option, insurance subsidies start to look more like direct payments to farmers. According to Iowa State economist Bruce Babcock, farm losses totaled $6.2 billion from the 2012 drought, but taxpayer-subsidized insurance resulted in $14 billion being shelled out to plan participants. With the new supplemental program, Babcock estimates that figure would have exceeded $20 billion.“Crop insurance created a windfall out of a drought.” Chicago Tribune. January 4, 2014.
True Market Prices Are Important Eliminating most direct payments is a great achievement for taxpayers and one that will ultimately help make the agricultural market stronger and more competitive. Their replacement with price guarantees, revenue support programs, and expanded taxpayer subsidies for crop insurance, however, is a troubling development. Government attempts to prop up prices may hamper trade with international partners. They also muddle the important signals for entrepreneurs that market prices send. The resulting miscalculations by businesses lead to harmful unintended consequences including surpluses, shortages, and wasteful misallocation of capital.Hayek, Friedrich A. “The Use of Knowledge in Society.” American Economic Review 35, no. 4, pp. 519–530. 1945. Those are the sorts of mistakes that cause businesses, including farms, to fail. Substituting expanded insurance subsidies for the controversial direct payment programs may mean net cost savings now, but it also means that spending will climb in unsound programs that will be even tougher to tackle.
Instead of reshuffling these subsidy schemes, lawmakers might instead consider cutting taxes that punish capital accumulation and stifle economic growth. That would be the best farm aid of all.
This article was originally published by the Platte Institute for Economic Research.
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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 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 9, No. 4 (Winter 2006)Austrians frequently lament the absence of an Austrian undergraduate money-macro curriculum, especially at the intermediate level. This is ironic in that a large body of work currently exists, both from “the masters” and more recent researchers that provides the essential theoretical underpinnings and historical and empirical analysis from which to mount a coherent Austrian macro course suitable for second or third year students. Unfortunately, that literature generally presupposes significant background knowledge in Austrian economics and thus does not ordinarily serve as a suitable platform upon which to build an intermediate money-macro course. Butos suggests all the components for such a course are in hand save one: an intermediate macro text appropriate for classroom use.
Volume 9, No. 4 (Winter 2006)
Ludwig von Mises (1981; 1998) is generally and properly credited by contemporary Austrians with having reintegrated monetary theory with general economic theory from which it had been severed by the neoclassical quantity theory. However, broader recognition of Mises’s contribution in merging monetary and value theory has been hindered by certain deficiencies in the organization of his exposition and the absence of a straight forward heuristic for conveying his achievement.
Volume 10, No. 1 (Spring 2007)The law of one price is one of the most basic laws of economics and yet it is a law observed in the breach. That a given commodity can have only one price, except for the briefest of transitions, seems to be almost an axiom. Economists are bent on considering their subject to be empirically based, yet the most elementary of laws seems to defy empirical confirmation. Would it not be wise to simply admit that economics cannot do without some a priori beliefs? Why has the law been accepted? Can the law be confirmed by data? If not, why is the law still accepted? and what does this acceptance tell us about good economic method?
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 3, No. 1 (Spring 2000)This note has shown that the possibility of the income effect of a price change is implied by the Misesian pure logic of choice. This note has not assumed that our individual must consume more than four loaves of bread to survive. No ad hoc assumption has been employed. Instead, the possibility of a backward bending labor supply has been logically derived from the subjective nature of value and the principle of diminishing marginal utility. Thus, it is clear that Salin’s views on the income effect of a price change are wrong. It is Rothbard who is correct and consistent with Misesian economics.
Volume 1 (Spring 1979)Lawrence H. White
In the penultimate section of his paper on "Spontaneous Order and the Coordination of Economic Activities,"[1] Gerald O'Driscoll performs a valuable service in bringing into the open a controversy, sparked by Professor Lachmann's thought, which has arisen in Austrian circles over the question of general equilibration. It is evident (especially within these same circles) that further clarification of the issues involved is required before a satisfactory avenue for resolution of this dispute can be found.
The basic question which has been raised regarding general equilibration is: to what extent does there exist a tendency toward an overall equilibrium of an economy of interconnected markets? To formulate an acceptable, answer to this question we must clearly specify at least three items: (1) the meaning given to "tendency" in this context; (2) the temporal perspective (ex ante or ex post) from which market processes are viewed, and (3) the particular conception of general equilibrium employed. There has been misunderstanding among the disputants on all three items. I shall briefly?undoubtedly too briefly?deal with each of these items in turn.
(1) The notion of a "tendency toward an overall equilibrium" has been infelicitously interpreted (by me no less than by others) as a process of movement which would, under specified conditions, eventually allow an economy to reach general equilibrium. Hayek noted years ago that "tendency" in this context is better interpreted as the likelihood that the configuration of an economy (particularly its array of prices) will be near to a general equilibrium configuration.[2] Under this interpretation no contradiction exists between the denial that general equilibrium (or complex ex ante coordination of plans) could ever be brought about in a real-world competitive economy and the affirmation that such an economy harbors a strong tendency toward an overall equilibrium. "Equilibrating forces" which possess the capability of maintaining an economic system at a high level of coordination may yet inherently lack the capability of bringing about perfect coordination.
The problem of specifying market conditions and forces sufficient to usher in the reign of perfect and final equilibrium seems ultimately insoluable, for there is a simultaneity problem involved with having each market participant finally adjust his own activities to accord with the market signals to be generated by the activities of all others. The market signals by which he orients himself must already embody the decisions taken by all others before any one agent can act in a sufficiently informed manner. Perfect foresight would allow agents to overcome the simultaneity problem, but only because perfect foresight would place them already in Hayekian general equilibrium. It would not allow a process by which they might reach that state. Imperfection of foresight forms an impassable moat around the kingdom of perfect harmony. We may nonetheless attempt to specify the essential characteristics of an overall equilibrium, as Hayek had best begun to do,[3] and to use that kingdom as an analytical point of reference in assessing the likelihood (tendency) for an economic system to be in its general vicinity (i.e. for the variables of the system to be approximately at equilibrium values) under specified circumstances.
(2) Austrian economists are in general agreement with the proposition that market forces must be traced back to the plans of market participants, particularly the plans of entrepreneurs. Analytical differences arise over whether emphasis is to be placed on the expectations and decisions in which plans originate (an ex ante perspective) or on the experience the testing of plans provides (an ex post perspective). It seems to me that both perspectives are necessary for the analysis of dynamic economic processes, and that neither should be allowed to eclipse the other permanently.
Lachmann has taken primarily an ex ante perspective, stressing the role of expectations and the pervasiveness of uncertainty in future-oriented decision-making. Yet he has also noted that expectations are "largely the result of the experience of economic processes."[4]
In serial expectational processes learning is possible, provided the sequence of decision, action, result, and interpretation takes place with speed sufficient to outrun significant changes in the objective circumstances. Learning can play an important role in providing accurate foresight and coordination of the decision-maker's (amended) plan with the plans of other market participants. Only in autonomous or unique expectation, where the decision made is unprecedented and can or will never be repeated under similar circumstances (this is the case where the taking of the decision itself significantly and irretrievably alters the circumstances), can learning play no equilibrating role. Only with regard to unique expectation can the ex post perspective be neglected.
Kirzner's focus on the pure arbitrage aspect of successful entrepreneurship amounts to the adoption of an exclusively ex post perspective, as success can be ascertained only ex post. This perspective obscures the uncertainty (surrounding future prices) faced by producer-entrepreneurs.[5] To say that intertemporal opportunities for pure profit "tend to become discovered" by "alert" entrepreneurs[6] is to slur over the fact of uncertainty, suggesting by the choice of terminology that entrepreneurs can see clearly into some aspect of the future. It is to suggest that the adoption of entrepreneurial plans depends upon knowledge of their actual outcomes (knowledge which in fact can only be gained in the future) rather than on expectations about their outcomes. Profit is then seen as the reward not for superior foresight, as Mises viewed it,[7] but for the discovery of a piece of knowledge which others lack.
(3) Kirzner's readiness to accord opportunities for profit a seemingly objective status conforms with his use of an equilibrium concept embodying Pareto-optimality.[8] The Hayekian conception of dynamic equilibrium is more appropriately subjectivist in carrying no requirement that every would-be useful fact be known to each market participant and thus carrying no requirement that optimality from the viewpoint of an omniscient observer be achieved.[9] Lachmann has framed his discussion exclusively with reference to neo-Walrasian models of temporary general equilibrium. That he (rightly enough) finds the world of these models inconceivable says little by itself about the analytical fruitfulness of the Hayekian dynamic equilibrium or the Misesian evenly-rotating economy, and says even less about the possible tendency (properly understood) of a market economy to approximate the Hayekian sort of overall equilibrium.
One final comment: O'Driscoll expresses concern that Lachmannian skepticism toward general equilibrium involves a weakening of the case for the market system. With regard to a case based on Paretian welfare considerations this may well be true, but defenders of the market system should already be wary of arguments which claim too much. The "failure" of the market system to conform to a neo-Walrasian model which strips it of essential attributes may be regarded as reflecting poorly on the model rather than on the market system, and this is the attitude which I believe Lachmann to be taking. In a world of ignorance and uncertainty, the virtue of spontaneous order lies not only in promoting uniformity in the coordination of plans, as the neo-Walrasian complete-knowledge model of the state "perfect competition" would suggest, but also in encouraging diversity in the exploration of possible new opportunities.[10]
[1] Gerald P. O'Driscoll, Jr., "Spontaneous Order and the Coordination of Economic Activities," in Louis M. Spadaro, ed., New Directions in Austrian Economics (Kansas City: Sheed, Andrews and McMeel, 1978), pp. 128-34.
[2] Friedrich A. Hayek, The Pure Theory of Capital (Chicago: University of Chicago Press, 1941; Midway Reprint 1975), p. 27 n.2.
[3] Hayek, "Price Expectations, Monetary Disturbances and Malinvestments" in Profits, Interest and Investment (London: George Routledge & Sons, 1939; Augustus M. Kelley Reprint, 1975), pp. 137-41; "Economics and Knowledge" in Individualism and Economic Order (Chicago: University of Chicago Press, 1948; Gateway Edition 1972), pp. 33-56; The Pure Theory of Capital, pp. 14-28.
[4] Ludwig M. Lachmann, "The Role of Expectations in Economics as a Social Science" in Capital, Expectations, and the Market Process (Kansas City: Sheed, Andrews and McMeel, 1977), p. 66.
[5] White, "Entrepreneurship, Imagination and the Question of Equilibration," unpublished ms. presented at the Austrian Economics Seminar at New York University (March, 1976), p. 3. For Kirzner's account of entrepreneurship see Israel M. Kirzner, Competition and Entrepreneurship (Chicago: University of Chicago Press, 1973), esp. pp. 1-19 and 37-43.
[6] Kirzner, "Hayek, Knowledge, and Market Processes," unpublished ms. delivered at the Allied Social Science Association meetings in Dallas, Texas (1975), pp. 28-29.
[7] Ludwig von Mises, Human Action, third revised edition (Chicago: Henry Regnery, 1966), p. 871. For an acknowledgment of the difference between his own emphasis and that of Mises, see Kirzner, Competition and Entrepreneurship, p. 86.
[8] Kirzner, Competition and Entrepreneurship, p. 26.
[9] Hayek, "Economics and Knowledge," p. 53.
[10] See Brian J. Loasby, Choice, Complexity and Ignorance (Cambridge: Cambridge University Press, 1976), pp. 170, 191- 92.
Volume 9, Number 3 (Spring/Summer 1988)Morgan O. Reynolds discusses W. H. Hutt's life work, his contributions to economics, and the legacy he will leave behind.
Volume 1, Number 2 (Spring 1978)Gary G. Short discusses the conference, Issues in Economic Theory: An Evaluation of Current Austrian Perspectives, which occurred on January 7-8, 1978 at New York University.
Jeff Deist discusses how the Fed creates a perilous landscape in which there is no honest pricing—everything has been distorted—even at the consumer level. Deist is the president of the Mises Institute.
Every once in a while, Paul Krugman gives an object lesson in Keynesian economics and his M.O. generally is as follows:
create a caricature of other points of view which is built on faulty assumptions and outright misrepresentations of the real positiondiscredit that phony caricatureclaim victoryIn a recent blog post, Krugman looks at unemployment and its causes, assigns the Austrians to something they don’t believe, and then claims that the Keynesian way is morally and economically superior even though his description of the Keynesian “solution” is to do exactly what he has condemned elsewhere: cutting real wages. To put it another way, it is more of the same. He writes:
So, start with our big problem, which is mass unemployment. Basic supply and demand analysis says that things like that aren’t supposed to happen: prices are supposed to rise or fall to clear markets. So what’s with this apparent massive and persistent excess supply of labor?
In general, market disequilibrium is a sign of prices out of whack; and most people commenting on our mess accept the notion that one or more prices are for some reason not adjusting. The big divide comes over the question of which price is wrong.
Then he jumps on the Austrians:
As I see it, the whole structural/classical/Austrian/supply-side/whatever side of this debate basically believes that the problem lies in the labor market. (I know, the Austrians will deny it — but it doesn’t matter what you say about their position, any comprehensible statement leads to angry claims that you don’t understand their depths.) For some reason, they would argue, wages are too high given the demand for labor. Some of them accept the notion that it’s because of downward nominal wage rigidity; more, I think, believe that workers are being encouraged to hold out for unsustainable wages by moocher-friendly programs like food stamps, unemployment benefits, disability insurance, and whatever.
Actually, this is not the Austrian position at all. Austrians hold that an inflationary boom ultimately runs its course and when the boom collapses, then certain segments of the economy no longer can operate as they did, and one of the effects is for those sectors to shed employees (and in many cases go out of business altogether). In one sense it is true that the sectors have lost “demand” for their goods, but the original demand was based upon an unsustainable injection of credit.
Take the infamous housing boom, for example. The government through the Federal Reserve System, banks, and other agencies directed huge sums of money into the housing sector. In the earlier days of that boom, people could borrow well above their actual equity, pay off their old mortgage, use the new money not only to essentially repurchase or refinance their house but have lots of money left over for which they purchased consumer goods.
The great thing was that the new house payments either were lower (because of lower interest rates) than they had been before, and homeowners could have all sorts of new goods that essentially were “free” to them, or did not increase their monthly payment obligations. It is not hard to see how Americans soon became addicted to that process. (One person whose principal payments had more than doubled told me, “Hey, it’s the American Way.”)
When the refinance boom spread to the game of housing and “house flipping,” Americans became addicted to that way of boosting their wealth, too. Now, sheer logic would tell you that this boom/bubble could not be continued for any length of time — even Krugman and the Austrians agreed on that — and when the end came, the economy was bound to shrink as the malinvestments that had piled up no longer could be financially sustained.
Where Krugman and the Austrians really part company is in how to handle the secondary effects, including unemployment problems that arise as the economy readjusts following the crash. When Austrians note that wages elsewhere are likely to have to fall, they are making that point because a lot of asset prices fall during the immediate and secondary contractions. Austrians believe that the markets should adjust because the quicker the adjustment, the sooner a recovery will begin. Krugman, on the other hand, declares:
What my side of the debate would call for, instead, is a reduction in the real interest rate, if possible, by raising expected inflation; and failing that, more government spending to increase demand and put idle resources to work. (emphasis mine)
Now, Krugman, who also has been agitating for higher minimum wages — that is, bring about real wage increases for the least-skilled workers — also seems to be following the line of the “trick” that Keynes himself recommended: use inflation to cut real wages. I’m using a paraphrase because my copy of the General Theory is in my office at Frostburg, but I believe this is a fair assessment of his position:
Keynes expressed, in numerous passages in The General Theory, the view that wages were “sticky” in terms of money. He noted, for example, that workers and unions tended to fight tooth-and-nail against any attempts by employers to reduce money wages (the actual sum of money workers receive, as opposed to the real purchasing power of these wages, taking account of changes in the cost of living), even by a little bit, in a way they did not fight for increases in wages every time there was a small rise in the cost of living eroding their “real wages.”
The idea was to “cut” real wages via inflation since workers, according to Keynes, were only interested in their “money wages.” Keynes did not argue that such a move would bring back full employment, but he did believe that workers would be less likely to notice that their real purchasing power had eroded.
Now, I believe that the current administration does hold to that viewpoint. Many of us in the workplace have not seen our incomes rise in many years, but the price of nearly everything we purchase has gone up, with some items seeing considerable price increases, including fuel and food. This is no accident; the Obama years have been hard ones for a lot of people, and for blacks, the situation is dire. (I suspect that had a white Republican been in the White House since 2009 and blacks had fared under him as they have fared under Obama, the Republican would be accused of being a racist who was deliberately targeting blacks for unemployment. Obama, on the other hand, gets a free ride.)
The cut-wages-through-inflation strategy is part of Krugman’s heads-I-win-tails-you-lose way of arguing. First he accuses Austrians of believing that all that is needed to restore the economy to full employment is for everyone to get a wage cut, and when Austrians protest such nonsense, he accuses them of trying to be mystics or something similar.
Krugman then attempts to employ a “cure” that cuts real wages as part of restoring full employment all the while claiming it is the Austrians that want others to go hungry. (Paul Krugman always is on the side of humanitarianism, and he is anxious for others to be forced to fund his humanitarian instincts.)
What do Austrians believe about allowing wages and other asset prices to fall? They believe that allowing all prices to return to market levels will hasten the correction and lead more quickly to a situation in which entrepreneurs are able to move assets from lower-valued to higher-valued uses, and strengthening the economy. Out-of-kilter asset prices are only one problem, but they do keep the necessary adjustments from occurring. These prices are the effect of a boom, and they have to settle back to realistic levels following the end of the unsustainable expansion. Rothbard writes:
Since factors must shift from the higher to the lower orders of production, there is inevitable “frictional” unemployment in a depression, but it need not be greater than unemployment attending any other large shift in production. In practice, unemployment will be aggravated by the numerous bankruptcies, and the large errors revealed, but it still need only be temporary. The speedier the adjustment, the more fleeting will the unemployment be. Unemployment will progress beyond the “frictional” stage and become really severe and lasting only if wage rates are kept artificially high and are prevented from falling. If wage rates are kept above the free-market level that clears the demand for and supply of labor, laborers will remain permanently unemployed. The greater the degree of discrepancy, the more severe will the unemployment be.
Rothbard makes it quite clear that out-of-balance wages and other asset prices are the result of the end of the previous boom. They have not caused the downturn; they are the result of the contraction. In other words, Krugman confuses the cause-and-effect process Austrians use by claiming Austrians believe effects actually are the cause of trouble. That is nonsense, but such misrepresentation is a staple of Krugman’s intellectual arsenal.
Krugman, on the other hand, insists that the way to correct the downturn is to create yet another boom. Never mind that the boom that had just collapsed was unsustainable, and that any new credit-fueled boom also will crash down to earth at a future date. However, Krugman apparently wants us to believe that such economic manipulation can go on forever.
But Krugman is not done, declaring:
So how can you tell which side is right? Well, these differing views make differing predictions. If you believe that the problem is excessive wages, you believe that the economy is fundamentally suffering from a supply-side constraint. In that case government borrowing is competing with the private sector for a limited quantity of resources, so big budget deficits should lead to soaring interest rates; meanwhile, because the supply of goods is limited, large increases in the money supply should lead to soaring inflation. Oh, and cuts in government spending should, if anything, be expansionary, because they both release resources to the private sector and make life tougher for workers who try to live on public benefits.
If, on the other hand, you believe that the problem lies in a shortfall of demand due to the zero lower bound, you believe that government borrowing needn’t drive up rates, because it puts unemployed resources to work; that monetary expansion won’t be inflationary, because the money will just sit there; and that fiscal austerity will be strongly contractionary.
Except that is not what Austrians are saying will happen. I’ve not read a single Austrian commentator who was predicting “soaring interest rates” and while some have predicted a lot of inflation, one has to remember what the term “inflation” means to Austrians versus Keynesians.
To a Keynesian, inflation is an increase in the government’s Consumer Price Index and nothing more. It is a statistic, a weighted average of data points that economists have constructed that supposedly would reflect the economic life of Jane and Joe Average. As long as the CPI is not rising by more than a few percent, to a Keynesian there is little or no inflation.
With the CPI not showing much more than a 2 percent annual increase in its official rate of inflation, Krugman can say that what the Obama administration and the Federal Reserve System are doing is good because it has “stimulated” the economy and not resulted in any problems with inflation.
In fact, Krugman looks at the results of the government’s actions and concludes that it is self-evident that the Keynesian viewpoint not only is economically correct, but also morally correct, as Keynesians actively are trying to put people back to work while Austrians want to wait on the slow, unpredictable market to end the misery. The Keynesian model well may be a crude and giant-sized input-output model with one input (aggregate demand) and one output (aggregate supply), but nonetheless it is easy to explain and easy for many to believe.
As Jeffrey Tucker notes in this article, however, the Krugman caricature of Austrian thinking simply is wrong. First, Austrians do not believe that inflation necessarily is measured in a government statistic; it is the increase of money in circulation, period, and the effects of inflation are not always easily captured in the Jane and Joe Average numbers. Instead, we find streams of money following assets such as stocks today. (The current bull market is touted as resulting from President Obama’s economic genius, just as the stock bubble in the late 1990s was attributed to President Clinton’s savvy. George W. Bush bragged about housing during his administration until the whole bubble collapsed.)
Housing prices are higher than they should be and certainly higher than current economic conditions would reflect, and even though corporate profits are high, the stock market has all of the trappings of yet another financial bubble to go along with the financial bubble that the Fed is helping to create in U.S. sovereign debt. In other words, we are seeing the new money take certain paths that are affecting asset values but not necessarily being reflected in overall consumer prices.
The exceptions are those goods tied closely to commodities, including food, fuel, and, yes, precious metals. Furthermore, as I mentioned earlier, most Americans have seen their real incomes drop substantially; they know they are getting poorer, and most people do not believe the U.S. economy rests on a solid foundation. Tucker writes:
… as Mises would predict, what seems like economic progress is not entirely fake but it comes with a rub. Incomes aren’t really increasing, because capital is not being accumulated. Prosperity exists and continues apace, but it has a very weak foundation. It is nothing more than a “castle in the air,” as Mises would say. (In the original German, the word is Luftschloss, meaning a dream that is not realistic.)
Notice that the scenario that Mises maps out here can include such things as the hyperinflation of history and legend, but it need not. Bad money does damage either way. And the damage is long term — not a crisis tomorrow or the next day, but a long-run effect that slowly erodes the foundation of a growing economy.
This is not to say that monetary expansion has no effect upon consumer or producer prices. Indeed, because Austrians hold to a marginal utility view of money (the expansion of the money stock reduces the value of the marginal unit of money, which forces up money prices) the huge expansions of the dollar as pushed by the Fed are going to push prices higher. There has not been a hyperinflation, however, because most of the increased money stock is in accounts such as bank reserves that have not become actual circulating dollars. This is not the same situation as having the government print dollars that directly go to workers, as was the case in Zimbabwe, Bolivia, and even Weimar Germany.
No, the problems in our economy won’t be “solved” with a giant real wage cut either by the market or by fiat or by a burst of inflation, and neither will they be solved by government borrowing, printing, and the Fed purchasing worthless assets in order to try to maintain “confidence” in financial institutions and in governments.
Krugman may ridicule the Austrian paradigm of sound money, savings, and entrepreneurship, but it works and works well. Writes Tucker:
People can live in a house a long time without paying attention to the reality that the foundation that holds up the building is cracked and rotting.
Right now, most Americans sense that something is wrong but are assured by the political classes and a large number of academic economists like Krugman that insist the economic foundations of this house are solid. At the same time, the very people who voice these assurances are taking the jackhammer to the structure all the while insisting that they are building an economy, not tearing it down.
Do you desire to be in a situation to decide between liberty and protection? Do you desire to appreciate the impact of an economic phenomenon? Inquire into its effects upon the abundance or scarcity of commodities, and not upon the rise or fall of prices. Distrust nominal prices; they will only land you in an inextricable labyrinth.Mr. Matthieu de Dombasle, after having shown that protection raises prices, adds:
"The enhancement of prices increases the expense of living, and consequently the price of labor, and each man receives, in the enhanced price of his products, compensation for the higher prices he has been obliged to pay for the things he has occasion to buy. Thus, if everyone pays more as a consumer, everyone receives more as a producer."
It is evident that we could reverse this argument, and say:
"If everyone receives more as a producer, everyone pays more as a consumer."
Now, what does this prove? Nothing but this, that protection displaces wealth uselessly and unjustly. In so far, it simply perpetrates spoliation.
Again, to conclude that this vast apparatus leads to simple compensations, we must stick to the "consequently" of Mr. de Dombasle, and make sure that the price of labor will not fail to rise with the price of the protected products. This is a question of fact that I remit to Mr. Moreau de Jonnes, that he may take the trouble to find out whether the rate of wages advances along with the price of shares in the coal mines of Anzin. For my own part, I do not believe that it does; because, in my opinion, the price of labor, like the price of everything else, is governed by the relation of supply to demand. Now, I am convinced that restriction diminishes the supply of coal, and consequently enhances its price; but I do not see so clearly that it increases the demand for labor, so as to enhance the rate of wages; and that this effect should be produced is all the less likely, because the quantity of labor demanded depends on the available capital. Now, protection may indeed displace capital, and cause its transference from one employment to another, but it can never increase it by a single farthing.
But this question, which is one of the greatest interest and importance, will be examined in another place. I return to the subject of nominal price; and I maintain that it is not one of those absurdities that can be rendered specious by such reasonings as those of Mr. de Dombasle.
Put the case of a nation that is isolated, and possesses a given amount of specie, and that chooses to amuse itself by burning each year one-half of all the commodities that it possesses. I undertake to prove that, according to the theory of Mr. de Dombasle, it will not be less rich.
In fact, in consequence of the fire, all things will be doubled in price, and the inventories of property, made before and after the destruction, will show exactly the same nominal value. But then what will the country in question have lost? If John buys his cloth dearer, he also sells his corn at a higher price; and if Peter loses on his purchase of corn, he retrieves his losses by the sale of his cloth. "Each recovers, in the extra price of his products, the extra expense of living he has been put to; and if everybody pays as a consumer, everybody receives a corresponding amount as a producer."
All this is a jingling quibble, and not science. The truth, in plain terms, is this: that men consume cloth and corn by fire or by using them, and that the effect is the same as regards money, but not as regards wealth, for it is precisely in the use of commodities that wealth or material prosperity consists.
In the same way, restriction, while diminishing the abundance of things, may raise their price to such an extent that each party shall be, pecuniarily speaking, as rich as before. But to set down in an inventory three measures of corn at 20s., or four measures at 15s., because the result is still 60s. — would this, I ask, come to the same thing with reference to the satisfaction of men's wants?
It is to this, the consumer's point of view, that I shall never cease to recall the protectionists, for this is the end and design of all our efforts, and the solution of all problems. I shall never cease to say to them: Is it, or is it not, true that restriction by impeding exchanges, by limiting the division of labor, by forcing labor to connect itself with difficulties of climate and situation, diminishes ultimately the quantity of commodities produced by a determinate amount of efforts? And what does this signify, it will be said, if the smaller quantity produced under the regime of protection has the same nominal value as that produced under the regime of liberty? The answer is obvious. Man does not live upon nominal values, but upon real products, and the more products there are, whatever be their price, the richer he is.
In writing what precedes, I never expected to meet with an anti-economist who was enough of a logician to admit, in so many words, that the wealth of nations depends on the value of things, apart from the consideration of their abundance. But here is what I find in the work of Mr. de Saint-Chamans (p. 210):
If fifteen million worth of commodities, sold to foreigners, are taken from the total production, estimated at fifty millions, the thirty-five million worth of commodities remaining, not being sufficient to meet the ordinary demand, will increase in price, and rise to the value of fifty millions. In that case the revenue of the country will represent a value of fifteen million additional.… There would then be an increase of the wealth of the country to the extent of fifteen million, exactly the amount of specie imported.
This is a pleasant view of the matter! If a nation produces in one year, from its agriculture and commerce, a value of 50 million it has only to sell a quarter of it to the foreigner to be a quarter richer! Then if it sells the half, it will be one-half richer! And if it should sell the whole, to its last tuft of wool and its last grain of wheat, it would bring up its revenue to 100 million. What a way of getting rich, by producing infinite dearness by absolute scarcity!
Again, would you judge of the two doctrines? Submit them to the test of exaggeration.
According to the doctrine of Mr. de Saint-Chamans, the French would be quite as rich — that is to say, quite as well supplied with all things — had they only a thousandth part of their annual products, because they would be worth a thousand times more.
According to our doctrine, the French would be infinitely rich if their annual products were infinitely abundant, and consequently, without any value at all.
Included in The Bastiat Collection (2011), this article appeared in Economic Sophisms (1845).
[Understanding the Dollar Crisis (1973)]
There was once a Russian school child whose cat had a family of kittens. When asked to write a paper for her class, the child wrote about the mother cat and the kittens. The next day she read her paper to the class. In it she told about how these kittens were born. There were five of them and they were all good little Communists. The teacher liked the paper, and when, a week later, one of the Moscow inspectors visited the school, the teacher, proud of her pupil, asked the child to read it again. The child read the paper. When she came to the part about the kittens she said there were five kittens and two of them were Communists. The teacher was quite surprised. The child had previously said all five were Communists; so the teacher asked the child why she had changed it. "Well," the little girl said, "three of them have opened their eyes."
One of the things we are trying to do in these lectures presented by the Centro de Estudios sobre la Libertad is to open the eyes of people who have heard so much about the promises of socialists and government interventionists to use political power to improve the economic situation of the poor, the sick, the young, the aged, and all others with whom they seek popularity. Actually, the only way for governments to improve the economic condition of their citizens is to provide equal protection of life, property, and the marketplace for everyone, while peacefully adjudicating disputes which might otherwise lead to frictions and infractions of the peace. Using the force of government to take from some to provide special privileges for favored groups will never improve the general welfare. Governments that play favorites sow the seeds of their own destruction and reduce the production of both the poor and the rich.
For each of us, life is a problem of how to use our limited means to produce more of the things that provide us and our loved ones with the greatest possible satisfaction. We daily strive to satisfy our most important wants before we try to satisfy those we consider less important. In short, we constantly seek to improve our situation by exchanging something we have for something we prefer. The prime function of government is to provide an atmosphere in which more and more mutually beneficial exchanges can take place.
Division of LaborAs individuals we cannot produce all the things we want. So we tend to specialize, and produce things that other people want. We then exchange the products of our efforts in the marketplace for the things that we want. This involves what economists call the division of labor.
In his great book, The Wealth of Nations, Adam Smith, the founder of English classical economics, tells how we can all have more if we specialize and trade. As mentioned in our previous lectures, it is our value scales that direct us in making our choices of how to use our limited means to attain more of the things we want most.
If man finds it easier to get what he wants by specializing his contributions and trading his specialties with those who produce what he wants, he will do so. He will take the easiest way he knows to improve his situation. Consequently, civilized men have resorted to specialization in production and the subsequent trading of the specialties they have produced. Such trading necessitates the use of a medium of exchange, or money. In our fifth lecture, we shall be dealing with that very serious part of the market problem. But it is money prices that we are talking about now. Most people are confused about prices. They seem to think that prices are set by producers and sellers, that they add up their costs and then add something more for their profit. This is how most people think prices are set.
Actually, the successful businessman looks for something that the people want, something he thinks he can produce for less than people will pay for it. So in the final analysis it is the values businessmen believe people have in their minds that determine what goods they will make, and how much they will make of each particular scarce good.
This question of what to make is one of the important problems that the socialists neglect. Marx thought there was no such problem. So did Lenin. They thought the only businessmen you needed were bookkeepers to keep the accounts. Nobody had to decide what needed to be produced. This was supposedly evident to everyone. The masses needed more food, more clothing, and more housing. For Marx and other socialists, the choice of what to make was no problem at all.
But this, of course, is not so. We cannot make everything people want. The most important decisions in this world are those that determine what should be made and what should not be made. These decisions seek to determine what things give the greatest human satisfactions, so that our scarce means of production are not wasted making things that people do not want as much as other things that could have been made with the available supplies of labor and raw materials.
In a market society, individual subjective values allocate the available supply of every scarce good so as to satisfy human wants in the descending order of their importance, whereby the particular want last satisfied is the one with the marginal utility. From beginning to end, price, and thus economic calculation, is the product of subjective valuations. Price is the result of the reciprocal impact of the subjective values placed on the good and on money by all interested parties. The resulting market prices must benefit all who exchange.
As we have said before, but should never forget, all life is a series of choices whereby we try to exchange something we have for something else that we prefer. The fewer the obstacles placed in our way in the form of higher costs, taxes, or other governmental interventions, the more exchanges we can make for the mutual advantage of all the participants.
The Economic ProblemWe are constantly faced with the economic problem. The economic problem is, of course, the problem of human beings, the problem of life. This problem is how to employ our available means in such a way that no important want is left unsatisfied because the means for attaining it were used to satisfy a less important want. Such a misuse of scarce means would provide less human satisfaction. It would be wasting valuable wealth. Acting man wants to know how to use what he has to provide the greatest attainable human satisfactions. This is the problem that concerns all of us. This is the problem that the market solves.
In trying to get what we want, we are directed by our ideologies. Ideologies are our ideas about how we think society operates. Sometimes we are influenced directly by an ideology. If we believe certain actions will produce the results we want, we take those actions. Ideas, as we stressed in the first lecture, are very important. But sometimes in our social activities, an ideology influences us indirectly. We follow certain procedures which by themselves we do not consider very helpful, because we do not want to offend those around us. We go along with certain widely held myths, certain popular prejudices, or certain accepted folkways, rather than take the actions we consider most efficient. We do this because we have to live with our fellow men and cannot always do things that we ourselves might consider best.
For a good to have value it must assure the satisfaction of a need or want of some human being. Thus, if that good did not exist, there would be some human want that would have to go unsatisfied. Every loss of an economic good means that there is one less human satisfaction attained. Goods can have a direct value, that is a use value, to us. Or they can have an indirect value, that is an exchange value, which means they have a use value to someone else. In that case, we can exchange them for something which has a use value to us.
In the marketplace it is the use value or the exchange value, whichever is greater, that determines our choice of actions. When we see something that is more valuable to us than its market price, we buy. When we have something that is more valuable in the market than it is to us, we sell. We do not trade for the fun of it. Otherwise we might trade back and forth all day long. We consider every exchange, every transaction, beforehand, and we continue exchanging up to the point or limit beyond which we do not expect to gain any further.
Trade Increases WealthSince all men are eager to satisfy their more important wants, those which are higher on their value scales, before they satisfy their less important wants, those which are lower on their value scales, they trade whenever they can find anyone who has opposite or contrary views on the relative values of two goods or services. By an exchange transaction, each good or service moves to that person who places the higher value on it. The wealth of each party is thus increased. They have both gotten a psychic profit, that is, a gain that they themselves consider a profit. This psychic profit cannot be measured, but it is a very real increase in satisfaction in the minds of the parties participating in the exchange. Market exchanges are not equal exchanges. They are unequal exchanges, from which both parties expect to gain.
So trade is productive of value. In a market economy goods are constantly moving from those who place a lower value on them to those who place a higher value on them. This is a fact of economic life that is not taken into consideration by mathematical economists. They seem to think that economic goods have a certain fixed value, usually based on the cost of production. They calculate this value as an unchanging fact, not realizing that when a good shifts from one person or place to another its value has been increased. The physical goods have greater value when they are owned by people for whom they can provide greater satisfaction.
It is the unequalness of the use and exchange values of different people that leads to exchange. These differences cannot be measured, only compared. They are in the mind. They are psychic. It is always a matter of greater or less. If the value of what you expect to receive is not greater for you than the value of what you will have to give up, then there is no trade. The differing use and exchange values of different individuals result in the emergence of prices — market prices. There are no other kinds of prices, only market prices.
Most scarce goods have many uses, or a use value for many people. The economic problem is to allocate them so as to give more human satisfaction to all concerned. Voluntary exchange is the only possible way in which all can benefit. It is the only system that allocates each scarce item to that use or person where it has the highest relative value. It is the only system that tends to minimize waste and maximize human satisfaction.
How Men Act in the MarketIn life we are faced with two questions as we go to the marketplace. These questions are whether or not to exchange, and if so, on what terms. The answers can be simple. There are three rules or postulates for answering these questions:
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Man will exchange only if he can exchange for an advantage.
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Man will exchange for a greater advantage, in preference to an exchange for a lesser advantage. If you can buy something for 250 pesos, you are not going to pay 275 pesos. You will always take that price which gives you the greatest advantage. Of course, sometimes it is not merely a matter of money. It may be primarily a matter of convenience. You may pay a slightly higher price for something in your neighborhood rather than take the time to go downtown, where you might get it for a few pesos less. Or you might pay a little more to a person or group you wanted to help, considering the difference a charitable contribution.
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Man will exchange for a small advantage in preference to not exchanging at all.
These three rules or postulates provide all the answers we need to solve the problems we face in the marketplace. Can you get an advantage? You can. Okay, you exchange. If you can get a greater advantage, you take it in preference to a lesser one, but you will take a small advantage in preference to no advantage at all. You are trying to improve your situation as best you can from your point of view.
Now here are a number of rather simple problems to show how prices evolve and how our value scales contribute to their emergence. Here we are going to assume that you have a use value for several objects you do not own, and that this value scale is:
1st — A
2nd — B
3rd — C
4th — D
Then you learn that you can exchange a "D" for an "A." This is new information, information you did not have when you had this original value scale. This new information changes your value scale and it becomes now:
1st — A
2nd — D
3rd — B
4th — C
5th .….… a second D
A "D" has gone up to second place, not because of its use value but because of its exchange value. You can exchange it for an "A." The fact that you have to take the trouble to exchange it to get the "A" places it below the "A." The second "D" would be valued for the use value of a "D."
So your value scales change as you get new information. You find out that you can buy something cheaper at another place, or you find that something unexpected has happened, or you learn that something new has been invented. You then have a new situation and it calls for a new value scale.
Simple BarterTable 5 presents a slightly more complicated, but still very simple, situation. These problems illustrate the principles that determine how prices are formed and how they are constantly being changed. We start here with an assumption that Smith has four horses. They appear in the first column. In the second column we have his value scales for horses and cows. If he had only four animals he would prefer first a horse, second a cow, third a second horse, and fourth a second cow.
Señor Black, in the third column, has four cows, and his value scale for horses and cows, in the last column, is in this order: first he would like a cow, second a horse, third a second cow, and fourth a second horse.
These two men meet. What happens? One owns four horses. The other owns four cows. When they come together, they soon find out that Smith will gladly trade his fourth horse for a cow. And Black will gladly trade his fourth cow for a horse. They make the exchange. They have both improved their holdings of these two kinds of animals.
In fact, they will go further, in a second step — Step B. Smith will gladly trade his third horse for a second cow, while Black will gladly trade his third cow for a second horse.
Table 5. SIMPLE BARTERMr. SMITH Mr. BLACKhas 4horses:his valuescale forhorses &cows: has 4cows:his valuescale forhorses &cows:1st H1st H 1st C1st C2nd H2nd C 2nd C2nd H3rd H3rd H 3rd C3rd C4th H4th C 4th C4th HSTEP A: Smith will gladly trade 4th horse for a cow.Black will gladly trade 4th cow for a horse.
STEP B: Smith will gladly trade 3rd horse for a 2nd cow.Black will gladly trade 3rd cow for a 2nd horse.
STEP C: No further trades of mutual advantage possible.
Then, they both have improved their situations and satisfied their value scales so far as this problem goes. Under these assumptions, no further trades are possible, because there is no advantage to be gained from any other transaction. They have each satisfied their value scales. If their value scales changed, you would have another problem, another situation. So much for that.
Satisfying a Value ScaleNow we go into another more complicated problem, shown in table 6. We assume here that Smith has six horses and Black six cows. In the column on the left we assume that they both have the same value scales. First they would like a horse, second a second horse, third a first cow, fourth a second cow, fifth a third horse, sixth a fourth horse, and down on to the bottom of the column, as you can see.
These two gentlemen come together. What happens? Now looking at these value scales we find that, in the existing situation, Smith has his 1st, 2nd, 5th, 6th, 7th, and 8th preferences, while Black has his 3rd, 4th, 9th, 10th, 11th, and 12th preferences. Under those circumstances, these two gentlemen meet. What happens?
Table 6. MORE COMPLEX BARTERValue Scaleof bothMr. Smith (S) has 6 horses (H)Mr. Black (B) has 6 cows (C)1st1st HS has his 1st, 2nd, 5th, 6th, 7th and 8th preferences;2nd2nd HB has his 3rd, 4th, 9th, 10th, 11th and 12th.3rd1st C Smith trades 6th H for Black's 6th C.4th2nd C 5th3rd HThen Smith has 5 horses and 1 cow:6th4th Hhis 1st, 2nd, 3rd, 5th, 6th and 7th preferences. Black has 5 cows and 1 horse:7th5th Hhis 1st, 3rd, 4th, 9th, 10th and 11th preferences.8th6th HSmith trades 5th H for Black's 5th C.9th3rd C 10th4th CThen Smith has 4 horses and 2 cows:his 1st, 2nd, 3rd, 4th, 5th and 6th preferences.Black has 4 cows and 2 horses:his 1st, 2nd, 3rd, 4th, 9th and 10th preferences.11th5th C12th6th CSmith would not gain, so no further trades with this value scale.
If the 5th preference on the value scale were a cow, one more trade would give each his first 6 preferences.
They certainly will be happy to make an exchange. So Smith trades his sixth horse for Black's sixth cow. Then we have a situation in which Smith has five horses and one cow. Now he has advanced his situation to the point that he has his 1st, 2nd, and 3rd (thanks to the trade), as well as his 5th, 6th, and 7th preferences. He has given up his eighth preference to obtain his third preference. He has improved his situation by getting the third item on his value scale in exchange for one that was lower down, in eighth place.
On the other hand, Black now has five cows and one horse. He has gotten his first preference and continues to have his 3rd, 4th, 9th, 10th, and 11th preferences. He has exchanged his 12th preference for his first preference. He, too, has certainly improved his situation from his own point of view.
Under these given conditions, it is also profitable for both of them to make another trade. Smith gladly trades his fifth horse for Black's fifth cow. Then Smith has four horses and two cows. He now has his 1st, 2nd, 3rd, 4th, 5th, and 6th preferences. He has exchanged his 7th preference for his 4th preference. He now has all of his first six preferences. He cannot improve his satisfaction with only six animals.
On the other hand, Black has four cows and two horses. He has his 1st, 2nd, 3rd, 4th, 9th, and 10th preferences. He has exchanged his 11th preference for his 2nd preference. He has his first four preferences, but he does not have his 5th, 6th, 7th, or 8th preferences. He would like to improve his situation further, but in the market you cannot improve your situation, you cannot have a transaction, unless both parties expect to gain. Since Smith could not gain from another trade, there will be no further trades with this value scale. Under these assumptions we have reached the end of the trading.
However, if the 5th or 6th preference on this value scale shifts to a cow, one more trade would give each of them their first six preferences. So this shows that as Value scales change, the possible trades change. Value scales affect everything that can occur in the marketplace. Each person tends to trade up to the point beyond which he cannot gain any more. But he has to find somebody else who will also gain, or there will be no transaction.
We have been talking about barter, the exchange of goods for goods. In a market economy we usually exchange goods for money or vice versa. Now we want to consider exchanges with the use of money, getting into what we call prices. A price can be defined as a quantity of money.
A Böhm-Bawerk ContributionMuch of the material for this lecture has been adapted from the works of Böhm-Bawerk. He was not only one of the greatest economists ever, but he was also a teacher of my great teacher, Mises. Böhm-Bawerk found it useful to compare the formation of prices to the breaking of waves and surf on the sea coast. Both are complex phenomena that seem to be completely "without rule or regularity," yet they are both subject to the strict operation of immutable laws.
When waves break on a rockbound coast, the path every drop of water follows may seem haphazard, but, given the essential data, the laws of physics can explain where every particle goes. Given the force of each wave, given the exact shape and resilience of the coast, and given the velocity and the direction of each gust of wind, there could only be one possible result. The laws of physics could then tell us where every drop of water must fall.
Likewise in economics, if we could know the ever-shifting value scales of every individual, and the available supplies of goods and services in the marketplace, then economic laws, the laws of human action, could tell us where every price would have to fall. Of course, in real life we cannot know the ever-changing value scales of all people. We can find them out in part, but only by reference to market exchanges.
When you go into a store, you do not usually tell the shopkeeper how much you might be willing to pay for a desired good. You try to find out the lowest price for which you can buy it. So when we participate in market transactions we seldom reveal how high we might go for the goods on our value scale. Therefore these values are seldom evident. But value scales determine all actions in the marketplace.
In developing man's understanding of economics, the British classical economists reduced everything to supply and demand. They took supply and demand as given. When they talked about supply and demand, they advocated that the businessman should strive to buy low and sell high. That is good business. But they did not go back to what creates supply and demand. This is a contribution of the Austrian School of economics.
Consumers Determine PricesAs I mentioned in my first lecture, science traces cause and effect by going back and back and back until one cannot go back any further. The Austrian economists demonstrated that you can go back behind supply and demand, and find out what it is that leads to both of them. Demand is determined by the value scales of consumers, while supply is determined by businessmen seeking to foresee, as accurately as they can, the future value scales of consumers. In the end, it is the value scales of consumers that determine both demand and supply and thus the prices of all goods and services sold in the marketplace.
Supply and demand are vague shibboleths that do not provide enough information. The central factor that explains price is found entirely in the subjective values of men. Market competition forces the pricing process into a zone between the subjective values of the border or marginal pairs, where the quantity offered for sale exactly equals the quantity there is a desire to buy at the market price. At that price, supply and demand are bound to be equal. You cannot buy more than are sold, but the price has to be one that benefits all who buy or sell.
Isolated ExchangeNow I'm going to present a few problems using money. You will pardon me if I use dollars here. It makes little difference which monetary unit is used. The first is a case of isolated exchange. (See table 7.) There are just two men involved. Farmer Brown needs a horse. A horse is worth more to him than $300 — that is, he will pay for a horse up to, but not more than, $300. If he has to pay more, it will not be worthwhile for him to buy it. Neighbor Smith has a horse with a use value to him of only $100.
These two men meet. What happens? Naturally it is to the advantage of both of them to make an exchange. We posed the essential questions earlier: whether or not they should exchange, and if so, at what terms. We have determined that these men should exchange. The question then becomes, at what price will the horse be sold.
Given this situation, will they trade? If so, at what terms? Every price from $100 to $300 is possible. The actual price within that range will depend upon the bargaining abilities of the two men. But a price below $100 is impossible. Smith would not sell for less, because the horse is worth that much to him. At a lower price he would use the horse rather than sell it. A price over $300 would not lead to a transaction because the horse is not worth sufficiently more than $300 for Farmer Brown to pay the higher price. So the price must fall between $100 and $300.
There is a rule that applies. It is not my opinion. It is not what I think it should be. It is a fact. It is an economic law. It is how men operate. The rule is that the price must fall between the buyer's subjective value and the seller's subjective value. Any other price is impossible. This seems simple and I hope it is understood. The price must benefit both parties.
Table 7ISOLATED EXCHANGE
Farmer Brown needs a horse. A horse is worth more than $300 to him, but not enough more for him to pay more than $300.
Neighbor Smith has a horse with a use value to him of $100.
Will they trade? If so, at what terms?
Every price between $100 and $300 is possible. The actual price, within that range, will depend on the bargaining abilities of the two men.
RULE: The price must be between the buyer's Subjective Value and the seller's Subjective Value.
One-Sided Competition among BuyersWe move on to a little bit more complicated problem. We take now an example of one-sided competition among buyers. And the question is: Who will buy and within what price range? (See table 8.) Smith has a horse, as before, with a use value to him of $100. As before, a horse is worth more than $300 to Brown. But this time we also have a Mr. Carey for whom a horse is worth just a bit over $200. Who buys Smith's horse? And what will be the price range?
Given this situation, Brown will buy at a price between $200 and $300. Any other price is unthinkable. If the price were below $200, Brown would have competition from Carey. If the price were over $300 the horse would not be worth it to him. So the only sale that can take place, given these assumptions, is between the prices of $200 and $300.
Table 8ONE — SIDED COMPETITION AMONG BUYERS
QUESTION: Who will buy and within what price range?
ASSUME: Smith has a horse with a use value to him of $ 100.
A horse is worth just over $300 to Brown.
A horse is worth just over $200 to Carey.
Brown will buy at a price between $200 and $300.
ASSUME FURTHER: A horse is worth more than $260 to Dell.
Brown will buy between $260 and $300.
ASSUME FURTHER: A horse is worth more than $320 to Ely.
Ely will buy at a price between $300 and $320.
RULE: The potential buyer who places the highest value on the good gets it at a price below his own valuation and above the highest value of all his competitors.
Now assume another man, Señor Dell, comes along. He wants to buy a horse, and a horse is worth more than $260 to him. What does this do to the situation? Who will buy the horse, and what price will he pay?
Mr. Brown will buy the horse, but he will have to pay more than $200 under these circumstances. He will have to outbid Mr. Dell. He will have to pay a higher price than $260, but of course he will still not pay more than $300.
Now assume further that another gentleman, Mr. Ely, comes along. For him a horse is worth more than $320. Now what happens? What is the answer to the question of who will buy and within what price range? It should be obvious by now that Mr. Ely will buy the horse. What price will he pay? He has to outbid our friend Mr. Brown. So he will have to pay more than $300, but he will not pay more than $320.
Now, these are not my opinions. This is not how I say it should be. But this is how men act. They try to get what they want at the best price they can, and they do not pay more than the good is worth to them. The rule for this type of exchange is that the potential buyer who places the highest value on the good gets it at a price below his own valuation and above the highest value placed on the good by any of his competitors.
What we are saying is simply that the market allocates scarce goods to those who place the highest values on them, to those prepared to make the greatest sacrifice to attain them. Here we have had competition on one side, competition among multiple buyers for one horse.
One-Sided Competition among SellersNow, we move to the very opposite situation, one-sided competition among sellers. (See table 9.) There is one buyer and there are many potential sellers. The question here is, who will sell and within what price range? Potential buyer Brown places a subjective use value of $300 on a horse. Potential seller Fort places a subjective value of $140 on his horse, while Green places a subjective use value of $200 on his, and another potential seller, Mr. Hall, has a subjective use value of $250 for his horse. Who will sell the horse to Mr. Brown, and within what price range?
It should now become obvious that it is not a question of my opinion. Every one of us should come to the same conclusion, because this is a matter of how all men act. It is an application of economic law.
Mr. Brown will buy the horse as cheaply as he can. He will not pay $200 if he can get a horse for less than $200. So, based on these assumptions, he will pay less than Mr. Green is asking. Mr. Fort will sell his horse to Mr. Brown at a price between $140 and $200. Any other price is unthinkable.
Moving on, we assume further that another gentleman, a Mr. Jate, wants to sell a horse. He places a subjective value of $180 on his horse. What does this do to the situation? It reduces the price that Mr. Fort will be able to ask. He will still sell his horse to Mr. Brown. But now it will NOT be between $140 and $200, but, according to his bargaining ability, between $140 and $180.
Table 9ONE-SIDED COMPETITION AMONG SELLERS
QUESTION: Who will sell and within what price range?
ASSUME: Potential Buyer Brown places a subjective value (S/V) of $300 on a horse.
Potential Seller Fort with a Subjective Value of $140.
Potential Seller Green with a Subjective Value of $200.
Potential Seller Hall with a Subjective Value of $250.
Fort will sell at a price between $140 and $200.
ASSUME FURTHER: Potential Seller Jate with a S/V of $180.
Fort will sell at a price between $140 and $180.
ASSUME FURTHER: Potential Seller Korn with a S/V of $120.
Korn will sell at a price between $120 and $140.
RULE: The potential seller who places the lowest subjective value on the good sells it at a price above his own valuation and below the lowest subjective value of all his competitors.
We assume another gentleman comes along, a seller, Mr. Korn, who places a subjective use value of $120 on his horse. Applying the same reasoning, Mr. Brown wants a horse, which is worth more than $300 to him, but he still doesn't want to pay any more than he has to. He puts these men into competition bidding against each other. The bidding goes down below the previous high price of $180. Mr. Brown can now buy a horse at a price between $120 and $140.
The rule here is that the potential seller who places the lowest subjective value on the good sells it at a price above his own subjective valuation and below the lowest subjective value placed on the good by any of his competitors. And so a horse moves from the potential seller who places the lowest value on a horse to the man who places the highest value on one. That is how the market works.
These problems have been relatively simple. The value of money is a factor in all of these. This too is not constant. The value of money is always shifting. As the values of horses and money shift, the value scales of people shift. They get different ideas about what is to their advantage. But they only trade when they expect to gain. In these examples we have assumed that their value judgments remain constant until the transactions are completed. The prices that resulted were formed under the impact of the entire quantity of horses on the value scales of all present at the market. All the competing suppliers and buyers had a chance to act to improve their situation according to their value scales as the market conditions permitted. Competition forced every successful buyer and seller to set his price with full regard to the relative subjective values of all concerned.
Bilateral CompetitionNow we come to an example of bilateral competition, as I call it. (See table 10.) This is a more complex situation, in which there is competition between both multiple buyers and multiple sellers for a limited quantity of goods, in this case, 13 taxi cabs.
Table 10. BILATERAL COMPETITION(Problem posed)
Assumed subjective valuation of similar taxis
Owners of 13 taxis Potential BuyersAce's1st$4,000 Law's3rd$2,750Bag's1st3,800 Moon's2nd2,920Cod's1st3,750 Nid's2nd3,080 Ace's2nd3,600 Law's2nd3,130Dove's1st3,500 Ott's1st3,400Eby's1st3,450 Pry's2nd3,550 Bag's2nd3,380 Moon's1st3,680Ace's3rd3,360 Law's1st3,780Fork's1st3,330 Pry's1st4,100 Gay's1st3,250 Nid's1st4,250Ace's4th3,050 Bag's3rd2,800 Dove's2nd2,600 Part 1 — How many sold? Within what price range?
Part 2 — Assume (a) sales tax of $50; (b) 10% tax.
In the column on the left-hand side are the owners of 13 taxicabs or taxis. Seven men own these 13 taxis; four of them are owned by Mr. Ace. In the next column we have the assumed subjective values these owners place on their taxis, that is, the figures below which they would not sell the taxis. If they can get a higher price for any one of the taxis than the figure shown in this column, they will sell that cab. On the right-hand side, we have some potential buyers and the highest prices they would pay, the subjective valuations they place on owning a taxicab. If they can get taxicabs for these figures, they will buy. If they cannot, they will not buy.
There are 13 cabs. We shall assume they are identical cabs with no material differences that need to be taken into account. The potential buyers and potential sellers all come together at one time and place. There are potential bidders here, ten, I believe. The questions are: How many of the cabs will be sold? How many will not be sold? And within what price range will the sales be made?
The answer is rather simple. There are many ways you can go about getting it. You can be quite complex and start the bidding low. Of course, no one will offer to sell a taxi for $2,600. If Mr. Dove tries to get, say, $2,700 for his second one, he will have every one of these ten potential buyers bidding for it. They are not going to let it be sold for $2,700. They are going to bid it up. As they bid it up, Mr. Bag comes in when it gets to a price above $2,800. Before then, Mr. Law's demand has dropped out. As the bidding goes higher, other cabs become available, and other potential cab buyers drop out. This goes on until you get into a price range where the number of cabs offered for sale and the number of potential buyers who will buy become equal.
Or you can start with the top. Mr. Ace would be glad to sell his top cab for $4,150 to Mr. Nid. But he is not going to get $4,150 because Mr. Nid is not going to pay $4,150, when all these other cab owners are competing to sell one for less. Competitive bidding will bring the price down, making fewer cars available for sale as it drops below the points in the left-hand column. At the same time, competition will increase the number of the potential buyers as it drops below points in the right-hand column. This will go on until the price reaches the price range where again the number offered for sale equals the number potential buyers will buy.
In this marketplace, we assume all these cabs are similar. There are no known differences, no dents in the fenders as in real life. There will be one price at which the owners will exchange all the cabs that are exchanged. The question is: How many will be exchanged and at what price? The answer is simple.
The best and easiest way to find the answer is to apply what I have already said about the market. This is the fact that the market allocates all scarce goods to those who place the highest values on them. You have 13 taxicabs. You have 23 desires for the taxicabs. Who ends up with the taxicabs? Those who place the 13 highest values on them.
So all you have to do is to find out quickly which are the 13 highest values. The answer to this problem is that six taxicabs will be sold, and the price will be between $3,360 and $3,380. All three methods reach the same result. No other answer or price is thinkable. (See table 11.)
At a lower price, Mr. Ace would not sell his third cab. At a higher price, Mr. Bag would try to sell his second cab. There would be seven potential sellers, but there would not be seven potential buyers. There would thus not be equality between the number offered for sale and the number that would be bought. The bidding would go on until that number was equal, because would-be sellers can never sell more than potential buyers will buy.
Table 11.So the subjective values of the market participants limit the price range, and the market allocates the scarce taxis to those who place the highest values on them. The 13 who place the highest values on them are those above the line on the left side and those below the line on the right side. When the transactions are completed, these parties are the ones who are going to own cabs. Given this assumed state of the market, the people on the left below the line do not value cabs enough to keep them, while the people on the right above the line do not value cabs enough to buy them.
If there were a 14th cab, one more desire for a cab could be satisfied. If there were 15 cabs, two more desires could be satisfied. But the reality of life on this earth is that there is a scarcity of the things men want, and the economic problem is to decide who gets these scarce goods and who must go without.
Law of PriceIn the market economy, this decision as to who gets the limited number of taxicabs, who goes without, and what the price will be, is determined by the Law of Price. The Law of Price is not opinion. It is not what I think it should be. Nor is it a law I would like the government to pass. It describes how men act, in a market situation, each man trying to improve his situation as best he can from his point of view. It is, however, just as immutable as any law of physics.
Under bilateral competition, market prices must fall within a range between upper and lower limits that are determined by the available supply and the subjective values of the interested parties. The upper limit is set by the subjective valuations of the lowest successful bidder and the lowest excluded potential seller, whichever is lower. The lower limit is set by the subjective valuations of the highest successful offerer and the highest excluded potential buyer, whichever is higher.
Prices are determined by the subjective valuations of the two marginal pairs, and must fall within the range between the middle two of these four valuations. Valuations above and below these middle two marginal pair valuations have no effect on the market price.
Now let us look at table 11 again and run through this Law of Price with the figures before us. According to the Law of Price, under bilateral competition, market prices must fall within a range between an upper limit and a lower limit. The upper limit is set by the lower of the pair with the X in the squares. Of those two, the lower one is the $3,380 figure. That is the upper limit.
The lower limit is set by the higher of the pair with the X in the circles. In this case, the higher is the $3,360. So the price has to fall between these middle two, $3,360 and $3,380.
At any other price, there would not be equal numbers willing to buy and willing to sell. This is not my opinion. It is how all men act. They will not buy unless they expect to improve their situation by getting something they value higher than they value the sum of money they pay for it. They will not sell unless they value the money received higher than they value the good they offer for sale. Every participant expects to gain from every transaction, and there must be a buyer for each unit sold. Likewise, men will not pay more than market conditions demand; nor will they sell for less than competitive market conditions compel potential buyers to pay.
Effect of TaxesNow we shall try to show what happens when the government places a tax on the transaction. First we shall assume a sales tax of $50 on every sale of a taxicab. That means you have to add $50 to the subjective value each potential seller places on his taxicab. He will have to get at least that much before he improves his situation by selling. What happens with this problem?
Under the assumed conditions, only five cabs would be sold, and the price would be in the range from $3,350 to $3,360. With the tax included, this price range would be from $3,400 to $3,410. (See table 12.)
Table 12. BILATERAL COMPETITION(Second part of problem answered)
Effect of Taxes
Assume sales tax added to sales price of each taxi in table 11.
If a flat rate of $50 per taxi: If a 10% sales tax rate:5 taxis will be sold at aprice of $3,350–3,360;with tax included,$3,400–3,410.
4 taxis will be sold at$3,250–3,330;with tax included,$3,575–3,663.
If the tax were 10 percent of the sales price, only four cabs would be sold, and the price range, with the tax included, would be between $3,575 and $3,663.
Now we have seen what would happen to the price. It goes up. We have also seen what would happen to the number of transactions. Fewer cabs are sold. This means that under the first assumption, the $50 tax, one taxicab has to remain with a man who places a lower value on it than another man, a potential buyer, does. Because of the tax, the taxicab cannot be transferred to the potential buyer who places a higher value on it, but for whom it is not worth the extra $50 he must now pay.
When the tax goes up as high as 10 percent of the sales price, two taxicabs have to remain with men who place a lower value on them than would be the case in a market where the taxes did not exist. So sales taxes stand in the way of transactions that would increase the satisfactions of both potential buyers and potential sellers.
Of course, those taxes might be necessary for the market to operate. In that case they are a necessary cost of doing business. But when they are just an interference with the market, or a tax to provide a subsidy for some privileged group, rather than an expense for the equal protection of all, they must diminish the satisfactions of the people operating in the marketplace. Every transaction prevented reduces the satisfaction of a potential buyer and a potential seller. In addition, it results in a rearrangement of market conditions in a manner that must reduce the highest potential satisfaction of human beings.
This is how prices come about. They emerge from the concatenation of the subjective values of all the people participating in the marketplace, each one trying to improve his situation as best he can from his own point of view. Except for the valuations of the middle marginal pair, changes in the valuations of the other parties have no influence, as long as they do not cross the price range of the middle marginal pair. If one of the potential buyers below the line was willing to pay up to $10,000 for a cab, it would have absolutely no influence on this particular situation, because he will not in fact pay more than he needs to pay, that is, the market price.
Remember that price must benefit all who trade. You do not trade unless you expect to benefit. Price must also allocate the available units to those who place the highest value on them. And every interference with free-market prices is an interference that must diminish the human satisfaction of moral persons. It leaves things where they are worth less than they would have been worth if the market had been free to transfer them to those placing the highest value on them.
The same is true of laws that do not directly affect price, but do directly affect what you can trade, the hours during which you can trade, or where you can trade. All such laws reduce transactions and must therefore reduce human satisfactions.
Economic CalculationWe have been talking about consumers' goods, or things that people seek for their own use satisfactions. Let us go into the more complicated part of the market — producers' goods, or goods that are eventually used to make consumers' goods. When valuing producers' or capital goods, men transfer values of consumers' goods to their factors of production, that is, to the various things that are needed to make the consumer goods. It is thus the market value of consumers' goods that determines the value of labor, machines, and raw materials. For this, economic calculation is necessary.
Under socialism, economic calculation is not possible. Without a market, socialists cannot calculate what goods will give the most satisfaction, or the most efficient way to make whatever they decide to make. Since the government owns and controls all the factors of production, there can be no competitive market bidding for scarce materials to decide how they should be allocated. This is a function of prices in a market economy. But there is no market for raw materials or other factors of production in a socialist or communist society.
In a socialist or communist society, those who want to find out whether steel is more expensive than aluminum or some other metal have to buy a newspaper from a country that has a market. Even then, the prices in that paper will reflect the relative values of that country's market and not those within the borders of the socialist area, where supply and demand conditions may be very different. Socialists have no other way of knowing relative values. They must rely on the opinion of some bureaucrat, someone with authority. Without competitive prices, planning production is like trying to solve a puzzle without an answer. Because it monopolizes raw materials, the government receives no help from competitors in determining relative values.
In our market calculations we grade, prefer, and set aside. Values are ordinal and comparative. Now let's take an example of what happens in the market with one of the factors of production. Take iron, for example.
The price of iron originates in the businessmen's appraisal of the consumers' subjective valuations of iron products, products of which iron is a part. After all, businessmen cannot sell their products unless consumers consider them a bargain. So their ideas of consumers' valuations determine how high they will go in bidding for iron and the other factors needed to make their product.
The available supply of iron, like that of taxicabs, always goes to the highest bidders, those who expect their use of the iron will bring the highest price from consumers. Of course, the larger the quantity offered for sale, the fewer the potential buyers who are disappointed. Money is the common denominator for calculating the most profitable uses of the limited supply, that is, the best-paid uses, the highest prices on the market.
The available iron is sold to the highest bidders, with the marginal buyer determining its price and thus the cost to all buyers, even those who might have been willing to pay more. The competition of sellers drives prices down on all iron products. If there are high profits, there will soon be more suppliers competing. General market bidding thus allocates all the available supplies of all factors of production so as to satisfy the highest not yet satisfied consumer wants. High market prices for a product induce businessmen to increase production of that product, while low market prices cause businessmen to use the factors of production to make other consumers' goods for which they expect prices to be higher.
Market Effect of SavingsWhenever additional savings are available, these new savings start a bidding for the factors of production needed to supply the highest not yet satisfied wants on consumers' value scales. This bidding raises costs, including wages, and ultimately results in more production, which tends to lower prices and squeeze or eliminate profits.
If the cost of some factor of production is too high for businessmen, it means there is another use for it for which consumers are expected to pay a higher price. Prices are expressions of relative scarcity in relation to demand. Values are not quantities but arrangements in order of importance in satisfying human wants. Adding values, like adding love, is crazy. We can only compare them.
As consumers' value scales change, the kinds of wealth produced must change. Market prices are the indicators that direct businessmen to change their production. Businessmen tend to produce units of every article up to the point at which they expect consumers to pay all costs of production, including interest. A profitable industry tends to expand to that point; an unprofitable one tends to shrink to that point. Thus consumers, by their buying or non-buying at or above the cost of production, determine how much should be produced in every branch of industry.
There prevails upon the unhampered market a tendency for consumers to encourage production in every industry up to that point at which the marginal producer or producers make neither a profit nor a loss. Flexible market prices are the means for revealing that point to producers. Any outside interference with freely flexible prices must misdirect production and lead to diminished satisfaction of consumers.
Subjective Values Determine PricesAs stated in the beginning, it is the subjective values of individuals which allocate the available supply of every good, so as to satisfy human wants in the descending order of their importance, whereby the particular want last satisfied is the one with the marginal utility. From beginning to end, prices, and thus economic calculations, are the products of subjective valuations. They are the results of the reciprocal impact of the subjective values placed on the goods and those placed on a quantity of money by all interested parties. Every price must benefit all who exchange.
There is nothing automatic or mysterious in the operation of the market. The only forces determining the continually fluctuating up-and-down state of the market are the value judgments of interested individuals, and their actions as directed by their value judgments. The ultimate factor in the market is the striving of each man to satisfy his needs and wants in the most economical way possible or known to him. The supremacy of the market is in fact a supremacy of the consumers. Interfering with the market interferes with the satisfactions of consumers.
QUESTIONS AND ANSWERSEffect of Consumers' Values on ProducersQ. What you have explained is all right for products which already exist. But does it apply to those that don't exist — to new ones?
A. Certainly it does! As I have said, people's wants are never fully satisfied. There are always some things they want that they do not have. When there are new savings in a market society, the saver becomes an investor. He tries to invest his savings in a way that will produce more goods. What goods? Those goods next lower on consumers' value scales, for which their needs have not yet been satisfied. These are the goods that businessmen expect consumers will pay more for in the future than their current cost of production. When he produces these new goods, he has got to bid for labor. He has got to bid for raw materials. Thus he pushes those wages and prices up to take the labor and raw materials away from other uses. Then he produces goods that have to be sold in competition with all existing goods. With more goods and no change in the quantity of money, prices are lower than they would have been, and everyone gets more for his own limited amounts of money. To answer the question more specifically, every businessman must pay attention to consumers' values — to what consumers want and will pay. This may mean producing larger quantities of presently available goods or entirely new items not previously available. In either case, more human wants are satisfied. If a businessman does not pay attention to consumers' wants, he will soon be out of business.
Morality of SpeculationQ. The majority of people consider speculation immoral. What do you have to say about that?
A. Calling speculation "immoral" is saying that all men are immoral, because we are all speculators. It is even a speculation to cross the streets in Buenos Aires — or New York. No one knows the future. We have to speculate. All of our choices and actions are speculations.
It is true that many consider immoral those "terrible" people who make money speculating. Do you know that you cannot make money speculating unless you serve society? If you speculate on the future and do not serve society, you lose. The normal process for successful speculation is to buy something cheap at one period and sell it high at a later period. Speculators make a profit when they can do this. But when they buy, they have no assurance that it is going to be higher later. It could be lower and then they lose. Try it in the stock market sometime and you will find out.
If the speculators buy something when its price is low, they are buying it when it is in relatively large supply and, because the price is low, people are using it as a cheap good. If they sell it later at a higher price, it is because it is then scarcer in relation to the demand for it. It is, therefore, worth more and serves human uses that are more valuable. So what the speculator does to earn his money is to buy the good when it is cheap and store it for when he hopes it may be more expensive. If this is something that is needed for life, like the grain in the story of Joseph in the Bible, when the seven plenteous years were followed by seven years of famine, the service to society becomes evident. Those who save goods when there is a plentiful supply and make it available when there is a famine, or no other supply, are speculators who make money by serving society. If, on the other hand, there is, later on, a larger supply, the speculator has to sell his stored supply at a cheaper price, pay for the warehouse, pay interest on his investment, and thus he loses. A speculator can make money only when he serves society. A speculator is a person who tries to foresee the future situation and prepare for it. Only if he sees and acts relatively more effectively than other people in satisfying human wants, does he make a market profit from his speculation. Serving society is never immoral.
On Effects of Intrinsic Value and QualityQ. What do you have to say about the influence of intrinsic value? And about the influence of quality?
A. Those are really two different questions. In economics, there is no such thing as intrinsic value. This is a very common error, particularly concerning the precious metals, including gold. Nothing has value in the market unless it satisfies some human want or need. The value of something is in a person's mind. It is not in the product. Of course, the physical qualities of a good contribute to its usefulness to men. However, it is only when men can see a use for a scarce good that it has value.
Now, of course, the quality of a good is an essence of its value. Rotten eggs have little value. There are people who will pay more for a higher quality. But the seller can charge a higher price for a higher quality only if people want the higher quality. Most of us, of course, prefer higher quality. We do not go around in rags. We buy suits that are made to fit us. We buy suits that look better on us than simple lengths of cloth that we could wind around us to keep us warm, and we pay more for them. It is the consumers who determine both the values and the qualities that are found in the market.
Competition and MonopolyQ. What happens to the Golden Rule when there is no perfect competition, that is to say, under oligopoly and monopoly?
A. First, about this "perfect competition," we could spend a whole evening on the fallacies embraced by that idea. There is no such thing as perfect competition. But in a market society there is always competition. In one sense everything in the market is in competition with everything else for the consumers' dollars.
We could spend another couple of evenings on the question of competition and monopoly. Actually, the only monopolies we have to fear are those that are monopolies because they have a special privilege from a government. If there is freedom to compete in the marketplace, you can maintain a monopoly only as long as you are superior to every prospective competitor. In a free-market society, you do not have a monopoly unless you are doing something better than any other person or group of persons could do it.
In one sense, we are all monopolists. We each have a monopoly on our own services. The man who is the best prize fighter, the champion of the world, has a monopoly on that title. The opera singer who can sing the highest note has a monopoly and gets the highest price. The man who owns the only gasoline station in a community has a monopoly. In a free-market society, if anyone can do better, he is free to compete.
The problems of monopoly get down to the question of monopoly prices. No one has to pay a monopoly price unless he is satisfied that doing so improves his situation. In a free market anyone should be able to compete, if he thinks he can compete.
Most of our monopoly problems come from special privileges granted by law. The answer there is always to take away the special privilege. With equality before the law, which was mentioned in one question following the first lecture, there is no significant monopoly problem. Everybody should have an equal right to compete. Then those who give consumers the greatest satisfaction will be the ones who succeed. If they get fat, lazy, and rich from their success, then somebody else will come along, compete, and knock them down. In a free market, newcomers are constantly trying to replace the giant firms on the top.
One of the worst effects of the New Deal in my country and of welfare state processes in other countries is that they keep at the top those who are already there. Interventionism tends to protect them from the competition of those at the bottom who would like to replace them.
For example, it is now impossible in my country to do what Henry Ford did forty years ago. What Henry Ford did was to employ men to make more automobiles for more people, who bought them all at prices that they considered bargains. He paid the workers higher wages than they could get anywhere else. He made these automobiles for the masses and became rich. What did he do with his wealth? He plowed it back into more or bigger factories, hiring still more men to make still more cars.
Today, with present tax rates, the government takes a good part of all profits, including more than half of the profits made by corporations. As a result a businessman in the United States can no longer expand as fast as Henry Ford could. He therefore cannot compete as easily against the giants already at the top. So these laws, supposedly directed against the top people, are more against the new, smaller, struggling competitors. They prevent newcomers from competing with those already on the top as efficiently as they could if they were permitted to keep and plow back into the business more of their early profits.
Calculation under CommunismQ. Considering the actual value scales existing in Communist Russia, must not the Communists calculate economic values on the basis of the cost of production?
A. They have no cost of production, or rather, their cost of production is the sweat and blood of their people. It is an order: You do this, or you do that, or you do something else. They cannot calculate market costs because they have no market to tell them costs. Their calculations have to be based on the judgments of a czar, the czar of each particular industry.
Some ten years ago, I put together an article that was largely quotations from Russian papers, Pravda and others. It related several interesting incidents, which indicated that these papers were not entirely happy with the operation of their own Russian Soviet system. It seems there was one industry that had to move goods from the north to the south on the Volga River. So they built a fleet of boats to move these goods from the north to the south, and the boats returned north empty. There was also another industry that had to move goods from the south to the north. So this industry built another fleet of boats that returned south empty.
Now in a market economy, there would be common carriers, or advertising that would bring the two industries together. In either case, the market economy would not waste its scarce labor and its scarce materials by building two fleets of ships to do what one could do.
Another interesting article was about the Soviet railroad organization. It was paid to carry things on the railroads. The railroads had some tank cars. If they moved oil in one direction, they got paid for it. If they came back empty, they did not get paid for it. So on the return trips they would fill up the tank cars with water. That way they got paid for the return trip. How can you calculate costs under such a system? There are many examples of such uneconomic actions. I shall cite one in a later talk. It concerns a trade agreement arranged between East Germany and the Soviet Union that resulted in a suicide.
The communists have no means of calculation unless they look outside the country to market economies. Then they have the relationship of supply and demand that exists within the other country. The communist system, because it has no economic calculation, has to be inefficient. Communists can never be forerunners. They must always be followers. When people understand this, they will no longer be afraid of them as an economic power. If communism were a good and strong economic system, we should adopt it. But the communists are not strong. They are weak. They are now trying to copy capitalistic production methods, but they cannot do so while the government controls and allocates all the factors of production. Without markets, they are blind as to real costs.
Christianity and CapitalismQ. Do you think that Protestantism has helped free-market principles?
A. Well, I am a very staunch believer that free-market principles are in full harmony with Christian principles and that the free market is the only economic system that is consistent with Christian or Judeo-Christian principles. I must say that in recent years the organized churches, both the Protestant and the Roman Catholic, have not been in harmony with free-market teachings, nor have they been in harmony with what I must hold are the principles taught in the Bible. The organized churches have largely accepted the welfare state ideology so popular today. This ideology has changed the original meaning of the Ten Commandments. I could give you quite a speech on that. However, I want to make just this one point. There is the Commandment which in English is only four words: "Thou shalt not steal." Today, most of our people think that it has been expanded to eight words. They think it is: "Thou shalt not steal except by majority vote." They seem to think that any stealing done by majority vote is all right.
Except when necessary for defense, neither capitalism nor Christianity approves of the use of force or coercion. The fundamental principle of the free market, voluntary social cooperation for mutual advantage, is in full conformity with Judeo-Christian teachings.
Antitrust Law InterventionsQ. What do you think about the antitrust laws?
A. How many weeks can we have to answer that? Antitrust laws are like all other interventions. They help certain interests and they hurt others. They always hurt the consumers. In my country the antitrust laws originated because the government had given privileges to certain industries, and the companies, particularly the railroads, used these privileges to enrich themselves at the expense of the consumers. By law, the railroads were handed monopoly privileges that protected them from competition. Once they had this monopoly, they raised rates above those that would have attracted competition; but no competitor could come in to lower them. Then the people and the government said, "We have to control these greedy monopolies!" This led to the creation of the so-called antitrust laws.
Most of the antitrust laws are aimed at trying to undo the damage created by earlier government laws. I have written an article on this subject, particularly with relation to labor unions. It is entitled, "Is Further Intervention a Cure for Prior Intervention?"First published in On Freedom and Free Enterprise: Essays in Honor of Ludwig von Mises, ed. by Mary Sennholz. (Princeton, New Jersey, D. Van Nostrand Co., Inc., 1956. Reprinted separately by the Foundation for Economic Education, Inc., Irvington-on-Hudson, N.Y.). My answer is "No." Marx wanted such interventions because, as he correctly stated in the Communist Manifesto, they will make matters worse, create a demand for more and more intervention, until they result in overturning the capitalistic system. This is what is happening in many countries today. When people think the remedy for anything they do not like is another law, you get more and more laws until there is no freedom left. Every one of these governmental interventions makes matters worse from the point of view of those who advocate them. Try and think of one that does not.
Are High Prices Helpful?Q. Do you think that the producer who sells his product at high prices benefits the community?
A. Yes, if he can get them. If the high prices mean a high profit, he is soon going to have competitors who will gradually bring the price down pretty close to the actual costs of production. Let me cite an example that has been before the world just recently, the case of the few doctors who are able to transplant human hearts. Suppose you only allowed them to charge $100 per operation, and they could only perform one operation a week, and there was need for many more. Who would be selected, and how many young doctors would train to learn that operation, if $ 100 once a week were all they could make? On the other hand, if they were allowed to charge the highest price they could get, the market would select their customers. If that price were really high, many young doctors would want to learn to perform that very intricate operation. In a short period of time, more doctors would be able to perform the operation; the price would come down and more people could benefit from that type of operation, if it could help them.
The remedy for high prices is prices high enough to attract competition. When you lower prices by law, you not only fail to attract new producers, but you also make it unprofitable for marginal producers to continue in business. So production goes down, and consumers are provided with less satisfaction.
We have seen that in my country in connection with the question of rent control. During World War II, they said we had to take care of the poor people and keep rents low. So they froze rents then in effect across the nation. Wartime inflation raised the costs of construction. What happened? Nobody built any houses for rent, not even after the war, when construction materials were again available for peacetime uses. Did that help the boys who came back from the war, married, and started new families? No. It only created a still greater shortage of rental housing.
What was the political solution? Another law — public housing. First, there was public housing for politically selected low-income families. Now it is public housing for politically selected middle-income families. Like the public schools a century earlier, it may be public housing for all incomes before long. In Russia, you take the housing the government assigns you. In Sweden, married couples sign up for space on a waiting list. By the time they get something they are ready for divorce.
On Politics and PovertyQ. How do you explain the fact that today, although we live in a free-market economy, every day there are fewer rich and every day more and more poor?
A. I do not know where the questioner lives! In my country and other countries of the Western civilization, we have had more and more wealth under relatively free-market economies. It is only where government intervention results in capital consumption that there is less wealth produced. Marx certainly never envisioned the automobiles you have running around the streets here. He thought that before the end of the 19th century people were going to be starving, and that then they would rise up, throw off their chains, and create a dictatorship of the proletariat.
Now the automobiles that you have in Buenos Aires are not for the rich only. Those who are really poor today are poor largely because government intervention keeps them from competing for jobs. I, of course, am no authority on your economy, but I do know that in my country the poor, and particularly the Negroes, are kept poor because the labor unions can legally keep them out of jobs. We shall be saying more on this subject in the next lecture. It is the interventionist laws that prevent the poor from getting on the bottom rung of the ladder so that they can start the climb up. The stress of poverty is greatest when production goes down, and this usually occurs as a result of government interferences with a market economy.
We may not have a free-market economy but we do have a market economy. We have what my great teacher calls a hampered market economy. It is hampered. Its operations are hindered by governmental interferences. Under this situation we all have less. Both the rich and the poor have less, but the poor suffer more. The rich can get along comfortably with a little less, but many of the poor cannot take that less. Most government intervention is intended to help the poor at the expense of the rich, but, short of a dictatorship, it is always at the expense of everyone, including the poor.
Speculators and ScarcityQ. Do you agree that a speculator can artificially create scarcity so as to sell at a high price?
A. No, I would not agree that he can artificially create scarcity except in a very, very temporary local situation. We had a case in New York. Some of you may remember that a couple of years ago our electricity went off late one afternoon, and remained off for some 15 hours. People were caught in elevators. Everything was dark. Radios and TVs were silent. No one knew why. The only news I could hear was the radio in my automobile, and the local stations were going off the air. All of our electricity had gone off. There was a scarcity of electricity, to put it mildly. Those people who had flashlights and candles to sell were in a position to make a nice little profit. But if those flashlights and candles had not been there, the people could not have had them. People can make these profits only when they foresee the future better than their competitors. In a free society everybody has the right to be a speculator. If you think the price of cotton is going to double by next year, buy it now. Sell it next year. You have as much right to do it as anybody else. But what if you do, and the price goes down? This is the chance the speculator takes. If someone destroys his own property to raise prices, he is going to invite competition, so that any gain will be short-lived.
Price ControlsQ. What are the consequences of imposing maximum and minimum prices?
A. Imposing a maximum price — that is, holding prices below those of the market — means that the marginal producer will not cover his costs and will go out of business. Imposing a minimum price — that is, holding prices above those of the market — has the opposite effect. It means that more will be produced than can be sold at the minimum price.
Mises tells the story of how they like to introduce these maximum prices by putting them on something that is very much needed, say milk for babies. The poor people need cheap milk. So we lower the price of milk by law. And what do the people who have the cows do? They use the milk to make cheese and ice cream, which are not under price control. So to keep the price of milk down you have to apply the price controls to cheese and ice cream. The controls then must be applied to the expenses of the dairy industry, and eventually from one product to another, until you get to the point that Hitler reached in Nazi Germany.
Establishing minimum prices, by which the government guarantees a higher-than-free-market minimum price to producers, as we have done in our farm programs in my country, means that you soon have surpluses piling up in warehouses. The taxpayers then have to pay subsidies to the farmers, storage, and higher interest charges, as well as higher prices for their food and cotton goods. In fact, all over the world new areas are now growing cotton and taking our former markets away from us. The free market would direct those now producing the surpluses to make something else that consumers prefer rather than more of the goods for which prices are held artificially high.
The maximum prices reduce production and the availability of the goods. The minimum prices increase production beyond what people want at prices that cover the marginal cost of production. Then the product has to be warehoused or destroyed. In your neighboring country, Brazil, they simply burned their surpluses of coffee.
Existence of a Free-Market EconomyQ. In the United States, do you have a free-market economy, and if so, tell us since when?
A. The free-market economy is like Christianity. It is a goal to move toward but human beings never quite attain it. We have never had a completely free economy in the United States. It was only relatively freer than any that had ever existed in the world before. It protected private property and brought us great capital accumulation, on which we are now living. The nearer you approach to the free-market economy, the higher the standard of living will be.
Product Durability vs. Higher SalesQ. Would you be so kind as to discuss briefly the soundness of a policy of manufacturing goods that do not last too long, thus insuring a continuing demand, creating manufacturing volume, and thereby reducing both costs and selling prices?
A. Well, a manufacturer's purpose is, of course, to maximize his profits. He has to compete with businessmen who may have different ideas of production. It is always the consumers who will decide which manufacturer gets the profits. I am the son of a Britisher and this question led to debates I used to have with my father about automobiles. As a Britisher, he defended the Rolls Royce, which did not change its models every year, had higher quality, and lasted almost a lifetime. In the United States, we change our automobile models almost every year in some way. The consumers then decide which of the two they will buy, the one that will wear out quickly, or the one that lasts a longer time.
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The same thing is true of styles. In my country, as in other countries, the women's wear industry has persuaded women to change their styles almost every year so the industry will have more sales. They are now trying to do it with the men. Clothing manufacturers would like us to throw our clothes away because they are out of style rather than because they are worn out. Any business can attempt this, but the final decision is always made by the consumers as they spend their money. So in the long run, the manufacturer has no choice; he must provide what the consumers will buy.
Right to Destroy WealthQ. Has the producer the right to destroy the products he produces?
A. The question is: Does he own them? If he has paid for them, he has the right to do that; and I suppose he has the right to commit suicide too. If you have something of value and want to destroy it without harming anyone else, that is your right. But if it has a market value, there is no inducement to destroy it.
This article is excerpted from Understanding the Dollar Crisis (1973).
Most of us, and all of us most of the time, deal with the market economy as a definite type of economic order, a sort of "economic technique" as opposed to the socialist "technique." For this view, it is significant that we call its constructional principle the "price mechanism." Here we move in the world of prices, of markets, of supply and demand, of competition, of wage rates, of interest rates, of exchange rates, and whatnot.
That is, of course, right and proper—as far as it goes. But there is a great danger of overlooking an important fact: the market economy as an economic order must be correlated to a certain structure of society, and to a definite mental climate which is appropriate to it.
The success of the market economy wherever it has been restored in our time—most conspicuously in western Germany—has resulted, even in some socialist circles, in a tendency to appropriate the market economy as a technical device capable of being built into a society which, in all other respects, is socialist.
The market economy then appears as part of a comprehensive social and political system which, in its conception, is a highly centralized colossal machinery. In that sense, there has always been a sector of market economy also in the Soviet system, but we all realize that this sector is a mere gadget, a technical device, not a living thing. Why? Because the market economy as a field of liberty, spontaneity, and free coordination cannot thrive in a social system which is the very opposite.
That leads to my first main proposition: the market economy rests on two essential pillars, not on one alone. It assumes not only the freedom of prices and competition (whose virtues the new socialist adepts of the market economy now reluctantly acknowledge), but rests equally on the institution of private property. This property must be genuine. It must comprise all the rights of free disposal without which—as formerly in Nationalist Socialist Germany and today in Norway—it becomes an empty legal shell. To these rights must be added the right to bequeath property.
Property in a free society has a double function. It means not only that the individual sphere of decision and responsibility is, as we have learned as lawyers, demarcated against other individuals, but it also means that property protects the individual sphere against the government and its ever-present tendency toward omnipotence. It is both a horizontal and a vertical boundary. And it is in this double function that property must be understood as the indispensable condition of liberty.
It is curious and saddening to see how blind the average type of socialist is vis-à-vis the economic, moral, and sociological functions of property, and even more that particular social philosophy in which property must be rooted. In this tendency to ignore the meaning of property, socialism has made enormous progress in our time. Traces of this may be discovered even in modern discussion on the problems of enterprise and management, which sometimes give the impression that the property owner is the "forgotten man" of our age.
The Role of Private Property The intellectual constructions of "market socialism" are a good example of how the most serious fallacies ensue if we overlook the functions of private property. These fallacies can already be demonstrated on the level of ordinary economic analysis. But I wish to suggest that it is the whole social climate, the form of life, and the habits of planning for life which matter.
There is a definite "leftist" ideology, inspired by excessive social rationalism, as opposed to a "rightist," conservative one, respecting certain things we cannot touch, weigh, or measure but which are of sovereign importance. The real role of property cannot be understood unless we see it as one of the most important examples of something of much wider significance.
It illustrates the fact that the market economy is a form of economic order that is correlated to a concept of life and a socio-moral pattern which, for want of an appropriate English or French term, we may call buergerliche in the wide sense of this German word, which is largely free of the disparaging associations of the adjective "bourgeois."
This buergerliche foundation of the market economy must be frankly acknowledged. All the more so because a century of Marxist propaganda and intellectualist romanticism has been astonishingly and alarmingly successful in spreading a parody of this concept. In fact, the market economy can thrive only as part of and surrounded by a buergerliche social order.
Its place is in a society where certain elementary things are respected and are coloring the whole life of the community: individual responsibility; respect of certain indisputable norms; the individual's honest and serious struggle to get ahead and develop his faculties; independence anchored in property; responsible planning of one's own life and that of one's family; thriftiness; enterprise; assuming well calculated risks; the sense of workmanship; the right relation to nature and the community; the sense of continuity and tradition; the courage to brave the uncertainties of life on one's own account; the sense of the natural order of things.
Those who find all this contemptible and reeking of narrow-mindedness and "reaction" must be seriously asked to reveal their own scale of values and to tell us what kind of values they want to defend against communism without borrowing ideas from it.
That is only another way of saying that the market economy supposes a society which is the opposite of a "proletarianized" one, the opposite of a mass society—with its lack of a solid and necessarily hierarchical structure, and its corresponding sense of being uprooted. Independence, property, individual reserves, natural anchors of life, saving, thrift, responsibility, reasonable planning of life, all these are alien to such a society. They are destroyed by it, at least to that extent that they cease to give the tone to society. But we must realize that these are precisely the conditions of a durable free society.
The moment has come to see clearly that this is the real watershed of social philosophies. Here the ultimate parting of ways takes place, and there is no getting around the fact that the concepts and patterns of life which clash against each other in this field are decisive for the fate of society, and that they are irreconcilable.
Once we admit this, we must be prepared to see its significance in every field and to draw the corresponding conclusions. It is indeed remarkable to see how far we all are already drawn into the habits of thinking of an essentially unbuergerliche world. That is a fact which the economists also ought to take to heart, for they are among the worst sinners.
Enchanted by the elegance of a certain type of analysis, how often we discuss the problems of aggregate savings and investments, the hydraulics of income flows, the attractions of vast schemes of economic stabilization and of social security, the beauties of advertising or installment credits, the advantages of "functional" public finance, the progress of giant enterprise and whatnot, without realizing that, in doing so, we take for granted a society which is already largely deprived of those buergerliche conditions and habits which I described.
It is shocking to think how far our minds are already moving in terms of a proletarianized, mechanized, centralized mass society. It has become almost impossible for us to reason other than, in terms of income and expenditure, of input and output, having forgotten to think in terms of property. That is, by the way, the deepest reason for my own fundamental and insurmountable distrust in Keynesian and post-Keynesian economics.
It is, indeed, highly significant that Keynes attained fame mostly for his trite and cynical remark that "in the long run, we are all dead." And it is even more significant that so many contemporary economists have found this dictum particularly spiritual and progressive. But let us remember that it only echoes the slogan of the Ancien Regime in the 18th century: Apres nous le deluge. And let us ask why this is so significant. Because it reveals the decidedly unbuergerliche, the Bohemian spirit of this modern trend in economics and in economic policy. It betrays the new hardboiled happy-go-luckiness, the tendency to live from hand to mouth, and to make the style of the Bohemian the new watchword for a more enlightened generation.
To incur debts becomes a positive virtue; to save, a capital sin. To live beyond one's means, as individuals and as nations, is the logical consequence. But what else is this than Entbuergerlichung, deracination, proletarianization, nomadization? And is not this the very opposite of our concept of civilization which is derived from civis, the Buerger?
Muddling through from day to day and from one expedient to another, to boast that "money does not matter"—that is, indeed, the opposite of an honest, disciplined, and orderly concept and plan of life. The income of people living on these lines may have become buergerliche, but their style of life is still proletarian.
A Growing Concept It is clearly impossible in the space of a short article to study the impact of all this in all the important fields. I have discussed it in regards to private property. It is further very disquieting to see how this concept has permeated more and more the economic and social policies of our time. One major example is the Mitbestimmungsrecht (codetermination—the right of workers and trade-union representatives to participate in the administration of industrial enterprises and thus to take over some functions of proper ownership) in West Germany.
To give an illustration: the director of a large power plant in Germany tells me how silly he felt the other day when, in wage negotiations with trade-union officials, he had to deal with the same men who, at the same time, sit beside him at meetings of trustees of the power plants themselves. He adds that the structure of enterprises in West Germany approaches more and more that which Tito seems to have in mind. And that is happening in the very country which is considered today the model of a successful restoration of the free-market economy!
Another example of this gradual dissolution of the meaning of property, and of the corresponding norms, which can be observed in many countries, is the softening of the responsibility of the debtor. By lax legal procedure with regard to execution and bankruptcy, this, more often than not, amounts—in the name of social justice—to the expropriation of the creditor. It is hardly necessary to recall, in this connection, the expropriation of the hapless class of house owners by rent control, and the effects of progressive taxation.
Let us apply our reflections to another most important field: money. Let us recognize that respect for money as something intangible is, like property, an essential part of the social order and of the mentality which are the prerequisites of the market economy.
To illustrate my case, I want to tell two stories which I take from the financial history of France. At the end of 1870, Gambetta, the leader of the French Resistance after the defeat of the Second Empire, left the besieged capital in a balloon for Tours to create the new republican army. In his desperate need for money, he remembered that his admired predecessors of the Revolution had financed their wars by printing and assignats. He asked the representative of the Banque de France to print for him a few hundred million notes. But he met with a flat and indignant refusal. At that time, such a demand was considered so monstrous that Gambetta did not insist. The Jacobin firebrand and all-powerful dictator yielded to the determined no of the representative of the central bank who would not accept even a supreme national emergency as an excuse for the crime of inflation.
A few months later, the socialist revolt known as the Commune occurred in Paris. The gold reserves and the plates of the notes of the Banque de France were at the mercy of the revolutionaries. But, badly in need of money and politically unscrupulous as they were, they strongly resisted the temptation to lay their hands on them. In the very midst of the flames of civil war, the central bank and its money were sacrosanct to them.
The significance of these two stories will not escape anyone. It would, indeed, be harsh to ask what has become of this respect for money in our time, not least of all in France. To restore this respect and the corresponding discipline in money and credit policy is one of the most important conditions for the durable success of all our efforts to restore and maintain a free economy and, therewith, a free society.
This article was originally published in The Freeman, January 11, 1954.
[On the Origins of Money (1892)]It is an error in economics, as prevalent as it is patent, that all commodities, at a definite point of time and in a given market, may be assumed to stand to each other in a definite relation of exchange, in other words, may be mutually exchanged in definite quantities at will. It is not true that in any given market 10 cwt. of one article = 2 cwt. of another = 3 lbs. of a third article, and so on. The most cursory observation of market phenomena teaches us that it does not lie within our power, when we have bought an article for a certain price, to sell it again forthwith at the same price. If we but try to dispose of an article of clothing, a book, or a work of art, which we have just purchased, in the same market, even though it be all once, before the same juncture of conditions has altered, we shall easily convince ourselves of the fallaciousness of such an assumption. The price at which anyone can at pleasure buy a commodity at a given market and a given point of time, and the price at which he can dispose of the same at pleasure, are two essentially different magnitudes.
This holds good of wholesale as well as retail prices. Even such marketable goods as corn, cotton, pig-iron, cannot be voluntarily disposed of for the price at which we have purchased them. Commerce and speculation would be the simplest things in the world, if the theory of the "objective equivalent in goods" were correct, if it were actually true, that in a given market and at a given moment commodities could be mutually converted at will in definite quantitative relations — could, in short, at a certain price be as easily disposed of as acquired. At any rate there is no such thing as a general saleableness of wares in this sense. The truth is, that even in the best organized markets, while we may be able to purchase when and what we like at a definite price, viz.: the purchasing price, we can only dispose of it again when and as we like at a loss, viz.: at the selling price. We must make a distinction between the higher purchasing prices for which the buyer is rendered liable through the wish to purchase at a definite point of time, and the (lower) selling prices, which he, who is obliged to get rid of goods within a definite period, must content himself withal. The smaller the difference between the buying and selling of an article, the more saleable it usually proves to be.
The loss experienced by anyone who is compelled to dispose of an article at a definite moment, as compared with the current purchasing prices, is a highly variable quantity, as a glance at trade and at markets of specific commodities will show. If corn or cotton is to be disposed of at an organized market, the seller will be in a position to do so in practically any quantity, at any time he pleases, at the current price, or at most with a loss of only a few pence on the total sum. If it be a question of disposing, in large quantities, of cloth or silk-stuffs at will, the seller will regularly have to content himself with a considerable percentage of diminution in the price. Far worse is the case of one who at a certain point of time has to get rid of astronomical instruments, anatomical preparations, Sanskrit writings, and such hardly marketable articles!
If we call any goods or wares more or less saleable, according to the greater or less facility with which they can be disposed of at a market at any convenient time at current purchasing prices, or with less or more diminution of the same, we can see by what has been said, that an obvious difference exists in this connection between commodities. Nevertheless, and in spite of its great practical significance, it cannot be said that this phenomenon has been much taken into account in economic science. The reason of this is in part the circumstance, that investigation into the phenomena of price has been directed almost exclusively to the quantities of the commodities exchanged, and not as well to the greater or less facility with which wares may be disposed of at normal prices. In part also the reason is the thorough-going abstract method by which the saleableness of goods has been treated, without due regard to all the circumstances of the case.
The man who goes to market with his wares intends as a rule to dispose of them, by no means at any price whatever, but at such as corresponds to the general economic situation. if we are going to inquire into the different degrees of saleableness in goods so as to show its bearing upon practical life, we can only do so by consulting the greater or less facility with which they may be disposed of at prices corresponding to the general economic situation, that is, at economic prices. The height of saleableness in a commodity is not revealed by the fact that it may be disposed of at any price whatever, including such as result from distress or accident. In this sense all commodities are pretty well equally saleable. A high rate of saleableness in a commodity consists in the fact that it may at every moment be easily and surely disposed of at a price corresponding to, or at least not discrepant from, the general economic situation — at an economic, or approximately economic, price. A commodity is more or less saleable according as we are able, with more or less prospect of success, to dispose of it at prices corresponding to the general economic situation, at economic prices.
The interval of time, moreover, within which the disposal of a commodity at the economic price may be reckoned on, is of great significance in an inquiry into its degree of saleableness. It matters not whether the demand for a commodity be slight, or whether on other grounds its saleableness be small; if its owner can only bide his time, he will finally and in the long run be able to dispose of it at economic prices. Since, however, this condition is often absent in the actual course of business, there arises for practical purposes an important difference between those commodities, on the one hand, which we expect to dispose of at any given time at economic, or at least approximately economic, prices, and such goods, on the other hand, respecting which we have no such prospect, or at least not in the same degree, and to dispose of which at economic prices the owner foresees it will be necessary to wait for a longer or shorter period, or else to put up with a more or less sensible abatement in the price.
Again, account must be taken of the quantitative factor in the saleableness of commodities. Some commodities, in consequence of the development of markets and speculation, are able at any time to find a sale in practically any quantity at economic, approximately economic, prices. Other commodities can only find a sale at economic prices in smaller quantities, commensurate with the gradual growth of an effective demand, fetching a relatively reduced price in the case of a greater supply.
[This article is excerpted from Conceived in Liberty (1975), volume 1, chapter 31: "Economics Begins to Dissolve the Theocracy: The Failure of Wage and Price Controls." An MP3 audio file of this article, narrated by Floy Lilley, is available for download.]
From the first, the Massachusetts oligarchy, seeing that in the New World land was peculiarly abundant in relation to labor, tried by law to push down the wage rates that they had to pay as merchants or landowners. Maximum-wage controls were persistently imposed. John Winthrop set the tone in 1633, complaining that "the scarcity of workmen had caused them to raise their wages to an excessive rate." What else was supposed to happen with a scarce product?
As in the South, there were at the base of New England's economic structure indentured servants and Negro slaves, who sometimes were farm labor but mostly were artisans, helpers, and domestic servants. After the servants' terms expired, they received small grants of land and became farmer-settlers. The Massachusetts gentry also supplemented this system of labor with general compulsory service in harvesting neighboring farms — a neat way of exploiting the local citizenry at wage rates far below the market.
Maximum-wage control always aggravates a shortage of labor, as employers will not be able to obtain needed workers at the statutory price. In trying to force labor to be cheaper than its price on the free market, the gentry only made it more difficult for employers to obtain that labor. By 1640 Winthrop was admitting that Massachusetts had
found by experience that it would not avail by any law to redress the excessive rates of laborers' and workmen's wages, etc. (for being restrained, they would either remove to other places where they might have more or else being able to live by planting or other employments of their own, they would not be hired at all).
Of course, one method of alleviating this induced shortage was by using the forced labor of slavery, servitude, and compulsory harvest service. Thus, one intervention by violence in the market created conditions impelling a further and stronger intervention. But apart from forced labor, the Massachusetts authorities, as we have noted, found it extremely difficult to enforce maximum-wage control.
The first maximum-wage law was enacted by Massachusetts as early as 1630. Due to the high wages commanded by the scarcity of construction craftsmen, the law concentrated on maximum-wage rates in the building trades. Carpenters, bricklayers, etc., were limited to two shillings a day and any payment above this rate would subject both the employer and the worker to punishment (for instance, a buying-cartel of employers established by the law punished the recalcitrant employer who decided to break ranks). Almost immediately, the magistrates decided to imbibe more of the magic medicine, and legal wage rates were pushed down to 16 pence a day for master carpenters and bricklayers, and correspondingly lower for other laborers.
But the economic laws of the market made enforcement hopeless, and after only six months, the General Court repealed the laws, and ordered all wages to be "left free and at liberty as men shall reasonably agree." But Massachusetts Bay was not to remain wise for long. By 1633 the General Court became horrified again at higher wage rates in construction and other trades and at the propensity of the working classes to rise above their supposedly appointed station in life by relaxing more and by spending their wages on luxuries. Denouncing "the great extortion … by divers persons of little conscience" and the "vain and idle waste of precious time," the court enacted a comprehensive and detailed wage-control program.
The law of 1633 decreed a maximum of two shillings a day without board and 14 pence with board, for the wages of sawyers, carpenters, masons, bricklayers, etc. Top-rate laborers were limited to 18 pence without. These rates were approximately double those of England for skilled craftsmen and treble for unskilled laborers. Constables were to set the wages of lesser laborers. Penalties were levied on the employers and the wage earners who violated the law. Sensing that maximum controls below the market wage led to a shortage of labor, the General Court decreed that no idleness was to be permitted. In effect, minimum hours were decreed in order to bolster the maximum-wage law — another form of compulsory labor. Workmen were ordered to work "the whole day, allowing convenient time for food and rest."
Interestingly, the General Court soon decided to make an exception for the government itself, which was naturally having difficulty finding men willing to work on its public-works projects. A combination of the carrot and the stick was used: government officials were allowed to award "such extraordinary wages as they shall judge the work to deserve." On the other hand, they were empowered to send town constables to conscript laborers as the need arose.
Although merchants were happy to join the landed oligarchy and the Puritan zealots in forcing down the wage rates of laborers, they were scarcely as happy about maximum controls on selling prices. The gentry were eager, however, to force downward the prices of products they needed to buy. A blend of mercantilist fallacies and Puritan suspicion of commerce, the result was persistent attempts to force commodities below their market prices. Having little conception of the function of the price system on the free market, the Massachusetts authorities also felt that maximum-price control would bolster the maximum-wage-rate program. There was no understanding that general movements in prices and wages are governed by the supply of and demand for money, and that this too can best work itself out on the free market.
Corn was the major monetary medium of the North, and in 1630 Massachusetts set the sterling price of corn at six shillings per bushel. Failing to work, this control was repealed along with the wage laws of 1631, and corn was "left at liberty to be sold as men can agree." In 1633, however, maximum-price controls were reimposed as an auxiliary to the wage controls.
The massive wage laws of 1633 were quickly discovered to be a failure; once again the quiet but powerful economic laws of the market had triumphed over the dramatic decrees of the coercive state. After one year the actual wage rates were 50 percent higher than the statutory levels. At that point, the General Court repealed the penalties against paying, but retained those against receiving, wages above the fixed legal rate. While, in fact, no employer had ever been tried or penalized under the old act, the wage law was now an open and flagrant piece of class legislation. This was nothing new, however, as there were ample precedents in English maximum-wage laws since the early 15th century.
Another change made in 1634 allowed a little flexibility in decreed prices and wages by permitting each town to alter the legal rate in case of disputes. Only a year later the General Court, despairing of the continued failure of the law to take hold, repealed the comprehensive wage controls and the auxiliary price controls. Just before this comprehensive repeal, the courts had apparently been driven by the failure to inflict ever harsher penalties; fines had been so heavy that two workers were imprisoned for failure to pay. The authorities were at the crossroads: should they begin to impose on workers violating clearly unworkable economic decrees the sort of punishment meted out to heretics or to critics of the government? Happily, common sense, in this case, finally prevailed.
Made wary by its thundering failure, the theocracy no longer attempted a comprehensive planned economy in Massachusetts Bay. From then on, it was content to engage in annoying, but not fatal, hit-and-run harassments of the market. Penalties were made discretionary, and in 1636 wage and price regulations were transferred by the provincial government to the individual towns, as suggested by the leading Puritan divine, Rev. John Cotton. The General Court was supposed to exercise overall supervision, but exerted no systematic control. Control by each town, as had been anticipated, was even more ineffective than an overall plan, because each town, bidding against the others for laborers, competitively bid wages up to their market levels. The General Court wailed that all this was "to get the great dishonor of God, the scandal of the Gospel, and the grief of divers of God's people." A committee of the most eminent oligarchs of the Bay colony was appointed to suggest remedies, but could think of no solution.
Of the towns, Dorchester was perhaps the most eager to impose wage controls. During the Pequot War, and again in 1642, it combined maximum wages with conscription of any laborer unwilling to work and to work long enough at the low rates. Hingham also enacted a maximum-wage program in 1641, and Salem was active in prosecuting wage offenders.
In 1635, the year of the repeal of the wage and price plan, the Massachusetts authorities tried a new angle: under the cloak of a desire to "combat monopolizing," the Massachusetts government created a legal monopoly of nine men — one from each of the existing towns — for purchasing any goods from incoming ships. This import monopoly was to board all the ships before anyone else, decide on the prices it would pay, and then buy the goods and limit itself to resale at a fixed 5 percent profit. But this attempt to combine monopoly with maximum-price control failed also. The outlawing of competing buyers could not be enforced and the import monopoly had to be repealed within four months. What ensued was far better but was still not pure freedom of entry. Instead, licensing was required of all importers, with preference usually given to friends of the government.
Generally, the merchants were the most progressive, worldly, and cosmopolitan element in Massachusetts life. The merchants were able to gain political control of the growing commercial hub of Boston by the mid-1630s. But the rest of Massachusetts remained in the hands of a right alliance of Puritan zealots and landed gentry who dominated the magistrates' council and the governorship. During the decade of the 1630s only 2 out of 22 magistrates were merchants, 1 of these being the Hutchinsonian leader William Coddington. This reflected the occupational differences of their native England. The gentry had, by and large, been minor gentry in rural England, while the merchants usually hailed from London or other urban centers. In contrast to the authoritarian and theocratic gentry, the merchants had a far more individualist and independent spirit and often opposed the Massachusetts oligarchy. It was no accident that almost all the merchants championed the Hutchinsonian movement — including Coddington, John Coggeshall, and the Hutchinson family itself. In spite of the earlier failures, Massachusetts tried to resume its harassment and regulation of the merchants, but even more sporadically than in the case of wages. Millers were fined for charging what were arbitrarily termed "excessive" prices for their flour. A woodmaker was fined in 1639 for charging the Boston government "excessive" prices for making Boston's stocks, and, as Professor Richard Morris notes in Government and Labor in Early America, the General Court "with great Puritan humor sentenced him, in addition, to sit in the stocks he himself had made." Heavy fines and Puritan denunciations were also the lot of merchants supposedly overcharging for nails, gold buttons, and other commodities. The Puritan church was quick to condemn these merchants, and insisted on penitence for this "dishonor of God's name" in order to regain membership in the church.
The most notable case of persecution of a merchant occurred in 1639. Robert Keayne, a leading Boston importer and large investor in the Massachusetts Bay Company, and the devout brother-in-law of Rev. John Wilson, was found guilty in General Court of gaining "excess" profit, including a markup of over 150 percent on some items. The authorities displayed once more their profound ignorance of the functions of profit and loss in the market economy. Keayne was especially aggrieved because there was no law on the books regulating profits. In contrast, the Maine court, in the case of Cleve v. Winter (1640), dismissed charges against a merchant for setting excessive prices, on the grounds that it was not legitimate to regulate a man's profit in trade. So a sounder strain of thought did exist despite the official view.
Massachusetts' sister colonies also tried to impose a theocratic planned economy. As we might have expected, the effort of New Haven Colony, founded in distaste for the alleged laxity of Massachusetts Puritanism, was the most comprehensive. New Haven's Act of 1640 established fixed profit markups of varying grades for different types of trade: 3 pence in the shilling, for example, for retail of English imports, and less for wholesale. Prices were supposed to be proportionate to risk for colonial products. Above all, a highly detailed list of maximum-wage rates for each occupation was issued. A year later, an ambitious new schedule was decreed, pushing down wage rates even further.
But even fanatical New Haven could not conquer economic law, and only nine months later the authorities were forced to admit defeat, and the entire program was repealed. After that resounding failure, no further comprehensive controls were attempted at New Haven, although there were a few sporadic attempts to regulate specific occupations.
Comprehensive wage control was also attempted in Connecticut. An abortive regulation of wages was imposed in early 1640, but repealed later the same year. The following year Connecticut, again alarmed about "excessive" and rising wages (with men "a law unto themselves"), enacted a maximum-wage scale for each occupation. However, instead of the heavy fines imposed by Massachusetts, the only prescribed penalty was censure by the colony's General Court.
Because the monetary medium of Connecticut was corn, wheat, or rye, maximum-wage legislation, to be effective, depended on minimum rates of exchange of these commodities in terms of shillings — otherwise, maximum wages in shillings would be effectively negated by declines in the shilling prices of corn. Minimum corn, wheat, and rye prices were, accordingly, fixed at legal tender for wage and other contracts. A slight reduction of wheat and corn prices, however, was allowed in 1644, and, finally, in 1650 Connecticut also abandoned the foolhardy attempt to plan the price and wage structure of the colony's economy.
This article is excerpted from Conceived in Liberty (1975), volume 1, chapter 31: "Economics Begins to Dissolve the Theocracy: The Failure of Wage and Price Controls." An MP3 audio file of this article, narrated by Floy Lilley, is available for download.
"How should prices be determined?" To this question we could make a short and simple answer: prices should be determined by the market.
The answer is correct enough, but some elaboration is necessary to answer the practical problem concerning the wisdom of government price control.
Let us begin on the elementary level and say that prices are determined by the supply and demand. If the relative demand for a product increases, consumers will be willing to pay more for it. Their competitive bids will both oblige them individually to pay more for it and enable producers to get more for it. This will raise the profit margins of the producers of that product. This, in turn, will tend to attract more firms into the manufacture of that product, and induce existing firms to invest more capital into making it. The increased production will tend to reduce the price of the product again, and to reduce the profit margin in making it. The increased investment in new manufacturing equipment may lower the cost of production. Or — particularly if we are concerned with some extractive industry such as petroleum, gold, silver, or copper — the increased demand and output may raise the cost of production. In any case, the price will have a definite effect on demand, output, and cost of production just as these in turn will affect price. All four — demand, supply, cost, and price — are interrelated. A change in one will bring changes in the others.
Just as the demand, supply, cost, and price of any single commodity are all interrelated, so are the prices of all commodities related to each other. These relationships are both direct and indirect. Copper mines may yield silver as a by-product. This is connexity of production. If the price of copper goes too high, consumers may substitute aluminum for many uses. This is a connexity of substitution. Dacron and cotton are both used in drip-dry shirts; this is a connexity of consumption.
In addition to these relatively direct connections among prices, there is an inescapable interconnexity of all prices. One general factor of production, labor, can be diverted, in the short run or in the long run, directly or indirectly, from one line into any other line. If one commodity goes up in price, and consumers are unwilling or unable to substitute another, they will be forced to consume a little less of something else. All products are in competition for the consumer's dollar; and a change in any one price will affect an indefinite number of other prices.
No single price, therefore, can be considered an isolated object in itself. It is interrelated with all other prices. It is precisely through these interrelationships that society is able to solve the immensely difficult and always changing problem of how to allocate production among thousands of different commodities and services so that each may be supplied as nearly as possible in relation to the comparative urgency of the need or desire for it.
Because the desire and need for, and the supply and cost of, every individual commodity or service are constantly changing, prices and price relationships are constantly changing. They are changing yearly, monthly, weekly, daily, hourly. People who think that prices normally rest at some fixed point, or can be easily held to some "right" level, could profitably spend an hour watching the ticker tape of the stock market, or reading the daily report in the newspapers of what happened yesterday in the foreign exchange market, and in the markets for coffee, cocoa, sugar, wheat, corn, rice, and eggs; cotton, hides, wool, and rubber; copper, silver, lead, and zinc. They will find that none of these prices ever stands still. This is why the constant attempts of governments to lower, raise, or freeze a particular price, or to freeze the interrelationship of wages and prices just where it was on a given date ("holding the line") are bound to be disruptive wherever they are not futile.
Price Supports for Export Items Let us begin by considering governmental efforts to keep prices up, or to raise them. Governments most frequently try to do this for commodities that constitute a principal item of export from their countries. Thus Japan once did it for silk and the British Empire for natural rubber; Brazil has done it and still periodically does it for coffee; and the United States has done it and still does it for cotton and wheat. The theory is that raising the price of these export commodities can only do good and no harm domestically because it will raise the incomes of domestic producers and do it almost wholly at the expense of the foreign consumers.
All of these schemes follow a typical course. It is soon discovered that the price of the commodity cannot be raised unless the supply is first reduced. This may lead in the beginning to the imposition of acreage restrictions. But the higher price gives an incentive to producers to increase their average yield per acre by planting the supported product only on their most productive acres, and by more intensive employment of fertilizers, irrigation, and labor. When the government discovers that this is happening, it turns to imposing absolute quantitative controls on each producer. This is usually based on each producer's previous production over a series of years. The result of this quota system is to keep out all new competition; to lock all existing producers into their previous relative position, and therefore to keep production costs high by removing the chief mechanisms and incentives for reducing such costs. The necessary readjustments are therefore prevented from taking place.
Meanwhile, however, market forces are still functioning in foreign countries. Foreigners object to paying the higher price. They cut down their purchases of the valorized commodity from the valorizing country, and search for other sources of supply. The higher price gives an incentive to other countries to start producing the valorized commodity. Thus, the British rubber scheme led Dutch producers to increase rubber production in Dutch dependencies. This not only lowered rubber prices but caused the British to lose permanently their previous monopolistic position. In addition, the British scheme aroused resentment in the United States, the chief consumer, and stimulated the eventually successful development of synthetic rubber. In the same way, without going into detail, Brazil's coffee schemes and America's cotton schemes gave both a political and a price incentive to other countries to initiate or increase production of coffee and cotton, and both Brazil and the United States lost their previous monopolistic positions.
Meanwhile, at home, all these schemes require the setting up of an elaborate system of controls and an elaborate bureaucracy to formulate and enforce them. This has to be elaborate, because each individual producer must be controlled. An illustration of what happens may be found in the United States Department of Agriculture. In 1929, before most of the crop-control schemes came into being, there were 24,000 persons employed in the Department of Agriculture. Today there are 109,000. These enormous bureaucracies, of course, always have a vested interest in finding reasons why the controls they were hired to enforce should be continued and expanded. And of course these controls restrict the individual's liberty and set precedents for still further restrictions.
None of these consequences seem to discourage government efforts to boost prices of certain products above what would otherwise be their competitive market levels. We still have international coffee agreements and international wheat agreements. A particular irony is that the United States was among the sponsors in organizing the international coffee agreement, though its people are the chief consumers of coffee and therefore the most immediate victims of the agreement. Another irony is that the United States imposes import quotas on sugar, which necessarily discriminate in favor of some sugar exporting nations and therefore against others. These quotas force all American consumers to pay higher prices for sugar in order that a tiny minority of American sugar cane producers can get higher prices.
I need not point out that these attempts to "stabilize" or raise prices of primary agricultural products politicalize every price and production decision and create friction among nations.
Holding Prices Down Now let us turn to governmental efforts to lower prices or at least to keep them from rising. These efforts occur repeatedly in most nations, not only in wartime, but in any time of inflation. The typical process is something like this. The government, for whatever reason, follows policies that increase the quantity of money and credit. This inevitably starts pushing up prices. But this is not popular with consumers. Therefore, the government promises that it will "hold the line" against further price increases.
Let us say it begins with bread and milk and other necessities. The first thing that happens, assuming that it can enforce its decrees, is that the profit margin in producing necessities falls, or is eliminated, for marginal producers, while the profit margin in producing luxuries is unchanged or goes higher. This reduces and discourages the production of the controlled necessities and relatively encourages the increased production of luxuries. But this is exactly the opposite result from what the price controllers had in mind. If the government then tries to prevent this discouragement to the production of the controlled commodities by keeping down the cost of the raw materials, labor, and other factors of production that go into them, it must start controlling prices and wages in ever-widening circles until it is finally trying to control the price of everything.
But if it tries to do this thoroughly and consistently, it will find itself trying to control literally millions of prices and trillions of price cross-relationships. It will be fixing rigid allocations and quotas for each producer and for each consumer. Of course these controls will have to extend in detail to both importers and exporters.
If a government continues to create more currency on the one hand while rigidly holding down prices with the other, it will do immense harm. And let us note also that even if the government is not inflating the currency, but tries to hold either absolute or relative prices just where they were, or has instituted an "incomes policy" or "wage policy" drafted in accordance with some mechanical formula, it will do increasingly serious harm. For in a free market, even when the so-called price "level" is not changing, all prices are constantly changing in relation to each other. They are responding to changes in costs of production, of supply, and of demand for each commodity or service.
And these price changes, both absolute and relative, are in the overwhelming main both necessary and desirable. For they are drawing capital, labor, and other resources out of the production of goods and services that are less wanted and into the production of goods and services that are more wanted. They are adjusting the balance of production to the unceasing changes in demand. They are producing thousands of goods and services in the relative amounts in which they are socially wanted. These relative amounts are changing every day. Therefore the market adjustments and price and wage incentives that lead to these adjustments must be changing every day.
Price Control Distorts Production Price control always reduces, unbalances, distorts, and discoordinates production. Price control becomes progressively harmful with the passage of time. Even a fixed price or price relationship that may be "right" or "reasonable" on the day it is set can become increasingly unreasonable or unworkable.
What governments never realize is that, so far as any individual commodity is concerned, the cure for high prices is high prices. High prices lead to economy in consumption and stimulate and increase production. Both of these results increase supply and tend to bring prices down again.
Very well, someone may say; so government price control in many cases is harmful. But so far you have been talking as if the market were governed by perfect competition. But what of monopolistic markets? What of markets in which prices are controlled or fixed by huge corporations? Must not the government intervene here, if only to enforce competition or to bring about the price that real competition would bring if it existed?
The fears of most economists concerning the evils of "monopoly" have been unwarranted and certainly excessive. In the first place, it is very difficult to frame a satisfactory definition of economic monopoly. If there is only a single drug store, barber shop, or grocery in a small isolated town (and this is a typical situation), this store may be said to be enjoying a monopoly in that town. Again, everybody may be said to enjoy a monopoly of his own particular qualities or talents. Yehudi Menuhin has a monopoly of Menuhin's violin playing; Picasso of producing Picasso paintings; Elizabeth Taylor of her particular beauty and sex appeal; and so for lesser qualities and talents in every line.
On the other hand, nearly all economic monopolies are limited by the possibility of substitution. If copper piping is priced too high, consumers can substitute steel or plastic; if beef is too high, consumers can substitute lamb; if the original girl of your dreams rejects you, you can always marry somebody else. Thus, nearly every person, producer, or seller may enjoy a quasi monopoly within certain inner limits, but very few sellers are able to exploit that monopoly beyond certain outer limits. There has been a tremendous literature within recent years deploring the absence of perfect competition; there could have been equal emphasis on the absence of perfect monopoly. In real life competition is never perfect, but neither is monopoly.
Unable to find many examples of perfect monopoly, some economists have frightened themselves in recent years by conjuring up the specter of "oligopoly," the competition of the few. But they have come to their alarming conclusions only by inserting in their own hypotheses all sorts of imaginary secret agreements or tacit understandings between large producing units, and deducing what the results could be.
Now the mere number of competitors in a particular industry may have very little to do with the existence of effective competition. If General Electric and Westinghouse effectively compete, if General Motors and Ford and Chrysler effectively compete, if the Chase Manhattan and the First National City Bank effectively compete, and so on (and no person who has had direct experience with these great companies can doubt that they dominantly do), then the result for consumers, not only in price, but in quality of product or service, is not only as good as that which would be brought about by atomistic competition but much better, because consumers have the advantage of large-scale economies, and of large-scale research and development that small companies could not afford.
A Strange Numbers Game The oligopoly theorists have had a baneful influence on the American antitrust division and on court decisions. The prosecutors and the courts have recently been playing a strange numbers game. In 1965, for example, a Federal district court held that a merger that had taken place between two New York City banks four years previously had been illegal, and must now be dissolved. The combined bank was not the largest in the city, but only the third largest; the merger had in fact enabled the bank to compete more effectively with its two larger competitors; its combined assets were still only one-eighth of those represented by all the banks of the city; and the merger itself had reduced the number of separate banks in New York from 71 to 70. (I should add that in the four years since the merger the number of branch bank offices in New York City had increased from 645 to 698.) The court agreed with the bank's lawyers that "the general public and small business have benefited" from bank mergers in the city. Nevertheless, the court continued, "practices harmless in themselves, or even those conferring benefits upon the community, cannot be tolerated when they tend to create a monopoly; those which restrict competition are unlawful no matter how beneficent they may be."
It is a strange thing, incidentally, that though politicians and the courts think it necessary to forbid an existing merger in order to increase the number of banks in a city from 70 to 71, they have no such insistence on big numbers in competition when it comes to political parties. The dominant American theory is that just two political parties are enough to give the American voter a real choice; that when there are more than this it merely causes confusion, and the people are not really served. There is this much truth in this political theory as applied in the economic realm. If they are really competing, only two firms in an industry are enough to create effective competition.
Monopolistic Pricing The real problem is not whether or not there is "monopoly" in a market, but whether there is monopolistic pricing. A monopoly price can arise when the responsiveness of demand is such that the monopolist can obtain a higher net income by selling a smaller quantity of his product at a higher price than by selling a larger quantity at a lower price. It is assumed that in this way the monopolist can realize a higher price than would have prevailed under "pure competition."
The theory that there can be such a thing as a monopoly price, higher than a competitive price would have been, is certainly valid. The real question is, How useful is this theory either to the supposed monopolist in deciding his price policies or to the legislator, prosecutor, or court in framing antimonopoly policies? The monopolist, to be able to exploit his position, must know what the "demand curve" is for his product. He does not know; he can only guess; he must try to find out by trial and error. And it is not merely the unemotional price response of the consumers that the monopolist must keep in mind; it is what the effect of his pricing policies will probably be in gaining the goodwill or arousing the resentment of the consumer. More importantly, the monopolist must consider the effect of his pricing policies in either encouraging or discouraging the entrance of competitors into the field. He may actually decide that his wisest policy in the long run would be to fix a price no higher than he thinks pure competition would set, and perhaps even a little lower.
In any case, in the absence of competition, no one knows what the "competitive" price would be if it existed. Therefore, no one knows exactly how much higher an existing "monopoly" price is than a "competitive" price would be, and no one can be sure whether it is higher at all!
Yet antitrust policy, in the United States, at least, assumes that the courts can know how much an alleged monopoly or "conspiracy" price is above the competitive price that might-have-been. For when there is an alleged conspiracy to fix prices, purchasers are encouraged to sue to recover three times the amount they were allegedly forced to "overpay."
Our analysis leads us to the conclusion that governments should refrain, wherever possible, from trying to fix either maximum or minimum prices for anything. Where they have nationalized any service — the post office or the railroads, the telephone or electric power — they will of course have to establish pricing policies. And where they have granted monopolistic franchises — for subways, railroads, telephone or power companies — they will of course have to consider what price restrictions they will impose.
As to antimonopoly policy, whatever the present condition may be in other countries, I can testify that in the United States this policy shows hardly a trace of consistency. It is uncertain, discriminatory, retroactive, capricious, and shot through with contradictions. No company today, even a moderate sized company, can know when it will be held to have violated the antitrust laws, or why. It all depends on the economic bias of a particular court or judge.
There is immense hypocrisy about the subject. Politicians make eloquent speeches against "monopoly." Then they will impose tariffs and import quotas intended to protect monopoly and keep out competition; they will grant monopolistic franchises to bus companies or telephone companies; they will approve monopolistic patents and copyrights; they will try to control agricultural production to permit monopolistic farm prices. Above all, they will not only permit but impose labor monopolies on employers, and legally compel employers to "bargain" with these monopolies; and they will even allow these monopolies to impose their conditions by physical intimidation and coercion.
I suspect that the intellectual situation and the political climate in this respect is not much different in other countries. To work our way out of this existing legal chaos is, of course, a task for jurists as well as for economists. I have one modest suggestion: We can get a great deal of help from the old common law, which forbids fraud, misrepresentation, and all physical intimidation and coercion. "The end of the law," as John Locke reminded us in the 17th century, "is not to abolish or restrain, but to preserve and enlarge freedom." And so we can say today that in the economic realm, the aim of the law should not be to constrict but to maximize price freedom and market freedom.
[Free Market Economics: A Basic Reader (1966; 1974)]
What was earth-shattering about the advent of economics, according to Ludwig von Mises, was its unprecedented discovery of regularity in the social realm. Just as Kepler, Galileo, and Newton had discovered that there were immutable laws that regulate the movements of physical bodies, the early economists discovered that there were immutable laws that regulate market phenomena.[1]
Key among these discoveries was the realization that prices are not arbitrary numbers that people simply tack on to commodities. There are causal laws that regulate their formation.
One of these laws has even become a household term. Everyone has at least heard of "supply and demand," although most do not really know what it means. Those who have taken an introductory economics course may have heard that prices settle at the level at which "supply equals demand."
The great Austrian economist Eugen von Böhm-Bawerk considered the supply-and-demand formulation as all well and good, but he discovered that prices are determined more directly by something else.
In any given market for a good, there will always be four people whose valuations put them in a special position. Böhm-Bawerk called these four people the "marginal pairs." It is these marginal pairs that directly determine prices.
In this article, I will walk the reader through how this occurs. The examples used below are largely drawn from book 4 of Böhm-Bawerk's The Positive Theory of Capital, although updated for the modern reader.
Isolated Exchange[product:10651]
A hallmark of the scientific/educational method of Austrian economics is to start with the simplest phenomenon, and then to work one's way up to greater complexity. And so Böhm-Bawerk starts analyzing price formation with the smallest number of participants conceivable: two. This is called "isolated exchange."
For example, you can have, on one side, someone who has silver and wants a horse. Let's call her Jockey Jane. In the market for horses, Jockey Jane is a buyer.
On the other side, you have a neighbor who has a horse, and wants silver. Let's call him Breeder Bill. In the market for horses, Breeder Bill is a seller.
And let's say the silver is denominated by weight in terms called "dollars," and that the smallest practically exchangeable amount of silver is 1/100 of a dollar.
Jockey Jane would be willing to pay $30 for Bill's horse, but not a penny more. Thus, we say Jockey Jane's maximum buying price is $30. We can draw up a "scale of values" that represents this state of affairs.
(Brackets represent items not presently possessed.)
Jockey Jane$30.01[A Horse]$30.00 ← Maximum buying priceBreeder Bill would be willing to sell his horse for $10, but not a penny less. Thus, we say Breeder Bill's minimum selling price is $10. His scale of values looks like this:
Breeder Bill[$10.00] ← Minimum selling priceA Horse[$9.99]Here we have sketched an "imaginary construction," or thought experiment. What can we logically deduce from the data of this imaginary construction?
First of all, we can see that there is a mutually beneficial exchange to be had here. A horse-for-money exchange made at any price from $10 to $30 would be beneficial to both Jane and Bill.
But we cannot a priori deduce exactly where in that range the price will ultimately fall. As Böhm-Bawerk wrote,
Here, then, is room for any amount of "higgling." 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.
One-Sided CompetitionNow, let's move up to the next level of complexity, and add another buyer. Glue-Maker Gabe is also interested in buying Breeder Bill's horse. His maximum buying price happens to be less than Jockey Jane's. He would be willing to pay $20, and not a penny more. Thus his scale of values is:
Glue-Maker Gabe$20.01[A Horse]$20.00 ← Maximum buying priceWhen you first glance at the data of this situation, it might seem that things are essentially the same: that the price can still range from $10 to $30, since any price within that range would be mutually satisfactory to some pair of market participants
However, the fact that the exchange is no longer "isolated" means that there is now room for competition. And competition changes things drastically.
Consider whether the price would actually settle, say, at $15. Jockey Jane is about to fork over $15 to Breeder Bill for the horse. Will Glue-Maker Gabe sit idly by while Jane rides off into the sunset, leaving him to walk?
No, Gabe would instead overbid the $15. He might offer $16, because that would be well under his maximum buying price of $20. And Breeder Bill would, other things being equal, prefer to sell for $16 than $15.
But that wouldn't be the end of it. It would then be in Jane's interest to overbid the $16. She might bid $17, since that is well under her maximum buying price of $30.
This mutual overbidding has a logically necessary stopping point. At any price under $20, both Jane and Gabe would find it in their interests to overbid each other. But as soon as Jane makes any offer above $20, she outbids Gabe, excluding him from the market (much to the relief of the horse).
Glue-Maker Gabe would then be an excluded buyer. Jockey Jane bids the horse away from Gabe because, having a higher maximum buying price than Glue-Maker Gabe, she is a more capable buyer than he is.
As always, the price will have to be below the successful buyer's maximum price. That is the upper limit.
But what about the lower limit? As always, the price will have to be somewhere at or above the seller's (Breeder Bill's) minimum price ($10). But, in this situation, the price will also have to exceed the excluded buyer's (Glue-Maker Gabe's) maximum price ($20); that is the level Jane must exceed in order to outbid Gabe. The exact price that is settled on within this range depends on the relative bargaining abilities of Bill and Jane.
Even though Gabe is excluded, his valuation is still important for the determination of the price Jane ultimately pays. If he had been more "capable" (had a higher maximum price), this would have raised the market's "floor." If he had been less capable, this would have lowered the market's floor.
Now let's add even more buyers: Farmer Frida, Polo Pete, and Cavalry Carl. Their maximum buying prices are $28, $25, and $22 respectively. Thus we can make the following table:
Horse Buyer
Maximum Buying Price
Jockey Jane
$30
Farmer Frida
$28
Polo Pete
$25
Cavalry Carl
$22
Glue-Maker Gabe
$20
Just as in the previous scenario, Jockey Jane is still the most capable buyer. She is in a position to outbid everyone else for Bill's horse. So we know she is the one who will ride away with it. But the range of possible prices that she would pay Bill is far different.
At any price under $20, five buyers would mutually overbid each other to get Bill's horse. But once the bidding exceeds $20, Glue-Maker Gabe is excluded. Above that, at any price over under $22, four buyers would overbid each other to get Bill's horse. But once the bidding exceeds $22, Cavalry Carl is excluded.
This process of overbidding and excluding continues until Jane outbids Frida and finally gets the horse.
Now we have multiple excluded buyers. As we saw in the previous scenario, an excluded buyer can have an impact on the ultimate price paid. Now from this scenario, we can see that it is one particular kind of excluded buyer that has this impact.
Frida (like Pete, Carl, and Gabe) is an excluded buyer. But she is special in that, out of all the excluded buyers, she has the highest maximum buying price. In other words she is the most capable excluded buyer; or, to use Böhm-Bawerk's term, the "first excluded buyer."
Although she walked away just as empty-handed as the other excluded buyers, as the first excluded buyer, her valuation is uniquely important for the ultimate price of the horse.
It is the valuation of the first excluded buyer that places a lower limit on the price of the horse. Jane will hold out for as low a price as she can; but she cannot insist on a price lower than $28, because, if she does, she will bring Frida back into the bidding.
Thus, in one-sided competition among buyers, the price range is bounded
at the top, by the maximum price of the successful buyer, andat the bottom, either bythe maximum price of the first excluded buyer, orthe minimum price of the sole seller (whichever is higher).Again, exactly where within this range the market settles is determined by bargaining between the seller and the successful buyer.
Also, we can plainly see how the more buyers there are in a market, the narrower will the range of possible prices tend to be, and the higher the ultimate price will likely be.
The situation would be essentially the same, except reversed, if there were multiple horse sellers and one horse buyer (of course, assuming the buyer considered all the horses to be of the same quality).
The most capable seller (the one with the lowest minimum selling price) would be the one who would succeed in unloading his horse. And the price of the horse would be bounded
at the bottom, by the minimum price of the successful seller, andat the top, either bythe minimum price of the first excluded seller (who is, of all the unsuccessful sellers, the one who would have been willing to accept the least for his horse), orthe maximum price of the sole buyer (whichever is lower).Two-Sided CompetitionOf course most real-life markets have multiple buyers and multiple sellers. So it is important to understand the dynamics of two-sided competition.
With so many factors involved, two-sided competition might seem too hopelessly complicated to figure out. But, don't worry; it's actually not that hard, once you are walked through it. But we will need to drop the cute names. Buyers will be B1, B2, etc., and sellers will be S1, S2, etc.
Ten buyers, each looking for a horse, approach 8 sellers, each looking to sell 1 horse.
Here are the 10 buyers, each wanting one horse, and their maximum buying prices:
Buyers
Maximum Buying Price
B1
$30
B2
$28
B3
$26
B4
$24
B5
$22
B6
$21
B7
$20
B8
$18
B9
$17
B10
$15
And here are the 8 sellers, each looking to sell 1 horse, and their minimum selling prices.
Sellers
Minimum Selling Price
S1
$10
S2
$11
S3
$15
S4
$17
S5
$20
S6
$21.10
S7
$25
S8
$26
First of all, we know that, at most, only 8 exchanges can occur, because there are only 8 horses to be sold. Only 8 of the 10 buyers can ride away with a horse.
Furthermore, we know it will be the 8 most capable buyers, if anybody, who each will get a horse, because they are in a position to outbid the 2 least capable buyers.
Let's say B5 starts off the bidding by announcing that he will pay $13 for a horse. From behind him comes a chorus of "me too!" All 9 of the other buyers jump at the prospect of paying such a low price. We therefore say that the quantity of horses demanded at $13 is 10.
But on the other side, only 2 of the sellers (S1, and S2) then lead their horses forward, because only they, the 2 most capable sellers, are willing to accept such a low price; the rest are excluded. We therefore say that the quantity of horses supplied at $13 is 2.
Clearly, at $13, the quantity demanded outstrips the quantity supplied. This lopsidedness of the market has important implications.
S1, and S2 can only satisfy 2 of the 10 willing buyers. Let's say they're about to hand over their horses to B2, and B4 for $13. Are the 8 other buyers, each of whom would gladly pay $14 for a horse, going to sit idly by and be excluded from doing business with the horse sellers most likely to offer the best deals?
Furthermore, are S1, and S2, who can plainly see the great number (and the eager looks) of the other buyers, going to hastily accept such a low price, when it is evident they can get more?
Clearly the sellers would find it in their best interest to hold out for more, and the buyers would be impelled by their value scales to mutually overbid one another.
As the price is bid up, the quantity demanded, and the quantity supplied, both change. Buyers are progressively weeded out, least capable first. Also, formerly excluded sellers get progressively drawn back in, most capable first.
For example, $16 will prove to be too rich for B10's blood, but just enough to bring S3 back into the market; then it's 9 buyers against 3 sellers. At $18, B9 says "thanks, but no thanks," while S4 says, "now you're talking!"; then it's 8 buyers against 4 sellers.
Thus the lopsidedness of the market begins to dwindle. Yet, as long as any lopsidedness remains, the mutual overbidding will continue. As Böhm-Bawerk put it,
So long, however, as the rival buyers are in the majority, and this fact is accurately known in the market, there can be no final settlement. For, on the one hand the sellers have always the chance, and the temptation, to take advantage of the excess of buyers and stand out for higher prices; and, on the other hand, the mutually opposed interests of the rival buyers compel them to bid still higher against each other.
An excess demand (in this case, a majority of buyers) is, therefore, inherently unsettling. The unsettled dynamic only goes away when the excess demand goes away.
For example, let us say the going price shifts from $19 to $21.05. At this point, B6 drops out, S5 is drawn back in, and we have 5 buyers versus 5 sellers. We no longer have a majority of buyers; the quantity supplied equals the quantity demanded.
Now, what if the sellers continue to try to hold out for a still higher price? They can, but only up to a certain point.
If, for example, sellers insist on $23, B5 will be pushed out of the market and S6 will be drawn back in. If that happens, there will be a majority of sellers, and therefore an excess supply.
Once this is the case, the exact opposite of what happened with the majority of buyers will happen. The surplus sellers will underbid each other, sending the price back downward.
The only settling condition in a market is one in which there is no majority, either of buyers or sellers: where "supply equals demand."
For example, our market might settle at $21.05. At this price, the five most capable buyers purchase the horses of the five most capable sellers. The market "clears."
This "market-clearing price" is the price at which there are no "frustrated buyers" (excess demand) who say, "I would have paid that for a horse" and no "frustrated sellers" (excess supply) who say, "I would have taken that for a horse." In other words, there is no "shortage" or "surplus."
There are only successful exchangers who say, "That was a good price for me," and unsuccessful exchangers who say, "That would not have been a good price for me."
The Marginal PairsFrom the above considerations, it can be inferred that there are four important positions on the market. These positions make up the "marginal pairs."
The first two important positions together make up the first marginal pair. They provide the upper limit for the market-clearing price, so let's call them the "upper marginal pair."
-
The Last BuyerThis is the least capable of the successful buyers. If the price were to continue to rise, he would be the first buyer to drop out; that is what makes him "marginal" (on the edge). If the price were to rise enough to knock him out, there would be an excess supply, and therefore an unsettled market.
-
The First Excluded SellerThis is the most capable of the unsuccessful sellers. He is "marginal," because if the price were to continue to rise, he would be the first seller to jump back in. If the price were to rise enough to draw him back into the market, there would be an excess supply, and therefore an unsettled market.
The upper bound of the market-clearing price is therefore determined either by the maximum price of the last buyer or the minimum price of the first excluded seller: whichever is lower.
And next we have the "lower marginal pair."
-
The Last SellerThis is the least capable of the successful sellers. If the price were to continue to drop, he would be the first seller to drop out. If the price were to drop enough to knock him out, there would be an excess demand, and therefore an unsettled market.
-
The First Excluded BuyerThis is the most capable of the unsuccessful buyers. If the price were to continue to drop, he would be the first buyer to jump back in. If the price were to drop enough to draw him back into the market, there would be an excess demand, and therefore an unsettled market.
The lower bound of the market is therefore determined either by the minimum price of the last seller, or the maximum price of the first excluded buyer: whichever is higher.
In real-life markets, with manifold buyers and sellers, these bounds will generally be extremely close together, often resulting in a single possible market-clearing price.
This is what Mises meant when he wrote that 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.[2]
We haven't enough space here to extend the analysis to cases in which market participants each buy or sell multiple horses. But as Rothbard demonstrates, such an extension "makes no substantial change in the analysis."[3]
It is still the marginal pairs who stand as two sets of twin sentries, demarcating the zones where markets can clear.[4]
The Social Function of Price RationingWhy is it important that markets clear? Why is the market-price system, characterized as it is by competitive bidding, important? Of all the possible standards for rationing, why is the standard of exchange "capability" (maximum buying price or minimum selling price) the best?
One factor that determines exchange capability is how direly the person wants the good in question. This cannot be quantitatively measured, but using our historical understanding, we can perceive a difference between, say, Farmer Frida wanting the horse to plow her field so she can feed her hungry family and Polo Pete wanting the horse for sport riding on the weekends. And we can easily imagine how the relative direness of Frida's need versus Pete's need would provide a relative boost to Frida's exchange capability.
Most people look kindly on the notion of such a difference expressing itself in a market outcome.
But then another factor that determines exchange capability is how wealthy the market participant is. For example, Jockey Jane, like Pete, also wants the horse for recreational purposes. Yet, perhaps because she has more money, she is able to outbid the desperate Frida.
Many people do not look kindly on that kind of a market outcome, and thus are severely critical of the market-price system.
What such critics miss, however, is that the market-price system's primary importance is not the bare fact that it rations already-produced goods a certain way on the spot. Its primary importance for humanity is the role such rationing has in coordinating and optimizing future production. As Mises put it,
The allocation of portions of the supply already produced and available to the various individuals eager to obtain a quantity of the goods concerned is only a secondary function of the market. Its primary function is the direction of production.[5]
As Mises characterized it, the market is distinguished by "consumer sovereignty." Consumers vote with their dollars to shape the productive structure to best satisfy their wants.
For example, let us say Jane and Frida were entrepreneurs and had actually been bidding for the horse for use in the production of other goods. If Jane is able to outbid Frida due to her superior wealth, this indicates that the consumers considered Jane to have been a better past steward of the means of production than Frida.
By voting for her with their dollars, they have put Jane in a more prominent place at the helm of production. Since everyone is first and foremost a consumer, and a producer only subordinately (production being for the sake of consumption), it is in the interest of everyone that the means of production be directed toward those who best arrange them according to consumer wants.
If, irrespective of bidding, a horse was rationed to Frida instead of Jane, this may be a one-off boon to Frida. But if such rationing were the rule, and the sovereign consumers were dethroned across the board, Frida would lose as a consumer far more than she gained as a producer.
One might then object that, in our earlier construction, Jane and Frida were not bidding for the horse as an intermediate good. Both Jane and Frida were bidding for the horse as a final good: Jane for riding, and Frida for subsistence farming. What does Jane's superior bidding power have to do with the market's structure of production in this case?
Jockey Jane may indeed have more votes than Farmer Frida in the consumer's democracy. But, insofar as her wealth was acquired on the market, its level is a function of how much she (or her benefactor), as a producer, contributed to satisfying consumer wants.
The more commensurately her past contribution is rewarded, the more she will be guided toward maximizing her future contribution. And this is true of all producers, including producers of horses, like Breeder Bill.
The market-price system that gives Jockey Jane more purchasing power than Farmer Frida, is the very same market-price system that guides and enables Bill and his fellow breeders to produce an abundance of horses. You cannot have one without the other, for they are one and the same.
[product:0]
With this system, horses (as well as other goods and services) will more likely be abundant and cheap enough for both Jane and Frida to get what they want. Without it, horses (as well as other goods and services) will more likely be so scarce and expensive that neither will.
In studying complex real markets, it is virtually impossible to know which four people make up the marginal pairs for any given price. The staffing of these roles is in constant flux. But still, the marginal pairs stand in silent vigil at the threshold between efficiency and waste, determining the prices that direct "the employment of the factors of production into those channels in which they satisfy the most urgent needs of the consumers."[6]
The author would like to thank Joseph Salerno, David Gordon, and Abhinandan Mallick for their indispensable advice regarding this article.
Notes[1] "Economics opened to human science a domain previously inaccessible and never thought of. The discovery of a regularity in the sequence and interdependence of market phenomena went beyond the limits of the traditional system of learning." Ludwig von Mises, Human Action, Introduction, Sec. 1.
[2] Mises, Human Action, Ch. 16, Sec. 1.
[3] Rothbard, Man, Economy, and State, Ch. 2, Sec. 5.
[4] To be precise there is a conceivable kind of instance in which this would not be the case, although it is of little practical significance. See Böhm-Bawerk, The Positive Theory of Capital, p. 215.
[5] Mises, Human Action, Ch. 30, Sec. 2.
[6] Ibid.
[On Freedom and Free Enterprise (1956)]
One of the cornerstones of economic theory is the economic value we attach to commodities and services that possess a relation to our well-being. Economic value is the importance which a good possesses for us because it is useful and scarce.
It is to the everlasting credit and fame of Carl Menger and other scholars of the Austrian School to have found and expounded this elementary knowledge of subjective value. They then proceeded to apply the value analysis in the field of complementary goods, i.e., goods that are required to cooperate in the rendition of use services, and finally in the field of capital goods, which they called "goods of higher order." The theory of the value of complementary goods then became the key for the solution of one of the most important and difficult problems of economics: the problem of distribution.
The valuations of the consumers in a market economy, in final analysis, determine the way in which the ultimate product is distributed among the cooperating factors of production. How little this elementary knowledge of economic valuation is known can be seen at the widespread acceptance and circulation of wage theories that deny any relation to the valuation process. The American public embraces and most institutions of economic education teach theories of "bargaining-power," "purchasing-power," "standard-of-living," the "subsistence theory," or even the unadulterated "exploitation theory."
Distribution through the valuation process seems to be known to a few remnants of "reactionary" and "outdated" scholars and writers only. It is to the enduring credit of Ludwig von Mises that he, for several decades, has been the foremost "reactionary" among scholars, a reactionary of reason and economic theory. For this he merits our admiration and gratitude.
Many people sincerely believe that the value of anything is determined by the labor used in producing it; that its price ought to reflect quite objectively the amount of labor put into it. The belief in this labor theory of value, however, is founded in myth, not fact. Day-to-day experiences reveal its error. For a far-fetched example, the same labor could be used to make mud pies as to make mince pies, yet the value in the market place would differ.
A service or a product of little value at one time or in one place may be highly valued at another time and place. For instance, an artist may produce hundreds of paintings considered freakish by others and be rewarded with starvation for his labors. But, let his style become the fad, and for less labor than before, he can revel in luxury.
Lost and adrift on a raft for days, a man might offer his fortune in exchange for a hamburger. Yet, the same person, following a lusty meal, might not offer a penny in exchange, though the hamburger had changed not at all.
Individuals have varying value judgments. Value in the market sense, therefore, is a subjective rather than an objective determination. In a way, it is like beauty. What is beauty? It is what you or I or other individuals think is beautiful. It depends on subjective or personal value judgments, judgments characterized by constant variation.
Value, as beauty, cannot be objectively determined. That all persons may think of a certain sunset as beautiful, a given monster as hideous, gold as desirable, or mud pies as useless does not alter the fact that these are subjective judgments. Such unanimity merely asserts that some subjective judgments are similar.
It is not at all surprising that many persons in the United States and throughout the world do not subscribe to the subjective nature of value. As far as can be determined, no one understood it well enough to try an explanation until the latter part of the 19th century. Prior to that, such a notable as John Stuart Mill and the very best of economists, including Adam Smith and Ricardo, were stymied in their development of economic theory because they accepted the cost-of-production or labor theory of value.
They simply could not explain what they otherwise knew to be the great advantages of the free market process of voluntary exchange. They knew full well that both parties must gain when each traded what he wanted less for what he wanted more, yet they could not show that such gain had been "earned," for they were unable to explain it in terms of labor costs. In short, they were unable to see how the free market price might be competitively or subjectively determined by individuals who had no accurate knowledge of the labor or other costs involved in producing a particular item.
How Adam Smith, holding to this labor theory of value, could have seen the great advantages of trade — the untold blessings of others, or society, to the individual — and could have come out in favor of private enterprise instead of socialism, is a miracle more to be attributed to sound instinct than to economic reasoning.
Marx, as distinguished from Adam Smith, followed the labor theory of value to its logical conclusion: socialism. Marx looked upon all things useful as one great "wages fund" and believed that the entire fund ought to be distributed directly to laborers. To allow any part of this fund as a return on capital would amount to unearned increment and, he argued, would be exploitation.
How any advocate of the cost-of-labor theory could believe in anything but socialism is difficult to understand. Smith, Ricardo, Mill, and many others instinctively, not logically, concluded otherwise.
Only if one understands the marginal utility or subjective theory of value based upon the judgments of countless individuals acting freely and voluntarily in the market may he proceed logically to a belief in private ownership and control of property. With this kind of an understanding, he can see why any person may have a perfect right to consume more than he could ever hope to produce by his own labor.
He can, it is plain, properly own anything others will freely offer in exchange for what he has to offer them. This means gains for all participants in the exchange process, gains which must always appear to be unearned in terms of labor expended. Nonetheless, it reflects the approval of all who are properly concerned in any transaction.
The marginal utility or subjective theory of value needs no other justification. Because it is based on willing exchange, it works without coercing anyone. The labor theory of value — the labor theory of price determination — on the other hand, founded on unwilling exchange, cannot function without coercion.
Now, let us proceed to the person whose father invested $500 in an early auto industry and who now wonders to whom he should give the resulting millions. He is no more the recipient of unearned increment than is the person who today works for a wage in the same company. Both exist on what they themselves do not and could not produce. And if the wage earner were to succeed in cutting off what he might think are the unearned riches of his "lucky" brothers, he would at the same time destroy his own source of livelihood.
Let us contemplate this wage earner. He lives in a house he could not build. Perhaps, given enough materials and tools properly fabricated and the plans some architect has drawn, he could put together something resembling a house.
But he wouldn't know how to make a lowly nail: mine the ore, alloy the metals, construct the furnaces, build the extrusion and other machinery, and so on. Could he make a hammer? A saw? Bring the lumber to its finished state? Even make the string on which his plumb hangs? Grow and gin and spin and comb and weave the cotton from which it is made?
Could he build the machinery that mines the coal he uses to heat his house? He could not make the lamp the miners wear if every ingredient depended solely on his own resources.
What about the automobiles he helps to put together, one of which he owns? Neither he nor any other person on this earth could produce it alone. What about the food he eats? The clothes he wears? The books and magazines he reads? The telephone he uses? The counsel on health that is his? The opportunities that are constantly presented to him?
All are done by a vast work and exchange process, millions of individuals with as many varied skills laboring cooperatively and competitively — a world of complex and flowing energy, the organization of which is more complicated than any one person can understand, let alone control. Others — society past and present — place within his reach goods and services and knowledge in such an array and abundance that he could not himself produce in thousands of years that portion of it which he consumes in a single day. And he obtains all of this in exchange for his own meager efforts.
The astounding thing is that it is possible for him to gain without any change in his efforts, his skills, his knowledge. Let others become more inventive and more productive, and he may receive more in exchange for what he has to offer. Parenthetically, it is also possible for him to lose out entirely, as might happen if he persisted in offering nothing in exchange but buggy whips.
There is a fact still more astounding. Our wage earner may think of his plight as hapless when compared to the one who inherited his millions. True, the millionaire has gained much from the doings of others. But the wage earner himself owes his life to the doings of others.
It is not that possessing millions and having life are alternative propositions. That is not the point. The point is that both flow from the same exchange process and that whatever each has — be it autos, houses, food, clothing, heat, millions, knowledge, or life itself — comes to him unearned in the sense that he alone did not produce all of it.
We trade because we can all get more satisfaction from our labor by that means. Vast stores are available to those who have anything to trade that others value. In the free market, each earns all that he receives in willing exchange. This is fantastically more than one could produce by himself.
In order fully to grasp the process by which one can consume in a day that which he could not produce in thousands of years — the process by which he can earn in a day that which he could not earn by himself in thousands of years — it is only necessary for one to see that one's earning power is capable of unlimited expansion by the productivity and exchange and value judgments of others.
This world of creative energy, this productivity exterior to self, then, becomes of singular importance to each one of us. Not only does our prosperity — material, intellectual, and spiritual — depend upon it, but life itself comes under its government. In short, each of us is the beneficiary of this productivity through division of labor and capital accumulation and investments by others.
Let us sample this world of productivity through division of labor from the standpoint of oneself as a potential beneficiary of its largess. The mathematics of nuclear fission is known to some scholars. I, however, do not know that much mathematics. Such knowledge conceivably can be mine. But I can possess it only by increasing my own perceptive powers.
It may very well be that the required increase in perception is beyond my competency or that I may choose to increase my perception along other lines to the exclusion of perceptive powers along this line. But, assuming that I do gain this knowledge, do I earn it? Yes, as much as though I gained the knowledge by direct revelation. Direct, or indirect through study of the knowledge of others, does not alter the matter.
The same principle applies to a product as to an item of knowledge. Luxurious yachts are available. Their making is as foreign and as unrelated to me as presently is the mathematics of nuclear fission. I do not have one. Such a possession conceivably could be mine. I could become the beneficiary of its existence by increasing my own exchange powers or, should all others become sufficiently productive, I could have one in exchange for efforts no greater than I now exercise.
But assume that I do obtain one in exchange for my present meager efforts; do I earn it? Yes, even though it is in the sense I earn a deer by choosing the path I will walk and by pulling the trigger on a gun. All else is supplied. The deer, a miracle about which man had nothing to do, crossed my path. The gun, the powder, the shot represented creative ingenuity flowing through space and time about which I have but the dimmest of notions.
As with the deer, so with the yacht. I earn it as though I had done it all myself. Others in their productivity, knowledge, skills willingly exchanged what I offered them.
Someone may argue that I could have exchange power to obtain a yacht had I been born the son of a father who "hit it lucky." By the same token, I might have the perceptive powers to understand the mathematics of nuclear fission had my parentage been different.
Seeing oneself in true perspective as related to all others is utterly impossible. We but dimly comprehend ourselves; the comprehension of others is much dimmer. However, it is not necessary that this perspective be perfect. It is only necessary that we grasp the idea of being a beneficiary of this benefactor, this division of labor, and that we understand and appreciate our dependence on and our relationship to it.
Looked at in this light — oneself as a beneficiary and division of labor as a benefactor — it becomes pertinent to re-examine one's own behaviors, attitudes, actions. If we would best serve our individual self-interest, we would do well to live in harmony with the facts of life, not in disharmony with them.
Looked at in this light, one should do everything possible to increase his own perceptive and exchange powers. It is only by self-improvement that one can best serve self. And, clearly, it is only by self-improvement that one can better serve others — that is, add to someone else's well-being.
Who composes this benefactor of ours, this storehouse of energy? It is composed of individuals who, like ourselves, are different from all others and who, like ourselves, depend on others. And what ought to be our attitude toward these millions of others if looked at from the standpoint of self-interest?
Self-reliance, a great virtue, should be emphasized. The way to be self-reliant is to keep off the backs of others and to engage in willing — never unwilling — exchange. This is the free market.
It is a primary fact of observation that these others, like one-self, will work at their best if permitted the ownership and control of the fruits of their own labor — and of their own participation in the exchange process. It is in one's interest to preserve his incentive. This is the institution of private property.
As with oneself, these others will act at their best creatively if left free to do so. One should, therefore, look with great disfavor on any interference with creative activity and on any inhibitions to free exchange and communication of creative action.
One's own interest is impaired if there are marauders or robbers or authoritarians among these others; if there are men among them practicing violence, fraud, misrepresentation, or predation. One's own interest suffers if voters use the political apparatus to gain their own ends at the expense of the vast majority of the public. The form of government that protects the smooth operation of the free market economy and its voluntary division of labor is limited government.
For each individual to save his own skin and soul he must give at least as much concern to the rights of others as he does to his own. He would be as eager to protect the creative energies and the free exchange and communication of others as his own. For each of us can truly say, "I am the beneficiary of their existence."
If we as individuals would save our own skins and our own souls, we would use all the moral suasion at our command to see that all men are free
to pursue their ambition to the full extent of their abilities;to associate with whom they please for any reason they please;to worship God in their own way;to choose their own trade;to go into business for themselves, be their own bosses, and set their own hours of work;to use their honestly acquired property or savings in their own way;to offer their services or products for sale on their own terms;to buy or not to buy any service or product offered for sale;to agree or to disagree with any other person;to study and learn whatever strikes their fancy;to do as they please in general, as long as they do not infringe the equal right and opportunity of every other person to do as he pleases.According to these observations, here is a way of life harmonious with the interests of others. The envy of others for accomplishments or rewards can be made naturally and easily to give way to appreciation and pleasure. Inequality, being but the teammate of variation without which survival is impossible, would, therefore, be favored rather than disparaged.
Are the riches received in a free society unearned? Only in the sense that all producers reap fantastically more than they could earn in isolation. The benefits flowing from our division of labor are available to all of us in willing exchange if freedom prevails.
Such are the thoughts of one who believes himself a beneficiary and who believes that all others who act creatively are his benefactors. I owe my life to them; hence if I would live and prosper, I shall work as diligently for their freedom as for my own.
In a money economy, the money commodity is on one side of every transaction, and hence reduces the number of relevant prices. The direct exchange ratio between any two commodities can easily be computed from their respective money prices. The "price" or purchasing power of money is the array of goods and services for which a unit of money can be exchanged.
Individual supply and demand schedules in a money economy are determined by the same principles applicable to a barter economy. An individual's value scale contains units of the money commodity as well as all other commodities and services, and the individual will engage in market exchanges to achieve the bundle of goods (including units of the money commodity) that he or she believes will yield the greatest utility. There have been various attempts to gauge the total "surplus" that individuals enjoy from the existence of markets, but these procedures suffer from methodological errors. Individuals benefit from voluntary exchanges, but it is nonsensical to ask how much they benefit, because utility is not a cardinal magnitude.
The utility from selling a good for money is the value of the most highly ranked use to which the additional money can be devoted (whether to spend on consumption, invest, or add to the cash balance). The utility from buying a good with money is the value of the most highly ranked end (consumption, production, or future sale) to which the good can be devoted.
Unlike the position of other goods, the economist must offer some explanation for the precise position of units of money on individuals' value scales. In short, the economist must explain, not only the relative prices of real goods, but also their absolute nominal (money) prices. For example, why aren't money prices double, or half, of what they in fact are?
To explain the current purchasing power of money (PPM), the economist relies on the current anticipations of the future PPM. That is, people right now give up other goods for units of money, because these people expect that these units of money will be exchangeable for other goods in the near future. The current anticipations of future PPM, in turn, are explained by people's memories of the prices of the immediate past, i.e., by the past PPM.
Ultimately, then, today's PPM is largely influenced by yesterday's PPM, and yesterday's PPM was in turn influenced by the day before yesterday's PPM, and so on. We push this explanation back until the moment when there were no media of exchange, and (what is now) the money commodity was valued solely for its direct use in consumption and/or production. (This is Mises's famous regression theorem or money regression.)
Durable goods yield a flow of services over time. The price of a service is the rental or hire price of the good and is determined by the marginal productivity or marginal utility of the service. The outright purchase price of a durable good is its capitalized value, and tends to equal the (discounted) present value of its total expected flow of future services.
This article is excerpted from Study Guide of Man, Economy, and State‚ chapter 4 summary (Power and Market), "Binary Intervention: Taxation" (2006).
Recently Ben Bernanke caused a stir when he suggested that, in the future, the Fed should play a role in combating asset bubbles. Although his specific ideas are analogous to asking Al Capone to combat organized crime, Bernanke's suggestion does involve a genuine debate among academic economists: When assessing the tightness or looseness of monetary policy, should we focus narrowly on consumer prices in the current period, or should we also look at the central bank's impact on asset prices?
The Austrians have always warned that a single-minded focus on consumer prices could lead to disaster. For example, during the 1920s, the official CPI and other price indices were quite stable, leading Irving Fisher and other mainstream economists to give the Federal Reserve of the day a sweeping endorsement for maintaining the dollar's purchasing power. Yet Austrians knew that the Fed's monetary expansion — though not showing up in sharp rises in CPI — was setting the economy up for a crash. From this perspective, the huge rise and then collapse of the stock market in the late 1920s was no surprise for Austrians.
By the same token, during the housing bubble years and even since the crisis of 2008, many Austrians have warned that the Fed's policies were distorting the economy in ways that the official CPI was overlooking.
In the present article, I'll summarize some of the key mainstream literature on the theoretical and practical case for including asset prices in a measurement of "inflation" (by which these economists mean "rising prices"). As we'll see, this isn't some obscure, crankish Austrian obsession, but actually is quite defensible on even neoclassical grounds.
The Theoretical Case for Including Asset PricesIn the mainstream literature, the seminal work in this area is a 1973 paper by UCLA giants Armen Alchian and Benjamin Klein entitled "On a Correct Measure of Inflation." To cut to the chase, they state upfront, "The analysis in this paper bases a price index on the Fisherian tradition of a proper definition of intertemporal consumption and leads to the conclusion that a price index used to measure inflation must include asset prices."
Alchian and Klein warn that the "inappropriate indices that dominate popular and professional literature and analyses are thereby shown to result in significant errors in monetary research, theory, and policy."
The Alchian and Klein paper is quite technical, involving mathematical utility functions and calculus. Yet its economic logic is sound from an Austrian perspective. An individual forms a plan of action involving his holdings of wealth, in order to provide for present and future flows of consumption services. If we are trying to determine whether the central bank is causing an increase in the "cost of living," it would be absurd, say Alchian and Klein, to focus merely on today's spot prices of consumer goods. We also should include today's prices for buying claims to future flows of consumption.
In a theoretical world of perfect certainty and no transactions costs, people today could enter dedicated markets for various consumption services available every day from now until their death. For example, Joe Smith could check to see how many dollars he had to pay today in order for a landlord to rent him an apartment unit in the month of July 2025. If the Fed printed a bunch of new money and caused this particular price to go up, then Joe Smith's "cost of living" would have risen, because part of his "living" today involves his plans for his future shelter. (By the same token, Joe Smith's employer might have to agree to give more money today in order to buy Joe Smith's labor services in the month of July 2025. This increase in nominal labor income would help Joe Smith weather the increased cost of living.)
Of course, the real world is hardly like the theoretical model we just described. In practice, people don't sell all of their labor services today for the rest of their careers, and they don't lock in all of their consumption purchases today for the rest of their lives. In reality, Alchian and Klein acknowledge, people today provide for future consumption by investing in various types of assets. This is why a correct measure of "the cost of living" must include asset prices.
To give a simple example (that is my own, not Alchian and Klein's), consider the flow of shelter services. In a world of perfect certainty and "complete markets," a person would be able to pay a lump sum today to a landlord, in order to rent an apartment unit for the next 20 years. Yet in practice, someone with this desire is much more likely to buy the unit outright. Thus we can see that a sharp rise in real-estate prices — even if current rental prices rise only moderately — can signal an increased "cost of living" and hence be a warning sign that the central bank is engaging in loose monetary policy.
The Practical Case for Including Asset PricesCharles Goodhart has written a 2001 paper claiming that the theoretical arguments of Alchian and Klein have never been refuted — though ironically Goodhart does cite Bernanke and Gertler (2000) for their practical misgivings! Goodhart uses various arguments to show that it can be quite practical to include assets in the measurement of (price) inflation, despite the critics. However, the details are a bit wonkish and I'll let interested readers peruse Goodhart's paper directly.
For our purposes, far more interesting is the observation of Austro-libertarian Gerald O'Driscoll in a 2008 paper:
After banking crises in the 1980s and 1990s, deposit insurance was put on a sound basis and that source of moral hazard was mitigated. In its place, monetary policy has become a source of moral hazard. In acting to counter the economic effects of declining asset prices, the Federal Reserve has come to be viewed as underwriting risky investments. Policy pronouncements by senior Fed officials have reinforced that perception. These actions and pronouncements are mutually reinforcing and destructive to the operation of financial markets. The current financial crisis began in the subprime housing market and then spread throughout credit markets. The new Fed policy fueled the housing boom. Refusing to accept responsibility for the housing bubble, the Fed's recent actions will likely fuel a new asset bubble.
O'Driscoll has here put his finger on a major inconsistency in the Fed's official line. Up until Bernanke's recent reconsideration, the Fed has denied that its job was to worry about asset bubbles. Alan Greenspan declared that it was impossible for the Fed to recognize an asset bubble in real time (whereas his successor, Bernanke, had always been less sure about the subject).
Yet here's the contradiction: In addition to not wanting to interfere with markets by popping asset bubbles, Greenspan also had his famous policy of the "Greenspan put." In other words, Greenspan viewed it as the Fed's job to intervene with loose money when asset prices crashed, but not to implement tight money when asset prices soared.
ConclusionAustrian economists have long recognized that the economy is far more complex than simple models capture, meaning that the reliance on a simple price index such as the CPI can be very misleading when assessing monetary policy. This is an area where the "common sense" of the Austrians is matched by the formal neoclassical models.
Even a theoretically perfect index of price inflation would include assets, meaning that the bubble in housing — and our current bubble in government debt — can be attributed to the easy-money policies of Bernanke and his fellow central bankers.
Book buyers have been used to hardback books being the most expensive, with softcover versions being priced much less, while e-book versions are cheaper still.
This pricing scheme comports with David Ricardo's doctrine that the value of consumption goods are determined by the "cost of production" or the labor theory of value. Obviously the production cost of a hardback book is greater than that for a paperback, with both of these far and away more expensive to produce than a Kindle or ePub version.
The costs of book preparation — formatting, editing, typesetting, indexing, marketing, and royalties — are incurred no matter what the book's version. However, with hard and softcover books, publishers must warehouse their inventory and there are costs associated with that. With e-books, as well as downloadable audio versions, no warehouse is required — just a hard drive somewhere.
But that's not the half of it. When Amazon or any bookseller runs through their inventory of a book in the physical form, they have to order and pay for more paper and ink to be constructed into the particular title so that orders can be filled. Replenishing inventory costs money. Not so for an e-book. Once the digital version has been created, it's good until the market doesn't accept it anymore.
So for those thinking David Ricardo had it right, expensive hardbacks and cheap e-books make all the sense in the world. But Austrians see the world differently. Consumers set prices based on their preferences. It doesn't matter what a book costs; what matters is what a reader will pay for it. Likewise, consumers in the Western world determine the prices — not by haggling — but by buying or not buying.
The illusion that costs of production determine price is created by the reality of financial viability. If you can't recover in proceeds what you have spent in production, you have to stop what you are doing or change the way you do it. If your profits are extremely high, you attract the competition to your endeavors, and then your prices have to fall. Over the long run, it's true, your marginal costs and marginal prices tend to equalize. What matters is the cause and effect: the price you can obtain for making something determines how much you can spend making it.
Buying the hardback means paying for shipping and waiting for the book to arrive. The same goes for the paperback. Physical books require shelving and space, which is, again, an expense.
E-books offer immediate availability and thousands of books can be stored in a single thin, lightweight piece of machinery, not to mention the many other cool features e-readers offer.
Carl Menger wrote in Principles of Economics,
There is no necessary and direct connection between the value of a good and whether, or in what quantities, labor and other goods of higher order were applied to its production.… Whether a diamond was found accidentally or was obtained from a diamond pit with the employment of a thousand days of labor is completely irrelevant for its value.
The other day my friends at Amazon sent me an email announcing that Joan Didion's new book, Blue Nights, is available for pre-order. The most expensive format to buy Didion's book is on audio CD or download for $16.50. The large-print paperback version is $15.51. The Kindle version sells for $12.99, and the hardcover is $13.99 for Prime customers (shipping included).
The cost to produce a CD or downloadable audio version of a book is much less than a hardcover. And the cost of producing the hardcover is more than the softcover. And the Kindle version is the least expensive to produce by a long shot, yet that version commands nearly as much as hardcover, including shipping.
The pricing of Ms. Didion's newest reflects consumer preference, not the cost of production. The chart below reflects changing consumer preferences.
Amazon's physical book sales versus Kindle book salesSource: Business InsiderSome people want personal libraries, but most don't have the space at home to accommodate shelf after shelf of books. Kindle, ePub, and audio versions make libraries possible without the required space.
However, these changes in consumer preference don't happen all at once. Many readers still insist on reading physical books. Giving a friend a physical book seems more personal than giving an e-book as a gift. But what's really at work is that everyone's tastes are different. And with technology creating new format options, consumers have more opportunities than ever to dictate prices.
A young woman visiting my home was aghast at our numerous and prominently displayed rows of books. "Who could possibly want all of these books?" she wondered, thinking the owners were out of earshot.
Menger explains,
There is no reason why a good may not have value to one economizing individual but no value to another individual under different circumstances. The measure of value is entirely subjective in nature, and for this reason a good can have great value to one economizing individual, little value to another, and no value at all to a third, depending upon the differences in their requirements and available amounts. What one person disdains or values lightly is appreciated by another, and what one person abandons is often picked up by another. While one economizing individual esteems equally a given amount of one good and a greater amount of another good, we frequently observe just the opposite evaluations with another economizing individual.
Indeed, for those who haul their entire libraries around on a Kindle or iPad, row after row of physical books doesn't look impressive; it looks silly and impractical. Toting a Kindle beats carrying even just a few physical books on a trip. For these reasons and many more, buyers are now willing to spend as much for an e-book as they do for a hardback.
Also, entrepreneurial errors are ruthlessly reflected in book pricing as well. Books produced in big print runs that turn out to be flops hit the bargain bin very quickly and are sold, not for 10 or 20 percent off the retail price but for pennies on the dollar, no matter the cost.
Book sales for all of last year rose 3.6 percent, from $11.25 billion in 2009 to $11.67 billion in 2010. But e-book sales rose a stunning 164.4 percent ($441.3 million vs. $166.9 million) and downloaded audiobook sales increased 38.8 percent, while physical audiobook sales decreased 6.3 percent.
The trends continued in the first quarter of this year with e-book sales up 146 percent from the year before, while hardcover sales grew modestly and paperback sales decreased.
Physical books still dominate total sales, but the consumer preferences are changing rapidly, and it's reflected not just in pricing but in the success and failure of business models. Brick-and-mortar, bankrupt bookseller Borders is in liquidation, while the New York Times reports, "Since April 1, Amazon sold 105 books for its Kindle e-reader for every 100 hardcover and paperback books, including books without Kindle versions and excluding free e-books."
"We had high hopes that this would happen eventually, but we never imagined it would happen this quickly," said Jeff Bezos, Amazon's chief executive, in a statement. "We've been selling print books for 15 years and Kindle books for less than four years."
Individuals engage in trade to make their lives better and satisfy their needs. Those wanting the e-book version of Joan Didion's book will decide (at a particular moment) what is worth more to them — keeping the $12.99 in their pocket or trading it for a downloadable version. What it costs Amazon to produce or obtain it is irrelevant.
Whether it's diamonds and water or hardbacks and e-books, the only cogent explanation for prices comes from the Austrians, not the classical economists.
This year in the online Mises Academy I have been leading students through Murray Rothbard's classic treatise, Man, Economy, and State. (For details on the current class, covering the final third of the book, see here.) In the previous class we covered Rothbard's analysis of the pricing of land. This is an illuminating topic because it involves capitalization and entrepreneurship, two areas where Austrians have made seminal contributions to economic theory.
Land Prices and RentsIn the opening of chapter 9, Rothbard offers a succinct summary of much of the preceding analysis in the book:
We have been using the term rent in our analysis to signify the hire price of the services of goods. This price is paid for unit services, as distinguished from the prices of the whole factors yielding the service. Since all goods have unit services, all goods will earn rents, whether they be consumers' goods or any type of producers' goods. Future rents of durable goods tend to be capitalized and embodied in their capital value and therefore in the money presently needed to acquire them. As a result, the investors and producers of these goods tend to earn simply an interest return on their investment. (pp. 557–558)
Although he packs a lot into this paragraph, Rothbard's statements are straightforward. All factors of production — whether a tractor, light bulb, or plot of land — yield a flow of services per unit time. The economist can explain the rental price of a factor according to its marginal productivity.
Suppose that sharecroppers calculate that an additional acre of Farmer Smith's land would allow them to increase their annual earnings by $250. If we have open competition (i.e., no government restrictions), then in equilibrium we would expect that the sharecroppers would pay rent of (nearly) $250 per acre per year for the use of Farmer Smith's land.
Now suppose that instead of renting out his land, Farmer Smith wants to sell it outright. How much could he expect to get for it?
In the baseline case of certainty about the future, the answer is that Smith would capitalize the present discounted value of all future rental payments accruing to the farmland. For example, suppose the farmland is expected to yield a perpetual annual flow of $250 rental payments. At a constant rate of interest of 5 percent, the market price of an acre of Smith's land would therefore be $5,000. That's how much Smith can ask for, and should receive, for selling off his land, at least in a world where everyone is certain about the land's future earning power and the constant interest rate.
"The Austrian School is known for its contributions to the theory of capital and income, as well as entrepreneurship. These issues all come together in the explanation of the market price of land."To see why this is the answer, consider an investor with $5,000. He can use that money to buy a bond yielding 5 percent per year (because we assumed that was the interest rate). That means our investor can reap a perpetual stream of $250 dividend payments from his bond. In a world of certainty, it's no riskier to invest in land than in bonds, so an acre of Farmer Smith's land — which also yields a perpetual income stream of $250 per year — must command a purchase price of $5,000 as well.
Once we understand the basic process, it's easy to see how changes in the underlying fundamentals will influence land prices. For example, if increased population drives up the demand for food, such that the sharecroppers will now pay $500 per year in rent, then the market price for the parcel of land will rise from $5,000 to $10,000.
On the other hand, suppose that the rental price of the land remains at $250 per year, but that the community's time preferences (degree of impatience) increase so that the interest rate rises to 10 percent. Now the capitalized asset value of the land drops from $5,000 down to $2,500. Even though the land is just as productive (even in terms of annual income) as before, the higher interest rate places twice as heavy a discount on future cash flows. Thus the current market price of the land falls in half when the interest rate doubles.
Marginal Land Earns a Positive RentRothbard explains that, in our world, it is an empirical fact that labor is scarcer than land. (This just happens to be the case; we could logically imagine the reverse being true.) Consequently, depending on population size and other factors, at any given time we can arrange the plots of land in a spectrum from least valuable to most valuable.
Because land is more abundant than labor, there will always be a threshold denoting the marginal plot of land, meaning the plot of land that it is just worthwhile to bring into cultivation. The land that is more fertile (or otherwise desirable) is the supramarginal land, which earns higher rents than the marginal land. In contrast, the submarginal land earns no rent and is not integrated into the production process.
Rothbard distinguishes the Austrian perspective from the standard mainstream approach:
It is important to recognize … that the marginal land will earn not zero, but only close to zero, rent. The reason is that, in human action, there is no infinite continuity, and action cannot proceed in infinitely small steps. Mathematically minded writers tend to think in such terms, so that the points before and after the point under consideration all tend to merge into one. Using marginal land, however, will pay only if it earns some rent, even though a small one. (p. 560)
In other words, mainstream economists tend to think of marginal land earning zero rent, because that is the only logical conclusion if we divide the spectrum of land fertility into infinitesimal units. But in the Austrian approach — characterized by purposeful choice, rather than indifference — somebody will obviously bring a parcel of land into cultivation only if it offers a prospective rent (however small).
Introducing UncertaintyThus far we have dealt with the simple but unrealistic case where the rental earnings from a piece of land are constant. Rothbard discusses the complications from changes, and how entrepreneurs deal with it:
At this point, let us consider a great bugaboo of the Henry Georgists — speculation in land that withholds productive land from use. According to the Georgists, a whole host of economic evils, including the depressions of the business cycle, stem from speculative withholding of ground land from use, causing an artificial scarcity and high rents for the sites in use.…
In many cases, however, a land site, once committed to a certain line of production, could not easily or without substantial cost be shifted to another line. Where the landowner anticipates that a better line of use will soon become available or is in doubt on the best commitment for the land, he will withhold the land site from use if his saving in "change-over cost" will be greater than his opportunity cost of waiting and of forgoing presently obtainable rents. The speculative site-owner is, then, performing a great service to consumers and to the market in not committing the land to a poorer productive use. By waiting to place the land in a superior productive use, he is allocating the land to the uses most desired by the consumers.
What probably confuses the Georgists is the fact that many sites lie unused and yet command a capital price on the market. The capital price of the site might even increase while the site continues to remain idle. This does not mean, however, that some sort of villainy is afoot. It simply means that no rents on the site are expected for the first few years, although it will earn positive rents thereafter. The capital value of ground land, as we have seen, sums up the discounted total of all future rents, and these rental sums may exert a tangible influence from a considerable distance in the future, depending on the rate of interest. There is therefore no mystery in the fact of a capital value for an idle site, or in its rise. The site is not being villainously withheld from production. (pp. 570-571)
We can illustrate Rothbard's analysis with two examples. First, consider something that is all too typical these days: An empty commercial building with a "FOR RENT" sign in the window. Further suppose that this building remains in such an idle condition for several months. What should we make of this strange outcome?
At first glance — and if we disregard the real-world problems of uncertainty — the owner of the building appears to be a fool. After all, if she just lowered her asking price, surely she could get some tenant to move into the building and start paying her rent. No matter how low the price, something is better than nothing, assuming the tenant won't physically damage the premises.
In reality, this critique of our hypothetical building owner is unfair. In the real world, the building owner doesn't know exactly what potential tenants are willing to pay to rent her space. If and when she does accept a new tenant, they will presumably sign a contract guaranteeing the tenant the space for a certain time (perhaps a year or longer), subject to various conditions. This is because the tenant wouldn't want to go to the trouble of setting up the space for his business, only to be kicked out two months later because the owner found a tenant willing to pay more rent.
Given that this is the type of arrangement she will reach with a new tenant, the building owner will not simply lower the asking price hour to hour until she closes a deal after the first day of vacancy. Rather, she will set a price (perhaps optimistically) for which she would be happy to rent the space. It's worth it to her to let the space stay vacant, perhaps for several months, waiting to find that special tenant willing to pay the price.
So we see that even on an unhampered market, there are reasons for resources to remain "idle." The process here is analogous to an unemployed person looking for a new job. There is a genuine search involved, where parties to a mutually advantageous trade need to first find each other.
For a different example, suppose that the government has declared a particular piece of land as a wetland, making it illegal to develop it commercially. Originally the land has a market price of $0. However, a few insiders catch wind that the incoming administration plans on removing the restriction. If that were to happen, then the marsh could be drained and a shopping mall could be built on the land, yielding fantastic revenues for the owners.
In this second scenario, insiders would purchase the land from its original owner, and would be willing to pay a hefty price for it, if necessary. Here too we would see land commanding a positive purchase price even though it would be earning zero rent.
ConclusionThe Austrian School is known for its contributions to the theory of capital and interest, as well as entrepreneurship. These issues all come together in the explanation of the market price of land. As usual, Rothbard's exposition in Man, Economy, and State is comprehensive and crystal clear. For those wanting a guided tour through his book, I welcome you to join our current Mises Academy class.
One of the reasons that most economists of the 1920s did not recognize the existence of an inflationary problem was the widespread adoption of a stable price level as the goal and criterion for monetary policy. The extent to which the Federal Reserve authorities were guided by a desire to keep the price level stable has been a matter of considerable controversy. Far less controversial is the fact that more and more economists came to consider a stable price level as the major goal of monetary policy. The fact that general prices were more or less stable during the 1920s told most economists that there was no inflationary threat, and therefore the events of the Great Depression caught them completely unaware.
Actually, bank-credit expansion creates its mischievous effects by distorting price relations and by raising and altering prices compared to what they would have been without the expansion. Statistically, therefore, we can only identify the increase in money supply, a simple fact. We cannot prove inflation by pointing to price increases. We can only approximate explanations of complex price movements by engaging in a comprehensive economic history of an era — a task which is beyond the scope of this study. Suffice it to say here that the stability of wholesale prices in the 1920s was the result of monetary inflation offset by increased productivity, which lowered costs of production and increased the supply of goods.
But this "offset" was only statistical. It did not eliminate the boom-bust cycle; it only obscured it. The economists who emphasized the importance of a stable price level were thus especially deceived, for they should have concentrated on what was happening to the supply of money. Consequently, the economists who raised an alarm over inflation in the 1920s were largely the qualitativists. They were written off as hopelessly old-fashioned by the "newer" economists who realized the overriding importance of the quantitative in monetary affairs. The trouble did not lie with particular credit on particular markets (such as stock or real estate); the boom in the stock and real-estate markets reflected Mises's trade cycle: a disproportionate boom in the prices of titles to capital goods, caused by the increase in money supply attendant upon bank credit expansion.The qualitative aspect of credit is important to the extent that bank loans must be to business, and not to government or to consumers, to put the trade cycle mechanism into motion.
The stability of the price level in the 1920s is demonstrated by the Bureau of Labor Statistics Index of Wholesale Prices, which fell to 93.4 (100 = 1926) in June 1921, rose slightly to a peak of 104.5 in November 1925, and then fell back to 95.2 by June 1929. The price level, in short, rose slightly until 1925 and fell slightly thereafter. Consumer price indices also behaved in a similar manner.The National Industrial Conference Board (NICB) consumer price index rose from 102.3 (1923 = 100) in 1921 to 104.3 in 1926, then fell to 100.1 in 1929; the Bureau of Labor Statistics (BLS) consumer good index fell from 127.7 (1935–1939 = 100) in 1921 to 122.5 in 1929. Historical Statistics of the U.S., 1789–1945 (Washington, D.C.: U.S. Department of Commerce, 1949), pp. 226–36, 344. On the other hand, the Snyder Index of the General Price Level, which includes all types of prices (real estate, stocks, rents, and wage rates, as well as wholesale prices) rose considerably during the period, from 158 in 1922 (1913 = 100) to 179 in 1929, a rise of 13 percent. Stability was therefore achieved only in consumer and wholesale prices, but these were and still are the fields considered especially important by most economic writers.
Within the overall aggregate of wholesale prices, foods and farm products rose over the period while metals, fuel, chemicals, and home furnishings fell considerably. That the boom was largely felt in the capital-goods industries can be seen by (a) the quadrupling of stock prices over the period, and by (b) the fact that durable goods and iron and steel production each increased by about 160 percent, while the production of non-durable goods (largely consumer goods) increased by only 60 percent.
In fact, production of such consumer items as manufactured foods and textile products increased by only 48 percent and 36 percent respectively, from 1921 to 1929. Another illustration of Mises's theory was that wages were bid up far more in the capital-goods industries. Overbidding of wage rates and other costs is a distinctive feature of Mises's analysis of capital-goods industries in the boom. Average hourly earnings, according to the Conference Board Index, rose in selected manufacturing industries from $.52 in July 1921 to $.59 in 1929, a 12 percent increase. Among this group, wage rates in consumer-goods industries such as boots and shoes remained constant; they rose 6 percent in furniture, less than 3 percent in meat packing, and 8 percent in hardware manufacturing. On the other hand, in such capital-goods industries as machines and machine tools, wage rates rose by 12 percent, and by 19 percent in lumber, 22 percent in chemicals, and 25 percent in iron and steel.
Federal Reserve credit expansion, then, whether so intended or not, managed to keep the price level stable in the face of an increased productivity that would, in a free and unhampered market, have led to falling prices and a spread of increased living standards to everyone in the population. The inflation distorted the production structure and led to the ensuing depression-adjustment period. It also prevented the whole populace from enjoying the fruits of progress in lower prices and insured that only those enjoying higher monetary wages and incomes could benefit from the increased productivity.
There is much evidence for the charge of Phillips, McManus, and Nelson that "the end-result of what was probably the greatest price-level stabilization experiment in history proved to be, simply, the greatest depression."C.A. Phillips, T.F. McManus, and R.W. Nelson, Banking and the Business Cycle (New York: Macmillan, 1937), pp. 176ff. Benjamin Strong was apparently converted to a stable-price-level philosophy during 1922. On January 11, 1925, Strong privately wrote,
that it was my belief, and I thought it was shared by all others in the Federal Reserve System, that our whole policy in the future, as in the past, would be directed toward the stability of prices so far as it was possible for us to influence prices.Lester V. Chandler, Benjamin Strong, Central Banker (Washington, D.C.: Brookings Institution, 1958), p. 312. In this view, Strong was, of course, warmly supported by Montagu Norman. Ibid., p. 315.
When asked, in the Stabilization Hearings of 1927, whether the Federal Reserve Board could "stabilize the price level to a greater extent" than in the past, by open-market operations and other control devices, Governor Strong answered,
I personally think that the administration of the Federal Reserve System since the reaction of 1921 has been just as nearly directed as reasonable human wisdom could direct it toward that very object.Also see ibid., pp. 199ff. And Charles Rist recalls that, in his private conversations, "Strong was convinced that he was able to fix the price level, by his interest and credit policy." Charles Rist, "Notice Biographique," Revue d'Èconomie Politique (November–December, 1955): 1029.
It appears that Governor Strong had a major hand, in early 1928, in drafting the bill by Representative James G. Strong of Kansas (no relation) to compel the Federal Reserve System to promote a stable price level.Strong thus overcame his previous marked skepticism toward any legislative mandate for price stabilization. Before this, he had preferred to leave the matter strictly to Fed discretion. See Chandler, Benjamin Strong, Central Banker, pp. 202ff. Governor Strong was ill by this time and out of control of the system, but he wrote the final draft of the bill along with Representative Strong. In the company of the congressman and professor John R. Commons, one of the leading theoreticians of a stable price level, Strong discussed the bill with members of the Federal Reserve Board. When the Board disapproved, Strong felt bound, in his public statements, to go along with them.See the account in Irving Fisher, ibid., pp. 170–71. Commons wrote of Governor Strong: "I admired him both for his open-minded help to us on the bill and his reservation that he must go along with his associates."
We must further note that Carl Snyder, a loyal and almost worshipful follower of Governor Strong, and head of the statistical department of the Federal Reserve Bank of New York, was a leading advocate of monetary and credit control by the Federal Reserve to stabilize the price level.See Fisher's eulogy of Snyder, Stabilised Money, pp. 64–67; and Carl Snyder, "The Stabilization of Gold: A Plan," American Economic Review (June, 1923): 276–85; idem, Capitalism the Creator (New York: Macmillan, 1940), pp. 226–28.
Certainly, the leading British economists of the day firmly believed that the Federal Reserve was deliberately and successfully stabilizing the price level. John Maynard Keynes hailed "the successful management of the dollar by the Federal Reserve Board from 1923 to 1928" as a "triumph" for currency management. D.H. Robertson concluded in 1929 that "a monetary policy consciously aimed at keeping the general price level approximately stable … has apparently been followed with some success by the Federal Reserve Board in the United States since 1922."D.H. Robertson, "The Trade Cycle," Encyclopaedia Britannica, 14th ed. (1929), vol. 22, p. 354. Whereas Keynes continued to hail the Reserve's policy a few years after the depression began, Robertson became critical,
Looking back … the great American "stabilization" of 1922–1929 was really a vast attempt to destabilize the value of money in terms of human effort by means of a colossal program of investment … which succeeded for a surprisingly long period, but which no human ingenuity could have managed to direct indefinitely on sound and balanced lines.D.H. Robertson, "How Do We Want Gold to Behave?" in The International Gold Problem (London: Humphrey Milford, 1932), p. 45; quoted in Phillips, et al., Banking and the Business Cycle, pp. 186–87.
The siren song of a stable price level had lured leading politicians, to say nothing of economists, as early as 1911. It was then that Professor Irving Fisher launched his career as head of the "stable money" movement in the United States. He quickly gained the adherence of leading statesmen and economists to a plan for an international commission to study the money and price problem.
Supporters included President William Howard Taft, Secretary of War Henry Stimson, Secretary of the Treasury Franklin MacVeagh, Governor Woodrow Wilson, Gifford Pinchot, seven senators, and economists Alfred Marshall, Francis Edgeworth, and John Maynard Keynes in England. President Taft sent a special message to Congress in February 1912, urging an appropriation for such an international conference. The message was written by Fisher, in collaboration with Assistant Secretary of State Huntington Wilson, a convert to stable money. The Senate passed the bill, but it died in the House. Woodrow Wilson expressed interest in the plan but dropped the idea in the press of other matters.
In the spring of 1918, a Committee on the Purchasing Power of Money of the American Economic Association endorsed the principle of stabilization. Though encountering banker opposition to his stable-money doctrine, led notably by A. Barton Hepburn of the Chase National Bank, Fisher began organizing the Stable Money League at the end of 1920, and established the League at the end of May 1921 — at the beginning of our inflationary era. Newton D. Baker, secretary of war under Wilson, and Professor James Harvey Rogers of Cornell were two of the early organizers.
Other prominent politicians and economists who played leading roles in the Stable Money League were Professor Jeremiah W. Jenks, its first president; Henry A. Wallace, editor of Wallace's Farmer, and later secretary of agriculture; John G. Winant, later governor of New Hampshire; Professor John R. Commons, its second president; George Eastman of the Eastman-Kodak family; Lyman J. Gage, formerly secretary of the Treasury; Samuel Gompers, president of the American Federation of Labor; Senator Carter Glass of Virginia; Thomas R. Marshall, vice president of the United States under Wilson; Representative Oscar W. Underwood; Malcolm C. Rorty; and economists Arthur Twining Hadley, Leonard P. Ayres, William T. Foster, David Friday, Edwin W. Kemmerer, Wesley C. Mitchell, Warren M. Persons, H. Parker Willis, Allyn A. Young, and Carl Snyder.
The ideal of a stable price level is relatively innocuous during a price rise when it can aid sound-money advocates in trying to check the boom; but it is highly mischievous when prices are tending to sag, and the stabilizationists call for inflation. And yet, stabilization is always a more popular rallying cry when prices are falling. The Stable Money League was founded in 1920–1921, when prices were falling during a depression. Soon, prices began to rise, and some conservatives began to see in the stable money movement a useful check against extreme inflationists. As a result, the league changed its name to the National Monetary Association in 1923, and its officers continued as before, with Professor Commons as president.
By 1925, the price level had reached its peak and begun to sag, and consequently the conservatives abandoned their support of the organization, which again changed its name to the Stable Money Association. Successive presidents of the new association were H. Parker Willis, John E. Rovensky, executive vice president of the Bank of America, Professor Kemmerer, and "Uncle" Frederic W. Delano. Other eminent leaders in the Stable Money Association were Professor Willford I. King; President Nicholas Murray Butler of Columbia University; John W. Davis, Democratic candidate for president in 1924; Charles G. Dawes, director of the Bureau of the Budget under Harding, and vice president under Coolidge; William Green, president of the American Federation of Labor; Charles Evans Hughes, secretary of state until 1925; Otto H. Kahn, investment banker; Frank O. Lowden, former Republican governor of Illinois; Elihu Root, former secretary of state and senator; James H. Rand Jr.; Norman Thomas, of the Socialist Party; Paul M. Warburg; and Owen D. Young. Enlisting from abroad came Charles Rist of the Bank of France; Eduard Benes of Czechoslovakia; Max Lazard of France; Emile Moreau of the Bank of France; Louis Rothschild of Austria; and Sir Arthur Balfour, Sir Henry Strakosch, Lord Melchett, and Sir Josiah Stamp of Great Britain.
Serving as honorary vice presidents of the association were the presidents of the following organizations: the American Association for Labor Legislation, American Bar Association, American Farm Bureau Federation, American Farm Economic Association, American Statistical Association, Brotherhood of Railroad Trainmen, National Association of Credit Men, National Consumers' League, National Education Association, American Council on Education, United Mine Workers of America, the National Grange, the Chicago Association of Commerce, the Merchants' Association of New York, and Bankers' Associations in 43 states and the District of Columbia.
Executive director and operating head of the association with such formidable backing was Norman Lombard, brought in by Fisher in 1926. The association spread its gospel far and wide. It was helped by the publicity given to Thomas Edison and Henry Ford's proposal for a "commodity dollar" in 1922 and 1923. Other prominent stabilizationists in this period were professors George F. Warren and Frank Pearson of Cornell, Royal Meeker, Hudson B. Hastings, Alvin Hansen, and Lionel D. Edie. In Europe, in addition to the above mentioned, advocates of stable money included: Professor Arthur C. Pigou, Ralph G. Hawtrey, J.R. Bellerby, R.A. Lehfeldt, G.M. Lewis, Sir Arthur Salter, Knut Wicksell, Gustav Cassel, Arthur Kitson, Sir Frederick Soddy, F.W. Pethick-Lawrence, Reginald McKenna, Sir Basil Blackett, and John Maynard Keynes. Keynes was particularly influential in his propaganda for a "managed currency" and a stabilized price level, as set forth in his Tract on Monetary Reform, published in 1923.
Ralph Hawtrey proved to be one of the evil geniuses of the 1920s. An influential economist in a land where economists have shaped policy far more influentially than in the United States, Hawtrey, director of financial studies at the British Treasury, advocated international credit control by central banks to achieve a stable price level as early as 1913. In 1919, Hawtrey was one of the first to call for the adoption of a gold-exchange standard by European countries, tying it in with international central-bank cooperation. Hawtrey was one of the prime European trumpeters of the prowess of Governor Benjamin Strong.
Writing in 1932, at a time when Robertson had come to realize the evils of stabilization, Hawtrey declared, "The American experiment in stabilization from 1922 to 1928 showed that an early treatment could check a tendency either to inflation or to depression.… The American experiment was a great advance upon the practice of the nineteenth century," when the trade cycle was accepted passively.Ralph O. Hawtrey, The Art of Central Banking (London: Longmans, Green, 1932), p. 300. When Governor Strong died, Hawtrey called the event "a disaster for the world."Leading stabilizationist Norman Lombard also hailed Strong's alleged achievement: "By applying the principles expounded in this book … he [Strong] maintained in the United States a fairly stable price level and a consequent condition of widespread economic well-being from 1922 to 1928." Norman Lombard, Monetary Statesmanship (New York: Harpers, 1934), p. 32n. On the influence of stable price ideas on Federal Reserve policy, see also David A. Friedman, "Study of Price Theories Behind Federal Reserve Credit Policy, 1921–29" (unpublished M.A. thesis, Columbia University, 1938). Finally, Hawtrey was the main inspiration for the stabilization resolutions of the Genoa Conference of 1922.
It was inevitable that this host of fashionable opinion should be translated into legislative pressure, if not legislative action. Rep. T. Alan Goldsborough of Maryland introduced a bill to "Stabilize the Purchasing Power of Money" in May 1922, essentially Professor Fisher's proposal, fed to Goldsborough by former Vice President Marshall. Witnesses for the bill were Professors Fisher, Rogers, King, and Kemmerer, but the bill was not reported out of committee. In early 1924, Goldsborough tried again, and Representative O.B. Burtness of North Dakota introduced another stabilization bill. Neither was reported out of committee.
The next major effort was a bill by Rep. James G. Strong of Kansas, introduced in January, 1926, under the urging of veteran stabilizationist George H. Shibley, who had been promoting the cause of stable prices since 1896. Rather than the earlier Fisher proposal for a "compensated dollar" to manipulate the price level, the Strong Bill would have compelled the Federal Reserve System to act directly to stabilize the price level. Hearings were held from March 1926 until February 1927. Testifying for the bill were Shibley, Fisher, Lombard, Dr. William T. Foster, Rogers, Bellerby, and Commons. Commons, Rep. Strong, and Governor Strong then rewrote the bill, as indicated above, and hearings were held on the second Strong Bill in the spring of 1928.
The high point of testimony for the second Strong Bill was that of Sweden's Professor Gustav Cassel, whose eminence packed the Congressional hearing room. Cassel had been promoting stabilization since 1903. The advice of this sage was that the government employ neither qualitative nor quantitative measures to check the boom, since these would lower the general price level. In a series of American lectures, Cassel also urged lower Fed reserve ratios, as well as worldwide central-bank cooperation to stabilize the price level.
The Strong Bill met the fate of its predecessors, and never left the committee. But the pressure exerted at the various hearings for these bills, as well as the weight of opinion and the views of Governor Strong, served to push the Federal Reserve authorities into trying to manipulate credit for purposes of price stabilization.
International pressure strengthened the drive for a stable price level. Official action began with the Genoa Conference, in the spring of 1922. This Conference was called by the League of Nations, at the initiative of Premier Lloyd George, who in turn was inspired by the dominant figure of Montagu Norman. The Financial Commission of the Conference adopted a set of resolutions which, as Fisher puts it, "have for years served as the potent armory for the advocates of stable money all over the world."Fisher, Stabilised Money, p. 282. Our account of the growth of the stable money movement rests heavily upon Fisher's work. The resolutions urged international central-bank collaboration to stabilize the world price level, and also suggested a gold-exchange standard.
On the Financial Commission were such stabilizationist stalwarts as Sir Basil Blackett, Professor Cassel, Dr. Vissering, and Sir Henry Strakosch.While Hawtrey was the main inspiration for the resolutions, he criticized them for not going far enough. The League of Nations, indeed, was quickly taken over by the stabilizationists. The Financial Committee of the League was largely inspired and run by Governor Montagu Norman, working through two close associates, Sir Otto Niemeyer and Sir Henry Strakosch. Sir Henry was, as we have indicated, a prominent stabilizationist.See Paul Einzig, Montagu Norman (London: Kegan Paul, 1932), pp. 67, 78. Furthermore, Norman's chief adviser in international affairs, Sir Charles S. Addis, was also an ardent stablizationist. Sir Henry Clay, Lord Norman (London: Macmillan, 1957), p. 138.
In 1921, a Joint Committee on Economic Crises was formed by the General Labour Conference, the International Labour Office (ILO) of the League of Nations, and the Financial Committee of the League. On this Joint Committee were three leading stabilizationists: Albert Thomas, Henri Fuss, and Major J.R. Bellerby. In 1923, Thomas's report warned that a fall in the price level "almost invariably" causes unemployment. Henri Fuss of the ILO propagandized for stable price levels in the International Labour Review in 1926.
The Joint Committee met in June 1925 to affirm the principles of the Genoa Conference. In the meanwhile, two private international organizations, the International Association for Labour Legislation and the International Association on Unemployment, held a joint International Congress on Social Policy, at Prague, in October 1924. The congress called for the general adoption of the principles of the Genoa Conference, by stabilizing the general price level. The International Association for Social Progress adopted a report at its Vienna meeting in September 1928 prepared by stabilizationist Max Lazard of the investment banking house of Lazard Frères in Paris, calling for price-level stability. The ILO followed suit in June 1929 terming falling prices a cause of unemployment. And, finally, the Economic Consultative Committee of the league endorsed the Genoa principles in the summer of 1928.
Just as Professors Cassel and Commons wanted no credit restraint at all in 1928 and 1929, so Representative Louis T. McFadden, powerful chairman of the House Banking and Currency Committee, exerted a similar though more powerful brand of pressure on the Federal Reserve authorities. On February 7, 1929, the day after the Federal Reserve Board's letter to the Federal Reserve Banks warning about stock-market speculation, Representative McFadden himself warned the House against an adverse business reaction from this move. He pointed out that there had been no rise in the commodity price level, so how could there be any danger of inflation? The Fed, he warned skittishly, should not concern itself with the stock market or security loans, lest it produce a general slump. Tighter money would make capital financing difficult, and, coupled with the resulting loss of confidence, would precipitate a depression.
In fact, McFadden declared that the Fed should be prepared to ease money rates as soon as any fall in prices or employment might appear.Cited in Joseph Stagg Lawrence, Wall Street and Washington (Princeton, N.J.: Princeton University Press, 1929), pp. 437–43. Other influential voices raised against any credit restriction were those of W.T. Foster and Waddill Catchings, leading stabilizationists and well known for their underconsumptionist theories. Catchings was a prominent investment banker (of Goldman, Sachs and Co.), and iron and steel magnate, and both men were close to the Hoover administration. (As we shall see, their "plan" for curing unemployment was adopted, at one time, by Hoover.)
In April 1929 Foster and Catchings warned that any credit restriction would lower the price level and hurt business. The bull market, they assured the public — along with Fisher, Commons, and the rest — was grounded on a sure foundation of American confidence and growth.Commercial and Financial Chronicle (April, 1929): 2204–06. Also see Beckhart, "Federal Reserve Policy and the Money Market," in Beckhart et al., The New York Money Market (New York: Columbia University Press, 1931), vol. 2, pp. 99ff. And the bull speculators, of course, echoed the cry that everyone should "invest in America." Anyone who criticized the boom was considered to be unpatriotic and "selling America short."
Cassel was typical of European opinion in insisting on even greater inflationary moves by the Federal Reserve System. Sir Ralph Hawtrey, visiting at Harvard during 1928–1929, spread the gospel of price-level stabilization to his American audience.See Joseph Dorfman, The Economic Mind in American Civilization (New York: Viking Press, 1959), vol. 4, p. 178. Influential British Labourite Philip Snowden urged in 1927 that the United States join in a world plan for price stabilization, to prevent a prolonged price decline. The London Statist and the Nation (London) both bemoaned the Federal Reserve "deflation."
Perhaps most extreme was a wildly inflationist article by the respected economist Professor Allyn A. Young, an American then teaching at the University of London. Young, in January 1929, warned about the secular downward price trend, and urged all central banks not to "hoard" gold, to abandon their "high gold reserve-ratio fetish," and to inflate to a fare-thee-well. "Central banks of the world," he declared, "appear to be afraid of prosperity. So long as they are they will exert a retarding influence upon the growth of production."Allyn A. Young, "Downward Price Trend Probable, Due to Hoarding of Gold by Central Banks," The Annalist (January 18, 1929): 96–97. Also see, "Our Reserve Bank Policy as Europe Thinks It Sees It," The Annalist (September 2, 1927): 374–75.
In an age of folly, Professor Young's article was perhaps the crowning pièce de résistance — much more censurable than the superficially more glaring errors of such economists as Irving Fisher and Charles A. Dice on the alleged "new era" prosperity of the stock market. Merely to extrapolate present stock market conditions is, after all, not nearly as reprehensible as considering deflation the main threat in the midst of a rampantly inflationary era. But such was the logical conclusion of the stabilizationist position.
We may conclude that the Federal Reserve authorities, in promulgating their inflationary policies, were motivated not only by the desire to help British inflation and to subsidize farmers, but were also guided — or rather misguided — by the fashionable economic theory of a stable price level as the goal of monetary manipulation.Seymour Harris, Twenty Years of Federal Reserve Policy (Cambridge, Mass.: Harvard University Press, 1933), vol. 1, 192ff., and Aldrich, The Causes of the Present Depression and Possible Remedies (New York, 1933), pp. 20–21.
This article is excerpted from America's Great Depression, part 2, chapter 6, "Theory and Inflation: Economists and the Lure of a Stable Price Level" (1963; 2008).
It is with great pleasure that I fully support the reproduction of these works. I congratulate Lew Rockwell and his team for having the foresight to do this in honor of Hayek, one of the most important economists of the last century.
An old Polish soldier who had settled in London after World War II exposed me to the teachings of Hayek when I was sixteen years old. He had fought the Nazi machine as a member of the Royal Air Force. An equally nasty totalitarian force subsequently occupied his country: the Stalinist Communists. After the war, he settled in my neighborhood, and I got talking to him. He was adamant that I read Hayek as Hayek could show me all that was wrong with totalitarianism. The book offered was The Road to Serfdom. I did. I dedicate this reproduction to all those people who have suffered untold hardship under various totalitarian regimes.
Setting my sights on the London School of Economics, where Hayek had taught for twenty-plus years in the 1930s through the 1950s, as a place to study, to my great pleasure, we could study, as part of our political theory course, The Constitution of Liberty. Although Hayek had taught at the LSE in the economics department, none of his economic works were taught. Indeed, I was totally ignorant, up until my mid-twenties (i.e., post-university) of his economic works, which needless to say were the works cited in the awarding of his Nobel Prize. Further, it was Hayek who led me to the works of Ludwig von Mises, about whom I am certain that I would have otherwise known nothing.
Just as my Polish friend sparked my social and political interest in Hayek, I hope this volume can do the same for others concerning his economic work. This volume intends to revitalize Hayek's contribution to the study of economic fluctuations (more commonly now called business cycles) and monetary theory. Hayek demonstrated an entrepreneurial and empirical attitude toward his work. Just as his social, political, and legal work is rich with warning about too much well-meaning government interference, so too are his neglected economic works.
After his time at the Institute for Business Cycle Research in Vienna, he funded his own trip to the United States to interview economists and develop his work. Hayek understood the importance of statistical verification but was also committed to getting the theory right rather than counting on empirics to generate their whole result. His legacy should be to complement theoretical quibbles with hard facts, and these essays contain rich avenues to pursue.
One particular area I would like to draw the reader to is his works contained here on the business cycle, which was the work that grew from Mises's initial work on the matter in 1912, which has become known as the Austrian theory of the business cycle. Most contemporary economists have dismissed this work as not being in accordance with the observable facts and thus not worthy of being taught; hence, perhaps why I never saw sight nor sound of his teachings as an undergraduate.
In brief Hayek contends that an artificial manipulation by government of the interest rate creates a subsidy of credit that causes entrepreneurs to bring forth projects that were hitherto marginal. In reality, the consumers do not want the goods of these projects, so there is a misallocation (malinvestment) of resources. A careful reading of these early Hayek essays preempts the modern debate over rational expectations and shows that the cluster of errors can be avoided by his steadfast commitment to methodological individualism. Entrepreneurs are neither lemmings nor computers because they are heterogeneous.
If we extend the assumption of heterogeneity from capital to entrepreneurs, the question is, which type of entrepreneur is creating the cyclical activity of interest? Standard economic theory suggests that it is the marginal entrepreneur who moves the market, and Hayek points us in a direction that very few scholars have acted upon. I would find great value in subjecting this point to empirical evidence, to see who these marginal entrepreneurs are (the ones who are exposed when their credit subsidy is removed in a monetary contraction), and the conditions of their entry and exit. Perhaps moral hazard is not the greatest problem created by subsidized credit, and the effects of adverse selection create even larger inefficiencies.
Hayek stressed the role of relative price movements and focused attention on the interest rate. But he also provided a rich and accomplished critique of the use of abstract, aggregate variables. This presents a temptation for theorists to overemphasize interest rate changes, despite the fact that they only affect the risk of highly leveraged firms. In many cases the volume of credit, raw money creation by the Central Bank, seems a more realistic variable than the rate of interest.
Hayek's faculty position at the LSE (1931–1950) not only raised the profile of the Austrian School, but also elevated capital theory to one of the key economic issues, by highlighting (and translating) the key Swedish and Austrian insights for the English-speaking orthodoxy. During this period the LSE was the frontier of the continental tradition, and Hayek, Keynes, Robinson, Sraffa, Shackle, Robbins, et al. were at the peak of their discipline. This volume reminds us of a time when Austrian theory sat at the top of the table of debate, and offers us the way to return there.
Hayek was writing in a tradition where economists were conscious of the practical relevance of their work. To be sure, Hayek utilized grand thought experiments and abstraction, but his theoretical work always sought to understand the real world. Since then a divergence has occurred between self-referential academics and a generation of business consultants who lack the rigor of price theory. I am sure that a reassessment of the likes of Hayek is of fundamental importance to any young economist seeking to bridge these two spheres and return to a science of commerce.
In fact, the critical problem of how individuals coordinate is the thread that runs throughout Hayek's work, and the monetary aspect returns with his late attention to the nationalization of money. In these works we see Hayek as a price theorist, and as a facilitator of economic inquiry. As an entrepreneur I recognize deep insights throughout Hayek's work, but also several points that have to be expanded and verified. This volume should not be seen as an example of preservation, but an engine of discovery.
One criticism of Austrian business-cycle theory is that it gives little insight as to what should be done to push an economy out of recession. Even accepting the premise that monetary overexpansion leads to a misallocation of capital goods, detractors claim that this says little in regards to the nature of the depression period. Leland Yeager, for example, argues that "Austrian economists can explain the continuing depression only lamely."Leland B. Yeager, The Fluttering Veil: Essays on Monetary Disequilibrium (Indianapolis, Indiana: Liberty Fund, 1997), p. 232. Lord Robert Skidelsky once made a similar comment in a live debate with George Selgin and Jamie Whyte.
It is somewhat true that most Austrian literature on intertemporal coordination deals with the allocation of capital goods either during periods of healthy growth or during extensive fiduciary expansion. This does not mean, though, that none of this research provides anything of use when describing the consequent depression. The laws of economic coordination, after all, do not cease to apply during eras of economic difficulty.
It is the understanding of economic calculation and coordination that leads most Austrians to argue in favor of what critics call "do-nothing" policies. Opposition to fiscal and monetary policy is based, not on a blind faith in markets, but rather on the idea that the recovery must rely on the same principle that governs the allocation of resources during times of prosperity: economization. It is because of this understanding that Austrians argue that government spending and monetary expansion are counterproductive and handicap economic calculation.
Coordination Theory Briefly ReviewedI have discussed macroeconomic coordination at some length in a prior article, "The Foremost Austrian Contribution to Economic Science." The basic premise of calculation theory is that money prices, formed on the basis of consumer preferences, convey certain pieces of knowledge to market agents. These prices allow individuals to economize the use of resources by providing a tool by which to calculate the merit of a certain action. That is, if an action is defined by using means to achieve an end, prices allow the economization of both means and ends based on the subjective valuation of the individual.
For instance, a person may want to buy an ebook reader, but the price may make it prohibitively expensive. That person may consider a different end a better use of that money. To put it concisely, money provides a standard to compare the values of different economic goods in a society characterized by advanced indirect exchange.
Money prices play an important role in intertemporal calculation. Without money prices, it is questionable whether advanced intertemporal calculation would even be possible.
Entrepreneurs also use these prices as a basis of economization, by exploiting differences between the present prices of relevant capital goods and the expected future prices of the goods they plan to produce. It is this constellation of prices in conjunction with entrepreneurial action, all of which finds its genesis in consumer preferences, that dictates the allocation of economic goods throughout the structure of production.
Austrian intertemporal-discoordination theory is an extension of coordination economics. It explains why there occurs a miscoordination of goods and why such a phenomenon must necessarily lead to a period of industrial depression. In its simplest form, the theory suggests that changes in the supply of fiduciary media in the loanable-funds market will impact the distribution of money throughout the structure of production.
Specifically, it will lead to a higher amount of nominal investment in the capital-goods sector. This is because low interest rates make it cheaper for entrepreneurs to invest in capital-good stages directly before the final consumer-good stage, which in turn increases the profitability of investment in preceding stages. Such investments, however, require real capital goods. Because these goods have not been set aside by a rise in savings, there is an insufficient amount of capital goods to complete ongoing productive processes. There follows a necessary liquidation and an industrial fluctuation.
Depression EconomicsWhat we know about the boom can tell us a lot about the bust. We know that the boom is characterized by a misallocation of economic goods, and that the bust is a product of the necessary liquidation of this malinvestment. Liquidation is necessary as a means of cutting one's losses. If the investment is unprofitable, and you will lose less if you end the investment rather than complete it, then it makes sense to do just that. It is this process that underlies the unfolding secondary events of the depression period.
The liquidation of investment causes the credit contractions typical of these sorts of fluctuations through three processes: a broad default on loans, a contraction of fiduciary media on the part of banks suffering from insufficient capital balances to deal with widespread financial losses, and an increase in the demand for money to deal with a rise in uncertainty. The causal relationship between malinvestment and credit contraction is an important one, because it sheds light on the (lack of) value of attacking what is not the root of the problem.
Within the context of the pricing process, this is a period of substantial chaos. Prices have to recalibrate based on consumer preferences amid credit contraction. How much time this will take is impossible to answer with any accuracy, but generally it will be roughly equal to the amount of time necessary to liquidate the malinvestment that pervades the market at the point of collapse — that is, the amount of time for total unaffordable debt to be defaulted on and for banks to stabilize.
Whether this process is "painful" is not relevant to its necessity; if resources have been misallocated, what purpose can maintaining this misallocation possibly serve? Liquidation of real investments and of unaffordable financial assets, therefore, is one aspect of the Austrian "policy" to restore health to the market.
While prices are adjusting, entrepreneurs must allocate capital goods toward production processes that are coordinated with consumer preferences. This may require a dramatic change in the structure of production. Capital goods are heterogeneous: nails cannot be turned to glass, nor hammers to automobile carburetors. How flexible an economic good is in its ability to move from one process of production to another varies, and this flexibility plays an important role in determining how the postboom stock of capital goods can be rearranged toward new lines of investment.
There may be a substantial amount of specific capital goods produced during the expansionary period that are no longer useful — that is, their purposes are no longer relevant to satisfying consumer demand. An example would be a machine that produces a very specific capital good useless for anything other than the original project it was intended for.
Some capital goods may not be useful at all, and they will lose their status as economic goods. Others may have to remain "idle" until their owners find it worthwhile to use them. These entrepreneurs may find it more profitable to invest in other capital goods instead of opting for means and ends with higher opportunity costs.
The rearrangement of the structure of production is not a simple process. Specificity aside, some capital goods require other capital goods for production purposes. If complimentary goods are unavailable or unaffordable, it may jeopardize the usefulness of the good in question. Or the product that can be produced with what is affordable will be much different from that produced when prices were skewed by fiduciary expansion. Goods that are substitutable for each other may alleviate some of the transition pains, but these too will impact the various production processes they are related to.
Another important aspect of depressions is the high unemployment that usually comes with a mass liquidation of productive processes. Like capital goods, labor must be reallocated. However, it is a grave error to prescribe policy based on unemployment alone. Employment of workers toward processes that do not satisfy the highest-valued consumer preferences is either unsustainable or comes at the cost of subpar productivity.
"Improvement in the labor market, therefore, is unquestionably tied to the capital structure."Sustainable employment can only be accomplished by mixing labor with capital goods toward production processes that are based on consumer valuations. Improvement in the labor market, therefore, is unquestionably tied to the capital structure. Without a structural readjustment, there can hardly be a sustainable or economical reduction of unemployment.
This structural readjustment is the Austrian "recommendation" of what needs to occur to restore healthy productivity to an economy. There are two main components: a correction in the pricing process and a readjustment in the capital structure. Whether these would be "unfair" or "painful," frankly, does not matter. Rather than blaming the readjustment, guilt should be associated with the interventions that made the liquidation and restructuring necessary in the first place — the inflationary policies that led to the depression. Any step taken to avoid the readjustment will at best prolong the recession, or at worst aggravate the problem.
Interventionism and Its ConsequencesOn the surface, fiscal stimulus seems like a sensible policy prescription for reinvigorating industrial productivity. The general idea is to put "idle" resources to work. But those who are trained within the Austrian framework know that this idea has no basis in reality. As explained above, the issue is not about merely putting resources to work; it is about putting resources to work in the right areas as to best service consumer desires. This requires economization. A more comprehensive theoretical argument as to why government cannot economize is provided in my article "Government Spending is Bad Economics."
The market rewards those who economize well with profits, and it punishes those who do not with losses. Therefore, there is a tendency for capital to be distributed to those who use it best. Once one entrepreneur ceases to use capital wisely, it flows toward a better one. Government taxation disrupts this process by expropriating capital from those who earned it through the market. It then invests it in projects that are based, not on calculation, but rather on political whim, such as building highways or whatever make-work program the government concocts. Government spending represents a waste. The waste is the production foregone in favor of opting for a subpar investment opportunity.
Part of the problem is theoretical. The Austrian School, so far, is the only one characterized by an accurate theory of intertemporal pricing and distribution (that is, capital theory). Other schools, including the mainstream neoclassical and Keynesian schools, do not enjoy this body of theory. Instead, for them capital is an aggregated concept. They believe capital goods to be homogeneous; they do not differentiate among nails, hammers, glass, and carburetors.
One can see, then, how economization fails to play an important role in these schools' alleged solutions to the depression period of an industrial fluctuation. All goods are homogeneous and therefore flexible and substitutable. If there is scarcity, there still needs to be some form of economization, but it becomes less important: there is no distinguishing what goods should be economized toward what ends. Furthermore, if there are idle resources then the issue becomes almost one of nonscarcity.
Capital goods are not homogeneous, and they cannot be aggregated. Buying resources through taxation and then investing them based on a government policy has underlying economic implications that impact the structure of production. Furthermore, as noted above, any investment undertaken by the government is necessarily inferior to the investment that would have occurred otherwise, because government investment is not part of the market process.
Fiscal policy is not a legitimate response to a fall in industrial productivity caused by a previous misallocation of resources. The consequence of such policy is an inferior structure of production or, worse yet, one that is completely unsustainable.
Instead, what an economy in depression needs is an adjustment period, characterized by deflation, price adjustment, and structural change. This is not a "do-nothing" policy; the dichotomy between government response and "do nothing" is a false one. The alternative is this: let the relevant market agents and the market process readjust to cope with the problems caused by government intervention.
A recent discussion regarding commodity prices on CNBC consisted virtually of sentence-by-sentence errors with respect to macroeconomic theory. Most of the misstatements involve either accidentally or intentionally — I don't know which — attributing economic and financial market events to various incorrect or misleading cause-and-effect scenarios, when the real explanation is simply the government's creation of money and credit.
Regrettably, these errors are not restricted to the CNBC commentators and guests in the segment in question, but in fact are characteristic of economic misunderstanding generally. Therefore, I offer the following as a step-by-step clarification of these issues, so that readers can gain a clearer understanding of both the truth and the misconceptions.
Will the Fed Raise Rates?The discussion began with CNBC's in-house economist Steve Liesman discussing whether the Fed should raise rates in response to reports of soaring wholesale inflation numbers. He explains that the Fed "has so far concluded that it would be the wrong medicine right now for the problem."
That alone brings us the first concern: It is difficult to imagine that the Fed has actively decided not to raise rates, when the fact is that — as things stand — it could not raise rates even if it wanted to (and it might want to). It can raise treasury rates by ceasing to buy treasuries, but it can't raise the federal-funds rate.
The Fed raises the federal-funds rate via open-market operations that withdraw money from the federal-funds market, making money more expensive. But given the massive amount of excess reserves that the banks hold at the Fed, it is virtually impossible for the Fed to withdraw all the reserves it has created without causing massive economic damage. Therefore, it is the excess money on the market that is keeping rates near zero. Thus, the banks — not the Fed — are in charge of interest rates. As the Economist stated:
The Fed could announce a federal funds target of 3% but the tsunami of excess reserves now out there swamps any conceivable demand, so the Fed funds rate would be guaranteed to remain stuck at zero. The target would be meaningless.[1]
It is because the Fed can't raise rates due to the excess reserves (along with the much-discussed concern that all those excess reserves will lead to inflation) that the notion of the Fed having "painted itself into a corner" in terms of trying to "unwind" all of the positions it took from failed Wall Street firms is so widespread.
Now, it would be possible for the Fed to raise the federal-funds rate by way of paying the banks significantly higher rates on their reserves than the current 0.25 percent. But such an action would cause banks to cease lending to the public, which would create a recession. Therefore, the Fed cannot raise rates without causing a recession.
Why the Fed Is Leaving Rates AloneNonetheless, Liesman explained the reasons the Fed has decided to leave rates unchanged. He first noted that the argument some put forth is that the Fed should raise interest rates in order to cool rapidly rising commodities prices that are leading to wholesale price inflation. But he then said that the Fed has stated it is not going to react to commodity prices, because those price increases are coming from economic growth in emerging markets, not from the Fed. (And, of course, the Fed is not going to publicly admit that due to its recent attempts to address the problems of its own prior actions, it can do nothing about rising prices now.)
What's wrong with this argument is the idea that commodities prices or inflation can arise from strong economic growth. What the Fed is referring to regarding emerging markets growth is the Keynesian notion that after a period of strong economic growth, inflation can arise from too much demand chasing too few goods. This "too much demand" is usually said to be caused by workers/consumers via increased spending resulting from increased employment. In this way, more employment would cause inflation. This increased employment and spending that leads to prices rising faster than goods is what Keynesians call demand-pull inflation. They admit that inflation causes prices to rise — though they claim that many, many other factors do as well — but only when the economy is operating at full capacity.
The main problem with this theory is that Keynesians claim that additional demand comes from additional production and employment instead of from the central bank. "Demand" consists of the desire plus the ability to purchase something. People can only demand and purchase something by paying for it. They pay for it by exchanging other goods that have been produced; money is simply the medium of exchange. Thus, production is the source of true demand. But when the medium of exchange — money — is increased, the price of the product being purchased will rise. Such a rise is not an increase in real demand; it is an increase in the prices of products being produced. Real demand can increase only by way of an increase in production, which in fact lowers prices.[2] In reality, the increased demand that the Keynesians refer to (but do not name) is increased monetary demand, not real demand. Increased monetary demand comes only from an increase in the quantity of money pushing up prices.
It is quite incorrect to argue that producing more goods will result in prices rising instead of falling. It is also incorrect to say that an economy can overheat as a consequence of (real) demand exceeding supply, since increased real demand comes from increased production, which itself results in a greater supply. An increase in demand — which is in fact an increase in supply — cannot cause prices to rise. Prices can rise only if the monetary unit is being devalued as more money is being added to the economy. Thus, the only thing "overheating" is the government's printing presses.
A Closer Look at Emerging-Markets Growth and CommoditiesTherefore, by definition, if emerging markets are truly growing quickly, they are creating new goods and services at a very fast rate; they are producing more commodities and other goods. Their demand for purchasing commodities is being enabled (i.e., paid for) by those other recently produced goods that are given in exchange for commodities, and whose creation lowers both domestic and international prices. And if the United States (and other Western economies) were truly growing as well, it, too, would be producing more goods, causing prices to decline. All of this increased production would cause all goods — including commodities — to fall in price, not to rise.
Indeed, unlikely as it is, there could — theoretically — just happen to occur simultaneously a slower supply growth rate of all of the hundreds of commodities produced in the world relative to the hundreds of thousands of other goods produced in the world, causing all of the various commodities to rise in value relative to other goods. But in the absence of more money being created, an increasing monetary demand for and an increasing price of commodities would be offset by a corresponding decrease in the monetary demand for and prices of other goods. Additionally, as the price of commodities rose, demand would fall.
But the demand for commodities and the prices of other goods have not been falling. Why? Because what is driving up commodity prices — while the prices of all other goods are rising at the same time — is simply an increase in the quantity of money. Market participants are bidding up the price of commodities, along with consumer goods and stock and bond prices (and, formerly, real-estate prices) with the additional money they are receiving from the central bank.
Rising asset prices are the manifestation of inflation. The prices of financial instruments and commodities are rising more rapidly than consumer prices because they are traded on exchanges, where banks, insurance companies, hedge funds, and the like insert funds newly borrowed at cheap rates from the world's central banks. Further, foreign central banks themselves redirect reserves earned from the US trade deficit into the financial markets. Therefore, new money flows disproportionately into the asset markets relative to the real economy.
For Federal Reserve officials to claim that the large amount of new money they have created in the last few years is not contributing to pushing up the price of commodities markets, and to (implicitly) assume that all of that money has instead flowed everywhere else in the economy except to commodities markets is indefensible. (And even if they were correct, the fact that other prices besides commodities are rising shows that the Fed must be responsible for those price rises).
But let's even say that they're right. In that scenario, because neither the money the Fed is creating nor emerging markets growth is responsible for pushing up commodity prices, then it must be new money being created in emerging markets or developed markets outside of the US that is responsible for rising commodity prices (but not for aggregate American prices).
But even in this case, the Fed still plays an indirect role. This is so because many countries in the world create new money only as a means to keep their currency in line with, or lower than, the US dollar, in order to support their mercantilist trade policies; when the Fed expands the money supply, lowering the value of the dollar, foreign central banks create money to respond to this event (by way of creating new local currency to match the excess dollars they receive through trade surpluses they have with the US). But what's certain is that either some or all of the central banks are the only entities responsible for rising commodity prices (but only the Federal Reserve can be responsible for aggregate American prices).
Transmission MechanismsIt is important to point out that the mechanism of transmission of monetary policy to the economy or financial markets discussed by mainstream economists concerns the interest-rate effect, not the money-supply effect. Most economists hold that lower interest rates spur economic activity by way of lower borrowing costs, which bring about additional investment spending and in turn consumer spending.
This additional production and consumer spending causes increased "demand" that stimulates the economy — sometimes to the point of inflation, as we saw above. But also as noted above, "demand" is usually implicitly seen to be some amorphous type of "strong economic activity"; the money-supply component of this monetary policy is rarely made explicit.
While lower interest rates indeed cause businesses to borrow and invest more, what is usually being borrowed, invested, and spent is new money, not previously existing money. Interest rates are lowered by increasing the money supply. It is this new and additional money that causes increased corporate revenues and profits, GDP, and asset prices. It is the new and additional money that is the sole cause of rising prices of any kind, anywhere (given that most other prices are rising simultaneously).
Similarly, it is usually said that the lower dollar causes commodities prices to rise because, since commodities are priced in dollars, as the dollar falls, commodities become cheaper in foreign-currency terms. Thus, demand, and therefore, prices, increase. This much is true. But rarely mentioned is the other side of this effect, which is the "money effect." The value of the dollar (of each dollar existing) falls because more dollars are created. It is those additional dollars that bid up commodity prices (new dollars flow disproportionately into commodities markets).
To the extent that the demand for dollar-priced commodities is from overseas (such as the commonly referred to "demand from China"), though the demand usually originates as real demand — i.e., production and real economic growth — the only "demand" that actually pushes up prices is additional monetary demand in the form of additional foreign currency being created overseas (which can be used to buy dollars with which to purchase commodities).
Wall Street Chimes InAnother discussant on the CNBC show was Milton Ezrati, senior economist and market strategist for Lord Abbett mutual funds. He agreed that the Fed has no control over commodity prices, and he said that raising rates might not be in accordance with the Fed's "long-term goals." Though he didn't say what those goals were, they are pretty clear: to keep an abundance of money flowing into the economy so that "demand" does not fall off and so that (artificial and contrived) employment does not fall; and to keep money flowing as well into the financial markets, so that there is the appearance of a "strong economy," because most people (falsely) believe that the financial markets rise because the economy is growing. Most importantly, the Fed's primary goal is to keep the money-supply growth positive, so that a monetary contraction will not take place and cause banks to become insolvent.
Ezrati is therefore correct in saying that changing monetary policy now could harm the Fed's "goals"; if the Fed slowed or reversed the rate of money pumping, both GDP and the financial markets would fall. Though it's not clear whether all economists understand the specific cause-and-effect relationships, the result would be a recession, unemployment, and bank and business losses. It would then be even harder to pump the economy back up again with artificial credit.
But, of course, Ezrati was incorrect in agreeing that the Fed has no control over commodities prices. Not only that, he went on to make another incorrect claim: he also mentioned that a major factor causing the dollar to fall is America's fiscal situation, which, he says, the Fed can't control. But this is completely sophistic. Without the Fed buying the government's bonds, the government could not have much of a fiscal deficit, since it would have to rely solely on taxes and real savings from individuals. But when the Fed purchases these bonds, it does so by creating money, which lowers the value of the dollar. The Fed is therefore the sole entity responsible for lowering the dollar.
Jim O'Sullivan, chief economist at MF Global, appeared on the program too. He said outright that it is too risky to raise rates because the bond and stock market might fall; he is thereby acknowledging that the Fed affects asset prices. Granted, he was likely thinking in terms of higher rates causing slower economic growth, resulting in less economic activity and thus lower asset prices (which supposedly reflect that activity). Still, even if he was not recognizing the more realistic transmission effect of more Fed-created money directly pushing up prices, his comments show that the Fed's policies affect asset prices — even if they don't (as I would argue) wholly drive them — in one way or another.
Curtailing the Rise in Commodities PricesLiesman then states that "some Fed officials suggest they could lower commodities prices only by tightening policy and reducing economic growth." For Fed officials to say that they can lower commodities prices by tightening policy is tantamount to contradicting their previous statement claiming that they are not driving commodities prices (unless it was different specific officials making each statement). The Fed officials are saying that if they raise interest rates and/or reduce money supply growth, the economy will slow. They are therefore saying that the economy is being driven — or at least pushed along — by low rates and by money and credit "being available" (as they would say). Therefore, the growing economy, in their view, causes a "demand" for commodities. They don't say that it is a monetary demand — just a general "demand."But they also acknowledge that if this demand were reduced with "monetary policy tools," demand for commodities would fall. Thus, they are simultaneously saying that their policies are not driving commodities prices higher, but that if they undo their policies, commodities prices will fall. The fact is that it is their money pumping that is driving both GDP growth and commodities prices — but not the real economy.
Falling Prices and WagesInterestingly, Liesman said that if the Fed did in fact tighten monetary policy and slow economic growth, that wages and prices would fall. In this case, he asserted, inflation-adjusted prices would not be changed at all. He said that "prices [would be] coming down, even though … wages are coming down too, and the actual affordability of the thing that's coming down hasn't changed … at all … so there's an asymmetry out there."
Now, if Liesman is referring to a sudden monetary-contraction-induced deflation that would come about from shutting off the money valves, he is right that prices and wages would both fall. But the way to prevent such a deflation is to not print money in the first place, as deflation of the money supply can come about only from having previously expanded the money supply. Additionally, falling prices and wages resulting from a contractionary deflation would be a temporary, not ongoing, occurrence.[3]
But if Liesman is — as appears to be the case — referring to falling prices that would come about from not expanding the money supply to begin with, he is dead wrong. Absent money printing, when prices fall, they fall due to an increase in the supply of goods. Wages, however, do not fall, because the supply of workers does not increase as the supply of goods increases.
Even if the number of workers did increase, the supply of goods would increase in proportion to the increased supply of workers (i.e., each new worker will produce additional goods). No matter how many workers are working, as their productivity increases, the supply of goods per worker increases. Thus, the prices of goods fall faster than the prices of labor. And if the labor supply does not increase, wages will never fall at all. In fact, this phenomenon of the prices of goods falling relative to the price of wages happens even when there is inflation of the money supply, because new money pushes up wages much faster than it pushes up the prices of goods, because goods are expanding faster than are people. That is how real wages rise whether prices are rising or falling.
So Liesman's idea that prices and wages would fall at the same pace fails to understand what an economy really is and how standards of living really improve. Further, it is insulting to say that people will be in the same shape in real terms, even if prices and wages do move together. This is because the mere act of printing money in order to make prices rise destroys savings, destroys capital, and therefore causes economic and financial crises. All of these things lower standards of living and make people worse off.
Consider just the savings effect of printing money. People have to save for their retirement because they have to have money to live on when they're no longer working. Their current savings will not support them in the future, so they must save more, especially because prices will be higher. Suppose that today it costs a 40-year-old $45,000 a year to live. With inflation of 3 percent per year, it will cost her over $94,000 a year to live when she retires at age 65. Thus, she must save heavily in order to have an amount of savings large enough to live off each year, and still have it grow for future years of retirement (say, into her 90s, given current life expectancies) at a rate faster than she is drawing down on it. A very high growth rate is needed, especially considering that she will be taxed on all her gains.
But consider an alternative scenario in which no money was printed, and that the rate of production increased at 3 percent per year. In this case, upon retirement, the living that used to cost the woman $45,000 would now cost just over $21,000. And by age 95, it would cost less than $8,500 per year — in real terms, and with nothing taxed! In that case, not only would workers not have to race against the inflation clock before and during retirement, but whatever savings they had would buy more each year.
So indeed, in today's world, because of the government's printing of money, even if wages keep up with inflation, people have to save more and consume less than they would otherwise, and once wages aren't earned anymore, most people usually begin falling behind immediately. Clearly, society would be in better shape with greater savings, a stronger economy, and with prices falling in both nominal and real terms on a monthly basis, as would be the case absent money creation and rising prices.
Nevertheless, Liesman goes on to express his outright surprise at Bank of Japan surveys that consistently show that people like falling prices more than rising prices (seriously, he was actually surprised). Even though this expert economist doesn't understand how people are any better off without credit expansion and inflation, actual people who face the consequences in their everyday lives do understand quite clearly.
Another problem with the statement regarding falling wages and prices is that, even if prices and wages did fall at the same rate, and even under monetary deflation, if there were no printing of money, commodities prices would fall at a much faster rate (because they have been rising at a much faster rate), causing people to more easily afford commodity-based products such as gasoline, food, and airline trips. In other words, in the absence of printing money, some prices would not, as now, rise so disproportionately faster than others; a better balance would be maintained.
For circumstantial proof that commodities prices would fall significantly if the Fed quit creating inflation, consider Figure 1, which shows the 2008 collapse in commodities prices — as measured by the Powershares DB Commodities Index — that resulted from the reduction in the rate of money-supply growth during 2005–07, and the subsequent reduction in credit growth and velocity of circulation (particularly in the financial markets) in 2007-08. As we all know, derivative prices, such as food and oil prices, also fell dramatically in 2008.
Figure 1The money-supply driven boom and bust of commodities prices during 2007–2008(Chart time frame is 2006–2011. Click to enlarge figure 1.)The Wage-Price-Spiral FallacyLiesman then states that one of the Fed's "tests" for inflation involves looking for a "wage-price spiral." The idea of the wage-price spiral — another construct of Keynesianism accepted by most economists and taught in virtually every economics program — is that workers demand higher prices in order to keep up with inflation, and that the higher wages in turn cause more inflation, prompting workers to once again push wages higher. Once this vicious circle process gets started, inflation can explode uncontrolled.
The fallaciousness of this argument once again brings us back to the quantity of money. Without additional money added to the economy, neither workers nor businesses could ever raise aggregate wages or prices for the reason that, given a fixed quantity of money, it is mathematically impossible for aggregate prices to rise. For a detailed proof of this, please refer to my last article (middle section).
As far as whether workers could raise individual prices, let's do a mental experiment. Consider an economy with $100 of demand, or, money and spending ("demand" and "spending" both consider velocity as well) with 100 workers that produce 100 units of goods. In this scenario, each worker is paid $1 and each good sells for $1.
Now suppose that workers somehow forced up wages by 33 percent, to the level of $1.33 per worker. With the same $100 of money and spending with which to pay salaries, only 75 people could be employed ($100 in spending for labor divided by $1.33 per worker = 75 people). Then, 75 people would receive $1.33 each. Every time workers forced wages higher, more workers would become unemployed.[4]
Similarly, suppose prices were somehow driven up 11 percent from $1.00 per unit to $1.11. The number of units sold would fall by 10 percent to 90 units sold ($100 in spending for goods divided by $1.11 per good = 90 goods sold). With production falling 10 percent, approximately 10 percent fewer workers would be needed, and unemployment would rise by 10 percent. Every time prices rose, the number of goods in the economy would decline, and more workers would be unemployed. Thus, workers would not keep driving up prices.
But in today's world, as wages and prices rise by the year at even a "slow" rate, unemployment levels do not rise, and the number of goods produced and sold does not fall. This is because the central bank is continually providing the economy with more money, so that wages can be bid higher without causing unemployment. When the increased dollar amount of wages is spent in the economy, resulting in increasing demand for goods, prices increase. Thus, if there is any semblance of a wage-price spiral, it is an artificial one caused by the Fed itself. So when the Fed says it is looking for a wage-price spiral, it is really looking for the results of its own money pumping in the form of price inflation. (And while it wants to restrain price inflation, it actively seeks and promotes asset-price inflation in the form of stocks and bonds.)
Another indicator that Liesman said the Federal Reserve uses to test for inflation is that of rising "inflation expectations." It is widely believed that the mere expectations of inflation can actually bring on inflation. For example, in a 2007 speech, Fed Chairman Ben Bernanke relayed that it's possible for "people [to] set prices and wages with reference to the rate of inflation they expect in the long run."[5]
Supposedly, according to this argument, workers expect inflation and, therefore, start demanding higher wages, or consumers begin paying higher prices for goods, even in the absence of businesses and consumers having received additional monetary purchasing power with which to bid up wages and prices. Thus, this unrealistic argument does not take into consideration that there would be no additional money in the economy with which to pay higher wages or higher consumer prices.
Indeed, there could be expectations of inflation, but expectations of future inflation are brought about only by the existence of previous inflation, or by observing that more money is being added to the economy, and knowing that the additional money will eventually raise prices. But the actual existence of inflation can come only from an increase in the quantity of money (and velocity, or the amount of times each dollar is spent, is driven mostly by the supply of money.)[6]
ConclusionThe CNBC program is an example of typical misunderstandings about macroeconomics. In order to understand the global economy correctly, one must have the correct economic lens through which to view it. While mainstream economists without a doubt are very bright people, they have learned — and they stick with — theories that cannot possibly be correct when thoroughly scrutinized.
Why do they not consider alternative explanations that explain and forecast their world better than their own theories? Depending on the case in question, they might not consider other theories due to one or more of the following reasons: they refuse to believe that they have incorrect theories, even if theirs don't often pan out; they truly haven't been exposed to other theories that could be plausible; they would have to make a large investment to learn a new theory; they would betray the ideology that they want to stick with no matter what; they prefer to speak the most common economic "language"; or, they benefit in various ways in their careers by supporting theories that even they know do not fully add up. Whatever the reason, we must remember that just because they say something doesn't mean it's true.
Notes[1] "The Truth About All Those Excess Reserves," (December 30th, 2009).
[2] And not by a supposed multiplier effect from monetary spending.
[3] And there is absolutely no need for or benefit from an increased supply of money (see last section of this article).
[4] This example is based on the example George Reisman uses.
[5] Federal Reserve Chairman Ben Bernanke, "Inflation Expectations and Inflation Forecasting" (speech).
[6] Since a lot of people ask me about this, I will refer anyone interested in learning more about the relationship of velocity to the money supply to George Reisman's Capitalism, p. 517 section 3, and p. 915 section 7, and to doing a text search on Mises.org for discussions on velocity by Henry Hazlitt, and by Frank Shostak.
What they don't understand: aggregation, relative prices, interest rates, capital structure, money pumping, and regime uncertainty, writes Robert Higgs.
This audio Mises Daily is narrated by Colin Hussey.
We cannot eat money. We cannot wear money. We cannot live in money. Money can't buy you love, writes Shawn Ritenour.
This audio Mises Daily is narrated by Keith Hocker.
If it is true that prices are signals which enable us to adapt our activities to unknown events and demands, it is evidently nonsense to believe that we can control prices, writes Friedrich A. Hayek (1899–1992).
This audio Mises Daily is narrated by Nathaniel Foote.
Depression babies learned early that "saving for a rainy day" was not something one hopes to do but a requirement. The saying originated when most people worked on the farm. And when it rained, the fields were too wet to plow, and the farmer — not to mention the hired hands — made no money.
Of course, my grandfather was the diligent sort who would use rainy days to do required maintenance on his implements, noting with derision other farmers who spent rainy days at the bar in town. He believed they would surely end up with broken equipment when the sun would reappear, keeping them from making hay.
So the idea of savings is not necessarily the return one receives on the money that's socked away, but the piece of mind that, when the weather doesn't cooperate, the saver has a little stash to tide him over. Of course, the vast majority of us don't have to worry about the weather.
But an economic storm hit a couple years ago and plenty of people have not had work, rain or shine. Those who took heed of that old saw have no doubt weathered the storm better than those who didn't. Most financial advisors recommend that a person have three month's worth of living expenses saved — and some say six months worth, just in case. But how many people heed that advice?
There is no caveat to the counsel that says, "Keep six months of savings around if the money is earning at least six percent." Even if the money sits there all shiny, not earning a thing, it's the liquidity and insurance against the unknown that's the issue.
Unfortunately, a central bank's debauchery of the currency serves to raise people's time preferences and impair their judgment. In a blog post recently, I highlighted the advice of life coach and author John P. Strelecky, who advises people to spend their tax refunds on an experience they will remember forever, rather than saving the few hundred or thousand dollars that the IRS may be giving back.
Live your life for today, says the life coach — a couple thousand bucks isn't going to matter anyway. I posted to the Mises Blog to point out how ludicrous this advice is. But most who commented sided with Strelecky:
I think his advice is spot-on, at least given the constraints of the times in which we live. What's the point in saving if inflation will ravage whatever you manage to accumulate?
You play by the rules of the game. Your savings growth will be puny due to pathetic interest rates, erased by inflation, and confiscated by a rapacious state. So go ahead, enjoy the "money" now, while it still has some value.
Most people don't really have a better place to put the money than into a pleasurable experience, which is all you will want in the end.
Gotta agree with the comments. Maybe not trips or other "experiences." But I feel safer with stuff than I do with Federal Reserve notes going forward.
That's just what central bankers like to hear. They are worried about deflation. A few months ago, the Chicago Fed's Charles Evans said,
It seems to me if we could somehow get lower real interest rates so that the amount of excess savings that is taking place relative to investment is lowered, that would be one channel for stimulating the economy.
Lord Keynes was constantly worried that people were saving too much and consuming too little — thus the need for more and cheaper money to stimulate the economy. Mr. Bernanke is nothing if not a good Keynesian, and his low rates make even the savviest question whether to forgo consumption.
$10 $8
And likely no retiree, when contemplating leaving the workforce, figured 1 percent interest rates (or less) into their retirement cash-flow planning. In a front-page article, the Wall Street Journal took a look at "retirees who find themselves on the wrong end of the Federal Reserve's epic attempt to rescue the economy with cheap money."
The WSJ rightly points out that the Fed's low rates have been a windfall for banks and borrowers, but a problem for those needing income from their savings to live on. People who thought they played the game right, worked hard, saved money, and now want to take it easy, are panicked that money-market funds are throwing off but 24 basis points. "That's one-tenth the level of late 2007 and the lowest on records dating back to 1959," the Journal reports.
As bad as the Fed-engineered low rates are for those trying to live off past savings, reporter Mark Whitehouse makes the point that the low rates keep young people from building up funds for the future — whether it's for emergencies or retirement. Working Americans put less money into financial assets last year than at anytime on record — except 2009, when people pulled money out. And while the Department of Commerce says the personal savings rate has risen to 5.8 percent, Whitehouse explains, "That's in large part because it counts reductions in personal debt, such as mortgages and credit-card balances, as savings." But most debt reduction, Whitehouse writes, has been driven by defaults, rather than saving.
The Fed's interest-rate policy also leads people into taking more risk with their savings than they should. "That's why most of us are in the stock market, because there's no place else to go," says 70-year-old John Lehman, who would rather have his money in bank certificates of deposit but must resort to speculating. "I hope my assets don't run out before I die."
Many retire with next to nothing as it is. According to AARP, 16 percent of Americans have not saved a dime for retirement, and nearly half have saved less than $50,000.
Those with no savings are more dependent on government and others when the unexpected occurs, whether it's job loss or the washing machine quits. Professor Paul Cantor reminds us in his article, "Hyperinflation and Hyperreality: Mann's 'Disorder and Early Sorrow,'" that "money is a central source of stability, continuity, and coherence in any community. Hence to tamper with the basic money supply is to tamper with a community's sense of value."
When the Fed makes saving seem futile and immediate pleasure seem rational, the world has been diabolically turned upside down. Just one step away from hyperinflation, the central banks' actions are threatening "to undermine and dissolve all sense of value in a society."
"Thus inflation serves to heighten the already frantic pace of modern life, further disorienting people and undermining whatever sense of stability they may still have," Cantor explains.
The social order is upended in Mann's story as wealth is transferred from those who diligently saved all of their lives to speculators. As it was in the Weimar Germany that Mann describes, so it is today, as people believe it futile to sock away a little money here and there, and instead feel compelled to either speculate or just blow what they have on good times.
And while the retirees mentioned in the WSJ article are being crippled financially, Cantor points out that Mann's portrayal of hyperinflation uncovers "something psychologically more debilitating happening to the older generation." Impetuous, high-time-preference behavior displayed by the young appears rational in an inflationary period, while prudence and conservatism appear to be not even quaint but downright silly.
As Mann described so long ago, the world of inflation is the illusion of wealth, created by the government's printing press, distorting everything we see and perverting our judgment. Meanwhile the cry for stimulus continues, while our culture and values are buried under a pile of paper.
As Ron Paul's "End the Fed" movement grows, more and more Fed economists are speaking up on behalf of the central bank. In a recent post, David Andolfatto of the St. Louis Fed argues that the systematic debasement of the currency has had a negligible effect on the average American. As we'll see, Andolfatto's evidence is completely irrelevant to the question. The Fed and commercial banks have been ripping off everyone who uses dollars.
Andolfatto Calls Foul In setting the stage for his critique, Andolfatto first quotes Ron Paul who wrote in End the Fed (p. 25):
One only needs to reflect on the dramatic decline in the value of the dollar that has taken place since the Fed was established in 1913. The goods and services you could buy for $1.00 in 1913 now cost nearly $21.00. Another way to look at this is from the perspective of the purchasing power of the dollar itself. It has fallen to less than $0.05 of its 1913 value. We might say that the government and its banking cartel have together stolen $0.95 of every dollar as they have pursued a relentlessly inflationary policy.
Andolfatto thinks this typical objection to the Fed is spurious. The fact that prices (quoted in dollars) have steadily risen since the founding of the Fed doesn't necessarily mean we're all poorer. Why? Because wages have steadily risen since the founding of the Fed too. To make his point, Andolfatto produces the graph below and then comments:
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According to this (publicly available) data, the price-level (CPI) has increased by about a factor of 10 since 1948. But the average nominal wage rate has increased by a factor of 25. …
The figure above implies that the real wage (the nominal wage divided by the price-level) has increased by a factor of 2.5 since 1948. This is undoubtedly a good thing because it implies that labor (the factor we are all endowed with) can produce/purchase more goods and services. More output means an increase in our material living standards. …
Now, an interesting question to ask is how the picture above might have been altered if the price-level had instead remained more or less constant. Judging by the emails I receive, many people evidently believe that the nominal wage path depicted above would have largely remained the same (that is, they apparently see no connection between nominal wages and the price-level). …
I [suggest] there is reason to believe that under an hypothetical regime of price-level stability, the nominal wage rate in the graph above would instead have ended up increasing only by a factor of 2.5 (more or less) — the factor by which real wages actually rose.
Before continuing, let's be clear on Andolfatto's argument: He claims that isolated statistics showing the fall in the purchasing power of the dollar (or what is the same thing, the general rise in the prices of goods and services) don't prove that the average Joe is getting ripped off by inflation. The Fed's injections of new money have led to higher gas and bread prices, yes, but by the same token they've led to higher wages and salaries.
Now if one believes — as most economists do — that money is "neutral" in the long run, then there is no reason to suppose that the relative prices of labor and other items will change just because of more or less money printing. For example, if adding a worker to a factory yields additional output of one DVD set per hour, then basic price theory says that the worker's hourly wage should roughly be able to buy one DVD set. If there has been moderate inflation, and the DVD sells for $25, then the worker's wage rate will be $25. If there has been significant inflation, and the DVD sells for $2,500, then (at least once things settle down) we would expect the worker to get paid $2,500 an hour.
What about Savings? The immediate response to Andolfatto's position is that he's ignoring the savings of the community. Here's how he handles that objection:
There are many episodes in history where savers have been hurt by an unexpected increase in inflation. I do not wish to defend the actions of any agency responsible for episodes of high and volatile inflation. … But this is not the regime we currently live in. … [I]nflation has been (relatively) low and stable for over 30 years now. And the Fed is committed to keeping inflation … "low and stable" (implicit inflation target is 2%). The argument that a "careful saver" over the last 30 years "just now" sees the purchasing power of that money destroyed seems implausible to me. Most people do not hold the bulk of their savings in the form of cash. (And if people were holding their savings in the form of Treasury bonds, they would have experienced significant capital gains over the last couple of years with the decline in nominal interest rates.) I think [it's] fair to say that most people, or the people who manage their money, expect inflation. …
So Andolfatto thinks, not only that workers haven't gotten a bum deal from the Fed, but that even retirees should be fine (at least during the last three decades, when price inflation was fairly predictable).
Rather than pinpointing Andolfatto's mistakes, it's easier to analyze a thought experiment.
The Counterfeiter Suppose Andolfatto's next-door neighbor tinkers with his color printer and comes up with the ability to print counterfeit $100 bills that are indistinguishable from the currency produced by the Treasury. (For those who haven't seen the Bureau of Engraving and Printing website's actual address, it's a hoot.)
In the first year, the man produces $1 million in counterfeit cash, and he uses it to buy jewelry, clothes, new cars, and other items with a total market value of $1 million. Now, how should the rest of us feel about this little operation?
Most people (except Walter Block) instinctively recoil at such selfish, antisocial behavior: the guy counterfeiting money in his basement is basically stealing from the rest of us. He is obtaining valuable goods and services even though he hasn't produced anything in exchange. He can't even argue that he's providing a valuable monetary asset, because he's merely fraudulently piggybacking on a system that he had nothing to do with. If merchants understood that the cash in his wallet came from his color printer, they wouldn't accept them in trade.
Now, in this scenario, what of Andolfatto's defenses of the Fed? For example, will the counterfeiter cause workers to suffer permanently lower "real" wages, i.e., paychecks adjusted for the new prices?
Not at all. If the counterfeiter restricts his activities to a one-shot burst of $1 million, then eventually all other prices in the economy will adjust to the new quantity of money. Prices in general will be higher, and that includes the price of labor (i.e., wages and salaries). Someone who had to work for a week in order to earn the money to pay the landlord probably still has to do the same; it's just that the numbers will be a little bit higher than they otherwise would have been.
So have I just proven that the counterfeiter didn't really hurt the community at all? No, of course he did. He really is driving around a new Ferrari, and he really does have a fancy new wardrobe. His printing up of $1 million didn't create new resources to facilitate the production of those goods; he merely redistributed them away from everyone else. The rest of the community is precisely that much poorer — even if we ignore the secondary disturbances caused by his injection of money.
What about Andolfatto's point concerning expectations? Is our hypothetical counterfeiter ripping people off because they don't expect the price hikes? Again, no. Suppose the counterfeiter is an avid reader of Andolfatto's blog, and so to assuage his conscience he always sends an anonymous tip to various Fed economists the month before he begins a new injection of counterfeit money. In this way, the community can brace for the rising prices that will inevitably follow. In this revised scenario, is the public now fully immune to the counterfeiter's scheme?
Of course not. If the community expects another $1 million, prices might rise ever so slightly, even before the counterfeiter gets to the stores. But he still has a fresh $1 million in (nonrecognizable) counterfeit money on him. He can still use it to buy valuable goods and services, which thereby reduces the amount left for everybody else.
There is simply no getting around this basic fact. Over time, as the counterfeiter jets around the world, eating fancy meals and buying expensive jewelry, he is siphoning off potential consumption (or accumulating wealth) from everybody else. The fact that wages rise as well as other prices, and that investors can begin to anticipate the price hikes and invest accordingly, doesn't negate this simple conclusion.
Where Did Andolfatto Go Wrong? There are at least two major things that Andolfatto overlooked in his analysis. In the first place, it's not true that every worker's nominal income would rise in proportion to the prices of the things the worker wants to buy. For a fanciful example, suppose our counterfeiter buys up all the known Mickey Mantle rookie cards on the planet. This will push up their market price, as the last remaining holdouts insist on top dollar.
Once things settle down, the final price of a Mickey Mantle rookie card will be much higher than the general increase in wages (and other prices). So somebody who had intended on using his Christmas bonus to buy one of the cards is now out of luck. Yes, his Christmas bonus will be bigger than before, but not enough to complete his intended transaction.
Here's a more serious example: if the counterfeiter buys real estate in New York, Los Angeles, and Chicago, he will push up land prices and rental rates in those markets more than he will, say, the price of eggs. People who live and work in those cities will thereby be hurt; their salaries won't rise to completely offset the jump in the cost of living.
The second major omission from Andolfatto's post is the inflation coming from fractional-reserve banking. Andolfatto looks at the "seigniorage" earned by the Treasury from the Fed's issuance of new fiat money, and concludes that it's "small potatoes" (his words). But that's because he's only focusing on the direct income to the Treasury remitted by the Fed on its excess interest income. (I explain that whole shady process in "The Fed as Giant Counterfeiter.")
Andolfatto is ignoring the commercial banks, which (typically) generate far more inflation than the Fed. Every time a commercial bank grants a new loan that is not backed up 100 percent by reserves, it is "creating money out of thin air" the same way Bernanke does when he buys toxic assets. (I explain the balance-sheet mechanics of fractional-reserve banking from a Rothbardian perspective in my video lecture, "The Theory of Central Banking.")
It's true, the more competitive the banking sector, the more these gains from fractional-reserve lending would be shared with the bank's customers. For example, fractional-reserve banks can afford to pay interest on checking accounts, which would probably not happen under 100 percent reserves.
Even so, if one subscribes to the Rothbardian view that the Fed is a cartelization device installed by the big bankers to enrich themselves, then we see the weakness of Andolfatto's defense. The general public is being bilked far more than just the "seigniorage revenue" would indicate.
Conclusion The general public's distrust of big bankers and the Federal Reserve is grounded in fact. Inflation really does make most of us poorer. Although there are some nuances to the argument, it is valid to point to the drop in the dollar's purchasing power since 1913 as an indication of the magnitude of the theft.
Anne-Robert-Jacques Turgot (1727-1781) was one of the foremost classical liberals of the 18th century. In the opinion of Murray Rothbard, he was one of the greatest economists of all time, and he served with distinction under Louis XVI as Minister of the Navy and Comptroller-General. In these positions, he attempted to put into practice his free market ideas, but, owing to the opposition they encountered, the king dismissed him.
The Turgot Collection provides a well-chosen collection of Turgot’s economic writings. Although he was a disciple of the Physiocrats, he extended economic theory, in remarkably original ways, beyond what this group had accomplished. He consistently defended free trade, arguing that the local knowledge of those engaged in trade was far superior as a guide to policy than whatever could be gleaned by government bureaucrats.
Turgot, as readers of this collection will discover, also developed an early though incomplete version of the subjective theory of value and anticipated the notion of opportunity cost. He did pioneering work on the importance of the capitalist-entrepreneur in the economic process.
Turgot’s work was by no means confined to economics. Like other figures of the Enlightenment, he believed that mankind progresses through a series of historical stages. “On Universal History,” included here, elaborates this view.
Like Voltaire, Turgot hoped that his reforms could be put into effect through appeal to an enlightened monarch. In that regard, he proposed that a system of state schools should be established. In this way, he hoped, young people could be taught liberal principles; and what he regarded as the malign influence of the Church on education could be reduced.
The book also includes selections from Turgot’s correspondence with other figures of the Enlightenment, including Voltaire, Condorcet, and Hume.
The Turgot Collection will give readers a thorough grounding in the work of a major economist and advocate of freedom.
Introduction by Murray N. Rothbard.
Jim Manzi is not a professional economist, but he has been asking some very good questions about the confidence economists have in their models. In response, actual economist Karl Smith has defended the broad macroeconomic models that invite further "stimulus" from both the government and Federal Reserve.
Ironically, Smith claims to be a fan of free markets, but he believes that one critical "market failure" requires massive fiscal and monetary intervention: sticky prices and wages. Although I've critiqued this notion before, it's worth going into it in greater depth.
Smith: Why Do We Have Recessions?In order to prescribe the right medicine for the economy, it's necessary to correctly diagnose the problem. Here is Smith's analysis:
I shouldn't speak for other academics but when I advise that stimulus be undertaken or that money be loosened it is not because I think that I have a model which accurately maps how said stimulus will impact the various sectors of the economy. …
The basic [idea] both in the models and in my thinking is that for the most part markets work and that they will direct resources to whatever their best use is.
Our task is to deal with particular market failures. In the case of recession the market failure is that we do not have perfectly flexible wages and prices. If we did there would be no recessions as we know them.
Let's pause to consider what Smith is saying here: In recessions "as we know them," what happens is that many people are unable to find work, and businesses are unable to sell as much as they had planned on producing. In other words, unemployment and spare capacity both shoot up. In terms of undergraduate supply-and-demand graphs, there would be a surplus (or glut) in the various labor and product markets.
But if all prices and wages instantly adjusted to the new situation, then these gluts should disappear. If there is 10 percent unemployment, then wage rates should fall, making workers more and more attractive to potential employers until unemployment returns to its normal level. Smith's argument here is exactly the one that Greg Mankiw used in his argument with me over negative interest rates.
Misallocated Resources, a Great Vacation, or Insufficient Aggregate Demand?Smith further clarifies his diagnosis of what's ailing our economy by comparing three different explanations:
Many smart commentators still see recessions as either a calamity akin to a crop failure or as punishment for excesses. If that was what a recession was then the result should be our working harder to overcome the calamity or make up for our excesses.
However, the key feature of an actual recession is that Aggregate Hours worked FALLS. That is, people work less, produce less, create less. This is not a solution to a calamity or overconsumption.
In a world of perfectly clearing markets a fall in Aggregate Hours would represent a Great Vacation. That doesn't seem like the proper response to a calamity or previous irresponsibility. Thus our search for a market failure.
When we work through our best guess at the source of this failure the answer tells me that: lower taxes, higher government spending and looser money would all serve to lean against this particular market failure.
Although he doesn't use the term, Smith is here attacking explanations such as the Austrian theory of the business cycle, which say a recession is an unfortunate necessity in order to reallocate workers and other resources into their proper niches after an unsustainable boom. (This idea is what Krugman has derided as the "hangover theory.")
Further, Smith's reference to a "Great Vacation" is a jab at "real business cycle" (RBC) theory, which is an equilibrium-always attempt to model recessions as perfectly rational responses to shocks in technology or other fundamentals.
To paraphrase, Smith rejects these diagnoses as silly. If the Austrians (and other "hangover theorists") were right, and the chickens have come home to roost because of our overconsumption during the housing bubble years, then the obvious prescription would be to work more and increase current output.
But that's not what's happening; large numbers of Americans are watching Let's Make a Deal rather than reporting to a factory five days a week. Because this can't possibly be a rational response to the problem — as described by the Austrians — then either the market is screwy, or the Austrians are wrong in their diagnosis. Either way, thinks Smith, we shouldn't sit back and let nature take its course, as the laissez-faire Austrians typically recommend. Instead there is a role for the government and Fed to help.
Support for the AustriansBefore tackling the issue of sticky wages head-on, let me first point out that there is plenty of evidence supporting the Austrian explanation (versus its Keynesian rival). In a previous article, I showed that Krugman's attempt to look at sectoral employment data blew up in his face; when the test is conducted properly, the numbers offer more support for the "reallocation-across-sectors" story than the "general-fall-in-demand" story.
Another huge problem with Smith's analysis is that he ignores the effects of prolonged unemployment benefits, TARP, the stimulus package, the health-insurance legislation, etc. Most Austrians opposed these measures and predicted that they would hamper recovery.
Let's take a step back and consider the big picture. Most economists — including Karl Smith, I would imagine — agree that outright central planning is an utter failure and would lead to a disastrous economy. Now then, looking at US economic history, when do we see the most sluggish recovery from a financial crisis? Now and during the 1930s.
Is it really such a stretch to suppose that when the US government (and Federal Reserve) brings the economy closer to outright socialism — as Hoover and FDR did in the 1930s, and as Bush, Obama, and Bernanke have done in our time — that those very interventions hamper the economy?
The "hangover" theory would look much more plausible if the government and Fed had followed (most) Austrians' advice and watched the housing bubble collapse. There would have been an awful 6–9 months, but I believe things would have bottomed out and true recovery would then have begun. By this point, the housing crash would have been an unpleasant — but distant — memory. We can't run controlled experiments in macroeconomics, but the Depression of 1920–1921 should give pause to those who explain the Great Depression on market failure.
Misallocation and WorkIn this section, let's take Smith's objection head-on. He is simply mistaken when he claims that the optimal response to a calamity (or a period of excess) would be to work more.
In my "sushi" article, I laid out a simple yet internally consistent story — with actual numbers — to demonstrate how a misallocation of resources could give rise to a temporary period of higher output at the expense of distorting the capital structure. During the corrective period, key workers in the economy would need to replace the worn-out capital goods, while others stood around and did nothing. Thus, "unemployment" was the rational response until the economy recovered from the profligacy of the boom.
We see the same pattern in Mises's famous metaphor of a master builder. To illustrate the difference between generic overinvestment versus malinvestment, Mises asked his readers to imagine a man building a house. He has all the materials on site, including lumber, shingles, glass, workers, etc. (He can't buy more materials; this is all he has to work with.) The problem is that the blueprints assume there are more bricks than the man actually has at his disposal.
At some point, work on the house will have to stop. The blueprints call for the use of more physical resources than are on hand; it is literally impossible to finish the house as depicted on the blueprints.
Mises's point is that things will go better for the builder the sooner he discovers his mistake. If instead his subordinates use tarps to hide the dwindling supply of bricks — thinking they are "keeping the good times going" and the workers happily employed on their project — they are doing a great disservice.
Extending Mises's metaphor, we can see the problem with Smith's argument. When the builder realizes his error — for example, when he sees there are only 5,000 bricks remaining, even though his blueprint calls for 7,000 — what will his first response be? He will get out the bullhorn and announce to all the workers on site, "Stop!"
By assumption, the builder can't go to Home Depot and buy more materials: he has to finish the house with whatever is on site. When he realizes the original blueprint is unachievable, he needs to go back to the drawing board. He (or his architect) needs to look at the current state of the house, assess the remaining materials on hand, and then design the "best" house that is now physically possible. Obviously, the further along in the original blueprints the house had progressed, the fewer options the builder has. This is why continuing the boom period (in the real world, through artificially low interest rates) is so destructive: it paints the entrepreneurs into tighter and tighter corners.
But for our purposes in this article, notice that while the builder is revising the blueprints, everybody else on the site is out of work. For example, if some of the crew had been sawing down the lumber in order to assemble a gazebo in the backyard, they need to stop immediately in case those pieces of lumber are necessary in order to finish the second floor of the house, according to the revised blueprints.
Of course, the real economy is not one giant house, and there is no central planner analogous to our master builder. However, the analogy still does a great job illustrating Mises's theory of the business cycle. The unsustainable boom period draws workers and other resources into improper channels. Once the bubble pops, it takes some time for the market to readjust and reallocate workers and resources to more appropriate sectors. In the immediate aftermath of the popping, this process "looks like" recessions as we know them.
Flexible Wages Would No Doubt Be a "Market Failure"Finally, we should note that "sticky wages" are not a market failure at all, but a quite appropriate response to the worker and employer's desire for predictability. In other words, it is not some arbitrary fluke that allows copper and gold prices to adjust by the second, while labor contracts tend to be for periods of a year or more.
Suppose things were the opposite, and that workers' wage rates could adjust every minute according to supply and demand. Someone making $20 per hour today, might make only $8 per hour tomorrow. In such an environment, workers would build up an enormous cushion of savings, because they would have to draw down their liquid assets to get them through periods of below-average wages. Very few workers would buy houses, but would instead rent apartments, ideally on month-to-month terms.
I have no doubt that if this were the norm, interventionists of various stripes would invent sophisticated mainstream models showing that such an outcome was "Pareto inefficient." If only the government would pass laws, requiring labor contracts to lock in wages for longer periods, then the enhanced predictability would increase the welfare of everyone in society.
Because they could count on their paychecks for a longer horizon, workers would reduce their antisocial "hoarding" of cash. Without such benevolent government intervention, the perfectly flexible wages of the cutthroat capitalist economy would be yet another example of market failure.ConclusionLike George W. Bush, Karl Smith thinks it is necessary to violate laissez-faire in order to save it. But in truth, our experience in the wake of the financial panic is consistent with the Austrian diagnosis. There is no "market failure" because some prices and wages are updated less frequently than others. If the government and Fed would stop intervening, the market would work just fine.
It was the physiocrats who broke with centuries of sound economic reasoning and contributed to what would become, in the hands of Smith and Ricardo, a reactionary and obscurantist destruction of the correct analysis of value, writes Murray N. Rothbard (1926–1995).
This audio Mises Daily is narrated by Jeff Riggenbach.
In the midst of the chaotic resurgence of various heterodox explanations of the business cycle, the principal Austrian contribution to the discussion has been all but completely lost. Take for instance P. Nicholas Rowe's recent criticism of Arnold Kling's "recalculation problem" theory,Nick Rowe, "Money, Barter, and Recalculation. A Response to Arnold Kling" (December 2010); Arnold Kling, "A Rant Against Monetarism" (December 2010) and "The Recalculation Story: A Summary" (July 2010). and Bradford DeLong's mistaken claim that Kling's more controversial beliefs somehow represent Austrian business-cycle theory.Bradford DeLong, "Nick Rowe on Why the Austrian Theory of the Business Cycle is Arrant Nonesense" (December 2010). DeLong would probably find it more fruitful to read a dedicated Austrian book on the business cycle, but this has most likely already been suggested to him countless times.
The point is that given the ever-expanding branches of alternative economic thought, many of which find their origins in the same roots, it is difficult to discern what theory constitutes part of what school.This is not only true of the Austrian School but of most schools of thought, including the Keynesians. There is a great deal of heterogeneity in the economic profession, and it calls into question the present state and direction of economic science in terms of accuracy. For the Austrian School this has meant a complete loss of their single most important contribution to economic science, made between 1871 and 1949.
This contribution, which is in present day almost always ignored in all forms, is the explanation of a working price mechanism. Not only is it ignored but when the Austrians are brought into the discussion, the critics usually focus on what they consider to be the theory's general conclusions. These are, unsurprisingly, usually discarded as retrogressive and unnecessarily pain inflicting.For example, see Paul Krugman, "Antipathy to Low Rates" (June 2010). Unfortunately, while these criticisms are by and large unserious, the current (unfair) status of the Austrian School as heterodox forces us to take these criticisms seriously. When approaching the task of responding to criticism from the "mainstream" (from whoever it may originate), the objective should not be to necessarily "defeat" the opponent — an overly aggressive method may in fact be counterproductive — but to persuade those readers who have not yet taken sides (or are willing to change their minds). Within that context, while the Austrian School has not really been able to topple economists like Krugman or DeLong, it is worthwhile to realize that we have been "winning" in the sense that our ranks have recently begun to swell. It is a case of not being able to see the forest for the trees — the forest, in this case, being the price mechanism, by which the market operates, uniting economic theory.The development of price theory owes its advances almost exclusively to Ludwig von Mises, who in The Theory of Money and Credit (1912) united price theory with Menger's subjective theory of value. See Joseph T Salerno,Money: Sound and Unsound (Auburn, Alabama: Ludwig von Mises Institute, 2010), pp. 61–114. Mises later expanded upon this earlier effort in Human Action (1949), where he elucidated the role of the price mechanism in society as a whole. This fact alone makes Mises the most important economist of the 20th century. It is worth mentioning that Hayek's role in developing the theory of the price mechanism was highly influenced by Mises's 1912 work; see Friedrich Hayek, Prices and Production and Other Works (Auburn, Alabama: Ludwig von Mises Institute, 2008), p. 253.
Not only is the price mechanism ignored or considered unimportant but it is also often assaulted for being a false characterization or even the source of our problems. Joseph Stiglitz, a Nobel Memorial Prize winning economist, Nobelprize.org; Stiglitz and two others won the prize in 2001 "for their analyses of markets with asymmetric information," which is a topic that should have everything to do with the price mechanism. Yet, in his prize lecture Stiglitz discusses only to a very limited degree the price mechanism as a whole, instead focusing on specific prices and arguing that these do not provide market agents information reflective of the health of the economy as a whole. This approach is inadequate because it fails to consider the relationship between different prices and the role of multiple sources of information, as well as the natural tendencies for there to be asymmetric information on the market. writes that "the reason that the invisible hand seems invisible is that it is not there."Joseph E. Stiglitz, Making Globalization Work (New York City: W.W. Norton & Company, Inc., 2006), p. xiv. In their criticism of markets, economists abstract the price mechanism into the "mystical" concept of the "invisible hand," which guides individuals' self-interest toward some universally beneficial end.Paul A. Samuelson, Economics: An Introductory Analysis (New York City: McGraw-Hill Book Company, 1948), p. 36. The "invisible hand" is oftentimes attributed to Adam Smith's Wealth of Nations , but Smith only mentions "invisible hand" once throughout the volume. See Gavin Kennedy, "Adam Smith and the Invisible Hand: From Metaphor to Myth," Econ Journal Watch 6, no. 2 (2009), pp. 239–63. Even defenders of the market often forget the obsolescence of the term "invisible hand," relying on it as a metaphor to illustrate the cooperative nature of the division of labor.Norman P. Barry, "In Defense of the Invisible Hand," Cato Journal 5, no. 1 (1985), pp. 133–48.
Peter Minowitz inadvertently strikes at the root of the mistake: "Centuries after Smith's death, we are still struggling to fathom a two-word phrase that stands out in a thousand-page book."Peter Minowitz, "Adam Smith's Invisible Hands," Econ Journal Watch 1, no. 3 (2004), p. 411. Indeed, the problem is that very few economists have come to fully realize that the mystical, intangible "invisible hand" has been long replaced by the very real theory of the price mechanism — prices are the way that the wants of consumers are transmitted to the entrepreneurs and the method by which the individuals that make up a division of labor coordinate.
Thus, when critics direct their efforts against the Austrian School they frequently do so within their own analytical framework, which is completely inadequate to accurately interpret the Austrian contributions to the science. They attack part of the theory without realizing that the various parts that make up the Austrian understanding of the market process are all interconnected within the "whole."This is not only true of the method by which the mainstream criticizes the Austrians but it also characterizes their own approach to economics. See Hayek, Prices and Production and Other Works, p. 199. Hayek criticizes the approach to monetary theory that virtually disengages it from the "main body of economic theory." The artery, so to speak, of the economic system (the whole) is the price mechanism, and so one can see how ignorance of the concept has led critics of the Austrian School far astray from the actual point.
Market CoordinationHow do independent market agents compete and coordinate in the catallactic market?Catallactics, as defined by Mises, is the study of all market relationships and actions preformed on the basis of monetary calculation — it follows that the price mechanism, or the system that makes possible monetary calculation, is the central tenet of the study of the market. Ludwig von Mises, Human Action (Auburn, Alabama: Ludwig von Mises Institute, 1998 [1949]), pp. 233–35. This question had long eluded the economics profession, and to the degree argued above it still does. The notion of the "invisible hand" was adequate only as a marker, to indicate that there was a broad understanding that some type of coordination mechanism existed, until something better arose to replace it. This "something" — the price system — was developed, as aforementioned, between 1871 and 1949, or between the publication of Carl Menger's Principles of EconomicsMenger, Principles of Economics (Auburn, Alabama: Ludwig von Mises Institute, 2007 [1871]). Menger's main contributions are his development of the subjective theory of value and his "causal-realist" theory of prices based on subjective value. See pp. 114–74, 191–225.Menger, (Auburn, Alabama: Ludwig von Mises Institute, 2007 [1871]). Menger's main contributions are his development of the subjective theory of value and his "causal-realist" theory of prices based on subjective value. See pp. 114–74, 191–225. (Auburn, Alabama: Ludwig von Mises Institute, 2007 [1871]). Menger's main contributions are his development of the subjective theory of value and his "causal-realist" theory of prices based on subjective value. See pp. 114–74, 191–225. and Ludwig von Mises's Human Action.Joseph T. Salerno, "The Place of Mises's Human Action in the Development of Modern Economic Thought," The Quarterly Journal of Austrian Economics 2, no. 1 (1999), p. 35. Writes Salerno, "Mises's outstanding contribution in Human Action was to singlehandedly revive [the Mengerian approach] and elaborate it into a coherent and systematic theory of price determination." Unfortunately, while Human Action set off a rich tradition of research in the area of entrepreneurship within Austrian circles, it had much less of an impact on the mainstream.
In a division-of-labor society, which is one in which the individual depends chiefly on others to satiate his desires, the consumer reigns supreme. The task of investing and risking the capitalIt is crucial for later discussion to acknowledge that capital is a monetary term. Mises wrote, "The whole complex of goods destined for acquisition is evaluated in money terms, this sum — capital — is the starting point of economic calculation" (Mises, Human Action, pp. 260–61). to produce the goods to meet these desires is that of the entrepreneur, and as such he is the driver of the market.Mises likens the consumer to a captain, while the entrepreneur is the one who steers the ship. See Mises, Human Action, p. 270. The theory of market coordination deals precisely with how entrepreneurs dissect and predict consumer preference, invest, produce, and distribute to meet demand. This is all encompassed within the umbrella of the price mechanism. Changes in preference are reflected in prices, thus changing the investment patterns carried out by entrepreneurs.
Without a dynamic price mechanism — trademark of a money-based, capitalist society — there can be no calculation, and without calculation there can be no advanced division of labor. What we enjoy today in the form of production and wealth is the direct consequence of monetary calculation by means of prices. Without money and monetary calculation our society would be no more advanced than it was during the age of barter.
We know that in a market society consumer preference is sovereign, and because of this entrepreneurs aim at investing into lines of production that best fulfill consumer desires. A further consideration is that monetary calculation allows entrepreneurs to determine profit and loss, which in turn reflects how well they satisfy consumer desire. Strictly monetarily speaking, we can assume that because the entrepreneur himself is interested in maximizing the satisfaction of his own desires, he will therefore strive to garner the greatest possible profit from whatever quantity of capital he may decide to invest into a particular line of production.
He does this by appraising his expected gains from a particular venture against the estimated cost of the factors of production he must put to use toward that venture. If the entrepreneur expects to profit from the endeavor and believes that no other use of his capital will reap greater profit (opportunity cost), he will make the investment. Thus, we see how in order to maximize his ability to satisfy his own desires the entrepreneur must invariably act to indulge the self-interest of the consumer.
The entrepreneur is not omniscient. He cannot perfectly forecast the future, as he is always planning amidst uncertainty. There are times when the entrepreneur makes a poor appraisement, expecting profit and instead incurring a loss. In this case, his investment did not adequately sate consumer preference. It follows that it is by this method — through profit and loss — that the market rewards those entrepreneurs who best satisfy the consumer and punish those who do not, redistributing capital into the hands of those who use it most efficiently.Mises makes an exception in Human Action regarding the notion that the market rewards the entrepreneur who best meets consumer demand. He suggests that this is only true in a market where there is either sufficiently elastic demand or there is competition between suppliers, arguing that if both factors are false, then the firm can exact a monopoly price that acts against the best interest of the consumer. See Human Action, pp. 354–76. Mises qualifies his discussion on monopoly price, however, by warning of the role of government in the creation of monopoly prices: "The great monopoly problem mankind has to face today is not an outgrowth of the operation of the market economy. It is a product of purposive action on the part of governments" (p. 363). It stands to reason that to Mises all but only a small fraction of market activity, save for that distorted by interventionism, is to the benefit of the consumer. However, it is also worth mentioning that Mises's monopoly theory has been convincingly criticized by both Murray Rothbard and George Reisman. See Murray N. Rothbard, Man, Economy, and State with Power and Market (Auburn, Alabama: Ludwig von Mises Institute, 2009 [1962]), pp. 629–754; George Reisman, Capitalism (Laguna Hills, California: TSJ Books, 1990), pp. 414–17.
Capital is distributed among the different avenues of production by means of the uniformity-of-profit principle.This term is borrowed directly from Reisman's Capitalism, pp. 172–94, but the principle predates Capitalism. For example, it is restated throughout Human Action. See Mises p. 358. Simply put, entrepreneurs will invest along the most profitable lines of production until either profits no longer cover costs or investment along other lines becomes more profitable, resulting from a fall in the price of the final consumer good(s) that these lines produce. Thus, the profit motive, in conjunction with changing prices, guides the distribution of capital throughout the structure of production. There is a tendency toward the uniformity of profit and prices, both geographically and intertemporally. This tendency is interrupted by the dynamic nature of the market, due both to changing preferences and to technological progress, as well as any permanent cost inequalities, such as differences in the cost of transportation over varying distances.
"Thus, we see how in order to maximize his ability to satisfy his own desires the entrepreneur must invariably act to indulge the self-interest of the consumer." This dynamic distribution of capital along countless lines of production is made possible only by economic calculation, which in turn relies entirely on a working price mechanism. Only by means of money prices can coordination between entrepreneurs and consumers take place in society. Prices are established by the consumers, as they bid money toward the goods they demand and away from the goods no longer wanted. This in turn determines the prices of the relevant capital goods, as it guides entrepreneurs in deciding how much capital to invest along the different stages of production.This is Carl Menger's theory of value by imputation, transformed by Mises into a theory of cost by imputation (prices are not measurements of value but derivations of value). See Menger, Principles of Economics, p. 152; Mises, Human Action, pp. 330–35.
The importance of the consumer cannot be overstated. That the prices of consumer goods decide the price of all relevant factors of production does not mean that efficient calculation can be achieved simply by attaching arbitrary prices to these consumer goods.This argument is briefly considered in David Gordon's ”A Truly Austrian Treatise" (2009), when comparing George Reisman's theory of cost to those of Carl Menger and Ludwig von Mises. If the efficient production and distribution of goods is a question of whether or not the consumer's demands were satisfied, then it follows that the arbitrary setting of prices runs contrary to this objective. The decentralized assignment of prices of consumer goods is imperative in accomplishing coordination between supply and demand, because only the individual consumer himself knows his own preferences.This is the nature of Friedrich Hayek's knowledge problem. See Friedrich Hayek, "The Use of Knowledge in Society," in Individualism & Economic Order (Auburn, Alabama: Ludwig von Mises Institute, 2009 [1948]). Artificial coordination, or that which takes place independent of the consumer, is therefore destined to failure.Otherwise, the central planner must not only consider prices of the immediate past (sometimes considered present prices) but must also predict prices of the future (themselves independent of past prices and relevant only to changing consumer preference) on an economy-wide scale. Salerno, Money: Sound & Unsound, pp. 183–85.
It is equally important to stress the interdependence of prices. If we study the relationship between the prices of consumer goods, we can derive the impact of changing prices on the entire structure of production. If prices are derived from value, then it follows that a change in the price of one good means an average revaluation of utility scales on the part of consumers, and therefore the value of other goods changes as well. In other words, the change in the price of one good will cause a change in the price of others. Since the price of capital goods is imputed from the price of the final product, it follows that the prices of the factors of production will be altered as well.
Knowing the importance of the price mechanism, it should now be exceedingly clear why it is so dangerous to ignore it when studying economic phenomena. Consumer-driven prices harmonize market activity, and artificial disruption of these prices may in turn disrupt said harmonization.
Hayek's ContributionFriedrich Hayek's role in developing price theory centers on his elucidation of intertemporal coordination, or that which takes place over a period of time, between consumers and producers — this area of price theory is oftentimes referred to as "capital theory." Hayek's involvement in capital theory began during the mid-1920s with the publication of a number of German-language papers on monetary theory, where he attributed the ongoing economic boom in the United States to the lowering price level.Fritz Machlup, "Von Hayek's Contributions to Economics," The Swedish Journal of Economics 76, no. 4 (1974), pp. 499–500. He was evidently influenced by Ludwig von Mises's 1912 treatise on money, where Mises had first ascribed this phenomenon as the cause of business cycles.Hayek, in Prices and Production and Other Works, p. 253, references a translated excerpt from Mises's The Theory of Money and Credit >. A more modern translation reads, "The increased productive activity that sets in when the banks start the policy of granting loans at less than the natural rate of interest at first causes the prices of production goods to rise while the prices of consumption goods, although they rise also, do so only in a moderate degree … but soon a countermovement sets in: the prices of consumption goods rise, those of production goods fall" (The Theory of Money and Credit, p. 401).
Hayek managed to impress Professor Lionel Robbins, who in 1929 became head of the Economics Department at the London School of Economics (LSE), and was invited to give a series of lectures on capital theory in early 1931.Bruce J. Caldwell, "Hayek's Transformation," History of Political Economy 20, no. 4 (1988), p. 516. These lectures were consolidated in written format in Prices and Production, published later that same year. While Hayek's theory was perhaps difficult to grasp, most economists of the LSE soon joined the Hayekian tradition.Regarding the difficulty of Hayek's theory it is important to consider two things. First, the lectures themselves were conducted in nearly unintelligible English. Second, the way the theory was presented and written made it difficult to comprehend. See Caldwell "Hayek's Transformation," p. 517; Friedrich A. Hayek, Contra Keynes and Cambridge (Indianapolis, Indiana: Liberty Fund, 1995), p. 21.
Hayek did not sit idle, and he soon developed a rivalry with John Maynard Keynes, beginning with a critique of Keynes's A Treatise on Money. Unfortunately, this would mark the beginning of the Hayekian demise in England. Hayek's approach received heavy criticism from important economists such as Joan Robinson, Piero Sraffa, and Keynes, the latter two in defense of Keynes's own framework.Hayek, Contra Keynes and Cambridge, pp. 21–31, 37–40. Soon, Frank Knight attacked Hayek's capital theory, and he was followed by Nicholas Kaldor, who had once been a follower of Hayek's. Caldwell, "Hayek's Transformation," pp. 517–18. Both Knight and Kaldor advanced their own theories of capital, both theories similarly as obscure.
By the late 1930s Hayek had lost most of his support at the LSE. Nevertheless, Hayek reformulated and refined his theory, publishing The Pure Theory of Capital in 1941. By this time, however, the economics profession had moved beyond the topic of the causes of industrial fluctuations.Machlup, "Von Hayek's Contributions to Economics," p. 508–12. In spite of this, Hayek's ideas should be considered invaluable in the study of cyclic fluctuations — in evaluating both cause and consequence.Interestingly, John Hicks — who was at the LSE during Hayek's time there — remained relatively loyal to Hayek's intertemporal approach to macroeconomic coordination. Although Hicks never came to fully accept Hayek's explanation of business cycles, he nevertheless maintained that the dismissal and abandonment of Hayek's capital theory was an unfortunate loss for mainstream economics. To this end, Hicks wrote Capital and Time in an attempt to synthesize mainstream economics with the Austrian time structure of production. See Mark Skousen, The Structure of Production (New York City: New York University Press, 1990), p. xi.
Production is derived from consumer preference. The explanation of the price mechanism above, however, simply assumes that the entrepreneur commands the necessary capital to invest and meet consumer desires. It is important to bear in mind that this capital, and the capital goods (producers' goods) that it represents, does not simply appear ex nihilo; rather, it is the product of prior accumulation (savings). Savings can only be described as consumption deferred to an unknown future point in time, allowing temporary use of said capital for investment. The investments, of course, are made for the purpose of satisfying that future consumption.Mises, Human Action, p. 487. In Prices and Production, Hayek set out to explain the workings of the price mechanism that coordinated present savings with present investment as a means of satisfying future consumption.Hayek, Prices and Production and Other Works, p. 253n54. Here Hayek references the quote provided in footnote 23 above and argues that the principal purpose of his lectures was to expand on just how intertemporal coordination occurs through the price mechanism. (Mises's 1912 work hardly expanded on the topic itself.)
"The decentralized assignment of prices of consumer goods is imperative in accomplishing coordination between supply and demand, because only the individual consumer himself knows his own preferences. Artificial coordination, or that which takes place independent of the consumer, is therefore destined to failure." The fundamental revision to monetary economics that Hayek wanted to see brought about was the replacement of the mechanistic approach to money and the general price level with one that recognized money's role in changing prices relative to each other. This revision suggested no less than revisiting the real effects of money on the structure of production.Machlup, "Von Hayek's Contributions to Economics," p. 502; Hayek, Prices and Production and Other Works, pp. 198–202.
Hayek explained changes in the structure of production as results of changes in aggregate nominal demandNominal demand here refers to money demand. toward consumption and investment. He presupposed that this could occur in one of two fashions: voluntary savings or monetary expansion. In both cases, like every other entrepreneurial action, changes in the structure of production are predominately profit oriented.
Two premises should be explained. The predominate price that coordinates savings and investment is the rate of interest, manifested on the market as the loan market rate of interest.Roger W.Garrison, "Hayekian Trade Cycle Theory: A Reappraisal," Cato Journal 6, no. 2 (1986), p. 440. The loan market rate of interest is not necessarily the same as the natural rate of interest, but it is derived from it. There are certain factors, including the dynamic disequilibrium, which preclude the two from being exactly the same at any one time. Furthermore, there are various other derivative rates of interest — discount rate, short-term, medium-term, and long-term loan rates, et cetera — on, or that affect, the loan market. Mises, Human Action, pp. 542–45. As savings rise, the rate of interest falls; as savings fall, the rate of interest rises. Ceteris paribus, debtors prefer to borrow at a lower rate of interest.
Also important, though not directly related to the topic of interest, is the distinction between specific and nonspecific factors of production. The former are capital goods useful for only certain forms of employment, while the latter are more widely employable. It follows that nonspecific capital goods are more mobile in the structure of production, while specific factors are immobile. Of course, the degree of specificity depends entirely on the good itself — Austrian belief in the heterogeneity of capital should be stressed. The availability of nonspecific factors of production is what allows entrepreneurs to redistribute capital goods from one phase of production to another.
In the case of a rise in voluntary savings, the rate of interest falls and the proportion of total capital in the hands of investors rises. This increases the price of capital goods relative to consumer goods, as the former rise and the latter fall. This process does not occur instantaneously or proportionally amongst all goods, however. The lengthening of the structure of production, as a result in the increase in available capital, will occur gradually, guided by the price mechanism. Investors may first focus new capital on the stages of production immediately earlier than the final stage, raising the prices of the factors of production necessary during this stage itself. Ultimately, as the fall in consumer nominal demand begins to affect the prices of goods in the final stage of production by causing them to fall, and given the rise in prices of the factors of production of the immediately preceding stages, investors begin to redistribute their capital to more roundabout methods of production.What is meant here by "roundabout" is investment into the production of goods farther away from the final consumer product. It is not a comment on the actual means of production used for the production of that particular good but rather on the distance the relevant capital good is from the final good to be produced for the consumer at some point in the future.
The lengthening of the structure of production goes on in this fashion, with a rise in the price of factors of one stage causing an increase in investment in the previous stage, which in turn instigates a fall in the prices of the factors of production in the later stages. This will occur until the profit margins between the stages of production narrow to the degree at which there is no longer an incentive to invest in an earlier stage. At this stage, there might be some confusion about what exactly is meant by "earlier" or "later," and "higher" and "lower" stages of production. The structure of production is composed of phases of production, some being farther away from the consumer than others. Stages farther away from the consumer are considered to be "earlier" in the process of production and "higher" in the structure of production, while stages nearer to the consumer are "later" and "lower."
Figure 1:Graphical exposition of the effects of a lengthening structure of production without a corresponding rise in real savings.Hayek's pivotal insight is that the effects of an increase in loanable funds causes the loan market rate of interest to depress below the natural rate of interest for a significant amount of time, leading to considerable discoordination within the structure of production. To put it in more understandable terms, it is the theoretical exposition of the effects of a price ceiling on the rate of interest. Like any other price ceiling, the effect is a shortage of the affected good and related chaos.For an excellent discussion on the chaos caused by the imposition of artificial prices see Reisman, Capitalism, pp. 219–64. Reisman makes clear that not only do artificial prices disrupt coordination in the production of the specific good in question but of all other goods as well.
Figure 1 illustrates the effects of a lengthening of the structure of production without a corresponding rise in savings.Taken from Friedrich A. Hayek, "Capital and Industrial Fluctuations," Econometrica 2, no. 2 (1934), p. 154. The real supply of available capital goods is shown by the curvilinear triangle represented by AB1C1. Contours between the axes represent the structure of production, rightward movements representing a deepening of the capital structure. Solid lines represent the degree to which the lengthened structure of production is supported by real savings, while doted lines mark the portion of the processes of production that are left incomplete as a result of the creation of a scarcity of capital goods.
What triggers the revelation of this incomplete investment, oftentimes described as "malinvestment,"The term "malinvestment" was stressed because it was used to distinguish the Austrian theory of the business cycle from other traditional — and erroneous — overinvestment theories. is a consequent rise in the price of consumer goods relative to capital goods. That capital deepening did not come at the expense of consumer demand but instead was made possible by an artificial increase in loanable funds, suggesting that the initial fall in the price of consumer goods that should have otherwise taken place did not actually occur. Consumer-goods prices will also rise as a factor of an increase in the price of labor, a product of an increase in the demand for labor as a factor of production, and as a result of a possible diminishing in the stock of capital goods, as some nonspecific goods are used in earlier stages of production. The rise in the price of consumer goods catalyzes the abrupt shortening of the structure of production, revealing a mass of malinvestment.
Hayek's contribution, building on what Mises had written, is invaluable. It is the only theory that builds on an accurate explanation of a working price system in a market economy. It does not just assume discoordination, but explains why this discoordination occurs.Those wary of the complexity of Hayek's exposition may instead prefer to read Ludwig M. Lachmann, Capital and Its Structure (Kansas City, Kansas: Sheed Andrews and McMeel, 1978); , Roger W. Garrison, Time and Money: The Macroeconomics of Capital Structure (New York City: Routledge, 2001); Murray N Rothbard, Man, Economy, and State with Power and Market (Auburn, Alabama: Ludwig von Mises Institute, 2001); Jesús Huerta de Soto, Money, Bank Credit, and Economic Cycles (Auburn, Alabama: Ludwig von Mises Institute, 2009).
Mainstream DeficiencyThe ultimate rejection of Hayek's capital theory by his peers is without a doubt the principal reason that it is not more widely accepted among mainstream economists today. Several possibilities for Hayek's eventual downfall have been suggested. Perhaps his theoretical exposition was not as watertight as one would have hoped. Furthermore, by the time Hayek published his defense (The Pure Theory of Capital), the profession was no longer interested. There is also no doubt that the difficulty of Hayek's presentation, illustrated by the fact that several reviews of his Prices and Production fell short of showing full understanding of it, may have contributed to his work falling to the wayside.One has only to read Piero Sraffa's vicious review of Prices and Production. Indeed, Sraffa opens with, "For, however, peculiar, and probably unprecedented, their conclusions may be, there is one respect in which the lectures collected in this volume fully uphold the tradition which modern writers on money are rapidly establishing, that of unintelligibility." In his review, Sraffa attacks Hayek's conception of neutral money, the purpose of which was to build an artificial model of the structure of production in equilibrium. His criticism of the study of money as that of the value of money itself fails to properly consider Hayek's central thesis: the price of all goods relative to each other. Hayek, Contra Keynes and Cambridge, pp. 198–209.
After his review of Keynes's A Treatise on Money, Hayek did not critique the former's General Theory, which took the profession by storm during the late 1930s and early 1940s.Hayek did critique Keynes's views held in The General Theory during his later life, but by this time Hayek and the Austrian School had become of secondary importance. Friedrich A. Hayek, Choice in Currency: A Way to Stop Inflation (Auburn, Alabama: Ludwig von Mises Institute, 2009 [1976]). The Keynesian revolution was left virtually unopposed, and Hayek persisted in studying capital theory at a time in which it was no longer considered at all relevant. At the time the world was still suffering the Great Depression, and Keynes's book, which dealt much more with the methods of ending the depression, simply made more sense.
"The point is not to cast these theories as erroneous — even if many of them are — rather, the objective is to highlight the inherent deficiencies of an analysis that fails to take into consideration the most important dimension of the problem: the price mechanism." Any strands of Hayekian thought left in the mainstream were promptly routed by the conclusions drawn during the Cambridge capital controversy — especially the notion of "reswitching," which was used to question the precision of Hayek's and Böhm-Bawerk's notion of capital intensiveness.For an overview, see Joseph E. Stiglitz, "The Cambridge-Cambridge Controversy in the Theory of Capital," The Journal of Political Economy 82, no. 4 (1974), pp. 893–903. Yet the relevance of technique reswitching to capital theory has yet to be established.
The controversy proved that lower rates of interest did not necessarily cause entrepreneurs to change the capital intensiveness of specific processes of productionPaul A. Samuelson, "A Summing Up," Quarterly Journal of Economics 80, no. 4 (1966), p. 569. but failed to address the general increase in capital intensiveness of economic activity. Hayek's time structure of production was unfairly discarded, and the loss can be most felt in the deficiencies of current mainstream doctrines.
Worst of all, the abandonment of intertemporal coordination — and thus discussion on that particular strand of the price mechanism — caused economic science to deviate away from all discussion and explanation of all coordination processes.
Thus, modern mainstream prescriptions for economic depressions are oftentimes woefully inadequate because they fail to take into consideration the necessity of reestablishing proper coordination between different market agents over an undefined period of time. What is the use of monetary stimulus if the effect is further discoordination? Why perform fiscal stimulus if the consequence is capital consumption without furthering the reestablishment of market coordination? These are important questions that are left ignored when academics pursue the topics at hand. The point is not to cast these theories as erroneous — even if many of them are — rather, the objective is to highlight the inherent deficiencies of an analysis that fails to take into consideration the most important dimension of the problem: the price mechanism.
In the first chapter of his Prices and Production, Hayek argues that the main deficiency of modern macroeconomics is overreliance on the quantity theory of money and too sharp a focus on changes in the general price level.Hayek Prices and Production and Other Works, pp. 197–200. Hayek also blames the profession's focus on specific parts of the system without considering the system as a whole. This can lead one to similar conclusions as those in the present essay. Hayek failed to realize the full scope of the profession's failures. The foremost failure was — and it remains — a complete lack of understanding of how the price mechanism guides economic activity and harmonizes the economic system. Their treatment of the topic is highly superficial and found entirely wanting.
Worst of all, a sophisticated explanation of the price mechanism is already available, in the words of the various scholars that made and make up the Austrian tradition. It is, without a doubt, the central thesis of the Austrian theory.
It is unfortunate for the profession — as much as it is for the individual academics themselves — that they have decided to disregard these insights in favor of their own flawed framework. How much decadence has befallen the economics profession is all too manifest in Bradford DeLong's sad confusion between Austrian theory and the far more primitive theory of the "recalculation problem."
Three weeks ago I read the news that a 24.78 carat "fancy intense pink" diamond sold for $46,158,674 at an auction held by Sotheby's in Geneva, Switzerland. The winning bid for "The Graff Pink," as it was named immediately after its purchase by London jeweler Laurence Graff, was the highest price ever recorded for a jewel at auction and more than double the $24.3 million price paid for the 35.56 carat Wittelsbach blue diamond purchased by Graff in 2008. Nowhere in the article was there any mention of the monetary costs of producing either gem, although I presume that in each case they were a negligible fraction of the diamond's price — if anyone alive today even knows those costs.
Last week I accompanied my wife to Walgreen's to buy lighted outdoor Christmas figures for display in my front yard. A snowman on display in the store caught our eye and we decided to purchase it only to be told by the manager that it was already out of stock. My wife, ever the negotiator, proposed that the manager sell us the figure at a $5 discount from the advertised price of the snowman. He agreed, even though the snowman on display probably cost the store $5 or $10 more to produce than the unavailable packaged item because it involved an additional hour of a stock clerk's labor to remove it from the packaging and assemble it.
Last night I was shopping online for tickets to a New Jersey Nets basketball game as a Christmas gift. The Nets are an NBA franchise in transit from New Jersey to Brooklyn, New York, and their temporary home for the next two years is the Prudential Center in Newark, New Jersey. On December 12, the Nets play the Los Angeles Lakers. Prices for individual tickets in the upper corner sections (the "nosebleed" seats) start at $24, in the lower center at $160, and in the courtside section frequented by celebrities at $400. Two days later, the Nets take on the Philadelphia 76ers: starting prices for tickets in exactly the same sections are $1.00, $29, and $150, respectively. So the price differential between the same seats at the Lakers' and 76ers' games ranges from two-and-a-half times higher for the priciest seats to 24 times higher for the cheapest seats. Presumably the average money cost of producing a basketball game for an individual occupying the same seat is identical for both games and does not differ much for individuals occupying different seats at the same game.
Now despite countless instances like these that we all regularly encounter in our market activities, most people still take for granted the view that costs of production basically determine prices. Furthermore, they believe that if prices greatly exceed costs, it is the result of price gouging, monopoly, or some other nefarious scheme on the part of producers. But as Carl Menger, the founder of the Austrian School of economics, brilliantly explained nearly 140 years ago, past expenses incurred during the production of a good are completely irrelevant to the determination of the current price of a good. For Menger, the market price of a good is determined solely by the relative valuations of goods and money by the buyers and sellers of the good, in conjunction with the number of units of the good currently in existence. The records and memories of how much money was spent to enlist the labor and other resources needed to produce the good have absolutely no effect on how much money people are currently willing to exchange for a unit of the good.
But Menger went even further and demonstrated that the (anticipated) selling prices of goods actually determine the costs of production for a good. Using the example of tobacco, Menger argued that if people completely lost their desire for consuming tobacco, not only would the prices of cigarettes, cigars, and pipes fall to zero, but raw tobacco and the machines specifically designed to produce these items would cease to command a price greater than zero, no matter how much it cost to produce them.
For Menger and modern Austrians, then, the ultimate source of value is the ceaseless efforts of individual human beings to use their scarce resources and money to improve their well-being by interacting with one another on the market to achieve their most cherished goals and desires while renouncing less-important desires and satisfactions. The actual market prices and costs of production we observe are simply the objective manifestation of this war of scarcity in the human soul. It is the current or future goods we have to sacrifice and the opportunities for satisfaction that we have to renounce that are the only relevant "opportunity costs" of the things that we purchase. These subjective and immediate experiences of renunciation and sacrifice — and not some recorded sum of money that one guy paid another guy to perform a production task last month or last year — these are the costs that will influence our decisions about what to buy and what not to buy and, thereby, determine the prices we pay during this Christmas shopping season.
Modern mainstream economists portray the Mengerian-Austrian theory of price as "extreme" and "one-sided," supposedly over-emphasizing subjective value while ignoring money costs of production. But it is precisely the one-sidedness of Austrian theory that makes sense of our market experiences. The higher cost "display" snowman sells for a lower price than the packaged snowman because most consumers view the former as a less-valuable "used" item. They do not care about the stock clerk's past exertions or wages. The Graff Pink commanded such a high price at auction because it is so scarce in relation to the number of people who want to possess it and the intensity of their desires for it relative to money and other things. Even if the production costs of the diamond were the same, the sudden discovery of 10,000 diamonds identical to the Graff Pink would drive its price down far below the recorded auction price. And I need not belabor the point that the price differential of up to 2,300 percent for the same seat in the same arena two days apart exists because, for most basketball fans, the experience of watching the talent-laden Lakers with their coaching icon and glorious tradition shred the dreadful and itinerant Nets is vastly preferable to witnessing a dreary contest between the Nets and the equally woeful 76ers.
The laws of value and price discovered by Carl Menger are universal and immutable. They are true and apply everywhere and at all times, so long as human beings consciously seek to improve their well-being by using their scarce time, energy, money, and material resources to attain their most important goals.
Now, let me go back online and check if the price of those unsold Nets-76ers tickets has plunged below a dollar yet.
Ordinarily I agree with John Stossel. Stossel does what many would have thought impossible: he uses economic reasoning to defend individual liberty and free markets on national media outlets. In a 2008 article Stossel claims that uniformed people should not vote. Stossel illustrates this idea by questioning audience members at a Rock the Vote concert. Many of the attendees of these events could not recognize pictures of the vice president or the Speaker of the House, and did not even know how many senators there are in the US Senate. Stossel suggests that people who lack such basic information have a duty not to vote. Conversely, people who are informed about politics should vote.
There is a veneer of plausibility to Stossel's argument. The idea that democracy works better when informed people vote would seem to make sense. However, the case for informed voting breaks down when we consider the difficulties of being well-informed about political options. In economic terms, voters need to evaluate alternatives for public policies and programs.
Strictly speaking, a rational voter must first estimate the overall effects of altering or abolishing specific public policies and programs. For each federal program or policy there are a range of reforms that might improve its functioning. A fully informed and rational voter would ascertain the best options for governmental reform. It is, however, very difficult to ascertain the effects of reforming even one policy or program. Changing one program or policy typically produces unintended consequences. Given the complexity of the United States — and the world for that matter — a significant change in public policy will cause a series of reactions from the people who feel the effects of these changes. No one person can predict these unintended consequences.
Another complication arises when you consider the sheer number of federal policies and programs that currently exist. The US government has dozens of agencies that implement thousands of policies. No one person can understand all of these programs and policies. The federal government is complex beyond anyone's comprehension. Of course, people who don't recognize the vice president do not understand what they would be voting for or against this November.
But how could even the most highly informed voters navigate the options that face modern voters?
There is an obvious response to the aforementioned critique of voting. Voters could defer to experts. Experts on antitrust policy could advise voters on the correct policies. Experts on macroeconomics could advise voters on fiscal policy. Politicians themselves could construct political platforms based on the best expert opinions.
There are several problems with this solution. First, experts offer opinions rather than facts. Since different experts disagree as to how policies should change, voters have to determine which experts are correct. This problem negates much of the purpose of having experts in the first place.
Second, experts provide opinions on the overall effects of reforming public policies. Rational voters are concerned more with the effects on themselves and those close to them than with the overall effects on the entire electorate. To assume that changes that benefit the group also benefit any member of that group entails the fallacy of division.
To be well-informed, a voter must first discover which policies deliver the best result for the entire nation. Each individual voter must then disaggregate this overall result into individual payoffs, and then ascertain the probability of receiving particular payoffs. Having done all this, a voter is now close to making a rational political choice. However, the voter must now estimate the probability of success from political action. The odds are that one vote will not change the outcome of a national election.
The fact of the matter is that voters cannot comprehend the impact that voting has on their own lives.See D.W. MacKenzie "The Use of Knowledge About Society" from the Journal of Economic Behavior and Organization, (September 2008). Casting a single vote, among over 100 million, is an act of futility.See Gordon Tullock, On Voting: The Public Choice Approach.
One could argue that while voting is much more complicated than most people realize, we have no alternative, no other way of changing the world for the better. The idea that there is no alternative to political participation is false.
In the private sector, for example, people deal with complexity simply by paying attention to prices. Prices reflect the relative demands of billions of consumers in the global economy. Every day people cast "dollar votes" in elections that determine how scarce resources get used. The price system is in this way a communications network that makes it possible for people to navigate a world that in all its detail is complex beyond anyone's comprehension.See Friedrich Hayek, "The Use of Knowledge in Society," American Economic Review (1945). The sellers who win the most dollar votes from consumers earn profits and stay in business. Sellers who lose elections through consumer spending of dollar votes incur losses and go bankrupt.See Ludwig von Mises, Human Action (1949).
The problem with voting in modern America is that we have a politicized society, and modern society is extraordinarily complex. Stossel suggests that only people who follow politics should vote. However, even those who follow politics very closely do not understand the implications of changes in public policy. The lesson here is that efforts to incrementally reform government policies and programs through the democratic process are futile. To the extent that we vote at all, rational people should vote to depoliticize the economy.
What this means is that we need to reintroduce the price system as the primary method of economic communication, and the profit-and-loss sorting mechanism as the primary method of social reform.
Canadian emergency rooms are infamous for their long wait times.The long wait times, in fact, prevail in most of the Canadian healthcare services, not only emergency rooms. A recent study has shown that in most of them the average wait time exceeds 6 hours and sometimes reaches up to 23 hours. While some call for action in reducing these extremely high figures by increasing the supply of healthcare services, others try to present the situation as, in principle, an unavoidable fact of life.
Both of these arguments are missing the target. The long wait times are unlikely to be significantly reduced under the current institutional arrangement, because any serious reduction would require transferring a formidable amount of resources from the other sectors of the economy. At the same time, constantly full waiting rooms are not an unavoidable fact of life but a product of a "priceless" supply system, where waiting for service acts as a rationing substitute for the market price. The incentive structure created by this institutional arrangement is not conducive to providing shorter wait times.
The purpose of this article is to provide more clarity when it comes to these important points and their implications. I will first describe the dynamics of a typical emergency waiting room and then use economic theory to explain the persistence of these dynamics, the high costs of changing the situation under the current system, and some of the benefits of an alternative, money-price mechanism.
The Dynamics of a Waiting RoomLike most parents of young children in Canada, my wife and I have spent a fair share of our first six years of parenthood waiting for service in emergency rooms. Without any exaggeration, it can safely be said that we had ample time to observe and analyze the waiting process in a typical Canadian waiting room. One thing that we noticed is that there is a remarkable regularity and stability in this waiting process. This suggests that the long waiting times in the current system are in fact a stable equilibrium outcome rather than an unplanned disruption.
During our usual six or more hours of waiting, I noticed the following process over and over again: There were about 30 people waiting at all times (which is a relatively small number considering that this is the main emergency room for Kitchener-Waterloo, a city of 300,000 inhabitants). About once an hour, a nurse would come out and call in about 5 people to go from the main waiting room into the next room where they would, eventually, be seen by a doctor. About the same number of new patients would come to the waiting room over the course of an hour. Thus, the total number of people in the room would remain fairly stable.
However, there is an order in which different people are called in. Only if one has an extremely severe, life-threatening condition (which seemed to be quite rare) could he or she be admitted immediately upon arrival. Otherwise, one would need to wait until those that came before were taken care of.
The arithmetic of waiting is as follows: Whenever a new person comes into the waiting room, there are about 30 people waiting in front of him or her. Because the doctor examines about 5 people per hour, it takes approximately six hours until this new person is admitted. But, in six hours, there will be 30 new people in the room, because about 5 new people enter the room over the course of an hour.
Consequently, the waiting room could be likened to a pool that is being emptied at the same rate as it is being filled. The level of water in such a pool remains unchanged over time.
A person that does not understand the laws of economics might come to a "revelation" and proclaim that we just need to add a small amount of resources in order to increase the rate of the emptying of the "waiting pool" just slightly above the rate at which the pool is being filled up. This would solve the waiting problem permanently! However, this is not true.
Unlike many hospital brochures, which offer merely a description of the waiting process, the following section offers a real explanation based on the principles of economics.
Time as Price in a "Priceless" SystemPrices have multifaceted functions in the market economy. First, they reveal some of the subjective and dispersed knowledge about the individual values of the millions of people constantly making production and consumption decisions. High prices send signals to entrepreneurs about the kinds of goods that are highly valued by the consumers. This in turn directs the allocation of resources into more highly valued purposes.
Another important function of the price mechanism is that it brings about the harmony between the quantity of goods that is demanded and the quantity that can be supplied at any given point in time. If a store keeper — let's call him Jim — sees people piling up in front of his store, he will interpret this as a signal that the price he is charging might be too low. By increasing the price, Jim achieves two outcomes at the same time: (1) he reduces the number of people piling up in front of the store without significantly reducing the number of customers per unit of time and (2) he increases his revenue.
"When the price is not allowed to perform its function of supply-and-demand rationing, something else will."The money price of a particular good or service acts as a lever that determines the amount of other goods and services one needs to give up in order to acquire that particular good. As the money price increases, only those people that are willing to give up a lot of other things keep buying the particular product.
If Jim was not allowed to charge a money price for his services, he would have no way of affecting the number of people entering his store, other than locking the door from time to time and making the interested buyers wait. Those that value the products in the store highly would be willing to wait a long time to save their spot in line.
Some people would be willing to wait because their time (or, more specifically, the foregone use of that time) would now be the only price they are paying for the service. Others might just look for another store offering similar products. However, if the products offered by this particular store are unique or if others are prohibited by law from providing a similar service in exchange for money, the wait time people would be willing to accept might be quite high.
The same laws of economics apply to any other service, such as, for example, healthcare services that are very specific and, in Canada, provided by a centrally planned, legalized monopoly that does not charge a direct per-unit price. Instead of the money price, this organization must rely on a nonmonetary mechanism of managing the demand for its services, such as administrative procedures and, unavoidably, waiting times.
Most people have some mild health-related problem most of the time, but it would not be worth it to them to wait for six hours to receive treatment. They might, however, be willing to wait 20 or 30 minutes or even an hour. The wait time is the only price they pay for the service, but if the price is too high, these people will choose not to use the service offered by the healthcare provider.
However, there are always a small number of people that would be willing to wait six or more hours because the value they put on their particular health problem is quite high. Generally, as the wait time decreases, the number of people willing to wait increases. For example, in our city of 300,000 people, I would expect far more than 5 (or even 30) persons per hour coming into the emergency waiting room if they had to wait only five minutes to receive a service and not provide any money in return.
While the exact relationship between the wait time and the number of people willing to wait for service is an empirical question, it could be conceptually represented as in figure 1. The figure shows a hypothetical demand curve for an emergency room services in a medium-sized Canadian city. It indicates that, as the wait time decreases, more people would be demanding service. We say that the quantity demanded increases as the price (i.e., the waiting time) goes down.
Figure 1. The inverse relationship between the wait time and the quantity of medical service demandedThe current minimum average waiting time of six hours is probably somewhere at the steep end of the curve (point A). For example, most people would probably be willing to wait that long if their child split her eyebrow open, broke her arm, or if she was vomiting all night. But most people would probably refrain from going to the emergency room for a health problem that they believed might go away on its own in a few days or weeks. On the other hand, most people would likely show up at the emergency room even for mild problems if they knew it would only take 10 or 20 minutes to get admitted.
Now, if we wanted to put in practice the "revelation" that a noneconomist could have about adding some additional capacity to eliminate the wait time, figure 1 would show us where we could be going wrong.
Suppose we wanted to double the capacity of the emergency room from five (point A) to ten people per hour (point B) for a short period of time in order to empty the "pool" of people in the waiting room. In our city, that would only involve adding another doctor (provided there is an idle doctor somewhere). This is because, currently, there are ten small individual examination rooms behind the main waiting room served by only one doctor. Most people spend an hour or two just sitting in one of these rooms waiting to be examined. Thus, there is infrastructural capacity available to accommodate an additional doctor.
Adding one more doctor would allow for ten people to be admitted every hour. This would initially reduce the wait time. However, the shorter wait time would induce some additional people to seek medical service. These are the people that were not willing to wait six hours but might be willing to wait, say, four hours. Thus, the two doctors would now face a new wave of patients — all those with the waiting tolerance lower than six hours but higher than the newly established, shorter waiting period.
"While paying for a service with money represents an exchange of claims over resource ownership, paying for the same service with time represents outright resource destruction."Suppose that the wait time of four hours is required to limit the number of new entrants to the total number of 10 people per hour. Then we would end up with the following situation: Two doctors are examining 10 people per hour. Ten new people are coming every hour. And, there are now 40 people in the waiting room, each being admitted after four hours of waiting. Thus, even though the waiting time is reduced, the reduction was not dramatic. Additionally, the number of people in the waiting room increased from 30 to 40, and the number of doctors needed to serve this demand would have to be doubled permanently.
Imagine now that every emergency room, every walk-in clinic, every MRI and CAT-scan clinic, and all other providers of medical services decided to double their capacity in the hope that they would significantly reduce the excess demand for their services. As shown in figure 1, a reduction in the wait time would be accompanied by an increase in the quantity demanded, in the same way a reduction in a money price would be. The higher the increase in supply and the corresponding reduction in the wait time, the greater the increase in the quantity demanded.
This indicates that the amount of resources needed to reduce the wait time in a system that does not directly charge a money price for specific units of service may be quite high. Moreover, the benefits to the healthcare-system employees and managers are not that clear, leading to weak incentives to alleviate the problem.
However, the healthcare employees are the last to be blamed for this situation, because they are just responding rationally to the incentive structure created by the given institutional framework. Who would want to stretch themselves beyond their capacity, for no apparent benefits? At the same time, starving the other sectors of the economy in order to provide the resources needed for a wait-free, priceless healthcare system would not be the wisest decision either.
Another issue that is often overlooked is the destructive nature of a system devoid of money prices. While paying for a service with money represents an exchange of claims over resource ownership, paying for the same service with time represents outright resource destruction. The time spent in waiting is lost forever and cannot be used in any productive activity, whereas the money paid for service could be used for purchasing goods and services that had already been produced. The time not spent in waiting could be used for the production of new resources.Note that some people would not be able to perform any other productive activity due to their poor health. However, there are many people who would know how to better use their time if they had this option. These are the people with less severe health conditions, and the people that accompany those with more severe conditions, as well as parents with sick children. In addition, spending time resting at home instead of in a crowded waiting room would likely have positive health effects.
ConclusionGiven the current structure of the Canadian healthcare system, the long patient wait times are here to stay. Those that believe the problem could be solved by increasing the supply of health services ignore the large demand effect of a reduction in wait times. Others, who believe that waiting is an unavoidable fact of life, ignore the fact that the long wait times are an artifact of the "priceless," politically administered supply system.
When the price is not allowed to perform its function of supply-and-demand rationing, something else will.Alchian, A.A. and H. Demsetz. 1973. "The Property Right Paradigm." Journal of Economic History, Vol. 33, No. 1, pp. 16–27. In the case of the Canadian healthcare system, this price substitute is our time. But many of us may not be aware of the destructive nature of this hidden and steep price tag. While the unseen costs are always easily ignored, they are constantly eating up the economy's productive resources.
Thomas Mun set forth what would become the standard mercantilist line. He pointed out that there was nothing particularly evil about the East India Company trade. The company imported valuable drugs, spices, dyes, and cloth from the Indies, and it re-exported most of these products to other countries, writes Murray N. Rothbard (1926–1995).
This audio Mises Daily is narrated by Jeff Riggenbach.
[This is an excerpt from an essay that was originally published in the Annals of the American Academy of Political and Social Science, volume 1 (1891).]
The question of the relation of cost to value is properly only a concrete form of a much more general question — the question of the regular relations between the values of such goods as in causal interdependence contribute to one and the same utility for our well-being.
The utility furnished by a quantity of materials from which a coat can be produced is apparently identical with the utility that the completed coat will furnish. It is thus obvious that goods or groups of goods that derive their importance to our welfare through the medium of one and the same utility must also stand in some fixed, regular relation to one another in respect to their value.
The question of this regular relation was first put into clear and comprehensive form by the Austrian economists; it had previously been treated only in a very unsatisfactory manner under the heading of cost of production. There is, however, a corollary to this general and important proposition that is not less important and interesting, but that has hitherto never received the modest degree of attention in economic theory that has been bestowed upon the problem of cost.
Very commonly, several goods combine simultaneously to the production of one common utility; for example, paper, pen, and ink serve together for writing; needle and thread for sewing; farming utensils, seed, land, and labor for the production of grain. Menger has called goods that stand in such relation to one another complementary goods. Here rises the question, as natural as it is difficult: How much of the common utility is in such cases to be attributed to each of the cooperative complementary factors? And what law determines the proportionate value and price of each?
The fate of this problem hitherto has been very remarkable. The older theory did not rank it as a general problem at all but was nevertheless compelled to decide a series of concrete cases that depended implicitly upon that problem. The question of the distribution of property especially gave occasion for such decisions. Since several factors of production — soil, capital, hired labor, and labor of the employer himself — cooperate in the production of a common product, the question as to what share of value shall be assigned to each of the factors, in compensation for its assistance, is obviously a special case of the general problem.
Now, how were these concrete cases decided? Each one was decided by itself without regard to the others, and hence, eventually, they formed a complete circle. The process was as follows: if rent was to be explained, it was decided that to the soil belonged the remainder of the product after the payment of cost of production, under that term was included the compensation of all the other factors — capital, labor, and profit of manager.
Here the function of all the other factors was regarded as fixed or known, and the soil was put off with a remainder varying according to the quantity of the product. If then it was necessary in another chapter to determine the profits of the entrepreneur, it was decided again that to him should be given the overplus left after all the other factors were compensated. In this case the share of the soil, the rent, was reckoned along with labor, capital, etc., as fixed, and the entrepreneur's profit was treated as the variable, rising and falling with the quantity of the product.
In just the same manner the share of capital was treated in a third chapter. The capitalist, says Ricardo, receives what is left from the product after the payment of wages. And as if to satirize all these classical dogmas, last of all, Mr. F.A. Walker has completed the circle by stating that the laborer receives what is left over from all the other factors.
It is easy to see that these statements lead in a circle, and to see, also, why they so lead. The reasoners have simply neglected to state the problem in a general form. They had several unknown quantities to determine, and instead of taking the bull by the horns and straightway inquiring after the general principle, according to which a common economic result should be divided into its component factors, they tried to avoid the fundamental question — that of the general principle. They divided up the investigation, and in this partial investigation allowed themselves each time to treat as unknown that one of the unknown quantities that formed the special object of the investigation — but to treat the others, for the time being, as if known. They thus shut their eyes to the fact that a few pages earlier — or later — they had reversed the operation and had treated the supposed known quantity as unknown, and the unknown as known.
"Instead of taking the bull by the horns and straightway inquiring after the general principle, according to which a common economic result should be divided into its component factors, they tried to avoid the fundamental question — that of the general principle." After the classical school came the historical. As often happens, they took the attitude of skeptical superiority and declared altogether insoluble the problem that they were unable to solve. They thought it to be in general impossible to say, for example, what percent of the value of a statue is due to the sculptor and what percent to the marble.
Now if the problem be but rightly put — that is, if we wish to separate the economic and not the physical shares, the problem becomes soluble. It is actually solved in practice in all rational enterprises by every agriculturalist or manufacturer. Theory has nothing to do but to rightly and carefully hold up the mirror to practice in order, in turn, to find the theoretical solution.
To this end, the theory of final utility helps in the simplest way. It is the old song again. Only observe correctly what the final utility of each complementary factor is, or what utility the presence or absence of the complementary factor would add or subtract, and the calm pursuit of such inquiry will of itself bring to light the solution of the supposed insoluble problem.
The Austrians made the first earnest attempt in this direction. Menger and the author of this paper have treated the question under the heading Theorie der komplementaren Guter; Wieser has treated the same subject under the title Theorie der Zurechnung (theory of contribution). The latter, especially, has in an admirable manner shown how the problem should be put, and that it can be solved. Menger has, in the happiest manner, as it seems to me, pointed out the method of solution.Menger, Grundsätze der Volkswirtschaftslehre, pp. 138 et seq. [See also the English translation, The Principles of Economics]; Böhm-Bawerk, "Grundzüge der Theorie des wirtschaftlichen Güterwerthes," part 1, pp. 56 et seq., Positive Theorie des Kapitales (1889), pp. 178 et seq. [See also the English translation of Böhm-Bawerk's The Positive Theory of Capital. ]; Wieser, Der naturliche Werth, pp. 67 et seq.
I have called the law of complementary goods the counterpart of the law of cost. As the former disentangles the relations of value that result from temporal and causal juxtaposition, from the simultaneous cooperation of several factors toward one common utility, so the law of cost explains the relations of value that result from temporal and causal sequence, from the causal interdependence of successive factors.
By means of the former, the meshes of the complicated network represented by the mutual-value relations of the cooperating factors are disentangled, so to speak, in their length and breadth; by the latter in their depth; but both processes occur within the all-embracing law of final utility, of which both laws are only special applications to special problems.Böhm-Bawerk, Positive Theorie, p. 201.
Thus prepared, the Austrian economists finally proceed to the problems of distribution. These resolve themselves into a series of special applications of the general theoretical laws, the knowledge of which was obtained by a tedious, but scarcely unfruitful, work of preparation. Land, labor, and capital are complementary factors of production. Their price, or what is the same thing, rate of rent, wages, and interest, results simply from a combination of the laws that govern the value of the materials of production, on the one hand, with the laws of complementary goods on the other hand.
The particular views of the Austrians on these subjects, I will here omit. I could not, if I would, give in this paper any proper statement of their conclusions, still less a demonstration of them; I must content myself with giving a passing view of the matters with which they are busied, and, where it is possible, of the spirit in which they work. I only briefly remark, therefore, that they have set forth a new and comprehensive theory of capitalBöhm-Bawerk, Kapital und Kapitalzins, 2 vols. vol. 1, Geschichte und Kritik der Kapitalizins-Theorien (1884); vol. 2: Positive Theorie des Kapitales (1889); differing from the older teaching of Menger's Grundsätze, pp. 143 et seq. [See also W. Smart's 1890 translation, Capital and Interest. into which they have woven a new theory of wages,Böhm-Bawerk, Positive Theorie, passim, and pp. 450–52. besides repeatedly working out the problems of the entrepreneur's profitsMataja, Der Unternehmergewinn (1884); Gross, Die Lehre vom Unternehmergewinn (1884). and of rent.Menger, Grundsätze, pp. 133 et seq.; Wieser, Der naturlichte Werth, pp. 112 et seq.; Böhm-Bawerk, Positive Theorie, pp. 380 et seq.
In the light of the theory of final utility, the last-named problem in particular finds an easy and simple solution, which confirms Ricardo's theory in its actual results and corroborates its reasoning in many details.
Of course, all the possible applications of the law of final utility have by no means been made. It is more nearly true that they are scarcely begun. I may mention in passing that certain Austrian economists have attempted a broad application of the law in the field of finance;Robert Meyer, Die Principien der gerechten Besteuerung (1884); Sax, Grundlegung (1887); Wieser, Der naturliche Werth, pp. 209 et seq. others to certain difficult and interesting questions of jurisprudence.Mataja, Das Recht des Schadenersatzes (1888); Seidler, "Die Geldstrafe vom volkswirtschaftlichen und sozialpolitischen Gesichtspunkt" in Conrad's Jahrbuch, N.F., vol. 20 (1890).
This is an excerpt from an essay that was originally published in the Annals of the American Academy of Political and Social Science, volume 1 (1891).
Property rights as they are circumscribed by laws and protected by courts and the police are the outgrowth of an age-long evolution. The history of these ages is the record of struggles aiming at the abolition of private property. Again and again despots and popular movements have tried to restrict the rights of private property or to abolish it altogether. These endeavors, it is true, failed. But they have left traces in the ideas determining the legal form and definition of property. The legal concepts of property do not fully take account of the social function of private property. There are certain inadequacies and incongruities that are reflected in the determination of the market phenomena.
Carried through consistently, the right of property would entitle the proprietor to claim all the advantages that the good's employment may generate on the one hand and would burden him with all the disadvantages resulting from its employment on the other hand. Then the proprietor alone would be fully responsible for the outcome. In dealing with his property he would take into account all the expected results of his action, those considered favorable as well as those considered unfavorable. But if some of the consequences of his action are outside of the sphere of the benefits he is entitled to reap and of the drawbacks that are put to his debit, he will not bother in his planning about all the effects of his action. He will disregard those benefits that do not increase his own satisfaction and those costs that do not burden him. His conduct will deviate from the line it would have followed if the laws were better adjusted to the economic objectives of private ownership. He will embark upon certain projects only because the laws release him from responsibility for some of the costs incurred. He will abstain from other projects merely because the laws prevent him from harvesting all the advantages derivable.
The laws concerning liability and indemnification for damages caused were and still are in some respects deficient. By and large the principle is accepted that everybody is liable to damages that his actions have inflicted upon other people. But there were loopholes left that the legislators were slow to fill. In some cases this tardiness was intentional because the imperfections agreed with the plans of the authorities. When in the past in many countries the owners of factories and railroads were not held liable for the damages that the conduct of their enterprises inflicted on the property and health of neighbors, patrons, employees, and other people through smoke, soot, noise, water pollution, and accidents caused by defective or inappropriate equipment, the idea was that one should not undermine the progress of industrialization and the development of transportation facilities.
The same doctrines that prompted and still are prompting many governments to encourage investment in factories and railroads through subsidies, tax exemption, tariffs, and cheap credit were at work in the emergence of a legal state of affairs in which the liability of such enterprises was either formally or practically abated. Later again the opposite tendency began to prevail in many countries, and the liability of manufacturers and railroads was increased as against that of other citizens and firms. Here again definite political objectives were operative. Legislators wished to protect the poor, the wage earners, and the peasants against the wealthy entrepreneurs and capitalists.
Whether the proprietor's relief from responsibility for some of the disadvantages resulting from his conduct of affairs is the outcome of a deliberate policy on the part of governments and legislators or whether it is an unintentional effect of the traditional wording of laws, it is at any rate a datum the actors must take into account. They are faced with the problem of external costs. Then some people choose certain modes of want satisfaction merely on account of the fact that a part of the costs incurred are debited not to them but to other people.
The extreme instance is provided by the case of no-man's property referred to above. If land is not owned by anybody, although legal formalism may call it public property, it is utilized without any regard to the disadvantages resulting. Those who are in a position to appropriate to themselves the returns — lumber and game of the forests, fish of the water areas, and mineral deposits of the subsoil — do not bother about the later effects of their mode of exploitation. For them the erosion of the soil, the depletion of the exhaustible resources and other impairments of the future utilization are external costs not entering into their calculation of input and output. They cut down the trees without any regard for fresh shoots or reforestation. In hunting and fishing they do not shrink from methods preventing the repopulation of the hunting and fishing grounds.
In the early days of human civilization, when soil of a quality not inferior to that of the utilized pieces was still abundant, people did not find any fault with such predatory methods. When their effects appeared in a decrease in the net returns, the ploughman abandoned his farm and moved to another place. It was only when a country was more densely settled and unoccupied, first-class land was no longer available for appropriation that people began to consider such predatory methods wasteful. At that time they consolidated the institution of private property in land. They started with arable land and then, step by step, included pastures, forests, and fisheries.
The newly settled colonial countries overseas, especially the vast spaces of the United States, whose marvelous agricultural potentialities were almost untouched when the first colonists from Europe arrived, passed through the same stages. Until the last decades of the 19th century there was always a geographic zone open to newcomers — the frontier. Neither the existence of the frontier nor its passing was peculiar to America. What characterizes American conditions is the fact that at the time the frontier disappeared ideological and institutional factors impeded the adjustment of the methods of land utilization to the change in the data.
In the central and western areas of continental Europe, where the institution of private property had been rigidly established for many centuries, things were different. There was no question of soil erosion of formerly cultivated land. There was no problem of forest devastation in spite of the fact that the domestic forests had been for ages the only source of lumber for construction and mining and of fuel for heating and for the foundries and furnaces, the potteries and the glass factories. The owners of the forests were impelled to conservation by their own selfish interests. In the most densely inhabited and industrialized areas up to a few years ago between a fifth and a third of the surface was still covered by first-class forests managed according to the methods of scientific forestry.Late in the 18th century, European governments began to enact laws aiming at forest conservation. However, it would be a serious blunder to ascribe to these laws any role in the conservation of the forests. Before the middle of the 19th century, there was no administrative apparatus available for their enforcement. Besides the governments of Austria and Prussia, to say nothing of those of the smaller German states, virtually lacked the power to enforce such laws against the aristocratic lords. No civil servant before 1914 would have been bold enough to rouse the anger of a Bohemian or Silesian magnate or a German mediatized Standesherr. These princes and counts were spontaneously committed to forest conservation because they felt perfectly safe in the possession of their property and were eager to preserve unabated the source of their revenues and the market price of their estates.
"The owners of the forests were impelled to conservation by their own selfish interests."It is not the task of catallactic theory to elaborate an account of the complex factors that produced modern American land-ownership conditions. Whatever these factors were, they brought about a state of affairs under which a great many farmers and the majority of the lumbering enterprises had reason to consider the disadvantages resulting from the neglect of soil and forest conservation as external costs.One could as well say that they considered the advantages to be derived from giving care to soil and forest conservation external economies.
It is true that where a considerable part of the costs incurred are external costs from the point of view of the acting individuals or firms, the economic calculation established by them is manifestly defective and their results deceptive. But this is not the outcome of alleged deficiencies inherent in the system of private ownership of the means of production. It is on the contrary a consequence of loopholes left in this system. It could be removed by a reform of the laws concerning liability for damages inflicted and by rescinding the institutional barriers preventing the full operation of private ownership.
The case of external economies is not simply the inversion of the case of external costs. It has its own domain and character.
If the results of an actor's action benefit not only himself but also other people, two alternatives are possible:
The planning actor considers the advantages he expects for himself so important that he is prepared to defray all the costs required. The fact that his project also benefits other people will not prevent him from accomplishing what promotes his own well-being. When a railroad company erects dikes to protect its tracks against snowslides and avalanches, it also protects the houses on adjacent grounds. But the benefits its neighbors will derive will not hinder the company from embarking upon an expenditure that it deems expedient.
The costs incurred by a project are so great that none of those whom it will benefit is ready to expend them in full. The project can be realized only if a sufficient number of those interested in it share in the costs.
It would hardly be necessary to say more about external economies if it were not for the fact that this phenomenon is entirely misinterpreted in current pseudoeconomic literature.
A project P is unprofitable when and because consumers prefer the satisfaction expected from the realization of some other projects to the satisfaction expected from the realization of P. The realization of P would withdraw capital and labor from the realization of some other projects for which the demand of the consumers is more urgent. The layman and the pseudoeconomist fail to recognize this fact. They stubbornly refuse to notice the scarcity of the factors of production. As they see it, P could be realized without any cost at all, i.e., without foregoing any other satisfaction. It is merely the wantonness of the profit system that prevents the nation from enjoying gratuitously the pleasures expected from P.
Now, these short-sighted critics go on to say, the absurdity of the profit system becomes especially outrageous if the unprofitability of P is merely due to the fact that the entrepreneur's calculations neglect those advantages of P that for them are external economies. From the point of view of the whole of society such advantages are not external. They benefit at least some members of society and would increase "total welfare." The nonrealization of P is therefore a loss for society. As profit-seeking business, entirely committed to selfishness, declines to embark upon such unprofitable projects, it is the duty of government to fill the gap. Government should either run them as public enterprises or it should subsidize them in order to make them attractive for the private entrepreneur and investor. The subsidies may be granted either directly by money grants from public funds or indirectly by means of tariffs the incidence of which falls upon the buyers of the products.
"Public works are not accomplished by the miraculous power of a magic wand. They are paid for by funds taken away from the citizens."However, the means a government needs in order to run a plant at a loss or to subsidize an unprofitable project must be withdrawn either from the taxpayers' spending and investing power or from the loan market. The government has no more ability than individuals to create something out of nothing. What the government spends more, the public spends less. Public works are not accomplished by the miraculous power of a magic wand. They are paid for by funds taken away from the citizens. If the government had not interfered, the citizens would have employed them for the realization of profit-promising projects the realization of which they must omit because their means have been curtailed by the government.
For every unprofitable project that is realized by the aid of the government there is a corresponding project the realization of which is neglected merely on account of the government's intervention. Yet this nonrealized project would have been profitable, i.e., it would have employed the scarce means of production in accordance with the most urgent needs of the consumers. From the point of view of the consumers the employment of these means of production for the realization of an unprofitable project is wasteful. It deprives them of satisfactions they prefer to those the government-sponsored project can furnish them.
The gullible masses, who cannot see beyond the immediate range of their physical eyes, are enraptured by the marvelous accomplishments of their rulers. They fail to see that they themselves foot the bill and must consequently renounce many satisfactions they would have enjoyed if the government had spent less for unprofitable projects. They have not the imagination to think of the possibilities that the government has not allowed to come into existence.Cf. the brilliant analysis of public spending in Henry Hazlitt's book Economics in One Lesson (New York, 1946), pp. 19–29.
These enthusiasts are still more bewildered if the government's interference enables submarginal producers to continue producing and to stand the competition of more efficient plants, shops, or farms. Here, they say, it is obvious that total production is increased and something is added to the wealth that would not have been produced without the assistance of the authorities. What happens in fact is just the opposite; the magnitude of total production and of total wealth is curtailed. Outfits producing at higher costs are brought into existence or preserved while other outfits producing at lower costs are forced to curtail or to discontinue their production. The consumers are not getting more, but less.
There is, for instance, the very popular idea that it is a good thing for the government to promote the agricultural development of those parts of the country that nature has poorly endowed. Costs of production are higher in these districts than in other areas; it is precisely this fact that qualifies a large part of their soil as submarginal. When unaided by public funds, the farmers tilling these submarginal lands could not stand the competition of the more fertile farms. Agriculture would shrink or fail to develop and the whole area would become a backward part of the country. In full cognizance of this state of affairs, profit-seeking business avoids investing in the construction of railroads connecting such inauspicious areas with the centers of consumption. The plight of the farmers is not caused by the fact that they lack transportation facilities. The causation is the other way round; because business realizes that the prospects for these farmers are not propitious, it abstains from investing in railroads that are likely to become unprofitable for lack of a sufficient amount of goods to be shipped.
If the government, yielding to the demands of the interested pressure groups, builds the railroad and runs it at a deficit, it certainly benefits the owners of farm land in those poor districts of the country. As a part of the costs that the shipping of their products requires is borne by the treasury, they find it easier to compete with those tilling more fertile land to whom such aid is denied. But the boon of these privileged farmers is paid for by the taxpayers who must provide the funds required to defray the deficit. It affects neither the market price nor the total available supply of agricultural products. It merely makes profitable the operation of farms that hitherto were submarginal and makes other farms, the operation of which was hitherto profitable, submarginal. It shifts production from land requiring lower costs to land requiring higher costs. It does not increase total supply and wealth; it curtails them, as the additional amounts of capital and labor required for the cultivation of high-cost fields instead of low-cost fields are withheld from employments in which they would have made possible the production of some other consumers' goods. The government attains its end of benefiting some parts of the country with what they would have missed, but it produces somewhere else costs that exceed these gains of a privileged group.This article is excerpted from chapter 23 of Human Action: The Scholar's Edition and is read by Jeff Riggenbach.
[This article is excerpted from chapter 7 of Individualism and Economic Order.]
Without some such central control of the means of production, planning in the sense in which we have used the term ceases to be a problem. It becomes unthinkable. This would probably be agreed by the majority of economists of all camps, although most other people who believe in planning still think of it as something that could be rationally attempted inside the framework of a society based on private property.
In fact, however, if by "planning" is meant the actual direction of productive activity by authoritative prescription of either the quantities to be produced, the methods of production to be used, or the prices to be fixed, it can be easily shown not that such a thing is impossible, but that any isolated measure of this sort will cause reactions that will defeat its own end, and that any attempt to act consistently will necessitate further and further measures of control until all economic activity is brought under one central authority.
It is impossible within the scope of this discussion of socialism to enter further into this separate problem of state intervention in a capitalistic society. It is mentioned here only to say explicitly that it is excluded from our considerations. In our opinion well-accepted analysis shows that it does not provide an alternative that can be rationally chosen or that can be expected to provide a stable or satisfactory solution of any of the problems to which it is applied.Cf. Ludwig von Mises, Kritik des Interventionismus (1929), trans. and republished as A Critique of Interventionism (1977).
But here, again, it is necessary to guard against misunderstanding. To say that partial planning of the kind we are alluding to is irrational is, however, not equivalent to saying that the only form of capitalism that can be rationally advocated is that of complete laissez-faire in the old sense. There is no reason to assume that the historically given legal institutions are necessarily the most "natural" in any sense.
The recognition of the principle of private property does not by any means necessarily imply that the particular delimitation of the contents of this right as determined by the existing laws are the most appropriate. The question as to which is the most appropriate permanent framework that will secure the smoothest and most efficient working of competition is of the greatest importance and one that, it must be admitted, has been sadly neglected by economists.
But, on the other hand, to admit the possibility of changes in the legal framework is not to admit the possibility of a further type of planning in the sense in which we have used the word so far. There is an essential distinction here that must not be overlooked: the distinction between a permanent legal framework so devised as to provide all the necessary incentives to private initiative to bring about the adaptations required by any change and a system where such adaptations are brought about by central direction. It is this, and not the question of the maintenance of the existing order versus the introduction of new institutions, which is the real issue.
In a sense both systems can be described as being the product of rational planning. But in the one case this planning is concerned only with the permanent framework of institutions and may be dispensed with if one is willing to accept the institutions that have grown in a slow historical process, while in the other it has to deal with day-to-day changes of every sort.
There can be no doubt that planning of this sort involves changes of a type and magnitude hitherto unknown in human history. It is sometimes urged that the changes now in progress are merely a return to the social forms of the pre-industrial era. But this is a misapprehension. Even when the medieval guild system was at its height, and when restrictions to commerce were most extensive, they were not used as a means actually to direct individual activity. They were certainly not the most rational permanent framework for individual activity that could have been devised, but they were essentially only a permanent framework inside which current activity by individual initiative had free play.
With our attempts to use the old apparatus of restrictionism as an instrument of almost day-to-day adjustment to change, we have already gone much further in the direction of central planning of current activity than has ever been attempted before. If we follow the path on which we have started, if we try to act consistently and to combat the self-frustrating tendencies of any isolated act of planning, we shall certainly embark upon an experiment that until recently had no parallel in history. But even at this stage we have gone very far.
If we are to judge the potentialities aright, it is necessary to realize that the system under which we live, choked up with attempts at partial planning and restrictionism, is almost as far from any system of capitalism that could be rationally advocated as it is different from any consistent system of planning. It is important to realize in any investigation of the possibilities of planning that it is a fallacy to suppose capitalism as it exists today is the alternative. We are certainly as far from capitalism in its pure form as we are from any system of central planning. The world of today is just interventionist chaos.
Classical political economy broke down mainly because it failed to base its explanation of the fundamental phenomenon of value on the same analysis of the springs of economic activity that it had so successfully applied to the analysis of the more complex phenomena of competition. The labor theory of value was the product of a search after some illusory substance of value rather than an analysis of the behavior of the economic subject.
The decisive step in the progress of economics was taken when economists began to ask what exactly were the circumstances that made individuals behave toward goods in a particular way. To ask the question in this form led immediately to the recognition that to attach a definite significance or value to the units of different goods was a necessary step in the solution of the general problem that arises everywhere when a multiplicity of ends compete for a limited quantity of means.
The omnipresence of this problem of value wherever there is rational action was the basic fact from which a systematic exploration of the forms, under which it would make its appearance under different organizations of economic life, could proceed. Up to a certain point, from the very beginning, the problems of a centrally directed economy found a prominent place in the expositions of modern economics. It was obviously so much simpler to discuss the fundamental problems on the assumption of the existence of a single scale of values consistently followed than on the assumption of a multiplicity of individuals following their personal scales that in the early chapters of the new systems the assumption of a Communist state was frequently used — and used with considerable advantage — as an expository device.Cf. particularly Friedrich von Wieser, Natural Value (London, 1893).
But it was used only to demonstrate that any solution would necessarily give rise to essentially the same value phenomena — rent, wages, interest, etc. — that we actually observe in a competitive society, and the authors then generally proceeded to show how the interaction of independent activities of the individuals produced these phenomena spontaneously, without inquiring further whether they could be produced in a complex modern society by any other means.
The mere absence of an agreed common scale of values seemed to deprive that problem of any practical importance. It is true that some of the earlier writers of the new school not only thought that they had actually solved the problem of socialism but also believed that their utility calculus provided a means that made it possible to combine individual utility scale into a scale of ends objectively valid for society as a whole. But it is now generally recognized that this latter belief was just an illusion and that there are no scientific criteria that would enable us to compare or assess the relative importance of needs of different persons, although conclusions implying such illegitimate interpersonal comparisons of utilities can still be found in discussions of special problems.
But it is evident that, as the progress of the analysis of the competitive system revealed the complexity of the problems that it solved spontaneously, economists became more and more skeptical about the possibility of solving the same problems by deliberate decision.
It is perhaps worth noting that as early as 1854 the most famous among the predecessors of the modern "marginal utility" school, the German Herman Heinrich Gossen, had come to the conclusion that the central economic authority projected by the Communists would soon find that it had set itself a task that far exceeded the powers of individual men.Herman Heinrich Gossen, Entwicklung der Gesetze des menschlichen Verkehrs und der daraus fliessenden Regeln für menschliches Handeln (Braunschweig, 1854), p. 231. Among the later economists of the modern school, the point in which Gossen had already based his objection, the difficulty of rational calculation when there is no private property, was frequently hinted at.
It was particularly clearly put by Professor Edwin Cannan, who stressed the fact that the aims of socialists and Communists could only be achieved by "abolishing both the institution of private property and the practice of exchange, without which value, in any reasonable sense of the word, cannot exist."Edwin Cannan, A History of the Theories of Production and Distribution (1893; 3rd ed., 1917), p. 395. Professor Cannan has later also made an important contribution to the problem of the international relation between socialist states. Cf. his essay on "The Incompatibility of Socialism and Nationalism," in The Economic Outlook (London, 1912). But, beyond general statements of this sort, critical examination of the possibilities of a socialist economic policy made little headway, for the simple reason that no concrete socialist proposal of how these problems would be overcome existed to be examined.A completely neglected attempt to solve the problem from the socialist side, which shows at least some realization of the real difficulty, was made by Georg Sulzer, Die Zukunft des Sozialismus (Dresden, 1899).
It was only early in the present century that at last a general statement of the kind we have just examined, concerning the impracticability of socialism by the eminent Dutch economist, N.G. Pierson, provoked Karl Kautsky, then the leading theoretician of Marxian socialism, to break the traditional silence about the actual working of the future socialist state and to give in a lecture, still somewhat hesitantly and with many apologies, a description of what would happen on the morrow of the Revolution.An English translation of this lecture, originally given in Delft on April 24, 1902, and soon afterward published in German, together with that of another lecture given two days earlier at the same place, was published under the title, The Social Revolution and On the Morrow of the Social Revolution (London, 1907). But Kautsky only showed that he was not even really aware of the problem that the economists had seen.
He thus gave Pierson the opportunity to demonstrate in detail, in an article that first appeared in the Dutch Economist, that a socialist state would have its problems of value just as any other economic system and that the task socialists had to solve was to show how in the absence of a pricing system the value of different goods was to be determined. This article is the first important contribution to the modern discussion of the economic aspects of socialism, and, although it remained practically unknown outside of Holland and was only made accessible in a German version after the discussion had been started independently by others, it remains of special interest as the only important discussion of these problems published before World War I.
It is particularly valuable for its discussion of the problems arising out of the international trade between several socialist communities.An English translation of Pierson's article is contained in the volume on Collectivist Economic Planning to which the present essay formed the introduction. All the further discussions of the economic problems of socialism that appeared before the first World War confined themselves more or less to the demonstration that the main categories of prices, as wages, rent, and interest, would have to figure at least in the calculations of the planning authority in the same way in which they appear today and would be determined by essentially the same factors. The modern development of the theory of interest played a particularly important role in this connection. After Böhm-Bawerk,In addition to his general work on interest, his essay on "Macht und ökonomisches Gesetz" (Zeitschrift für Volkswirtschaft. Sozialpolitik und Verwaltung [1914]) should be specially mentioned, since in many ways it must be regarded as a direct predecessor of the later critical work. it was particularly Professor Gustav Cassel who showed convincingly that interest would have to form an important element in the rational calculation of economic activity.
But none of these authors even attempted to show how these essential magnitudes could be arrived at in practice. The one author who at least approached the problem was the Italian economist Enrico Barone, who in 1908, in an article on the "Ministry of Production in the Collectivist State," developed certain suggestions of Pareto's.Vilfredo Pareto, Cours d'économie politique, (Lausanne, 1897), vol. 2, p. 364ff. This article is of considerable interest as an example of how it was thought that the tools of mathematical analysis of economic problems might be utilized to solve the tasks of the central planning authority.An English translation of Barone's essay forms the Appendix to the volume on Collectivist Economic Planning.
When, with the end of the war of 1914–1918, socialist parties came into power in most of the states of central and eastern Europe, the discussion on all these problems necessarily entered a new and decisive phase. The victorious socialist parties had now to think of a definite program of action, and the socialist literature of the years immediately following World War I was for the first time largely concerned with the practical question of how to organize production on socialist lines.
These discussions were very much under the influence of the experience of the war years when the states had set up food and raw material administrations to deal with the serious shortage of the most essential commodities. It was generally assumed that this had shown that not only was central direction of economic activity practicable and even superior to a system of competition but also that the special technique of planning developed to cope with the problems of war economics might be equally applied to the permanent administration of a socialist economy.
Apart from Russia, where the rapidity of change in the years immediately following the revolution left little time for quiet reflection, it was mainly in Germany and even more so in Austria that these questions were most seriously debated. Particularly in the latter country whose socialists had long played a leading role in the intellectual development of socialism, and where a strong and undivided socialist party had probably exercised a greater influence on its economic policy than in any other country outside Russia, the problems of socialism had assumed enormous practical importance.
It may perhaps be mentioned in passing that it is rather curious how little serious study has been devoted to the economic experiences of that country in the decade after the First World War, although they are probably more relevant to the problems of a socialist policy in the Western world than anything that has happened in Russia. But, whatever one may think about the importance of the actual experiments made in Austria, there can be little doubt that the theoretical contributions made there to the understanding of the problems will prove to be a considerable force in the intellectual history of our time.
Among these early socialist contributions to the discussions, in many ways the most interesting and in any case the most characteristic for the still very limited recognition of the nature of the economic problems involved, is a book by Otto Neurath that appeared in 1919, in which the author tried to show that war experiences had revealed that it was possible to dispense with any considerations of value in the administration of the supply of commodities and that all the calculations of the central planning authorities should and could be carried out in natura, i.e., that the calculations need not be carried through in terms of some common unit of value but that they could be made in kind.Otto Neurath, Durch die Kriegswirtschaft zur Naturalwirtschaft (Munich, 1919).
Neurath was quite oblivious of the insuperable difficulties that the absence of value calculations would put in the way of any rational economic use of the resources and even seemed to consider it as an advantage. Similar strictures apply to the works published about the same time by one of the leading spirits of the Austrian Social Democratic Party, Otto Bauer.Otto Bauer, Der Weg zum Sozialismus (Vienna, 1919). It is impossible here to give any detailed account of the argument of these and a number of other related publications of that time. They have to be mentioned, however, because they are important as representative expression of socialist thought just before the impact of the new criticism and because much of this criticism is naturally directed or implicitly concerned with these works.
In Germany discussion centered round the proposals of the "socialization commission" set up to discuss the possibilities of the transfer of individual industries to the ownership and control of the state. It was this commission or in connection with its deliberations that economists like Emil Lederer and Eduard Heimann and the ill-fated Walther Rathenau developed plans for socialization that became the main topic of discussion among economists.Rathenau was assassinated in 1922.
For our purpose, however, these proposals are less interesting than their Austrian counterparts, because they did not contemplate a completely socialized system but were mainly concerned with the problem of the organization of individual socialized industries in an otherwise competitive system. For this reason their authors did not have to face the main problems of a really socialist system. They are important, nevertheless, as symptoms of the state of public opinion at the time when and in the nation in which the more scientific examination of these problems began.
One of the projects of this period deserves perhaps special mention not only because its authors are the inventors of the now fashionable term planned economy but also because it so closely resembles the proposals for planning now [1935] so prevalent in Great Britain. This is the plan developed in 1919 by the economics and labor minister, Rudolf Wissel, and his undersecretary of state, W. von Moellendorf.This plan was originally developed in a memorandum submitted to the cabinet of the Reich on May 7, 1919, and later developed by Rudolf Wissel in two pamphlets, Die Planwirtschaft (Hamburg, 1920) and Praktische Wirtschaftspolitik (Berlin, 1919). But interesting as their proposals of organization of individual industries are and relevant to many of the problems discussed in England at the present moment as is the discussion to which they gave rise, they cannot be regarded as socialist proposals of the kind discussed here but belong to the halfway house between capitalism and socialism, discussion of which for reasons mentioned above has been deliberately excluded from the present essay.
The distinction of having first formulated the central problem of socialist economics in such a form as to make it impossible that it should ever again disappear from the discussion belongs to the Austrian economist Ludwig von Mises. In an article on "Economic Calculation in a Socialist Community," which appeared in the spring of 1920, he demonstrated that the possibility of rational calculation in our present economic system was based on the fact that prices expressed in money provided the essential condition that made such reckoning possible."Die Wirtschaftsrechnung im sozialistischen Gemeinwesen," Archiv für Sozialwissenschaften und Sozialpolitik, vol. 58, no.1 (April 1920), reproduced in an English translation in Collectivist Economic Planning. Most of this article has been embodied in the more elaborate discussion of the economic problems of a socialist community in part II of Professor Mises's Gemeinwirtschaft (Jena, 1922; 2nd ed., 1932); English trans. by J. Kahane under the title Socialism (London, 1936). The essential point on which Professor Mises went far beyond anything done by his predecessors was the detailed demonstration that an economic use of the available resources was only possible if this pricing was applied not only to the final product but also to all the intermediate products and factors of production, and that no other process was conceivable that would in the same way take account of all the relevant facts as did the pricing process of the competitive market.
Together with the larger work in which this article was later incorporated, Professor Mises's study represents the starting point from which all the discussions of the economic problems of socialism, whether constructive or critical, which aspire to be taken seriously must necessarily proceed.
While Professor Mises's writings contain beyond doubt the most complete and successful exposition of what from then onward became the central problem, and while they had by far the greatest influence on all further discussions, it is an interesting coincidence that about the same time two other distinguished authors arrived independently at very similar conclusions.
"Professor Mises's study represents the starting point from which all the discussions of the economic problems of socialism, whether constructive or critical, which aspire to be taken seriously must necessarily proceed."The first was the great German sociologist Max Weber, who in his posthumous magnum opus, Wirtschaft und Gesellschaft, which appeared in 1921, dealt expressly with the conditions that in a complex economic system made rational decisions possible. Like Mises (whose article he quotes as having come to his notice only when his own discussion was already set up in print), he insisted that the in natura calculations proposed by the leading advocates of a planned economy could not provide a rational solution of the problems that the authorities in such a system would have to solve.
He emphasized in particular that the rational use and the preservation of capital could be secured only in a system based on exchange and the use of money, and that the wastes due to the impossibility of rational calculation in a completely socialized system might be serious enough to make it impossible to maintain alive the present populations of the more densely inhabited countries:
The assumption that some system of accounting would in time be found or invented if one only tried seriously to tackle the problem of a moneyless economy does not help here: the problem is the fundamental problem of any complete socialization and it is certainly impossible to talk of a rationally "planned economy" while in so far as the all-decisive point is concerned no means for the construction of a "plan" is known.Max Weber, Wirtschaft und Gesellschaft ("Grundriss der Sozialökonomik," vol. 3 [Tübingen, 1921]), pp. 55–56.
A practically simultaneous development of the same ideas is to be found in Russia. Here, in the summer of 1920, in the short interval after the first military successes of the new system, when it had for once become possible to utter criticisms in public, Boris Brutzkus, a distinguished economist mainly known for his studies in the agricultural problems of Russia, subjected to a searching criticism, in a series of lectures, the doctrines governing the action of the Communist rulers.
These lectures, which appeared under the title "The Problems of Social Economy under Socialism" in a Russian journal and were only many years later made accessible to a wider public in a German translation,The original title under which these lectures appeared in the winter of 1921–22 in the Russian journal Ekonomist was "Problems of Social Economy under Socialism." They were later reprinted in the original Russian as a pamphlet that appeared in Berlin in 1923, and a German translation under the title Die Lehren des Marxismus im Lichte der russischen Revolution was published in Berlin in 1928. This essay, together with a discussion of the development of economic planning in Russia, appeared in an English translation in Boris Brutzkus, Economic Planning in Soviet Russia (London, 1935). show in their main conclusion a remarkable resemblance to the doctrines of Mises and Max Weber, although they arose out of the study of the concrete problems that Russia had to face at that time and although they were written at a time when their author, cut off from all communication with the outside world, could not have known of the similar efforts of the Austrian and German scholars. Like Professor Mises and Max Weber, his criticism centers round the impossibility of a rational calculation in a centrally directed economy from which prices are necessarily absent.
Although to some extent Max Weber and Professor Brutzkus share the credit of having pointed out independently the central problem of the economics of socialism, it was the more complete and systematic exposition of Professor Mises, particularly in his larger work on Die Gemeinwirtschaft, that has mainly influenced the trend of further discussion on the Continent. In the years immediately succeeding its publication a number of attempts were made to meet his challenge directly and to show that he was wrong in his main thesis and that even in a strictly centrally directed economic system values could be exactly determined without any serious difficulties. But, although the discussion on this point dragged on for several years, in the course of which Mises twice replied to his critics,Ludwig von Mises, "Neue Beitrage zum Problem der sozialistischen Wirtschaftsrechnung," Archiv für Sozialwissenschaften, vol. 51 (1924), and "Neue Schriften zum Problem der sozialistischen Wirtschaftsrechnung," Archiv für Sozialwissenschaften, vol. 60 (1928). it became more and more clear that, in so far as a strictly centrally directed planned system of the type originally proposed by most socialists was concerned, his central thesis could not be refuted.
Much of the objections made at first were really more a quibbling about words caused by the fact that Mises had occasionally used the somewhat loose statement that socialism was "impossible," while what he meant was that socialism made rational calculation impossible. Of course any proposed course of action, if the proposal has any meaning at all, is possible in the strict sense of the word, i.e., it may be tried. The question can only be whether it will lead to the expected results, that is, whether the proposed course of action is consistent with the aims that it is intended to serve.
Insofar as it had been hoped to achieve by means of central direction of all economic activity at one and the same time a distribution of income independent of private property in the means of production and a volume of output that was at least approximately the same or even greater than that procured under free competition, it was more and more generally admitted that this was not a practicable way to achieve these ends.
But it was only natural that, even where Professor Mises's main thesis was conceded, this did not mean an abandonment of the search for a way to realize the socialist ideals. Its main effect was to divert attention from what had so far been universally considered as the most practicable forms of socialist organization to the exploration of alternative schemes.
It is possible to distinguish two main types of reaction among those who conceded his central argument. In the first place, there were those who thought that the loss of efficiency, the decline in general wealth that will be the effect of the absence of a means of rational calculation, would not be too high a price for the realization of a more just distribution of this wealth. Of course, if this attitude is based on a clear realization of what this choice implies, there is no more to be said about it, except that it seems doubtful whether those who maintain it would find many who would agree with their idea.
The real difficulty here is, of course, that for most people the decision on this point will depend on the extent to which the impossibility of rational calculation would lead to a reduction of output in a centrally directed economy compared with that of a competitive system. Although in the opinion of the present writer it seems that careful study can leave no doubt about the enormous magnitude of that difference, it must be admitted that there is no simple way to prove how great that difference would be. The answer here cannot be derived from general considerations but will have to be based on a careful comparative study of the working of the two alternative systems and presupposes a much greater knowledge of the problems involved than can possibly be acquired in any other way but by a systematic study of economics.It is perhaps necessary in this connection to state explicitly that it would be wholly inconclusive if such a comparison were made between capitalism as it exists (or is supposed still to exist) and socialism as it might work under ideal assumptions — or between capitalism as it might be in its ideal form and socialism in some imperfect form. If the comparison is to be of any value for the question of principle, it has to be made on the assumption that either system is realized in the form that is most rational under the given condition of human nature and external circumstances that must of course be accepted.
The second type of reaction to Professor Mises's criticism was to regard it as valid only as regards the particular form of socialism against which it was mainly directed and to try to construct other schemes that would be immune to that criticism. A very considerable and probably the more interesting part of the later discussions on the Continent tended to move in that direction.
Here is the first accurate translation of Richard Cantillon's 1755 masterpiece on economics. This treatise is widely credited with being the first to describe the market process as one driven by entrepreneurship. William Stanley Jevons, in the first blush of discovery, proclaimed Cantillon’s Essai, “the cradle of political economy.”
A cradle holds new life; and there can be little doubt that the Essai added new life to the organizing principles of economics. But “political economy” does not accurately describe the subject Cantillon addressed. Indeed, he scrupulously avoided political issues in order to concentrate on the mechanics of eighteenth-century economic life. When confronted by “extraneous” factors, such as politics, Cantillon insisted that such considerations be put aside, “so as not to complicate our subject,” he said, thus invoking a kind of ceteris paribus assumption before it became fashionable in economics to do so.
Murray Rothbard, for this reason, called Cantillon the "founding father of modern economics."
This book preceded Adam Smith by a generation. Unlike any previous writer, Cantillon explicated the vital role of the entrepreneur with perception and vigor. Hence, he deserves to be called “the father of enterprise economics.”
We know little of Cantillon’s life and the circumstances of his authorship. The manuscript that was eventually published in 1755 circulated privately in France for almost two decades before; when published, it appeared under mysterious circumstances.
Mark Thornton and Chantal Saucier have accomplished the arduous task of bringing forth a new and improved translation of Cantillon’s famous work. Heretofore the only English translation of the Essai available has been the 1931 edition produced by Henry Higgs for the Royal Economic Society. Though competent, it has become less serviceable over time, as more and more of its shortcomings devolved (not the least of which is the antiquated use of “undertaker” in place of “entrepreneur”).
Saucier provides a more accurate and lucid account, better suited to the 21st century. Thornton’s hand shows not only in competent guidance of the translator but in the inclusion of numerous explanatory footnotes that add historical context.
Robert F. Hébert writes the foreword.
In recent months, fiscal austerity among governments on all levels has come to the political fore, albeit for different reasons.
In some cases, such as Greece, belt-tightening measures were essential to avert a sovereign-debt crisis. The Greek government enacted significant deficit-reduction solutions in order to receive monetary aid from the International Monetary Fund and European Union. In so doing, it continued the de facto monetization of Greek debt by the European Central Bank.
Other governments are finding fiscal consolidation necessary to bridge the gap between paltry tax takes and ballooning expenditures — like those of G8 nations Britain, Japan, and Germany, and most US states, which (unlike the federal government) must at least nominally "balance" their budgets on an annual basis."Balanced" budgets are evaluated on a cash basis. Inflows of monies, whatever their source (e.g., borrowing, deferring payments to the next fiscal year, or one-time windfalls) must equal outflows. A more honest standard would be a structurally balanced budget requirement, which would mean ongoing inflows (taxes) equal ongoing expenditures.
In Washington, the backlash against further deficit spending is ephemeral; it has only become fashionable, conveniently, just prior to a midterm election. Members of Congress recently balked at the price of a "Tax Extenders" bill that would continue certain tax-and-spend provisions from the 2009 stimulus legislation, as though doing so would exonerate them from their damning $1.4 trillion deficit.
Ongoing deficit-reduction solutions inherently entail two policy options: (1) permanent spending reductions or (2) permanent increases in taxes. The former reduces the state's claim on the material results of private economic activity — the wellspring of production, consumption, and an increasing standard of living. The latter confiscates private property for forced consumption spending, distorts economic decisions, and retards capital accumulation. Consequently, the former method of deficit reduction is by far economically preferable to the latter.
Nevertheless, cutting government spending is a daunting undertaking. Public reaction to proposed spending reductions is typically negative, emotional, and severe. One can expect a backlash that at a minimum includes media commentary and reports bemoaning the supposed dire economic consequences and job losses arising from reductions in government spending.Such contentions assume that government spending and jobs are not merely derived from diversion of the private sector resources. It might also include attempts by special-interest groups (SIGs) imperiled by potential cuts to sway public opinion in their favor. The backlash could even include protests on the streets and at the capitol. In some cases protests turn violent, prompting the destruction of private property or the tragic loss of life, as was the case of the three bank employees killed in Athens.
The purpose of this article is to identify the principal factors that make it so difficult to effectuate reductions in the state's seizure and consumption of the fruits of private enterprise. Combining the perceptive writings and analytical tools of the Austrian School and my experience as a fiscal- and economic-policy staffer on the legislative level, I have arrived at several conclusions. While the conclusions are by no means exhaustive, they are as applicable on the local level as they are on the federal level — the only difference is in the scope of each government or policymaker's reach.
Voting and Special InterestsEvery dime of government spending pleases some in-built constituency. Once legislators give money away (that is, spend tax monies), it is much harder subsequently to take the spending back.
Whether it is public employees, government agencies, trade unions (teachers, fire, police, etc.), pensioners, or particular businesses and industries benefitting from government largesse, each constituency or special interest has its sacred cows of government spending. In times of plenty — such as cheap-money-induced economic booms — when the government's tax take is bountiful, each constituency fights for additional appropriations to be directed to their favored cause, whether it is new spending programs, special tax credits for social-welfare causes, or pseudo-economic purposes. In times of dire fiscal conditions, each constituency fights vehemently to oppose a loss of their share of seized private property.
This difficulty of reducing government spending is aggravated by the boom-and-bust cycle itself. In times of plenty, it is easy for politicians (who are spending someone else's money anyway) to budget new, ongoing spending programs lauded by the special interests — on top of what are clearly extraordinary and one-time boosts in tax take.Capital gains taxes and corporate income taxes are among the most sensitive to the economic cycle, producing extraordinary tax receipts during the boom and disappear during the bust as mal-investments financed by cheap credit are liquidated. When the bust occurs and taxes dry up, not only do legislators have to bring ongoing spending into alignment with ongoing tax revenue, but they must also undo the extraordinary additions to spending that were approved during the boom — with the attendant fiscal pain and inevitable public backlash.
The inherent significance of in-built constituencies is the creation of what economists call a "collective action problem."See Mancur Olson, Jr., The Logic of Collective Action: Public Goods and the Theory of Groups (Harvard University Press, 1971). On the one hand are constituencies that are small relative to the overall population but disproportionately impacted by increases or reductions to government spending. On the other hand is the general public, which is large, disparate, and individually loses or gains relatively little when government spending is provided for or taken away from those constituencies.The costs of any particular spending program or special tax credit can be spread across the entire populace, conveniently diluting its direct financial impact on citizens. Consequently, recipients of government spending will organize and fight vigorously to protect their special interests, while it makes little difference to any individual member of the general public to oppose government spending (e.g., writing to his or her representative to complain) because the individual cost is little relative to that which is accrued by the in-built constituencies.
Constituencies that stand to gain and lose acutely from increases and reductions in government spending mobilize politically to wield significant influence over the political process.
Again, whether they are government employees, unions, subsidized industries, or government contractors, the in-built constituencies establish political organizations and associations to influence the appropriations process. These special-interest groups typically perform or fund some or all of the following functions: direct government lobbying, politically motivated policy research, media-and-public-relations activities, and campaign financing of like-minded candidates to protect their special interests.
"Constituencies that stand to gain and lose acutely from increases and reductions in government spending mobilize politically to wield significant influence over the political process." SIGs diligently work to identify, vet, financially support, help elect, and ultimately work with and lobby like-minded politicians once they are in office. Prior to elections, SIGs often distribute comprehensive questionnaires, conduct lengthy interviews, and perform intense evaluations of both aspiring office holders and incumbents to find politicians willing to support their preferred policy positions.
Candidates meeting SIG "purity tests" enjoy political endorsements and accompanying campaign monies.This observation does not imply that officeholders do not leverage their positions to extract campaign donations from SIGs, too. Specters like "tax reform" often are convenient mechanisms for politicians and their political parties to keep campaign coffers full. It is best to think of politicians, political parties, and the SIGs as symbiotic entities — or other, more-appropriately incestuous partners in legalized plunder. Throughout the legislative cycle, SIGs monitor office-holders' voting records, public comments, and policy stances to determine whether reelection support is merited or not.
Once elected, politicians find they have a number of differing "constituencies." They are accountable to their party, the legislative district they represent, their base voters who actually supported them at the polls, and the SIGs that endorsed and funded their campaigns. Now in office, the candidates are dealing with the competing priorities of all of those constituencies; however, the constituents they will be dealing with most on a day-to-day basis are those very SIGs that helped get them to office.
SIGs in turn ask elected officials to sponsor or support special interest legislation developed and drafted by the SIGs and oppose legislation threatening SIG-supported appropriations and public policies.
The legislative system is inherently a labyrinth of trade-offs, compromises, and deals, resulting in opaque and contradictory outcomes in public policy.
In a bicameral legislative system, the passage of bills requires majority support in both legislative bodies and an executive signature. For example, in a bicameral body consisting of 60 representatives, 30 senators, and one executive, the passage of a bill requires a sponsoring legislator to collect 31, 16, and one vote, respectively. Unless the bill is as innocuous as a resolution recognizing January as the first month of the calendar year, legislators face a labyrinth of challenges to get their proposals through the entire process.
Generally in the United States both legislative houses are divided between two principal parties separated in numbers by slim majorities. Politicians hailing from a wide variety of backgrounds, who possess diverse personalities and interests, establish, adopt, amend, and repeal laws in policy areas as distinctive and complex as education, health, environment, taxation, appropriations, economic development, industry regulation, and public safety. When one takes into account the difficulty of securing majority votes, heavy SIG involvement, bills spanning several different spheres of public policy, it is easy to see how the system engenders an environment rife for trade-offs, compromises, and oftentimes curious outcomes from a policy perspective.
Any bill — for example, one that originates in the House of Representatives — must make it through assigned committees, house-floor debates and votes, go to the senate for the same vetting, and ultimately be considered by the executive. Each step in the process entails public scrutiny, serious opposition, negotiations, and trade-offs, as there will be winning and losing constituencies with any piece of legislation.
Constituencies (particularly the SIGs), legislators, and the executive will actively work to try to kill bills, freeze them at a certain stage of the legislative process, or muster the votes necessary to amend bills beyond recognition. At each stage of the process, constituencies and legislators will demand compensation from one another — for example, votes on each other's favorite bills, or an agreement to kill someone else's bill — a phenomenon commonly known as "log rolling." Taking bills hostage — that is, holding bills in committee, or keeping them off the calendar for a floor vote, a privilege of legislative leadership and committee chairmanships — is common to extract concessions elsewhere.
Thus, it is little wonder there are earmarks and log rolling in the political process. No legislator is going to get something for nothing. SIGs will call in political favors, make trouble for legislators and the executive in the media, or find other leverage points (like campaign donations) to influence the fate of certain bills. What one gets in the legislative system is accomplished through negotiations, trade-offs, and backroom deals, resulting in a bevy of legislation that is often contradictory, convoluted, or illogical.For example, although all taxes are objectionable, there is very little reason why a sales tax is applied to auto parts, but not the labor performed on the car at an auto repair shop. In most states, there are hundreds of exemptions of goods and services from sales taxes, as well as individual and corporate income tax credits. A few of these may have legitimate economic or public policy rationales, but most have scant public benefit or purpose, and were instead the creature of some political trade-off to satiate particular SIGs, legislators, or executives at some point in time.
Budget votes endure this entire process. Legislators buy votes, hold each other's bills hostage, and trade off policies to get a budget passed. Budget cuts can only elevate the difficulty and attendant rancor. Likening legislative politics to making sausage does not do the process justice and no mainstream textbook or politically sanitized public school classroom adequately describes this process.
Voters are generally overburdened, under- or misinformed (by political spin and the media), and apathetic.
As Thomas Di Lorenzo points out,
Modern government is much too large for any citizen to possess knowledge about anything other than a miniscule percentage of its activities. The average citizen is "rationally ignorant": he has little incentive to become informed about the activities of government, for he spends most of his time earning a living, educating himself, raising his family, etc. To make matters worse, the state, its media lapdogs, and its court intellectuals comprise a vast propaganda apparatus designed to confuse the voters about what the state is really up to.
This problem is compounded by the fact that government has grown so large that it is involved in every aspect of life. It is sometimes unfathomable to realize modern governments possess a claim on one's wages (Social Security, Medicare, and payroll and withholding taxes, income (progressive income taxes), property (property taxes), spending (sales taxes and VATs) — and this is not to mention the destruction of savings and distortion of prices through inflation. With no prospect of relieving any of these profound burdens, it is little wonder the average citizen is largely apathetic and alienated by modern government.
Taking the notion of "rational ignorance" and the "collective action problem" described earlier in this article further, one understands why elections (democracy's supposed proof that government outcomes are the will of the people) typically have low levels of participation, particularly in local and nonpresidential-year elections. It is the base of voters with the greatest amount of time, interest, or direct personal and financial stake (unions, pensioners, government employees, government contractors) who wield the greatest amount of voting clout in the political system.
"With no prospect of relieving any of these profound tax burdens, it is little wonder the average citizen is largely apathetic and alienated by modern government." In general, citizens, particularly those voters who tend to actively participate in the political process, want government spending directed toward their favorite programs, but are reluctant to pay for it. Typically they conveniently advocate policies to force someone else — be it "greedy corporations," small businesses, the wealthy, or future generations — to pay for what they want. Accordingly, every voter has his or her own opinions on what spending constitutes the highest priority, as well as how and by whom it should be paid for.
The bottom line is that people like to get goods and services but hate to pay for them.
Cuts and CalculationThe economic value of government services cannot be calculated on a profit-and-loss basis. Government-spending cuts, like the spending itself, are arbitrary and irrational. This uniquely Austrian insight is the most critical facet of understanding why it is so difficult to reduce government spending. Government cannot calculate: it does not operate on the same basis as private enterprise.Although there are several superb Austrian writings on this subject, this article liberally utilizes Mises's treatment of this issue in Ludwig von Mises, Bureaucracy (New Haven: Yale University Press, 1946).
Businesses exist to serve customers. By bidding for factors of production (labor, land, and capital) entrepreneurs incur costs in making a final product for sale to customers, with the expectation of earning a surplus of yield over cost: profit.
In the free-enterprise system, customers are sovereign. Their ever-shifting tastes and demands determine what goods and services should be produced, in what quality, and whether each and every business earns or does not earn a profit. Consumers are integral in constantly shaping the quality, quantity, and types of goods and services produced in the market economy and the attendant utilization and remuneration of the various factors of production.
At the heart of the capitalist system is the reality that all business planning and decision making must be based on market prices. Prices are used to determine whether various configurations of the factors of production are available at prices low enough to yield a profit based on the expected prices customers are willing and able to pay for businesses' products.
It follows then that valuation of business performance can be made through the method of accounting. By accounting for the market prices paid for the business inputs (factors of production employed) and the market prices received for business outputs (products sold to customers), business managers may ascertain whether a profit or loss is being made. In particular, business managers can use this accounting information to identify which aspects of the business are yielding profits and which ones are not.
"At the heart of the capitalist system is the reality that all business planning and decision making must be based on market prices." In some cases cuts in certain parts of the business may be justified; in other cases a redeployment of factors of production from one line of the business to another may be necessary to improve profitability. Calibrating business operations to minimize costs and maximize profit is the task of business managers and entrepreneurs.This delicate balancing act to achieve profits gives rise to the business schools, MBA and other business education programs, and the innumerable business periodicals and self-help books published annually. The accounting ledger displaying profits and losses, based on market prices, allows business managers to make rational decisions about whether to cut spending, redeploy resources, or invest more capital in certain lines of production altogether.
Conversely, government does not operate by the rules of the marketplace. As the only organization in society — save criminal gangs — that parasitically thrives on plundering the fruits of others, its existence, purpose, and method of evaluation are distinctly different from business.
Government agencies do not operate on the basis of profit and loss; this method of calculation is inapplicable because government does not incur costs and receive revenues the same way a business does. Government operations are not funded through the sale of goods and services to customers; rather, monies are acquired through coercion — principally taxation — and then allocated to each agency through the Byzantine legislative process described earlier.
Regarding costs, government agencies' operations are confined to the lump-sum and dedicated line-item appropriations, regulations, and statutes meted out by legislators. The costs incurred to operate are based what is available on the market — e.g., the price of concrete for road construction — as well as approximations or imitations of market prices for inputs, such as wage rates for bureaucrats.The wage rates for bureaucrats are not based on the marginal productivity of wage-earners, as they are in the private sector. As there is no way of calculating the value of the service provided by government agencies, it follows that there is no way of determining the marginal productivity of each bureaucrat within the agencies.
Because there is no link between the "revenue" acquired by government agencies and the costs these entities incur to perform public functions, there is no way of utilizing the yardstick of profitability to evaluate whether agencies are performing a useful function.
As Ludwig von Mises succinctly puts it, "bureaucratic management is management of affairs which cannot be checked by economic calculation."Ludwig von Mises, Bureaucracy.
Unlike the business manager of a private enterprise, bureaucrats and elected representatives have no means of rationally evaluating the value of any public service. This means that any cuts to that spending are intrinsically irrational — one simply lacks a reliable means of making a decision. Given this vacuum of objective assessment criteria, legislators, voters, SIGs — and really, anyone — may manufacture their own methods of justifying an increase or decrease to any dime of government spending, whether through persuasion, political pressure, or any other means available. Constituencies necessarily drive the appropriations process.
Economic calculation does not apply to government services; that is fundamentally why cutting spending is so hard to do.
What Does It All Mean?Taken together, each of the factors above do much to explain why it is so difficult to reduce the scope of government through budget cuts. They also demonstrate the impossibility of calculating whether some government functions add economic value to the public, given government's inherent inability to operate according to profits and losses.
From the constituencies created by every dime of spending to the voters who tend to like government spending but hate to pay for it themselves, cutting budgets is extremely difficult, frustrating, and incremental. Given this reality, what do these impediments to fiscal austerity say about legislative politics and democracy itself?
"Because there is no link between the 'revenue' acquired by government agencies and the costs they incur, there is no way of utilizing the yardstick of profitability to evaluate whether agencies are performing a useful function." As Hans Hermann-Hoppe adeptly describes in Democracy: The God That Failed, the democratic state is inherently a "public" monopoly. Unlike privately owned monopolies — for example, monarchies where the sovereign generally has an incentive to moderate expropriations of property to preserve the realm's present value for heirs — state officials in a democracy are mere caretakers who cannot privately enrich themselves from ownership or sale of government property.
Rather, a moral hazard and tragedy of the commons ensues as bureaucrats, politicians, and special interests may merely exercise use of government property while being a member of the government apparatus, precipitating a strong inducement to maximize current use of government property, irrespective of whether such activities entail dire consequences for taxpayers and the economy at large.
As concerns government finance, officials conduct the borrowing, spending, and taxation, and enjoy the resultant political plaudits from the constituencies that benefit from state largesse, while other private citizens defray the expenditures and debts through taxation or government-stoked money creation.
Hoppe also points out that democracy abolishes the distinction between rulers and ruled. And it assumes that any member of the political system may ascend to the upper echelons of governance. Given the state's indispensable need to steal for its subsistence and the nearly unfettered entry into the ranks of the ruling class, democracy renders it that much easier for politicians and their connected special interests to accelerate exactions from the public, as the gates remain open for any individual or faction to gain access to governmental powers and impose the same taxes, regulations, and direct spending themselves. As democracy has taken root in the United States and elsewhere, jostling between rival political factions has not been about how flaccid or robust the state should be, but rather about what direction the state should take as its scope expands.
The ability of elected politicians and entrenched bureaucrats to institutionalize and enforce systematic predation and redistribution of private property is an outcome of the democratic ethos itself. Indeed, the grand bargain of democracy is this: every individual within the system — voluntarily or not — cedes the inviolable title to his or her property for the ability to elect, participate in, or marshal a political movement that competes for the privilege of seizing and spending everyone else's money. It follows that individual responsibility and private property ownership are seriously impaired and denigrated. Furthermore, the government-instituted "law of the jungle" fosters base, innate human characteristics such as envy, self-preservation, and keenness for gratification.
As Frédéric Bastiat explains in The Law, self-preservation and self-development are universal instincts among men, as is the preference to do so with the minimum amount of pain and the maximum level of ease. Plunder then is favored over production, so long as the risks and inputs of confiscation are not as agonizing or as indomitable as the painstaking act of production and exchange. When given an opportunity to seize private property or stipulate regulations on an owner's use thereof, as democratic rule is wont to do, participants in the political system vie for the chance to apply the state's coercive arm in service of their supporters' ends.
Bastiat argues that the onset of universal plunder undermines the purpose of law, which in his view is the collective organization of the individual right to defend life, liberty, and property. The moment law is perverted to engineer ends contrary to individual liberty — e.g., enshrining the notion that individuals are entitled to a portion of each other's property absent voluntary agreement — morality is pitted against the adulterated law. Thus, moral chaos is the outcome of democratization, as one must either relinquish respect for the law or compromise moral sense.
It's little wonder that cutting government spending is hard to do.
[This article is excerpted from chapter 21 of Human Action, the Scholar's Edition and is read by Jeff Riggenbach.]
The life of primitive man was an unceasing struggle against the scantiness of the nature-given means for his sustenance. In this desperate effort to secure bare survival, many individuals and whole families, tribes, and races succumbed. Primitive man was always haunted by the specter of death from starvation. Civilization has freed us from these perils. Human life is menaced day and night by innumerable dangers; it can be destroyed at any instant by natural forces which are beyond control or at least cannot be controlled at the present stage of our knowledge and our potentialities. But the horror of starvation no longer terrifies people living in a capitalist society. He who is able to work earns much more than is needed for bare sustenance.
There are also, of course, disabled people who are incapable of work. Then there are invalids who can perform a small quantity of work; but their disability prevents them from earning as much as normal workers do; sometimes the wage rates they could earn are so low that they could not maintain themselves. These people can keep body and soul together only if other people help them. The next of kin, friends, the charity of benefactors and endowments, and communal poor relief take care of the destitute. Alms folk do not cooperate in the social process of production; as far as the provision of the means for the satisfaction of wants is concerned, they do not act; they live because other people look after them. The problems of poor relief are problems of the arrangement of consumption, not of the arrangement of production activities. They are as such beyond the frame of a theory of human action that refers only to the provision of the means required for consumption, not to the way in which these means are consumed. Catallactic theory deals with the methods adopted for the charitable support of the destitute only as far as they can possibly affect the supply of labor. It has sometimes happened that the policies applied in poor relief have encouraged unwillingness to work and the idleness of able-bodied adults.
In the capitalist society there prevails a tendency toward a steady increase in the per capita quota of capital invested. The accumulation of capital soars above the increase in population figures. Consequently the marginal productivity of labor, wage rates, and the wage earners' standard of living tend to rise continually. But this improvement in well-being is not the manifestation of the operation of an inevitable law of human evolution; it is a tendency resulting from the interplay of forces that can freely produce their effects only under capitalism. It is possible and, if we take into account the direction of present-day policies, even not unlikely that capital consumption on the one hand and an increase or an insufficient drop in population figures on the other hand will reverse things. Then it could happen that men will again learn literally what starvation means and that the relation of the quantity of capital goods available and population figures will become so unfavorable as to make part of the workers earn less than a bare subsistence. The mere approach to such conditions would certainly cause irreconcilable dissensions within society, conflicts the violence of which must result in a complete disintegration of all societal bonds. The social division of labor cannot be preserved if part of the cooperating members of society are doomed to earn less than a bare subsistence.
The notion of a physiological minimum of subsistence to which the "iron law of wages" refers and which demagogues put forward again and again is of no use for a catallactic theory of the determination of wage rates. One of the foundations upon which social cooperation rests is the fact that labor performed according to the principle of the division of labor is so much more productive than the efforts of isolated individuals that able-bodied people are not troubled by the fear of starvation that daily threatened their forebears. Within a capitalist commonwealth the minimum of subsistence plays no catallactic role.
Furthermore, the notion of a physiological minimum of subsistence lacks that precision and scientific rigor that people have ascribed to it. Primitive man, adjusted to a more animal-like than human existence, could keep himself alive under conditions that are literally unbearable to his dainty scions pampered by capitalism. There is no such thing as a physiologically and biologically determined minimum of subsistence, valid for every specimen of the zoological species homo sapiens. No more tenable is the idea that a definite quantity of calories is needed to keep a man healthy and progenitive, and a further definite quantity to replace the energy expended in working. The appeal to such notions of cattle breeding and the vivisection of guinea pigs does not aid the economist in his endeavors to comprehend the problems of purposive human action. The "iron law of wages" and the essentially identical Marxian doctrine of the determination of "the value of labor power" by "the working time necessary for its production, consequently also for its reproduction,"Cf. Marx, Das Kapital (7th ed. Hamburg, 1914), I, 133. In the Communist Manifesto (Section II) Marx and Engels formulate their doctrine in this way: "The average price of wage labor is the minimum wage, i.e., that quantum of means of subsistence which is absolutely required to keep the laborer in bare existence as laborer." It "merely suffices to prolong and reproduce a bare existence." are the least tenable of all that has ever been taught in the field of catallactics.
Yet it was possible to attach some meaning to the ideas implied in the iron law of wages. If one sees in the wage earner merely a chattel and believes that he plays no other role in society, if one assumes that he aims at no other satisfaction then feeding and proliferation and does not know of any employment for his earnings other than the procurement of those animal satisfactions, one may consider the iron law as a theory of the determination of wage rates. In fact the classical economists, frustrated by their abortive value theory, could not think of any other solution of the problem involved. For Torrens and Ricardo, the theorem that the natural price of labor is the price that enables the wage earners to subsist and to perpetuate their race without any increase or diminution was the logically inescapable inference from their untenable value theory. But when their epigones saw that they could no longer satisfy themselves with this manifestly preposterous law, they resorted to a modification of it that was tantamount to a complete abandonment of any attempt to provide an economic explanation of the determination of wage rates. They tried to preserve the cherished notion of the minimum of subsistence by substituting the concept of a "social" minimum for the concept of a physiological minimum. They no longer spoke of the minimum required for the necessary subsistence of the laborer and for the preservation of an undiminished supply of labor; they spoke instead of the minimum required for the preservation of a standard of living sanctified by historical tradition and inherited customs and habits. While daily experience taught impressively that, under capitalism, real wage rates and the wage earners' standard of living were steadily rising, while it became from day to day more obvious that the traditional walls separating the various strata of the population could no longer be preserved, because the social improvement in the conditions of the industrial workers demolished the vested ideas of social rank and dignity, these doctrinaires announced that old customs and social convention determine the height of wage rates. Only people blinded by preconceived prejudices and party bias could resort to such an explanation in an age in which industry supplies the consumption of the masses again and again with new commodities hitherto unknown and makes accessible to the average worker satisfactions of which no king could dream in the past.
It is not especially remarkable that the Prussian Historical School of the wirtschaftliche Staatswissenschaften viewed wage rates no less than commodity prices and interest rates as "historical categories" and that in dealing with wage rates it had recourse to the concept of "income adequate to the individual's hierarchical station in the social scale of ranks." It was the essence of the teachings of this school to deny the existence of economics and to substitute history for it. But it is amazing that Marx and the Marxians did not recognize that their endorsement of this spurious doctrine entirely disintegrated the body of the so-called Marxian system of economics. When the articles and dissertations published in England in the early 1860s convinced Marx that it was no longer permissible to cling unswervingly to the wage theory of the classical economists, he modified his theory of the value of labor power. He declared that "the extent of the so-called natural wants and the manner in which they are satisfied, are in themselves a product of historical evolution" and "depend to a large extent on the degree of civilization attained by any given country and, among other factors, especially on the conditions and customs and pretensions concerning the standard of life under which the class of free laborers has been formed." Thus "a historical and moral element enter into the determination of the value of labor power." But when Marx adds that nonetheless "for a given country at any given time, the average quantity of indispensable necessaries of life is a given fact,"Cf. Marx, Das Kapital, p. 134. Italics are mine. The term used by Marx which in the text is translated as "necessaries of life" is "Lebensmittel." The Muret-Sanders Dictionary (16th ed.) translates this term "articles of food, provisions, victuals, grub." he contradicts himself and misleads the reader. What he has in mind is no longer the "indispensable necessaries," but the things considered indispensable from a traditional point of view, the means necessary for the preservation of a standard of living adequate to the workers' station in the traditional social hierarchy. The recourse to such an explanation means virtually the renunciation of any economic or catallactic elucidation of the determination of wage rates. Wage rates are explained as a datum of history. They are no longer seen as a market phenomenon, but as a factor originating outside of the interplay of the forces operating on the market.
However, even those who believe that the height of wage rates as they are actually paid and received in reality are forced upon the market from without as a datum cannot avoid developing a theory that explains the determination of wage rates as the outcome of the valuations and decisions of the consumers. Without such a catallactic theory of wages, no economic analysis of the market can be complete and logically satisfactory. It is simply nonsensical to restrict the catallactic disquisitions to the problems of the determination of commodity prices and interest rates and to accept wage rates as a historical datum. An economic theory worthy of the name must be in a position to assert with regard to wage rates more than that they are determined by a "historical and moral element." The characteristic mark of economics is that it explains the exchange ratios manifested in market transactions as market phenomena the determination of which is subject to a regularity in the concatenation and sequence of events. It is precisely this that distinguishes economic conception from the historical understanding, theory from history.
We can well imagine a historical situation in which the height of wage rates is forced upon the market by the interference of external compulsion and coercion. Such institutional fixing of wage rates is one of the most important features of our age of interventionist policies. But with regard to such a state of affairs it is the task of economics to investigate what effects are brought about by the disparity between the two wage rates, the potential rate that the unhampered market would have produced by the interplay of the supply of and the demand for labor on the one hand, and on the other the rate that external compulsion and coercion impose upon the parties to the market transactions.
It is true, wage earners are imbued with the idea that wages must be at least high enough to enable them to maintain a standard of living adequate to their station in the hierarchical gradation of society. Every single worker has his particular opinion about the claims he is entitled to raise on account of "status," "rank," "tradition," and "custom" in the same way as he has his particular opinion about his own efficiency and his own achievements. But such pretensions and self-complacent assumptions are without any relevance for the determination of wage rates. They limit neither the upward nor the downward movement of wage rates. The wage earner must sometimes satisfy himself with much less than what, according to his opinion, is adequate to his rank and efficiency. If he is offered more than he expected, he pockets the surplus without a qualm. The age of laissez-faire for which the iron law and Marx's doctrine of the historically determined formation of wage rates claim validity witnessed a progressive, although sometimes temporarily interrupted, tendency for real wage rates to rise. The wage earners' standard of living rose to a height unprecedented in history and never thought of in earlier periods.
The labor unions pretend that nominal wage rates at least must always be raised in accordance with the changes occurring in the monetary unit's purchasing power in such a way as to secure to the wage earner the unabated enjoyment of the previous standard of living. They raise these claims also with regard to wartime conditions and the measures adopted for the financing of war expenditure. In their opinion even in wartime neither inflation nor the withholding of income taxes must affect the worker's take-home real wage rates. This doctrine tacitly implies the thesis of the Communist Manifesto that "the working men have no country" and have "nothing to lose but their chains"; consequently they are neutral in the wars waged by the bourgeois exploiters and do not care whether their nation conquers or is conquered. It is not the task of economics to scrutinize these statements. It only has to establish the fact that it does not matter what kind of justification is advanced in favor of the enforcement of wage rates higher than those the unhampered labor market would have determined. If as a result of such claims real wage rates are really raised above the height consonant with the marginal productivity of the various types of labor concerned, the unavoidable consequences must appear without any regard to the underlying philosophy.
The same is valid with regard to the confused doctrine that wage earners are entitled to claim for themselves all the benefits derived from improvements in what union officers call the productivity of labor. On the unhampered labor market wage rates always tend toward the point at which they coincide with the marginal productivity of labor. The concept of the productivity of labor in general is no less empty than all other universal concepts of this kind, e.g., the concept of the value of iron or gold in general. To speak of the productivity of labor in a sense other than that of the marginal productivity is meaningless. What these union officers have in mind is an ethical justification of their policies. However, the economic consequences of these policies are not affected by the pretexts advanced in their favor.
Wage rates are ultimately determined by the value the wage earner's fellow citizens attach to his services and achievements. Labor is appraised like a commodity not because the entrepreneurs and capitalists are hardhearted and callous but because they are unconditionally subject to the supremacy of the pitiless consumers. The consumers are not prepared to satisfy anybody's pretensions, presumptions, and self-conceit. They want to be served in the cheapest way.
This article is excerpted from chapter 21 of Human Action, the Scholar's Edition and is read by Jeff Riggenbach.
Suppose there were food insurance. Rather than everyone paying for food with their own money, people would pay a certain fee to their insurance company every month, and in return the insurance company would pay for all of its clients' groceries.
Sound like a good idea? Perhaps, but what do you suppose would happen if we had this kind of food insurance?
One thing we should expect is that there would be a general increase in food consumption, with a particular increase in more-expensive foods. As of today, who can afford a Kobe porterhouse steak with white truffles and saffron, La Bonnotte potatoes and Almas Iranian caviar on the side, a Perrier Jouet Belle Epoque Blanc de Blanc to wash it down with, and a Chocopologie by Knipschildt and Kopi Luwak coffee for dessert? But if you're paying the same whether you get this or a hamburger with fries and a soft drink, why not give the steak dinner a try?
As more expensive foodstuffs become popular, cheaper food will become repackaged and given higher prices. Which would you pay more for: a can of green beans, or a can of hand-picked, hand-selected haricots verts? The French term for "green beans" just makes you want to spend a few dollars more on it, doesn't it?
Thus, consumers will drive up the overall cost of food. Indeed, insurance or not, it is always the consumer who is responsible for upward pressure on prices. This is kept in check by the fact that consumers have to spend their own, limited funds. Remove that check, and the check on prices will be removed as well.
Naturally, farmers will begin to make huge profits from this increased demand. There will be an expansion of the agricultural sector. More exotic foods will be introduced, and well-known food will, again, be repackaged and sold as more exotic in order to compete.
Since demagogues are always on the lookout for situations to exploit, farmers would then be cast as villains, unfairly profiting off the consumer. People do have to eat, after all. How can one profit off something people need to survive? One could expect several decades of demand that the government do something about rising food prices.
In the meantime, insurance companies will begin trying to figure out how to cut costs. Premiums will go up, making it harder for poorer people to afford food insurance. The government will likely step in to offer FoodCare and FoodAid for the elderly and the poor. Grocery stores will build up huge bureaucracies to deal with the private and government insurance, driving up prices still further as they cover those employees' wages.
"Rising prices are kept in check by the fact that consumers have to spend their own, limited funds. Remove that check, and the check on prices will be removed as well."Both private and government insurance will try rationing, negotiating prices with stores, and dictating what stores consumers can go to and what those consumers can buy. Demagogues will start complaining about the insurance companies, how they are charging high premiums but not allowing consumers to get what they want.
Eventually, people will begin to think that it's just awful that anyone has to pay for their own groceries at all. Stores won't display their prices, and store managers will act offended if you even ask about cost. And as people pay more to the insurance companies while getting less and less — people will of course have forgotten what it was like before insurance, when food was cheap and abundant — they will demand that someone do something about it.
And someone will. Regulations on agriculture, grocery stores, and insurance companies will increase, typically exacerbating problems in such a way that the companies will further be blamed for continued problems. The same problems will be used to justify more control over each industry. Finally, socialized food will be proposed.
With socialized food production and distribution come long food lines and limited rations among limited choices. (That is, when there's even food available.)
Don't think this could happen? All we need is a wartime excuse to cap wages on the average worker, giving employers an incentive to come up with nonsalary compensations — such as insurance — to attract workers. Something like the incentives adopted during the wage controls imposed during World War II.
Still think it couldn't happen? Change "food" into "healthcare," "grocery stores" into "hospitals," and "farms" into "pharmaceutical companies," and the above narrative can explain why the healthcare industry is in the situation it is in — and why we have moved more and more toward a socialized healthcare system in this country.
The bottom line here is that insurance of this kind — as opposed to catastrophic insurance like car insurance, which pays for accidents and not for oil changes and general repairs — creates moral hazard. Prices help provide accurate information, but when you are insulated from the real costs of something, you receive bad information about that product — and no one can make good decisions with bad information.
The less expensive something is, the more we are likely to consume. For example, my wife tells me she once had great insurance — a ten-dollar copay for anything. So she went to the doctor over the tiniest sniffle. Today she is a public school teacher, and as such her insurance is nowhere near as generous, so seasonal colds are waited out and treated with over-the-counter medicines that are cheaper (and work just as well).
I have no insurance, so I don't go to the doctor at all. Of course, if the US healthcare-insurance model had not been driving up prices for the better part of a century, I could afford to see the doctor anyway. But don't worry about me. The current federal health-insurance legislation will soon force me to buy insurance even though I can't afford it — and I, as well as those like me, will contribute to the next mortgage crisis when we are forced by law to buy insurance rather than choose, as I have done, to pay my mortgage instead.
In deciding to hire a worker, the employer does not ask himself what the worker gets as take-home wages. The only relevant question for him is, What is the total price I have to expend to secure the services of this worker?
This audio Mises Daily is narrated by Jeff Riggenbach.
[This article is excerpted from chapter 21 of Human Action: The Scholar's Edition and is read by Jeff Riggenbach.]
What the employer buys on the labor market and what he gets in exchange for the wages paid is always a definite performance which he appraises according to its market price. The customs and usages prevailing on the various sectors of the labor market do not influence the prices paid for definite quantities of specific performances. Gross wage rates always tend toward the point at which they are equal to the price for which the increment resulting from the employment of the marginal worker can be sold on the market, due allowance being made for the price of the required materials and to originary interest on the capital needed.
In weighing the pros and cons of the hiring of workers, the employer does not ask himself what the worker gets as take-home wages. The only relevant question for him is, What is the total price I have to expend for securing the services of this worker? In speaking of the determination of wage rates, catallactics always refers to the total price which the employer must spend for a definite quantity of work of a definite type, i.e., to gross wage rates. If laws or business customs force the employer to make other expenditures besides the wages he pays to the employee, the take-home wages are reduced accordingly. Such accessory expenditures do not affect the gross rate of wages. Their incidence falls entirely upon the wage-earner. Their total amount reduces the height of take-home wages, i.e., of net wage rates.
It is necessary to realize the following consequences of this state of affairs:
Audiobook read by Jeff RiggenbachIt does not matter whether wages are time wages or piecework wages. Also where there are time wages, the employer takes only one thing into account; namely, the average performance he expects to obtain from each worker employed. His calculation discounts all the opportunities time work offers to shirkers and cheaters. He discharges workers who do not perform the minimum expected. On the other hand a worker eager to earn more must either shift to piecework or seek a job in which pay is higher because the minimum of achievement expected is greater.
Neither does it matter on an unhampered labor market whether time wages are paid daily, weekly, monthly, or as annual wages. It does not matter whether the time allowed for notice of discharge is longer or shorter, whether agreements are made for definite periods or for the worker's life time, whether the employee is entitled to retirement and a pension for himself, his widow, and his orphans, to paid or unpaid vacations, to certain assistance in case of illness or invalidism or to any other benefits and privileges. The question the employer faces is always the same: Does it or does it not pay for me to enter into such a contract? Don't I pay too much for what I am getting in return?
Consequently the incidence of all so-called social burdens and gains ultimately falls upon the worker's net wage rates. It is irrelevant whether or not the employer is entitled to deduct the contributions to all kinds of social security from the wages he pays in cash to the employee. At any rate these contributions burden the employee, not the employer.
The same holds true with regard to taxes on wages. Here too it does not matter whether the employer has or has not the right to deduct them from take-home wages.
Neither is a shortening of the hours of work a free gift to the worker. If he does not compensate for the shorter hours of work by increasing his output accordingly, time wages will drop correspondingly. If the law decreeing a shortening of the hours of work prohibits such a reduction in wage rates, all the consequences of a government-decreed rise in wage rates appear. The same is valid with regard to all other so-called social gains, such as paid vacations and so on.
If the government grants to the employer a subsidy for the employment of certain classes of workers, their take-home wages are increased by the total amount of such a subsidy.
If the authorities grant to every employed worker whose own earnings lag behind a certain minimum standard an allowance raising his income to this minimum, the height of wage rates is not directly affected. Indirectly a drop in wage rates could possibly result as far as this system could induce people who did not work before to seek jobs and thus bring about an increase in the supply of labor.In the last years of the eighteenth century, amidst the distress produced by the protracted war with France and the inflationary methods of financing it, England resorted to this makeshift (the Speenhamland system). The real aim was to prevent agricultural workers from leaving their jobs and going into the factories where they could earn more. The Speenhamland system was thus a disguised subsidy for the landed gentry saving them the expense of higher wages.
[This article is excerpted from chapter 20 of Human Action: The Scholar's Edition and is read by Jeff Riggenbach.]
"Unemployment in the unhampered market is always voluntary."If a job seeker cannot obtain the position he prefers, he must look for another kind of job. If he cannot find an employer ready to pay him as much as he would like to earn, he must abate his pretensions. If he refuses, he will not get any job. He remains unemployed.
What causes unemployment is the fact that — contrary to the above-mentioned doctrine of the worker's inability to wait — those eager to earn wages can and do wait. A job seeker who does not want to wait will always get a job in the unhampered market economy in which there is always unused capacity of natural resources and very often also unused capacity of produced factors of production. It is only necessary for him either to reduce the amount of pay he is asking for or to alter his occupation or his place of work.
There were and still are people who work only for some time and then live for another period from the savings they have accumulated by working. In countries in which the cultural state of the masses is low, it is often difficult to recruit workers who are ready to stay on the job. The average man there is so callous and inert that he knows of no other use for his earnings than to buy some leisure time. He works only in order to remain unemployed for some time.
It is different in the civilized countries. Here the worker looks upon unemployment as an evil. He would like to avoid it provided the sacrifice required is not too grievous. He chooses between employment and unemployment in the same way in which he proceeds in all other actions and choices: he weighs the pros and cons. If he chooses unemployment, this unemployment is a market phenomenon whose nature is not different from other market phenomena as they appear in a changing market economy. We may call this kind of unemployment market-generated or catallactic unemployment.
The various considerations which may induce a man to decide for unemployment can be classified in this way:
The individual believes that he will find at a later date a remunerative job in his dwelling place and in an occupation which he likes better and for which he has been trained. He seeks to avoid the expenditure and other disadvantages involved in shifting from one occupation to another and from one geographical point to another. There may be special conditions increasing these costs. A worker who owns a homestead is more firmly linked with the place of his residence than people living in rented apartments. A married woman is less mobile than an unmarried girl. Then there are occupations which impair the worker's ability to resume his previous job at a later date. A watchmaker who works for some time as a lumberman may lose the dexterity required for his previous job. In all these cases the individual chooses temporary unemployment because he believes that this choice pays better in the long run.
There are occupations the demand for which is subject to considerable seasonal variations. In some months of the year the demand is very intense, in other months it dwindles or disappears altogether. The structure of wage rates discounts these seasonal fluctuations. The branches of industry subject to them can compete on the labor market only if the wages they pay in the good season are high enough to indemnify the wage earners for the disadvantages resulting from the seasonal irregularity in demand. Then many of the workers, having saved a part of their ample earnings in the good season, remain unemployed in the bad season.
The individual chooses temporary unemployment for considerations which in popular speech are called noneconomic or even irrational. He does not take jobs which are incompatible with his religious, moral, and political convictions. He shuns occupations the exercise of which would impair his social prestige. He lets himself be guided by traditional standards of what is proper for a gentleman and what is unworthy. He does not want to lose face or caste.
Unemployment in the unhampered market is always voluntary. In the eyes of the unemployed man, unemployment is the minor of two evils between which he has to choose. The structure of the market may sometimes cause wage rates to drop. But, on the unhampered market, there is always for each type of labor a rate at which all those eager to work can get a job. The final wage rate is that rate at which all job seekers get jobs and all employers as many workers as they want to hire. Its height is determined by the marginal productivity of each type of work.
Wage rate fluctuations are the device by means of which the sovereignty of the consumers manifests itself on the labor market. They are the measure adopted for the allocation of labor to the various branches of production. They penalize disobedience by cutting wage rates in the comparatively overmanned branches and recompense obedience by raising wage rates in the comparatively undermanned branches. They thus submit the individual to a harsh social pressure. It is obvious that they indirectly limit the individual's freedom to choose his occupation. But this coercion is not rigid. It leaves to the individual a margin in the limits of which he can choose between what suits him better and what less. Within this orbit he is free to act of his own accord. This amount of freedom is the maximum of freedom that an individual can enjoy in the framework of the social division of labor, and this amount of coercion is the minimum of coercion that is indispensable for the preservation of the system of social cooperation. There is only one alternative left to the catallactic pressure exercised by the wages system: the assignment of occupations and jobs to each individual by the peremptory decrees of an authority, a central board planning all production activities. This is tantamount to the suppression of all freedom.
It is true that under the wages system the individual is not free to choose permanent unemployment. But no other imaginable social system could grant him a right to unlimited leisure. That man cannot avoid submitting to the disutility of labor is not an outgrowth of any social institution. It is an inescapable natural condition of human life and conduct.
It is not expedient to call catallactic unemployment in a metaphor borrowed from mechanics "frictional" unemployment. In the imaginary construction of the evenly rotating economy there is no unemployment because we have based this construction on such an assumption. Unemployment is a phenomenon of a changing economy. The fact that a worker discharged on account of changes occurring in the arrangement of production processes does not instantly take advantage of every opportunity to get another job but waits for a more propitious opportunity is not a consequence of the tardiness of the adjustment to the change in conditions but is one of the factors slowing down the pace of this adjustment. It is not an automatic reaction to the changes which have occurred, independent of the will and the choices of the job seekers concerned, but the effect of their intentional actions. It is speculative, not frictional.
Catallactic unemployment must not be confused with institutional unemployment. Institutional unemployment is not the outcome of the decisions of the individual job seekers. It is the effect of interference with the market phenomena intent upon enforcing by coercion and compulsion wage rates higher than those the unhampered market would have determined. The treatment of institutional unemployment belongs to the analysis of the problems of interventionism.
This article is excerpted from chapter 20 of Human Action: The Scholar's Edition and is read by Jeff Riggenbach.
After the deaths of three bank employees, Greek president Karolos Papoulias lamented that the debt-ridden country had finally "reached the edge of the abyss." It should be so lucky. Abysses allow for falls into the deep unknown. If real wages would make the plunge, Greek workers would have a future with more options than striking and senseless destruction.
Many input prices — commodities for example — adjust instantly and painlessly on well-organized exchanges. Wages, however, are often fixed in advance, and comprise a large portion of input costs, making them the typical example of the sticky price.
Nobody likes taking a wage cut — present company included — but the deeper question is "why not?" Inflationary environments, with purchasing power constantly and inauspiciously confiscated from workers, create an intense dislike for nominal wage reductions. If prices are continually climbing for consumers' goods, a reduction in a nominal wage will result in significant cuts to one's purchasing power. The result of an inflationary environment is an engrained mindset — suspicious and, at times, intolerant of any wage cut.
Central banks — those institutions created to combat the reductions in output caused by downward sticky prices — paradoxically are the reason some prices exhibit this stickiness to begin with. As the money supply is increased, price inflation follows. As price inflation sets in, wage fixity becomes the norm; workers cry out against reductions in their purchasing power through nominal wage cuts (or even for a lack of wage increases paced with price inflation).
During periods of price deflation (or price constancy), nominal wage cuts need not necessarily translate into purchasing power losses. If, for example, prices of consumers' goods declined by 3 percent last year, and a waitress forwent any nominal pay raise, her real wage (in terms of purchasing power) would increase by the 3 percent in question.
Decades of central banks increasing the money supply have resulted in a sustained period of rising prices. Within the eurozone, this has been especially pronounced for many of the southern countries.
Greece has proven to be an extreme example. After its ascension to the European Union, Greece witnessed a period of increased demand for its government bonds. The decline in the perceived risk of default resulted in lowered interest rates. This seeming good fortune allowed for an orgy of spending, driving prices upward in a frenzied spiral.
A prime enabler of this inflationary boom was the European Central Bank (ECB), which was willing to accept the government bonds of any EU member state as collateral on its lending programs. Greek debt was effectively monetized, driving inflationary pressures higher.
The country's recent fiscal mess has done nothing to alleviate this precarious situation. The ECB will continue accepting Greek government bonds — now rated as junk — further monetizing the Hellenic republic's debts and prolonging the inflationary trap.
"Refusing to accept wage reductions, workers must accept unemployment."The trap strengthens, because the longer the inflationary forces reign, the stronger will be the workers' aversion to pay cuts. Refusing to accept wage reductions, workers must accept unemployment (which, thanks to relatively generous unemployment insurance, is already an attractive option for many). Without a productive workforce, exit from the current recession will be unlikely.
The Greek economy thus suffers from its abnormally high cost rigidity.
This problem is state-instigated. It is, for example, more expensive to transport a bag of potatoes from the mountainous north of the country to Athens than it is to transport the same bag from Athens to Germany. Freight, like many sectors of the Greek economy, is comprised of impenetrable cartels unwilling to adjust prices to the new reality.
Employees are by-and-large unwilling to accept wage cuts, for fear that continued price increases will destroy their purchasing power. A heavily unionized labor force complicates the process further, because any calls for austerity are met by aggressive protests at the spurring of union bosses. Current price levels make existing salaries unattractive for many. Thanos Petrou, an Athens University student, lamented that "If I get a job as a trainee lawyer, I'll only earn €300 a month. How can anyone survive on that?"
The plot thickens, unfortunately, when we look at further measures that will serve to reinforce the Greek loathing toward pay cuts. A true reckoning of wages can only be done on an after-tax basis. One does not go golfing, after all, and score only the strokes after the ball hits the green. With teams of IMF and eurozone bureaucrats pushing for austerity packages for Greek public-sector employees, tax adherence will come to the fore.
Few enjoy paying taxes, especially in Greece. Discrepancies between what people earn or the taxable assets possessed, and what is declared to the taxing authority are wide and widely acknowledged.
One wealthy suburb of northern Athens, where summer temperatures regularly reach 90 °F, had just 324 residents declaring pools on their tax returns last year. Tax investigators scrutinized satellite photos of the neighborhood and found the true number a little different — 16,974 pools were tucked away in backyards to provide refreshment during the steamy summers.
Similarly, a survey of 150 doctors in the trendy neighborhood of Kolonaki — with offices nestled between Prada shops and Chanel boutiques — found that half of all residents declared income of less than $40,000. Thirty-four claimed an income less than $13,300, the maximum level exempting them from all tax charges.
One study by the Federation of Greek Industries estimated that tax evasion could have amounted to upward of $30 billion last year. This money would go a long ways toward easing the ailing government's credit woes, and is sure to be found by the prying eyes of Greece's cautious saviors — sympathetic European Union countries and the International Monetary Fund. With the current bailout placing $146 billion (€110 billion) on the line, these creditors would be hard-pressed to allow such levels of blatant tax evasion to persist for long, lest their repayment be jeopardized.
Such behavior may prove more difficult to change in deed than word. Tax evasion is high in Greece for a myriad of reasons. Some reckon its long history of Turkish occupation makes Greeks skeptical of their government, and weary of funding it. Indeed, hiding wealth in a culture where the widespread belief is that money is an evil — the productive are thought to have plundered the unproductive and to be obligated to pay their retribution — is a rational response to preserve wealth. More likely, Greeks fundamentally disagree with the way that their tax euros are directed — one would be much less inclined to refuse remitting taxes if the cause at least matched their preferences.
Asking Greek workers to take a wage cut and start paying all their taxes will be a difficult sell — provided that prices do not swiftly decline.
Since the government will probably use the increased tax income to increase its own spending programs, pressures on price inflation will see little relief. Nor will inflation be tamed so long as the ECB continues to monetize Greek debt. With no respite from inflation, workers will not accept wage cuts (or even wage stability). With no fall in input costs — which are led by wage rates — output will decline. This output decline is "fixed" in the short term by increased taxation and more ECB-induced inflation completing the deadly cycle.
Greeks have little idea that deflation could be a healthy alternative, nor that taking wage cuts is an essential element of recovery. An oppressive tax regime has transformed them into a people reliant on dodging taxes to maintain their lifestyles.
The actions of the eurozone, and especially the ECB, over the past weeks have signaled that the mindset skewed toward expecting prolonged inflation will not change yet. Scores of eurozone bureaucrats will soon force the payment of taxes, so long avoided by the Greek populace. Neither outcome will usher the country to sustainable recovery.
[Excerpted from Defending the Undefendable. An MP3 audio file of this article, read by Jeff Riggenbach, is available for download.]
The scene is familiar from hundreds of movies featuring labor themes: the young eager worker comes to the factory for the first time, determined to be a productive worker. In his enthusiasm, he happily produces more than the other workers who have been at the factory many years, and who are tired, stooped, and arthritic. He is a "rate buster."
Not unnaturally, antipathy springs up between our eager young worker and his senior colleagues. After all, they are cast in a slothful role. In contrast to his youthful exuberance, their production levels look meager indeed.
As the young worker continues his accelerated work output, he becomes more and more alienated from the other workers. He becomes haughty. The older workers, for their part, try to treat him with compassion. But when he remains resistant, they subject him to a silent treatment and commit him to a worker's purgatory.
As the film continues, there occurs a climactic moment when the youthful rate buster comes to his senses. This comes about in any number of ways, all dramatic. Perhaps he sees a sick old woman, an ex–factory worker, or a worker who has been injured in the factory. If the movie in question is avant-garde, the conversion can be sparked through the good offices of a cat grousing around in an overturned garbage can. Whatever the method, the young man does come to see the error of his ways.
Then, in the last dramatic scene, which usually ends with all the workers — reformed rate buster included — walking off arm-in-arm, a kindly old worker-philosopher takes over center stage. He gives the young worker a five-minute course in labor history, from ancient Roman times down to the present, showing the constant perfidy of the "bosses," and proving beyond question that the only hope of the workers lies in "solidarity."
There has always been, he explains, a class struggle between the workers and the capitalists, with the workers continually struggling for decent wages and working conditions. The bosses are portrayed as always trying to pay the workers less than they deserve, pushing them as far as they can until they drop from exhaustion. Any worker who cooperates with the bosses in their unceasing, merciless, and ruthless efforts to "speed up" the workers, and to force them to increase their productivity levels, is an enemy of the working class. With this summation by the worker-philosopher, the movie ends.
This view of labor economics contains a tangle of fallacies that is interwoven with each part resting in complex ways on other parts. However, there is one core fallacy.
The core fallacy is the assumption that there is only so much work to be done in the world. Sometimes called the "lump of labor" fallacy, this economic view holds that the peoples of the world only require a limited amount of labor in their behalf. When this amount is surpassed, there will be no more work to be done, and hence there will be no more jobs for the workers.
"The core fallacy is the assumption that there is only so much work to be done in the world."For those who hold this view, limiting the productivity of the eager young workers is of overriding importance. For if these workers work too hard, they will ruin things for everyone. By "hogging up" the limited amount of existing work, they leave too little for everyone else. It is as if the amount of work that can be done resembles a pie of a fixed size. If some people take more than their share, everyone else will suffer with less.
If this economic view of the world were correct, there would indeed be some justification for the theory espoused by the labor-philosopher of the movie. There would be some justification for insisting that the younger and more active worker not take away more than his share of the "pie." However, adherence to this theory has proved to be inefficient and uneconomic, with tragic results.
This false view is based upon the assumption that people's desires — for creature comforts, leisure, and intellectual and aesthetic achievements — have a sharp upward boundary that can be reached in a finite amount of time; and that when it is reached, production must cease. Nothing could be further from the truth.
To assume that human desires can be fully and finally satisfied is to assume that we can reach a point at which human perfection — material, intellectual, and aesthetic — has been fully realized. Paradise? Perhaps. If it were somehow achieved, then certainly there would be no "unemployment" problem — for who would need a job?
There is as much work to be done as there are unfulfilled desires. Since human desires are, for all practical purposes, limitless, the amount of work to be done is also limitless. Therefore, no matter how much work the eager young man completes, he cannot possibly exhaust or even make an appreciable dent in the amount of work to be done.
If the eager worker does not "take work away from others" (because there is a limitless amount of work to be done), what effect does he have? The effect of working harder and more efficiently is to increase production. By his energy and efficiency, he increases the size of the pie — the pie that will then be shared among all those who took part in its production.
The rate buster should also be considered from another vantage point. Consider the plight of a family shipwrecked on a tropical island.
"To assume that human desires can be fully and finally satisfied is to assume that we can reach a point at which human perfection — material, intellectual, and aesthetic — has been fully realized."When the Swiss Family Robinson seeks refuge on an island, their store of belongings consists only of what was salvaged from the ship. The meager supply of capital goods plus their own laboring ability will determine whether or not they survive.
If we strip away all the novelistic superficialities, the Swiss Family Robinson's economic situation is that of facing an unending list of desires, while the means at their disposal for the satisfaction of these desires are extremely limited.
If we suppose that all the members of the family set to work with the material resources at their disposal, we would find that they can satisfy only some of their desires.
What would be the effect of "rate busting" in their situation? Suppose one of the children suddenly becomes a rate buster and is able to produce twice as much per day as the other members of the family. Will this young punk be the ruination of the family, "take work away" from the other family members, and wreak havoc upon the mini-society they have created?
It is obvious that the Swiss Family Robinson rate buster will not bring ruination upon his family. On the contrary, the rate buster will be seen as the hero he is, since there is no danger that his increased productivity would cause the family to run out of work. We have seen that for practical and even philosophical reasons, the wants and desires of the family are limitless. The family would hardly be in trouble even if several members were rate busters.
If the rate-busting family member can produce ten extra units of clothing, it may become possible for other members of the family to be relieved of their clothing manufacturing chores. New jobs will be assigned to them. There will be a sorting out period during which it is decided which jobs should be undertaken.
But clearly, the end result will be greater satisfaction for the family. In a modern, complex economy the results would be identical, though the process more complicated. The sorting out period, for example, may take some time. The point remains, however, that because of rate busting, society as a whole will move toward greater and greater satisfaction and prosperity.
Another aspect of rate busting is the creation of new items. Thomas Edison, Isaac Newton, Wolfgang Mozart, J.S. Bach, Henry Ford, Jonas Salk, Albert Einstein, plus innumerable others, were the rate busters of their day, not of quantity, but of quality. Each "busted" through what was considered by their society to be a "normal" rate and type of productivity. Yet each of these rate busters contributed incalculably to our civilization.
Print:$15 $13
MP3 $20 $15
An Audiobook in MP3 Format"Because of rate busting, society as a whole will move toward greater and greater satisfaction and prosperity."In addition to understanding rate busting from the point of view of quantity and innovation, rate busting should also be considered in terms of the new lives on this earth that it makes possible. The amount of human life that the earth can support is related to the level of productivity human beings achieve. If there are fewer rate busters, the number of lives this earth can support will be severely limited. If however, the number of rate busters increases significantly in each respective field, the earth will then be able to support an ever-expanding population.
The conclusion then is that not only are rate busters responsible for satisfying more of our desires than a slower, less efficient rate of production, they are also responsible for preserving the very lives of all those who would have to die were it not for the rate busters enlarging the scope of human satisfactions. They provide the means with which the increasing global birth rate can be supported.
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This article is excerpted from Defending the Undefendable. An MP3 audio file of this article, read by Jeff Riggenbach, is available for download.
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From Part I of A History of Money and Banking in the United States: The Colonial Era to World War II: "The History of Money and Banking Before the Twentieth Century". Narrated by Matthew Mezinskis.
When Rothbardian economists propose that the United States needs a Federal Reserve about as much as it needs a federal car company, it's not surprising that Keynesians ridicule the notion. What is surprising is that otherwise laissez-faire economists, particularly of the Chicago School variety, think that the market economy is good at producing goods and services except when it comes to money.
Specifically, these lukewarm free-marketeers think that, in a pure capitalist system, wages are "sticky." This observation supposedly proves the necessity of a central bank willing to inject whatever inflation is necessary to kick start the economy out of a deep recession.
As we'll see, this analysis is incorrect. Much of the alleged "stickiness" of wages is due to government policies, and the focus on macroeconomic aggregates overlooks the distortions among sectors that massive inflation causes. Economists who support the free market in other areas should bite the bullet and join the call to end the Fed.
The Alleged Problem of Sticky WagesIn his response to my earlier critique of his call for inflation, Greg Mankiw laid out the mainstream case. After quoting my argument that falling prices could restore equilibrium even if the economy needed "negative real interest rates," Mankiw wrote,
I think this analysis is correct, under the maintained assumption that prices (including wages) are completely and instantaneously flexible. But if prices are sticky, then the immediate deflation and concurrent increase in expected inflation won't occur painlessly. Instead, it would take a while for the price level to fall, and as we wait, the economy would suffer through a period of depressed economic activity.
According to conventional new Keynesian analysis, sticky prices are the ultimate market imperfection that makes aggregate demand matter. If you deny that prices are sticky and assume they can instantaneously jump downward to new equilibrium levels, many macroeconomic problems become much easier to solve. Indeed, you don't need to solve them at all, as the market would do it.
I wish we lived in the world that Mr Murphy describes, but my reading of the evidence is that we don't. (emphasis in original)
Mankiw is not alone in his view. For example, I recently debated a Fed economist who agreed with me on just about every major economic issue. But he thought that in periods when the demand to hold money increases sharply — such as in the early 1930s — that it is the job of the Federal Reserve to print new money to quench the thirst.
Because the Fed did not do so, it meant the exchange value of dollar bills had to rise, which is the same thing as saying that prices (quoted in dollars) had to fall. This led to massive unemployment, because workers' wages allegedly were much stickier than the prices of other products, meaning that businesses saw labor getting more and more expensive as the Depression intensified.
Finally, we have the case of Scott Sumner, a "right-wing" economist who is quite libertarian on most points. But Scott's claim to fame is that he thinks Bernanke was too timid during the crisis of 2008, and didn't create enough new money in the midst of the global financial panic. As a result, Scott thinks the United States suffered through an unnecessarily sharp recession, which a healthy dose of inflation could have greatly mitigated.
The Government Itself Makes Wages StickyAs so often happens, the proponents of government intervention are pointing to a problem that is greatly exacerbated by the government itself. Recall that the trouble stems from workers not being willing to take pay cuts. When the demand from employers drops, at the old wage rate there is now surplus labor — a.k.a. unemployment. Only when market wages drop to a lower level, so that demand once again matches supply, will equilibrium be restored in the labor market.
Now we have to ask, why do workers hold out for so long without jobs, insisting on wages that no one is willing to pay? After all, the other goods and services in the economy see their prices fall in a speedy fashion even though the sellers of these items depend on them for their livelihood. So if a street vendor knows enough to slash his hot dog prices when demand collapses, why don't hairdressers accept pay cuts when the same happens to their industry?
"After the 1929 crash, Herbert Hoover gathered the nation's leading businessmen for a conference in Washington and urged them to allow profits and dividends to take the hit, but to spare workers' paychecks."In the case of the Great Depression, the answer is simple enough: the federal government didn't allow wages to fall. After the 1929 crash, Herbert Hoover gathered the nation's leading businessmen for a conference in Washington and urged them to allow profits and dividends to take the hit, but to spare workers' paychecks. Rather than cut wages, businesses were supposed to implement spread-the-work schemes where workers would cut back their hours.
The rationale for Hoover's high-wage policy was that the worker supposedly needed to be paid "enough to buy back the product." Hoover had bought into the trendy new economic theory blaming depressions on underconsumption. The idea was that wage cuts would just cause workers to cut their spending, which would in turn lead to another round of wage cuts in a vicious downward spiral.
Because of the uncertainty and actual reduction in the stock of money (an accident of the fractional reserve banking system when people withdraw their cash from banks), prices in the economy fell drastically in the early years of the Depression. But because of pressure from the government, businesses allowed wage rates to fall very slowly. As a result, real wages (i.e., paychecks adjusted for price deflation) actually rose more quickly during the early years of the Depression than they had during the Roaring Twenties! Because labor got more and more expensive, unemployment surged to an unprecedented 25 percent by 1933.
In our times, the extension of unemployment benefits is the most obvious example of a government intervention that prolongs job searches. Rather than accepting a job for lower pay than they are accustomed to, laid-off workers can continue their quest for much longer than would be the case in a free market. (Incidentally, Chicago School economists agree, and so does Mankiw.)
To see that wages can adjust on a relatively free market, even in the face of massive shocks to the economy, consider the 1920–1921 depression. From its peak in June 1920, the Consumer Price Index fell 15.8 percent over the next 12 months — a one-year price deflation that was half again more severe than any one-year drop during the Great Depression.
Even so, the economy quickly bounced back and entered the prosperous 1920s. The answer wasn't a massive injection of Fed money, either; in fact the Fed had jacked rates up to record high levels.
On the contrary, the reason the US economy quickly adjusted in the face of massive price deflation was that wages fell quickly too, dropping about 20 percent in a single year.
There's More to an Economy than Aggregate Price LevelsIn the above section we saw that the argument that a free market has "sticky wages" and therefore requires massive doses of inflation simply doesn't hold up empirically. Ever since the 1930s, there have been systematic government (and labor union) efforts to prop up wages during economic downturns. In the relatively laissez-faire year 1920, wages fell quite rapidly to eliminate unemployment in the face of a collapse in prices.
But let's put all that aside, and tackle the issue head-on: Suppose that even on a relatively free market for some reason the demand to hold cash suddenly spikes. If the central bank stands by and does nothing, the increased demand for cash balances (with a constant stock of money) would lead to a general fall in the prices of goods and services. As businesses saw the demand for their products plummet, they would lay off workers. In principle, it could take years for wage rates to fall as much as other prices, meaning the economy would be operating below capacity for a long time.
"By dumping gobs of new money into a few access points of the economy, the central bank overlays the market's nuanced signals with a huge amount of interference."In our hypothetical scenario, couldn't the central bank alleviate the misery by printing up wads of new cash early on? That way, the demand to hold more money would be satisfied by an increase in the number of dollar bills rather than by a wrenching fall in prices.Notice that if someone wants to, say, double the amount of purchasing power in his wallet, he has two options: (A) He can get twice as many dollar bills, with prices staying constant, or (B) he can keep the same amount of dollar bills in his wallet, with prices falling by half.
To see why this suggested remedy is quite dangerous, let's forget about the sudden demand to hold more cash. Suppose we had an economy with a stable demand for cash, and all of a sudden the central bank doubled the money supply. What would happen?
Of course, in the long run, prices in general would rise, perhaps doubling. But in the interim, there would be other effects. In practice, when the central bank increases the money supply, it doesn't magically augment every single person's cash balance by the same percentage. No, some lucky recipients get the new money first. These people then have the ability to spend the newly created dollars at the old prices. They would therefore become relatively richer.
On the other hand, the people who were last in line to receive (or spend) the new money, would see prices rising at the store while their incomes were stuck at the old levels. These latecomers to the party would become relatively poorer.
Beyond the one-shot redistributive effects, there is also the damage caused by the existence of an inflationary central bank in the first place. Knowing that the bank had the ability to inject massive doses of new money into the market, investors and businesspeople would have less faith in the long-run purchasing power of the money unit. They would spend time and devote resources to hedging themselves against erratic central banking decisions, rather than focusing exclusively on the "fundamentals."
All of these problems hold true in a scenario starting with a sudden demand to hold more cash. In reality, it's not the case that every single person suddenly wants to increase his cash holdings by x percent, or that the central bank can instantly endow every person in the economy with the exact amount of new cash that he wishes to accumulate. (And even if it could, who wouldn't then say, "In that case, I'd like some more hundred dollar bills, please"?)
When people become fearful of the future in times of economic uncertainty, they naturally aim to bolster their liquid assets, especially their holding of money. But each person will cut back on his "normal spending" in a unique way. One person might cut out his weekly visit to his favorite restaurant, while another will sell some of his old baseball cards. In order for these subtle differences to be communicated through the economy, entrepreneurs need to see the changes in relative prices. In our example, workers need to leave the restaurant industry, while speculators may want to attend baseball card shows looking for bargains.
By dumping gobs of new money into a few access points of the economy, the central bank overlays these nuanced signals with a huge amount of interference. Only in simplistic macro models, which contain a few variables like M and P, does the "shock" of the increase in demand for money become perfectly offset by the increase in M. In reality, these two different disturbances don't cancel each other out. The economy is in fact left to deal with the real events that fueled the panic in the first place — people don't suddenly decide to hold a bunch of cash for no good reason — as well as the huge injection of money into the hands of politically connected bankers.
ConclusionThe argument of sticky wages does not justify the existence of a central bank. Market prices, including wages, are flexible enough to smooth out macroeconomic disturbances. To the extent that workers hold out for a better job, rather than take a pay cut, this too reflects a legitimate outcome on a free market. Only in a simplistic macro model, with ad hoc assumptions about wages and prices, can the central bank improve the economy.
[Excerpted from Ludwig von Mises on Money and Inflation: A Synthesis of Several Lectures, compiled by Bettina Bien Greaves. This lecture was given at the Foundation for Economic Education (FEE).]
Everything that is done by a government against the purchasing power of the monetary unit is, under present conditions, done against the middle classes and the working classes of the population. Only these people don't know it. And this is the tragedy. The tragedy is that the unions and all these people are supporting a policy that makes all their savings valueless. And this is the great danger of the whole situation.
The conditions under which people are living in the industrial countries of the West, which today means in practically all the countries where the standard of civilization has made some progress since the 16th or 17th century, the masses are in a position, fortunately, in the years in which they are able to work, in which they are in full health, to provide for the state of affairs as it will prevail in later years when they will either be absolutely unfit to work, or when their capacity to work will have decreased on account of old age or other changes.
Under conditions as they are today, these people can only provide for their old age practically by either entering into labor contracts that give them a pension for their later age, or they can save a part of their income and invest it in such a way that they can use it in later years. These investments can be either simple savings deposits with banks, or they can be life-insurance policies or bonds, for instance, government bonds that appear in many countries as perfectly safe. In all these cases the future of these people who are providing in this way for their old age, for their families and children, is closely connected with the purchasing power of the monetary unit.
The man who owns an agricultural estate, the producer of oil or of foods, or the businessman who owns a factory is in a different position. When the prices of the products that he is selling go up on account of the inflation, he will not be hurt in the same way in which other people are hurt by the inflation. The owner of common stock will see that, by and large, most of this common stock is going up in price to the same degree as the prices of commodities are going up on account of the inflation.
But it is different for people with fixed incomes. The man who retired 25 years ago with a yearly pension, let us say of $3,000, was by and large in a good situation or was believed to be in a good situation. But this was at a time when prices were much lower than they are today. I don't want to say any more about this situation and the consequences and effects of inflation for the people.
What I want to point out is that the greatest problem today is precisely this, although the people don't realize it. The danger is due to the fact that people consider inflation as something that hurts other people. They realize very well that they too have to suffer because the prices of the commodities they are buying go up continually, but they don't realize fully that the greatest danger for them is precisely the progress of inflation and the effect it will have on the value of their savings.
All over Europe today you see unrest due to the fact that the European masses are discovering that they have been the losers in all these financial operations, which their own governments have considered as a very wonderful thing. And, therefore, also from the point of view of making it possible for the masses to enjoy the improvement of economic conditions and to make them partners, real partners, in the great development of industrial production that is going on practically now already in all countries of Europe and North America, even including Mexico, it is necessary to abandon the policy of inflation.
The great unrest that is today characteristic of everything that is going on in Europe, the revolutionary ideas of the masses, especially of the sons of the middle classes who are studying at the universities, are due to the fact that the European governments, with the exception perhaps of the government of the little country Switzerland and other such very small countries, have in the last 60 years again and again embarked upon a policy of limitless inflation.Mises was referring to the student riots that took place in Paris in the spring of 1968. The British had devalued the pound on November 18, 1967, from US $2.80 to US $2.40 and there was an international gold crisis in March 1968. The French wanted to return to the gold standard. In May "rebellious students at the Sorbonne and elsewhere, rioted, battled police and were joined by some 10,000,000 workers who launched nationwide strikes and took over many factories. The nation was almost completely paralyzed." Finally after pay increases were awarded the strikers and Army tanks were called out, normalcy was returned in early June. See World Almanac, 1969, pp. 63, 72, 512–513.
When talking about conditions in France, one should not overlook what inflation actually means. The French were right when, in the 19th century and in the beginning of our century, they declared that the social stability and the welfare of France is to a great extent based upon the fact that the masses of the French population are owners of government-issued bonds and therefore consider the financial welfare of the country, of the government, as their own financial advantage. And now this has been destroyed.
Frenchmen who were not in business themselves, i.e., the majority of the population, were fanatical savers. All their savings were destroyed when the tremendous inflation reduced the value of the franc to practically nothing. The French franc may not have declined completely to zero, but for a Frenchman, who had $100 before and then had only $1 — for such a Frenchman, the difference was not very great. Only a very few people can still consider themselves owners of some property when their property is reduced to 1 percent of what it was before.
In talking about inflation, we should not forget that over and above the consequences of destroying a country's monetary standard, there is the danger that depriving the masses of their savings will make them desperate. For decades there were only a very few who would agree with me in this position. Even so, I was astonished to read today in Newsweek that the majority of the people in the nation are not interested in the preservation of the purchasing power of the monetary unit. Unhappily, the article did not say that the destruction of the savings of the masses was a much more serious matter than the famous war now being waged on poverty. It is ridiculous for the government to finance a "war on poverty"President Lyndon Johnson had announced, in his January 8, 1964 State of the Union address, an "unconditional war on poverty in America." The money was intended especially for "the chronically distressed areas of Appalachia." (World Almanac, 1965, p.142) By December of that year, Congress had appropriated $784.2 million for various projects in Appalachia and parts of 10 other states, primarily for highways and new jobs. (World Almanac, 1965, pp. 42, 47) by taxing, inflating, and spending, and so sacrificing the savings of the masses who are trying to improve themselves through their own efforts.
"The real war on poverty was the industrial revolution."This is one of the many contradictions that we have in our political, not our economic, system. To explain what I have in mind, consider the dreadful contradiction of the American government when it says: "We have to wage a war against poverty. Certainly many people are poor and we must make them wealthier." And yet this government taxes the people in order to make bread more expensive. You will say, "So, bread is more expensive; this is an exception." But it is not an exception! The American government spends also billions of tax money in order to make cotton more expensive. Cotton goods are certainly not luxury goods; they are perhaps luxury goods when compared with bread, but the government does the same thing, it follows the same policy, with bread.
The real war on poverty was the industrial revolution and the industrialization of modern factories. At the beginning of the 19th century, shoes and stockings were luxury items for most of the people of continental Europe; they were not articles of daily wear. And the condition of these people was not improved by taxing, by taking money or shoes from the rich to give to the poor. It was the shoe industry, not the riches of the government, that improved the condition of the poor, that made a revolutionary change in the peoples' condition.
A statesman may say, "If I had more money to spend I could do things that would make me very popular in my country." The government tries to make itself popular by doing these things, but the technique it uses is to spend; and then it tries to ascribe to itself the good results of an expenditure. An expenditure is not always good. Sometimes an expenditure is just buying bombs and throwing them into a foreign country.
But if the expenditure is beneficial, let us say if it makes it possible to improve some things in the country, then the statesman says, "Look, you never had such a wonderful life as you have under my regime. There are some bad people, some inflationists, some people who are profiteers, but I have nothing to do with them. This is not my fault." And so on.
Our economic situation depends largely on the relation of the government and the ruling political party or parties to the labor unions. We have "inflation," in the sense of higher prices, built into our economic system because the unions every year, every two years, or in exceptional cases every three years, ask for higher wages. The great majority of workers want continually higher wages and they assume wages can be manipulated ad libitum, at will, by the government.
The unions have the power, by using violence, with the aid of certain laws and of certain institutions in Washington, to force people to agree to their wage demands. If wages do not continue to go up, no one knows what will happen. The only possible solution to the inflation problem is an open opposition to the unions and to the idea that higher money wages are the only means for improving the condition of the masses. Union members should also realize that their conditions would improve if the money prices of the things they wanted to buy went down, even if their money wages did not rise. I do not want to say anything more about this problem except to add that the government started it when it began to increase the quantity of money by printing it.
To give an example of how inflation destroys savings, there was in a European country a poor boy educated in an asylum for orphans, very well educated because when he had finished school and his life in the orphanage he emigrated to the United States. In the course of a long life he accumulated a considerable fortune by producing and selling something that was very successful. When he died, after living 45 years in the United States, he left a considerable fortune of $2,000,000. Not everybody leaves such a fortune; this was certainly exceptional.
"The only possible solution to the inflation problem is an open opposition to the unions and to the idea that higher money wages are the only means for improving the condition of the masses."This man made a will according to which this $2,000,000 was to be sent back to Europe to establish another orphan asylum such as that in which this man had been educated. This was just before World War I. The money was sent back to Europe. According to the usual procedure it had to be invested in government bonds of this country, interest to be paid every year to keep up the asylum. But the war came, and the inflation. And the inflation reduced to zero this fortune of $2,000,000 invested in European marks — simply to zero.
To give another example, a German who in 1914 owned a fortune that was the equivalent of US $100,000 had left from that fortune nine years later one-half cent perhaps, something like that, or five cents — it doesn't make any difference; he had lost everything.
And there were similar experiences in the European universities. For instance, lots of foundations were set up in the course of centuries by people who wanted to make it possible for poor boys to study at the university and to achieve what they had achieved from the good education they had gotten at these universities. And what happened? In all these countries, in Germany, France, Austria, and Italy, there came great inflations. And these inflations again destroyed these investments. For whose benefit? For the benefit, of course, of the government. And what did the government do with the money? It spent it; it threw it away.
People still believe, however, that destroying the value of the monetary unit is something that does not hurt the masses. But it does hurt the masses. And it hurts them first. There is no better way to bring about a tremendous revolution than to destroy the savings of the masses that are invested in savings deposits, insurance policies, and so on.
An example of what I mean was furnished by the president of a bank in Vienna. He told me that as a young man in his 20s he had taken out a life-insurance policy much too large for his economic condition at the time. He expected that when it was paid out it would make him a well-to-do burgher. But when he reached his 60th birthday, the policy became due. The insurance, which had been a tremendous sum when he had taken it out 35 years before, was just sufficient to pay for the taxi ride back to his office after going to collect the insurance in person.
Now, what had happened? Prices went up, yet the monetary quantity of the policy remained the same. He had in fact for many, many decades made savings. For whom? For the government to spend and devastate.
If you talk about a catastrophe of money, you need not always have in mind a total breakdown of the currency system. Such a thing did occur in this country in 1781 with the so-called "continental currency." And it occurred in many other countries later, for instance, the most famous inflation, the breakdown of the German mark currency in 1923. These changes are not the same, nor to the same degree in various countries. But one should not exaggerate the difference in the effects brought about by the greater inflations as against the smaller inflations. The effects of the "smaller inflations" are also bad.
We must realize that in the market economy, in the capitalistic system, all interhuman relations that are not simply personal and intimate, all interpersonal relations, are expressed, made, counted in money terms. A change in the purchasing power of money affects everybody and not in such a way that you can say it is beneficial if the purchasing power of the money is going up or down.
"We must realize that in the market economy all interhuman relations that are not simply personal and intimate, are expressed in money terms. A change in the purchasing power of money affects everybody."All our relationships, the relations between individuals and the state, and between individuals and other individuals, are based on money. And this is true not only for the capitalistic countries. It is true for all kinds of conditions. For instance, in predominantly agricultural countries, in which the small- or medium-sized farm prevails, it is usual, necessarily usual, that at the death of the owner of such a farm, one of his children takes over the farm and the other children, the brothers and sisters inherit only a part of the farm.
The man who gets the farm has to pay to the others in the course of his life, step-by-step, the share of the inheritance that is theirs. That means that the man who inherits the farm gets no more and no less than the other members of the family. But when this is arranged by transferring the property to one heir and giving the others claims in money terms against this heir, claims to be settled in the course of the years, this means that everyday, if there is an inflation in progress, the share of the man who got the farm is increasing and the shares of the other brothers and sisters are sinking.
We have had in this country, continually now for several years, an outspoken inflationary increase in the quantity of circulating money. However, conditions are influenced by this situation. There has been a general rise in prices. You hear about it; you read about it; people compare prices and talk about it enough.
Yet I shouldn't exaggerate what has happened already to the dollar. What has happened to the dollar is still not something that makes a catastrophe unavoidable. If you were to go to certain other countries — Brazil or Argentina, for instance — you would be in a country that also has inflation, but a much bigger inflation. And if you ask a man in Brazil what he considers a stable money that does not drop in purchasing power, he would say, "The US dollar … that's wonderful!" Of course, it is when compared with his country's money.
The problem of money, the practical problem of money today in the whole world is precisely this: the governments believe that in the situation that I have pointed out before, when there is a choice between an unpopular tax and a very popular expenditure, there is a way out for them — the way toward inflation. This illustrates the problem of going away from the gold standard.
Money is the most important factor in a market economy. Money was created by the market economy, not by the government. It was a product of the fact that people substituted step-by-step a common medium of exchange for direct exchange. If the government destroys the money, it not only destroys something of extreme importance for the system — the savings people have set aside to invest and to take care of themselves in some emergency — it also destroys the very system itself. Monetary policy is the center of economic policy. So all the talk about improving conditions, about making people prosperous by credit expansion, by inflation, is futile!
From the introductory undergraduate to the advanced PhD courses in microeconomics, most students are taught that the concept of an indifference curve is very useful in analyzing individual choice. I emphasize the term "useful" for a reason. No professor I have asked about the concept ever said it was literally true. I don't think anyone who understands the concept would ever try to claim that this is how humans actually make choices. Rather, we have been instructed to treat the microeconomic models only as tools for prediction of phenomena.
Murray Rothbard and other economists of the Austrian School have rejected the concept of indifference and have developed an approach based on Menger's law of diminishing marginal utility and Mises's axiom of action. This approach, built upon ordinal rankings of human ends, is formulated in Rothbard's treatise Man, Economy, and State as the value-scale concept. Professor Rothbard used this concept to derive the laws of diminishing marginal utility and of demand and supply, and he used it to explain price formation and other economic phenomena.
However, Bryan Caplan, a George Mason University professor, claims that this value-scale approach is inadequate for explaining the so-called income and substitution effects of a price change. Caplan claims that, while Rothbard's consumer theory is not capable of explaining the distinction between the income and the substitution effects of a price change, Rothbard still uses these terms in his work. Professor Caplan goes on to argue that Professor Rothbard has "borrowed" these terms from mainstream neoclassical theory.
This claim is based on the observation that the mainstream neoclassical derivations of the income and substitution effects are based on the use of indifference curves and the constrained-optimization framework. The implicit assumption here is that that the derivation of the income and substitution effects in general is somehow dependent on the concept of indifference, and thus not possible within Rothbard's theoretical framework.
The thesis of the following article is that Caplan is wrong. It can be shown that a price change does indeed have its income and substitution effects within Rothbard's theoretical framework. A clear indication that Professor Rothbard was aware of this, although he did not go through the steps of explicitly demonstrating the two effects, is the following paragraph of his Man, Economy, and State:
All consumers' goods are, on the other hand, partial substitutes for one another. When a man ranks in his value scale the myriad of goods available and balances the diminishing utilities of each, he is treating them all as partial substitutes for one another. A change in ranking for one good by necessity changes the rankings of all the other goods, since all the rankings are ordinal and relative. A higher price for one good (owing, say, to a decrease in stock produced) will tend to shift the demand of consumers from that to other consumers' goods, and therefore their demand schedules will tend to increase.Man, Economy, and State, p. 282.
Thus, Rothbard notes that individual value scales are formed using one's knowledge of the relevant money prices and that a change in prices will change the ordering of different items on one's value scale. Consequently, a price change will have its substitution effect. Moreover, the idea that money prices are the key element of individual value scales is also at the root of Mises's regression theorem, which Rothbard elaborated at some length.
It also may be obvious that, given a fixed stock of money, an increase (or decrease) in the money price of an item reduces (or increases) the purchasing power of that stock, and thus reduces (or increases) the quantities of different items that can be purchased. Essentially, this is the economic meaning of the income effect of a price change.
However, given the claims that the value-scale approach is somehow inadequate for defining the income and substitution effects, it seems that there are still some benefits to going through the steps of the value-scale approach. I will demonstrate how and why a price change affects the purchasing power of a stock of money, and how and why substitution between different items takes place.
In the following sections, I will first present the mainstream neoclassical framework for deriving the income and substitution effects of a price change, and then develop an example of how Rothbard's value-scale approach could be applied to the problem.
The Indifference-Curve ApproachThe mainstream neoclassical consumer theory rests on the concept of an indifference curve. Within this framework, an indifference curve depicts all combinations (or bundles) of quantities of two goods that are associated with exactly the same level of utility. It is said that, without money prices attached to any of the two goods, an individual would be indifferent among all these bundles — he or she does not prefer any of the bundles.
Next, some assumptions about the properties of the individual utility function and the associated indifference curves are adopted to facilitate mathematical operations, namely, finding a unique solution using calculus. I will not go into the details of these assumptions, as they are elaborated elsewhere at great length. Instead, I will use an example to demonstrate how the effect of a price change is analyzed within this framework.
Suppose that figure 1 represents preferences for apples and oranges, and the budget constraint of a hypothetical consumer, Jim, in a two-dimensional coordinate system.
Figure 1
A graphical representation of a two-good constrained-optimization problem when the price of one of the goods changesJim faces the initial price of $1 per apple and $1 per orange, and he has some fixed budget to spend on apples and oranges. Budget line 1 shows all the combinations of apples and oranges that Jim can buy using his entire budget.
The indifference curve U1 depicts all bundles of apples and oranges to which Jim attaches exactly the same level of utility, U1. Any indifference curve closer to the origin of this coordinate system is associated with a lower level of utility. Similarly, any indifference curve further away from the origin is associated with a higher level of utility.
Jim will not want to buy any old combination of apples and oranges but the one that he values the most. This bundle is depicted by the point where his budget line is tangent to the indifference curve U1 (point A). Any other point on Jim's budget line would be on an indifference curve that is closer to the origin than U1, and thus associated with a lower level of utility. Consequently, point A depicts the combination of apples and oranges that Jim would purchase had he decided to spend his entire budget on apples and oranges.
Next, let us examine what happens when the price of oranges increases from $1 to $2 per orange. Now, Jim's budget line is represented by budget line 2. Oranges are now more expensive. Thus, for any given quantity of apples, Jim can now buy fewer oranges, using up his entire budget. For example, if Jim's budget was $5, he was able to buy, say, 1 apple and 4 oranges before the price increase. Now he can buy only 2 oranges if he wants to buy 1 apple.
In order to determine his optimal bundle, Jim will now find the point at which his new budget line is tangent to another indifference curve, U2, (point C). Point C depicts the combination of apples and oranges that Jim would buy had he decided to spend his entire budget on apples and oranges, given the new price of oranges.
It is evident that Jim is buying more apples and fewer oranges now. Let us focus on his consumption of oranges to further examine the effects of the price increase. First, we can see that his consumption of oranges has decreased by Δ oranges. This decrease could next be decomposed into the income effect and the substitution effect.
Figure 2 illustrates this decomposition process. Point B divides the total price effect (Δ oranges) into the income effect (IE) and substitution effect (SE). Point B belongs to a hypothetical budget line (BL 3) tangent to the indifference curve U2. The slope of BL 3 is determined by the initial prices of apples and oranges ($1 per apple and $1 per orange).
Figure 2
A graphical representation of the income and substitution effects within the constrained-optimization frameworkThis line shows by how much the initial income would have to be reduced in order to bring Jim's utility down to U2. In a sense, this is intended to show that a price increase reduces individual utility in a similar way as does a reduction in income.
Another important characteristic of the point B is that this is a point of tangency between the hypothetical budget line BL 3 and the indifference curve U2. This means that if only the income-reducing effect was taken into account, with the relative prices staying unchanged, Jim's new optimal bundle would be B. Thus, the reduction in the quantity consumed between the points A and B can be attributed to the income-reducing effect of the price increase. This is the income effect of the price change.
However, in addition to the income-reducing effect, the increase in the price of oranges also makes apples more desirable relative to oranges. This is why Jim substitutes oranges with apples and "moves" from point B to point C as his budget line becomes steeper under the new price of oranges. This is the substitution effect (SE) of the price change.
Many neoclassical economists would argue that this is the end of the story and that nothing more or nothing different could be said. However, Murray Rothbard had important criticisms of the above-presented approach. In essence, these criticisms boil down to the fact that this is not how we, humans, actually make decisions.For more details, see Rothbard's Man, Economy, and State
Taken literally, this approach would imply that humans solve complicated mathematical problems, involving differentiation of functions and many other operations, without even being aware of doing so. The typical defence of this mechanistic approach goes along the lines that the approach is useful as long as we don't interpret it literally but interpret it as if the consumers were making their choices in this manner.Nicholson. 2005. Microeconomic Theory: Basic Principles and Extensions. 9th Edition. Thomson: Willard, OH.
However, Rothbard was not satisfied with this justification and thus developed a different approach based on Menger's law of diminishing marginal utility and Mises's axiom of action. The next section presents an application of this approach to individual purchasing decisions where the individual is put in a similar context as before.
The Value-Scale ApproachThe consumer, Jim, from the previous section, would, according to Rothbard's framework, rank his ends in the order of diminishing marginal importance or utility. Next, he would assess the means available to satisfy these ends. In this case, Jim's specific ends are unknown to us, but we know that whatever they may be, the only means to satisfy them are the money that he owns and the apples and oranges that can be bought using that money. In the same fashion, he would then rank all his means in the order of diminishing marginal importance. In fact, he orders his actions in time, with the most important being performed first.
In the example presented above, Jim has some stock of money, say $5, that he wants to exchange for apples and oranges. The price of both apples and oranges is $1. Jim's particular ordering of apples, oranges, and money on his value scale is an empirical question, known only to him, but suppose that it looks like the distribution in figure 3.
Figure 3
A hypothetical value scaleWe can see that he would exchange the first dollar for the first apple, since the first apple is more important to him than the first dollar. Similarly, he would exchange the second dollar for the second apple, and the third dollar for the third apple.
At this point, Jim would stop exchanging his money for apples. This is because acquiring the fourth apple is less important to him than owning the fourth dollar — the fourth apple is lower on his value scale compared to the fourth dollar.
Moreover, the first orange is more important than the fourth dollar. This is why Jim would benefit from exchanging the fourth dollar for the first orange. Finally, he would exchange his fifth dollar for the second orange.
Jim has now exchanged the entire stock of money that he allocated for purchasing apples and oranges. He bought 3 apples and 2 oranges. In mainstream neoclassical language, this would be his "optimal" bundle of apples and oranges.
The next question that needs to be answered is what happens when the price of oranges increases from $1 to $2.
Looking at Jim's value scale in figure 3, it can be seen that he would not be able to buy the second orange. This is because, after spending the third dollar on the third apple, Jim would need to pay 2 dollars for the first orange. This would exhaust his entire stock of money, and thus, Jim would now have 3 apples and only 1 orange.
But this analysis ignores the fact that Jim's value scale is price-dependent. Any change in the price would involve a reordering of different items, or, to reiterate Rothbard's words:
A higher price for one good (owing, say, to a decrease in stock produced) will tend to shift the demand of consumers from that to other consumers' goods, and therefore their demand schedules will tend to increase.Man, Economy, and State, p. 282.
In fact, what I have done here is to demonstrate that, ceteris paribus, due to the increase in the price of oranges, Jim would have less money to spend on other items that are ranked lower on his original value scale. This is the income effect of a price increase.
The next thing that needs to be done is to take into account the fact that Jim prefers paying less for the same thing. This is because paying less for the same thing leaves more money available for satisfying other ends. Since it is always better to satisfy more ends compared to less, it is also better to pay less for the same thing. Consequently, Jim would choose a $1 orange over a $2 orange, given the chance to do so.Except in the case that Jim has some peculiar need for paying a higher price for oranges. This would, in turn, imply that the act of paying a higher price for oranges is one of Jim's ends. This would imply that the act of exchange is an end to itself, which removes the conventional economic meaning of exchange. Thus, it is assumed that paying a higher price for oranges is not one of Jim's ends. This implies that the first $2 orange must be lower on his value scale compared to the first $1 orange.
We could extend this reasoning and conclude that the first $3 orange would be ranked lower than the first $2 orange; the first $4 orange would be ranked lower than the first $3 orange, etc. The same applies for the second, third, and so on. This reordering could be continued indefinitely. Consequently, there is no lower bound on how low an item can move down the value scale as its price increases.
Thus, it may well be that the first $2 orange ends up not only below the first $1 orange but also below the fifth apple. Again, where, exactly, different items will end up is an empirical question that depends entirely on Jim's subjective valuations of his means and ends. At this point, I will hypothesize that Jim's new value scale looks like figure 4.
Figure 4
A hypothetical value scale after a price increaseAccording to this value scale, Jim will still exchange the first 3 dollars for the first 3 apples. However, the $1 oranges are not available anymore, and the $2 oranges are placed below the fifth dollar. This means that the fourth dollar will be exchanged for the fourth apple, and the fifth dollar will be exchanged for the fifth apple, since each of these two consecutive dollars is valued less than each of the two apples.
Finally, Jim ends up exchanging his $5 for five apples. Consequently, the quantity of oranges bought dropped from the initial 2 to 0. This is the total effect of the increase in the price of oranges. This total effect can be decomposed into the income effect, where, as shown earlier, the quantity of oranges bought fell from 2 to 1, and the substitution effect where the quantity of oranges bought fell from 1 to 0. However, these two effects happen simultaneously. The purpose of the chronological presentation is just to indicate the elements of the two effects with more transparency.
A similar exercise could be done for a price decrease. Then, the amount of money available for all other goods, placed lower on the original value scale, would increase. In addition, the relative desirability of the good whose price decreased would then increase. Thus, the income and substitution effects work both ways within the value-scale framework.
In this particular example, the effect of a price change on the quantity of oranges purchased was observable. But it is also possible that we do not observe any change in the individual quantity purchased of some good whose price increased or decreased. In these cases, we would likely observe only the income effect on the purchased quantity of other goods.
Suppose Jim was a passionate smoker. Then, for him, an increase in the price of cigarettes would likely have an impact only on the quantity of other goods that he would buy, but not on the quantity of cigarettes. This is because cigarettes are very high on his value scale. The price change may not be sufficient to "push" some quantity of cigarettes down his value scale to become less important than the last dollar in his stock of money. Rather, the reduction in the purchasing power of his stock of money would bring about a change in, say, the number of haircuts Jim has, and/or the number of evenings out, etc.Neoclassical economists using the indifference-curve framework might approach this problem using a Leontief utility function. The interested reader is encouraged to see a depiction of this function here
Clearly, more-complicated examples involving not only quantity but also quality of goods could be thought of. But this would be outside of the scope of this article, where the purpose was to demonstrate the derivation of the income and substitution effects using the value-scale framework.
ConclusionThe value-scale concept, when applied with all its elements, is capable of explaining the income and the substitution effects of a price change. Caplan's claim that the value-scale approach is inadequate for explaining these effects is simply an incorrect interpretation of Professor Rothbard's theoretical framework.
Brian Leiter is incensed.
Mr. Leiter — famous primarily for his website containing comparative rankings of philosophy programs, as well as his blog, which covers job-related news in academic philosophy — has recently learned that King's College, London (KCL) is facing budget problems and must cut back on staff. In order to assess the extent of layoffs, the school will require every faculty member to interview for their current position. Leiter has kept his readers updated on the situation through his blog, and linked to The Times Higher Education's coverage of the event — which, in an article titled "'Draconian' measure: King's to cut 205 jobs," emphasizes how the cutbacks will affect the humanities and focuses on the reaction this has set off among academics:
A proposal on "restructuring" in the School of Arts and Humanities, where 22 jobs are at risk, tells staff that "all academic roles … will be declared at risk of redundancy."
Selection of the redundancies "will be done through an assessment based on the performance of each role holder," it adds.
A group of 26 academics from nearby University College London have written to the head of the school, Jan Palmowski, warning that such a "savage reduction of staff numbers" would mean that the best candidates in the humanities will "shun the institution."
Only in academia — or in government — could the reduction of just over two hundred jobs from among thousands (and in this economic climate!) be considered "draconian" and "savage" in an unqualified sense. The reaction of these academics betrays the degree to which an entitlement mentality has permeated institutions of higher education.
"Draconian Measures" and the Entitlement MentalityNo one enjoys it when resources are mismanaged, time and money are wasted, and an organization must face tough decisions on how to clean up after its past mistakes. Sometimes these corrections include firing staff members, some of whom may have been hard-working and dedicated employees. However, while personnel changes caused by financial problems are often tragic, the alternatives — pretending that no such problems exist, for example — are much worse.
Unsustainable activities cannot continue forever, for the simple reason that they are wasteful by definition and must eventually either collapse or become a drag on the rest of society (e.g., through tax- or inflation-funded transfers of wealth). Those companies and institutions not on the public dole do not have the second option: profit and loss mechanisms ensure that all organizations which weigh down the rest of society are dissolved, reformed, sold to more capable owners, reorganized, etc.
However, this is not the case with universities and colleges, most of which are entirely state owned and the majority of which receive sizeable benefits supplied by the public. Administrators at these institutions enjoy the privilege of negotiating political solutions for their financial problems, which amounts to bypassing the need to please consumers first and foremost. Yet this comes at a cost: if you earn your living not by voluntary exchange but through entitlement, it is impossible to run an organization on sound financial principles.
During the good times, few notice the tension between economic reality and university policy. There is enough money to go around, and schools routinely enlarge their scope of activity by hiring promising young scholars and expanding the number of programs they offer. But when recessions hit and everyone is forced to rein in his spending, academics desire to retain their right not to be affected by the rest of the world's concerns. They ride the boom but refuse to feel the bust.
Leiter on KCL: A Moral ArgumentEven the reorganization of one school such as KCL — in this case, the reduction of a small percentage of its faculty — can send academics across the world into a fury. Brian Leiter comments on the situation:
KCL Philosophy is a remarkably consistent unit in terms of strength, so it is an insult that any member of staff should have to re-apply for his or her job. Indeed, we can go much further: it is an insult and an outrage that any professional hired with an expectation of permanent employment absent gross dereliction of duties should have to re-apply for his or her job.
Terms like "insult" and "outrage" imply that the morality of a matter is clear and needs little or no explanation. Yet it is not apparent why KCL's reorganization is such a case.
Granted, KCL has broken promises it made to its professors, who were "hired with an expectation of permanent employment." However, there are many situations in which breaking a promise — while undesirable — is nevertheless necessary in order to avoid an even worse state of affairs. When an institution makes grand promises of a prosperous future, it should be obvious that the fulfillment of such claims is simply not within its control. Who is KCL to decide that it will remain prosperous regardless of a change in the economic climate?
It's not outrageous to fall short of a promise you never should have made; on the contrary, to make questionable commitments is unwise and blameworthy in itself. Consider an industry that has experienced its own crisis in recent years: real-estate–management firms boasted record high profits in 2005, with promises of ever-greater expansion in the future. During 2007 I worked in a massive, new complex with offices, retail space, and residential areas that had been planned at the height of real-estate mania. It was built on the expectation of steady increases in real-estate prices, but to this day only a fraction of its condos and offices have been sold or leased. The project remains a massive failure.
The firm that executed the project, their investors, their clients, and their employees were all deceived: in reality, the real-estate boom was a sham, and the project, which seemed like a sure bet, never had a chance. And so the consequences for their foolishness had to be met. Promises could not be kept; painful cutbacks and reorganization were needed to survive. Many were disappointed.
Strangely enough, I have never seen any outraged letters to the editor about asset managers losing their jobs. Everyone recognizes that there was simply too much real-estate–related activity at the time, pushing too many, often ill-conceived projects. Most also realize that to continue the illusion can only delay the recovery and readjustment to normality. If there are too many workers in real estate, some of them need to find productive work in other fields.
The same principles must apply to higher education no less than they do to real estate, whether we choose to recognize this or not. The only difference — and the reason busts appear to go easy on universities — lies in the political connectedness of most schools. When times are tough, the taxpayers are expected to eat the lion's share of costs (since university professors after all are "hired with an expectation of permanent employment").
Perhaps one might object that KCL has done more than merely break a promise. One could take the position that tenure is a contractual obligation or close to it. On this view, revoking tenure would be like slashing pay in violation of an express and binding agreement.
To this I would respond that tenure is a privilege given to professors to solidify their academic freedom — the agreement is that a professor will not, for example, be fired one day only to be replaced by someone else the next. Schools nevertheless are free in times of financial difficulty to cut back on staff — including tenured professors — or even to eliminate an entire department. The objection we are considering takes the spirit of tenure to entail a near-contractual promise of lifetime employment. Yet such a contract would be foolish to the point of being untenable from the word go.
In business, promises and contracts made in a distorted market are often broken. While this phenomenon is unfortunate, it is often necessary. To be sure, there remain penalties to be paid and justice to be served; yet few would assert that the original, irrational promises and contracts must be maintained at all costs. Why should the situation in academia be any different?
Universities, no less than other industries, expanded during the good years. They undertook projects on the assumption that the money would continue to pour in. They promised life-long, paid positions that (were the boom revealed to be the sham it was) they were in no position to promise. The real moral outrage in this situation is the hubris with which academics and administrators themselves have acted — often assuming that their budget ought to rise continually without interruption or at most remain stable during difficult economic times.
Leiter on KCL: An Economic ArgumentLeiter's moral contempt is not the only argument he advances. He also makes an economic case against KCL's actions:
Besides the ugliness and cruelty of this whole business, it is clear the KCL administrators didn't consult any economists, for they might have learned that this whole maneuver will end up costing KCL much more money over the longterm. Here's why: if academics are not going to receive compensation in the form of job security, they are going to have receive [sic] it in the form of money. This effect won't be immediate, and, of course, KCL can dodge the consequence altogether if it decides that it doesn't want to compete at all in the major academic disciplines, or it decides it doesn't care who it appoints. But if KCL imagines it can remain part of the Russell Group, and get RAE results more to its liking, then it will have to appoint serious academics, and no serious academic will go near King's without either guarantees of job security (which won't be credible after this fiasco) or much higher compensation. [emphasis original]
Leiter's argument relies on the idea that academics today enjoy such advantages in their current or prospective employment that they can be picky in deciding where to work — and also that these privileges will continue well into the future. But is this really the case? Perhaps for a tiny minority of those considered elite in their respective fields of scholarship. However, ask any recent graduate with a PhD whether jobs are easy to come by, and you will receive a much different view on the state of finding work in academia.
Certainly, in a world where teachers and scholars are in short supply, colleges and universities must compete for competent workers with promises of high pay or other benefits (such as assurances of long-term job security). We do not, however, live in such a world: instead, recent PhDs search long and hard to find employment, often without any luck. In many cases they scrape together teaching "jobs" that consist of ad hoc assignments or adjunct positions rather than full-time, paid positions. This is especially true in the humanities, where the supply of teachers and scholars has long overpowered demand for them.
Leiter nevertheless seems confident that, from an economic standpoint, KCL is making a poor choice. Even though there are many capable-but-unemployed scholars in the world, professional pride, he believes, will keep worthy scholars and teachers from ever considering a teaching position at the school — absent costly incentives.
Again, while this may be true for a small handful of the elite in academic philosophy, the facts on the ground contradict his theory. All over the country, schools that advertise an open position receive hundreds of qualified applications for a single spot. Prospective professors often accept heavy teaching loads at low pay or accept non-tenure-track positions. Those who have teaching jobs, whatever their circumstances, consider themselves lucky to have them. Why should we think KCL, in this environment, couldn't find competent workers? (Which is worse: accepting a job with a potentially shaky future or remaining unemployed?)
Of course, Leiter isn't ruling out just any academic; he has in mind specifically the top talent in philosophy. Surely none of these will accept employment from a struggling institution. Yet the sheer abundance of workers, including many from top programs, eagerly seeking a job is a clear signal that good help will not be too hard to find. These young academics may not be well established in their field right now, but they are looking for an opportunity to do good work. A job to which someone of Leiter's stature might turn up his nose could very well be filled by a future star.
And even well-established scholars may not require extraordinary measures from KCL to consider employment there. KCL is experiencing a budget crisis now, but several years down the road — thanks, perhaps, to their current restructuring — they may be in much better financial shape than, for example, many state schools in the United States. This would put them in a position to make competitive offers to scholars working in struggling institutions. By that time (as we will see below), many schools will have since undertaken a KCL-like restructuring. It is difficult to imagine an unorganized, pride-induced embargo lasting through such circumstances.
Thus run Leiter's moral and economic arguments. It seems to me that in both cases he is confused. But there is a deeper issue at stake here. After all, Leiter is speaking in a manner consistent with general academic attitudes and practices: his opinions on the matter reflect those of most in the profession. Any time there is sustained, industry-wide support of an intrinsically unsupportable system, there is a good chance that interventionism is feeding ideas and practices which otherwise could not be sustained. The determination of academics to secure a lifetime guarantee, for all of their colleagues, on jobs that ought not to have been created is surely evidence that interventionism is involved.
The Bubble Must BurstDespite the systemic redirection of wealth from its most productive uses to the fantasies of academics and central planners, cracks are appearing on the surface of higher education. The bubble is not sustainable. Too many students attend school without good reason; too many jobs are held by too many highly paid teachers; too many programs are wasting money and time. Sorting out which are economically viable and which need to be liquidated is something that only a system of prices, established through voluntary exchange, can establish.
Even if universities are immune from having to please consumers, their customers (students) are not. In many cases — especially in the liberal arts, Mr. Leiter's field — earning a degree no longer pays off for the average graduate, and the increasing average rate of student-loan debt puts liberal-arts majors at a big disadvantage early in their careers. Many with bachelor's or even master's degrees are taking jobs that require no more than a high-school education. States themselves are increasingly unable to afford the cost of their patronage of higher learning.
At some point, institutions will need to reckon with reality and plan their own budgets accordingly. Along the way, private institutions that excel in education — not to mention taxpayers — will suffer, as state institutions continue to receive special consideration at the public trough.
What are colleges and universities to do? They will have to assess their current standing and find ways of consolidating their losses, in order to ensure that the most urgent needs of the institution are met and (if possible) provide for the survival of the school. But they face a dilemma: much of their payroll expenses are in the form of guaranteed jobs for life. They have been living beyond their means for years, relying on increasingly leveraged investments and public subsidies to keep the party going.
Their unrealistic promises and financial habits have put them in a bind: they must remove the dead weight, but they cannot simply eliminate their least-valued positions (as every other nongovernmental institution has been forced to do by the recession). Because of the public status of most schools, there are few market signals they can rely on to make their decision, and whatever they decide will spark further outrage. It seems as though everyone loses on the deal.
How Long Can the Facade Last?Mr. Leiter might be right, for now: the first schools that begin to face reality and cut back on staff will indeed face the scorn of the entirety of academia. There is no fair way to cut back on jobs when you have promised everyone a tenured position. Some qualified people who have dedicated themselves to your school will lose out.
$14 $12
There remains among many scholars an air of entitlement and invincibility. Many professors believe themselves to be among the least appreciated members of white-collar society and above "capitalist" concerns of profit and loss. But King's College, London and the state schools in California are merely the first fruits of a collapsing system — and notably one that has made us all poorer in the meantime. In recent weeks there have been an increasing number of schools who are considering or taking KCL-like action. Because of the problems created by the tenure system, the restructuring of these schools is guaranteed to be much more painful than it would otherwise have been.
The inevitable collapse — and the moral outrage of those it hurts — will continue for as long as the public buys into the myth that higher education (and its professors) are too important to have to keep their costs and production in line with consumer demand.
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[Chapter 9 of This Bread Is Mine]
We must return to Adam Smith.
This great economist and father of the modern theory of free markets propounded an error which has haunted us ever since.
Smith's "labor theory of value" was mistaken. However, David Ricardo accepted it and elaborated it. As elaborated by Ricardo, the labor theory of value was still further developed by Karl Marx. Thus, we have a socialist theory of economic value resultant from a doubly compounded error. This error has become the moral fulcrum on which the political socialist lever rests.
What Smith was getting at, and what most individualists would agree with, is the moral certainty that the laborer is entitled to the full product of his own labor. Indeed, earlier in this essay that has been listed as a basic right of every human being.
Getting All That You EarnThe "surplus value" theory of Marx is derived from the "labor theory of value" of Smith and Ricardo. Briefly, the theory can be explained thusly: It is evident that natural resources do not prepare themselves for the use of man. Human energy and tools must be applied to the resources before they can be converted into usable form and transported to places where a demand for them exists.
One does not pay money to natural resources. Nor does one pay money to tools. It may be an essential to pay the person who owns the resources or the tools. But essentially, all money passes from one human hand into another human hand. And the passage relates to the amount of labor performed by the human energy supplied in each case.
Thus, one does not buy logs or lumber for building; one purchases the labor that has gone into the felling of the trees, the milling of the lumber. What are the logs worth while they are still trees? Fundamentally, they are worth whatever it costs to convert them. And here is Marx: If more than that basic cost of labor is included in the purchase price, the element of profit or "surplus value" appears. If you must pay a lumberman five dollars to fell a tree, trim it, saw it into usable lengths and thicknesses, and then deliver it, the tree is worth five dollars, no more, no less.
Superficially, this is reasonable enough — reasonable, that is, if this were a world in which hand tools were all that could ever be employed, land could never be privately owned, and our wants were such simple things as log houses. We are far from such a world. Such a world is contrary to the nature of man's basic rights; there is no desire for such a world. The "labor theory of value" is fallacious and the notion of "surplus value" based upon it is equally in error.
What Smith, Ricardo, and Marx have done, and what the followers of the latter two continue to do, is to confuse the meanings of two important words: cost and value. While it may be true in the above instance that it might cost five dollars to produce the lumber from a given tree, the value of the lumber from that tree has no immediate relationship to cost.
Value, as Eugen Ritter von Böhm-Bawerk, Ludwig von Mises, and others demonstrate is inevitably the result of a subjective judgment. Lumber may cost $5, but the intensity with which you, as a purchaser, desire the lumber determine whether it is worth $1 or $20 to you. If it is worth only $1 to you, you will not purchase it if it is priced above that sum, regardless of the cost expended in producing it. Similarly, if you would be glad to pay as much as $20 for it, you will consider it a bargain if it is priced at $10, even though the cost of producing the lumber was $5 and the other $5 represents a profit to the producer.
In short, as a purchaser, you do not consider either cost or profit to others. You concern yourself with value, which relates to your own desire and your own ability to pay. It is in this area that Smith, et al., come to grief. They conclude that cost and value are the same thing.
Two Kinds of PiesPerhaps an illustration will best provide the demonstration. We are indebted to Leonard E. Read of the Foundation of Economic Education for the illustration. Let us suppose that "A" has a bakery. He hires a number of workers, buys the best raw materials, and produces the finest mince pies in town. His costs, including the interest on the money he has borrowed, the rent of the land he uses, and all of the other factors that enter into the equation, make it possible for him to produce these pies and deliver them to your door for 40¢. He charges 50¢.
Marx would insist that he should sell at a figure which excludes interest. But he may pay himself a salary for his pains. Marx in "Das Kapital" recognizes the validity of managerial work, contrary to popular belief, and wishes it to be paid for at a modicum. Marx will not recognize a profit as a legitimate part of the economic cycle.
So in the above case, he would hold that the man who has run the risk, borrowed the money, bears the responsibility, manages the enterprise and owns the tools, should receive only a salary and no more. We will deal with this idea in a moment. Let us concentrate on the 50¢ mince pie. At this price, the owner and manager can pay himself a salary and in addition can accrue a profit if business is brisk.
Now, let us consider "B." "B" also has a bakery. He hires the same number of workers as "A," buys the best raw materials, and produces the finest mud pies in town. His costs, the interest on the money he has borrowed, the rent of the land he uses, and all of the other factors that enter into the equation make it possible for him to produce these mud pies and deliver them to your door for exactly the same price as the mince pies of his competitor, "A." Now whether "B" insists on a profit or not, the fact of the matter is that it is almost inconceivable to imagine a going business in mud pies.
But, if Smith, Ricardo, and Marx are correct, then the product of "A's" factory, which costs 40¢ to produce, must be valued at precisely the value of the product of "B's" factory, since this product, also, costs just 40¢ to produce. If value is determined by cost, the mud pies and mince pies are of equal value if the sum expended to produce is equal.
Certainly, this is ridiculous. But this is the labor theory of value, to wit: The cost of the human energy expended in the production of any commodity is the value of the commodity.
One has only to imagine a situation such as this: Some enterprising genius discovers a way to manufacture yachts by an extrusion process which makes the cost of a yacht so small that it can be purchased in quantity lots for as little as $100 each. A second individual discovers a way to make elaborate igloos of ice and snow, completely equipped with air conditioning, which cost $1,000 each because of all the hand labor which must be utilized in the construction. In the Marxian catalogue, the igloo would be worth ten times what the yacht would be worth, regardless of the fact that many people would like to buy the yacht and there are virtually no takers for the igloos.
But, under Marxian or Fabian socialism, both industries would be owned and operated by the government; the taxpayers would underwrite the costs of both, and thus all persons would help to pay for igloos, of which few, if any, are wanted.
It is inconceivable that rational human beings could endorse such stupidity, but so cleverly have the results of socialist fallacy been hidden from them, and so thoroughly are they imbued with the holy grail of equality, that they shut their eyes to the certain results and blindly support the doctrine.
Question of ProfitNow let us examine more closely the "surplus value" concept, since the "labor theory of value" has been revealed for what it is. What Marx and other socialists envisage is the elimination of all profits, interest, and rent. What we must immediately do is to examine the nature of enterprise to discover, if we can, if enterprise can exist without the so-called element of surplus value, or profit.
Here the socialists contribute to their own downfall. For virtually, without exception, the socialist wishes to see all costs of production paid. What he is getting at, he says, is not the cheating of any human being, but rather the elimination of cheating. He wants the laborer to be paid what he is worth and not one cent less.
Very well, what are the costs of doing business? Again, we are indebted to the American Economic Foundation. There are only five costs. Whatever business you wish to select as an illustration, five costs will cover all expenses in connection with its operation. These five costs are:
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Goods and Services Furnished by OthersThe socialist will have no objection to meeting this payment. He expects those who furnish services and goods to be reimbursed. He just wants to make certain that profits are eliminated. But he has no objection to a person paying for the goods or services he hires. In fact, the socialist would insist that these things be paid for.
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Human EnergyHere the socialist will wax eloquent. This is precisely the point, he will tell you. He wants the human energy paid for at full cost value. So he certainly has no objection to item two.
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TaxesHere again you will find no objection from the dyed-in-the-wool wealth-sharer. Since he is probably privy to the fact that the socialist movement is in the process of transferring all goods and all wealth out of private hands and into the hands of the state, the socialist will strongly support taxes, even high taxes, which others must pay.
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Maintaining ToolsThis one will cause the socialist to review his position slightly. But if one presents his facts carefully, one can usually convince the collectivist that machines do wear out and must be replaced. Further, machines can be improved upon and such improvements or replacements cost money.
After careful review, the socialist will concede, though begrudgingly, for he rarely thinks about such mundane things as repairs, research, and maintenance, that item four is an essential. If tools aren't replaced, they are broken or worn out and there will be no more work. There is no job in existence which does not require a certain amount of tooling, from the steel man with his enormous blast furnaces, to the door-to-door salesman selling brushes.
- Using the ToolsAgain we remind the socialist that tools do not grow on trees, nor do they protrude from the wrist of homo sapiens. Tools have to be made. Also, they have to be paid for. And somewhere the money has to be found to provide the tools of production.
If you can convey the idea of paying for the use of tools, as well as the purchase of goods and services, the socialist is defeated. This is the most difficult point to get across. But non-socialists will ultimately see that the man who owns the tools will not permit others to use them unless he is paid for so doing. Why should he? Why should anyone share what he has with someone else unless he gets something in return?
So the tool owner wants to be paid for his goods and services, just as the shopkeeper wishes to be paid for his goods and the worker wishes to be paid for his labor. If you will not pay for the goods, you are not entitled to them. If you will not pay for the labor, you are not entitled to it. If you will not pay for the use of the tools, you are not entitled to use them.
If this is finally granted, behold, we have covered the item of profit. Profit is the payment to the owner of the tool for its use. The owner of the tool can be anyone. Tools can be owned by individuals, partnerships, or corporations. In the latter case, and especially when large and expensive tools are required, stockholders are the true owners. But whether the owner uses the tool himself or permits others to use it, a payment for that use is both essential and honest.
We have by no means exhausted this subject. But if a little time is spent on this formula of the five costs of production, it is simple to establish that there is no such thing as "surplus value," and that the "labor theory of value" is an oversimplification.
This article is excerpted from the book This Bread Is Mine.
Lecture 14 of 16 from Austrian Economics: An Introductory Course, presented at New York Polytechnic University in 1972.
Lecture 7 of 16 from Austrian Economics: An Introductory Course, presented at New York Polytechnic University in 1972.
Thou shalt not sell a certain product or service below a certain price, e.g. wheat, cotton, corn, cheese, sugar. This will result in an artificial unsold permanent surplus, as it does in the American farm situation. Initially resources are attracted into the field, but the artificially high price discourages buyer demand. This kind of interventionary tampering with market signals destroys the market tendency to adjustment and brings about losses and misallocation of resources in satisfying consumer wants.The principles of minimum price controls apply to minimum wage laws, which lead to involuntary mass unemployment.
Part 5 of 14. Presented in 1986 at New York Polytechnic University.
The disappearance of oil has been forecast every decade. Prices were overlooked. When the price is high it is more profitable to look for oil. Total reserves on the ground are higher than they were in 1890. Treating demand as a fixed quantity, the oil industry tried to control production and prices. Gas rationing was implemented. 55 MPH limit was legislated without economic or safety benefit. Safety belts increased fatalities of pedestrians. Natural gas experienced increasing shortages when it became artificially cheap. An insane price structure led to the shut down of older wells.
Part 4 of 14. Presented in 1986 at New York Polytechnic University.
In the last several months, retail stores have sales on all sorts of products. Discounts go as far as 90% off. Some of these widespread price reductions can be attributed to the holiday season behind us, while most of them, it seems, were triggered by the recent fall in consumer demand due to the macroeconomic downturn.
This might induce some individuals to be concerned that sellers are now highly inclined to use little tricks to compel us to buy things we don't really need or want. For example, the "buy-one-get-one-half-off" deal, where, as the name says, the buyer pays the whole price for the first unit of a good but only half of the price for the second unit.
Some writers caution against buying something one does not really need just because it is offered under the buy-one-get-one-half-off deal. Some describe it as "slick marketing," and others advise people to beware of such deals because they are just 25% discounts in disguise. The purpose of this article is to shed some more light on this issue in the hope of showing why this type of discount is as popular as it is.
The Popularity PuzzleTyping the phrase "buy one get one half off" in Google search, results in about 7 million hits (for the exact phrase), while the number of hits for "25% off" is about a tenth of that (i.e., somewhat more than 700 thousand). This could be interpreted as a rough indication that the first discount option is much more popular than the second.
But, cutting the price of the second unit of a purchased good by 50% is arithmetically equivalent to reducing the price of both units by 25%. Why wouldn't the sellers just offer a buy-two-for-25%-off deal instead of going through the hassle of pricing different units of the same good differently?
One might think there is no difference between buying two units for 25% off and buying the first unit for the full price and the second pair for half price. As a result, one might think that this is a trick to make the buyer feel like he or she made a good deal when he or she really didn't. What's the "trick?" What do these "sneaky" sellers know that we don't? How is it that they are able to "manipulate" us over and over again?
Similar hints of negative ethical judgment can be found in some economic literature, resting on the works of Alfred Marshall. This type of deal would be characterized as price discrimination. According to this interpretation, the seller tries to charge the highest possible price a buyer is willing to pay for a product and thus transfer some "amount" of "consumer's surplus" (i.e., consumer's benefits from an exchange) into his own hands.[1]
However, this approach still fails to explain why sellers would prefer to offer buy-one-get-one-half-off instead of buy-two-for-25%-off. The average per-unit price would be the same. It must then be that this type of deal is offered because consumers prefer it.
But, what is the merit of such deals for consumers? Is this just an illusion? As it will become apparent in the remainder of this article, there is a much more plausible explanation than a persistent inability of buyers to recognize the "trick."
The fact that the buy-one-get-one-half-off deals have existed for quite a while, and that there are many people who continue to participate in them, suggests that this is not simply a trick. If it were, one would expect people to learn from their experience and to start avoiding such deals the same way most people learn to recognize and avoid con artists. Thus, it seems that this particular exchange arrangement has evolved simply because it tends to work well for both parties involved.
The Economic ExplanationFirst, we need to know about the law of diminishing marginal utility, formulated by Carl Menger, further elaborated by Ludwig von Mises and Murray Rothbard, and recently clarified by Art Carden. This law states that a person values the first-acquired unit of a good the most.
"Value scales are purely ordinal. Thus, no meaningful comparisons in distance between pairs of points on one's value scale are possible."Each next unit is valued less than the previous one. This is because humans rank their wants and needs. The higher the rank, the higher the value attached to the unit of a homogeneous good used to satisfy that want or need.
With the first acquired unit, we satisfy the most highly ranked want or need. Thus, the first-acquired unit of a good is valued the most. The next unit goes to satisfy the next want or need, which is, by definition, ranked lower than the previous one and higher than the next one.
The other fundamental element is to realize that human decisions are made at the margin. Whether one will acquire an additional (i.e., marginal) unit of some good is determined by the value of whatever needs to be given up in order to acquire that unit.
As long as the last unit of a good acquired is valued more than anything else that needs to be given up in return, a person will keep acquiring additional units of that good. Since each additional unit of a homogeneous good is valued less than the previous one, there is a point at which the value of the next unit that could be acquired becomes less than the value of something else that needs to be given up.
In our everyday life, money is generally seen as the good that is being given up in return for consumption goods and services. Actually, what is being given up is the alternative use of that money.
When deciding on a purchase, a person assesses the value of an item and compares it with the values of other things that could be obtained using the money needed to make that purchase. To illustrate this marginality principle, I will present several scenarios involving a buyer and a seller.
Consider a person, Jim, buying shoes. Suppose that the price of a pair of shoes is $100. Jim would be willing to pay $100 for the first pair of shoes. The value that he attaches to the second pair of shoes is lower than for the first pair. This is because, as said earlier, the first pair goes for satisfying a more important need or want.
Jim is willing to pay, say, $60 for the second pair, but not $100. For him, the value of the second pair is less than the value of something else that he could acquire using the additional $100. Thus, Jim decides not to buy the second pair.
Suppose that, prior to buying the first pair of shoes, Jim had $150 in his pocket, and suppose that he knew that there was a sweater in another store priced at $75 and t-shirts priced at $25 each. Deciding to buy the first pair of shoes for $100 implies that the $75 sweater must be foregone in order to have the shoes. In other words, a pair of shoes was more important to Jim than the sweater. With the remaining $50, he may buy two t-shirts. Suppose that he chose to do so. As a result he spent $150 on one pair of shoes and two t-shirts.
Consider now a different scenario. Suppose that the shoe seller, Janis, realized that her sales were slow and decided to cut the price by 25%. Now shoes can be bought for $75 a pair. Imagine that Jim is being faced with this choice instead of the one in the first scenario. He would be happy to buy the first pair of shoes for $75 instead of for a $100.
Now, he is left with $75 to use for something else. Suppose that he chooses to spend the remaining $75 on the sweater. This means that he valued the sweater more than anything else he thought of doing with the remaining $75, namely, either saving the $75 for tomorrow or exchanging it for either the second pair of shoes or for two t-shirts and $25 left in his pocket.
Finally, suppose that instead of the previous two scenarios, Jim came to the store after Janis had realized that the 25% price reduction wasn't such a good idea. She was originally hoping that after the price reduction, people that were not willing to pay $100 for a pair of shoes may decide to buy them for $75 and that this increase in quantity sold would be more than enough to offset the reduction in price.
However, it turned out that this didn't work, and Janis's total revenue ended up lower than she had expected. This means that the price reduction did not attract enough people to be worthwhile. It seems that offering a deal where some customers would choose to buy two pairs of shoes instead of only one would be a better option.
"There is nothing inherently knowledge-concealing in the offer. In fact, the structure of the offer has important information built into it."Now, Janis is considering offering the 25% reduction only to people who want to buy two pairs of shoes. This way, she would not lose out on those customers that would buy only one pair for $100, regardless of the discount. Additionally, she may provide an incentive for those that would buy two pairs for $150 to buy the second pair. She realizes that there are two ways she could do this: she could say, (1) "if you buy two pairs, I'll take 25% off the price," or (2) "buy the first pair for $100 and get the second pair for half price."
Suppose she decided to use the second option. This means that the price of the second pair of shoes would now be $50. Imagine that Jim is facing this offer. We know that he would buy the first pair of shoes because, for him, this is the most important item that he doesn't have, and it is more valuable than anything else that he could obtain in exchange for $100.
Next, Jim has a choice between saving the remaining $50 for tomorrow or spending it on either the second pair of shoes or two t-shirts. If the second pair of shoes is more valuable to him than either the t-shirts or having the $50 tomorrow, he will buy the second pair. Suppose that this is exactly what happens: Jim buys two pairs of shoes, the first for $100 and the second for $50.
Note that the average price of the shoes did not change compared to the situation when all shoes cost $75 a pair (or 25% off). As a result, Janis sells two pairs of shoes for a total of $150. She is happy about selling more shoes at the same unit price — her total revenue is higher. Jim is happy because he exchanged $100 for a pair of shoes worth to him more than $100 and $50 for a pair of shoes worth to him more than $50. As a result, Jim and Janis participated in a mutually beneficial exchange. Thus, both benefit.
But, one might say, "Wasn't Jim tricked into buying the second pair if he didn't want to pay $150 for two pairs in the previous scenario?" No, and here's why:
Following the theoretical framework of Murray Rothbard, we can reconstruct Jim's scale of preference. This is shown in Figure 1, where money that he owns and objects that he does not own are ranked on a single scale in the order of decreasing importance. Exchanging his money for things higher on his value scale makes Jim better off.
Figure 1A hypothetical individual value scaleAccording to this value scale, Jim would be better off if he exchanged $75 for the first pair of shoes and the next $75 for a sweater, when faced with a uniform 25% reduction in price. Since having either two t-shirts and $25 for tomorrow or a second pair of shoes is lower on his value scale, these items are given up in order to obtain what is more important — one pair of shoes and a sweater.
In the buy-one-get-one-half-off scenario, Jim would still exchange $100 for the first pair of shoes, because he values the first pair more than $100. But now, only $50 is left to be used for other purposes. He cannot buy a $75 sweater any more. Note that he would not try to buy a sweater instead of the first pair of shoes, because the sweater is valued less than the shoes.
Thus, the sweater must be given up in order to have a pair of shoes. The next best thing Jim can do with the remaining $50, according to his value scale, is to buy the second pair of shoes for $50. The need for two t-shirts was left unsatisfied because it was less important than the need for a second pair of shoes. Again, Jim benefits because he exchanged something he values less ($50) for something that he values more (a second pair of shoes).
Benefits from Exchange RevisitedIn all three scenarios, the buyer, Jim, did the best he could given the circumstances. The seller, Janis, also did her best to understand these circumstances and make the best of them for herself. Jim would choose to buy the second pair of shoes if it was priced at $50, but he would buy a sweater if both pairs were priced at $75. It is hardly Janis's duty to forego profit just for the sake of knowing that she induced Jim to spend his money in another store.
"Offering two pairs of shoes for $150 would create an artificial unit for mental analysis. For most people, the appropriate unit of shoes is one pair."In addition, we are unable to say whether Jim would benefit more from exchanging the first $75 for a pair of shoes and the next $75 for a sweater, compared to exchanging the first $100 for the first pair of shoes and the next $50 for the second pair. Murray Rothbard, in his Man, Economy, and State, points out that value scales are purely ordinal. Thus, no meaningful comparisons in distance between pairs of points on one's value scale are possible.
Thus, Jim was not tricked into doing something he would regret, given that his knowledge of his own wants and needs does not change later. Indeed, even if his knowledge does change, the deal itself had nothing to do with that. There is nothing inherently knowledge-concealing in the offer. In fact, the structure of the offer has important information built into it.
It turns out that the really interesting question is not whether Jim is better off or worse off in one or the other situation. The more interesting question is, why would Janis choose to offer a buy-one-get-one-half-off deal and not buy-two-for-25%-off?
The answer has much to do with the above described marginality principle. In short, Janis was wise enough to choose the language more palatable to Jim, the buyer. She eased Jim's assessment of the value of the two pairs of shoes by allowing him to assess each pair's value separately.
Offering two pairs of shoes for $150 would create an artificial unit for mental analysis. For most people, the appropriate unit of shoes is one pair. People rarely have a single immediate end that would be satisfied by purchasing two pairs of shoes. Thus, when offered two pairs up front, people first need to disaggregate the offered two-pair unit into one-pair units and align them with different ends on their value scales, together with different combinations of money prices that add up to $150.
This is an additional effort that can easily be avoided by specifying the price of each pair separately. Taking into account the law of diminishing marginal utility, Janis translated this offer into a more understandable language — the language of human action.
Conclusion$50 $40
Some buyers may be willing and able to take the additional time and effort needed to translate less-understandable offers into a more-understandable language. But there may be some that would not bother. It is in the sellers' best interest not to lose these buyers.
Equivalently, it is in the best interest of the buyers, the customers, to be offered a deal that is convenient for mental calculation so that they don't forego potentially beneficial purchases. However, expecting the seller to leave money on the table for no apparent reason would be unrealistic. After all, as motivated producers are necessary for providing marketable goods, so motivated sellers are necessary for delivering these goods to the willing buyers.
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Notes[1] For an excellent critique of quantifying benefits from exchange, refer to pages 257–268 of Murray Rothbard's Man, Economy, and State.
Price is determined by the equilibrium price and the equilibrium quantity. If your good is not selling, you lower the price. If your goods fly off the shelves you are selling too cheaply and you raise prices. Demand changes constantly, e.g. the shift to white wines away from dark hard liquor. Prices will fall when demand falls.
Part 3 of 14. Presented in 1986 at New York Polytechnic University.
William H. Hutt's outstanding accomplishment is his pathbreaking reconstruction of the macroeconomic analysis of price and resource allocation, the long-established core of neoclassical economics. He demonstrates its indisputable and abiding relevance to the macroeconomic problems of inflation, unemployment, and depression. In the course of this undertaking, Hutt presented a theory of unemployment and depression that, while completely consistent with the important macroeconomic truths embodied in a rehabilitated Say's Law of markets, is fully capable of explaining observed macroeconomic fluctuations, including the puzzling and seemingly intractable contemporary problem of stagflation.
Hutt's contribution takes on added significance when it is recognized that it came during an era, roughly from the late 1930s to the late 1960s, when all but a tiny handful among the economics profession had abandoned such grueling enterprises for the facile, aggregative analysis propounded by John Maynard Keynes. In that epoch of virtually unchallenged Keynesian ascendancy, Hutt's work served as a beacon for those who refused to renounce the truth that an adequate explanation of economic phenomena must refer to the choices and actions of the individual participants in the economic process. More recently, some of Hutt's insights have been rediscovered by mainstream macroeconomists, such as supply-siders and new classicists, who have sought to devise microeconomic foundations for their macroeconomic analyses.
Hutt, born of a working-class family in the East End of London and educated at the London School of Economics, began his academic career in 1928 at the University of Cape Town in South Africa. After a career of remarkable scholarly productivity, including six books and over thirty professional journal articles,Reynolds, Morgan O., ed. 1986. W.H. Hutt: An Economist for the Long Run. Chicago: Regnery Books, pp. 153–58. Hutt retired from Cape Town in 1965 and emigrated to the United States. Here, he held the position of distinguished visiting professor at a number of colleges and universities, including the University of Virginia, Texas A&M, and the University of Dallas.
As an American academic, Hutt's scholarly output did not flag, and, while a septuagenarian, he authored three major worksHutt, W.H. 1973. The Strike-Threat System: The Economic Consequences of Collective Bargaining. New Rochelle, NY: Arlington House; Hutt, W.H. 1974. A Rehabilitation of Say's Law Athens, OH: Ohio University Press; Hutt, W.H. 1979. The Keynesian Episode. and published substantially lengthened editions of two others.Hutt, W.H. 1975. The Theory of Collective Bargaining 1930–1975: A Critique of the Argument that Trade Unions Neutralise Labour's 'Disadvantage' in Bargaining and Enhance Wage Rates by the Use, or Threat, of Strikes. 2nd ed. London: The Institute of Economic Affairs; Hutt, W.H. 1977. The Theory of Idle Resources: A Study in Definition. 2nd ed. Indianapolis, IN: Liberty Press. Nonetheless, because he labored most of his career in the academic backwater of South Africa, Hutt's contributions have not yet received in the United States the recognition that they merit, even among free-market economists and others.
In economic theory, Hutt drew his basic orientation from the great British economists Phillip H. Wicksteed and Edwin Cannan, the latter being Hutt's teacher at the London School of Economics. As Hutt himself has noted, his postwar writings were also heavily influenced by the Austrian approach to economics, especially as expounded in Ludwig von Mises's magnum opus, Human Action.Hutt, W.H. 1977. The Theory of Idle Resources.
While building on the contributions of the best of his predecessors and contemporaries, whom he graciously and frequently acknowledged, Hutt achieved what only a handful of economists have: he constructed a broad and unified vision of the overall economic process that is original without being idiosyncratic or cranky. Hutt's achievement is all the more noteworthy because he elaborated his vision in a series of books and articles that were addressed to the educated public as well as to an academic readership.
In the great tradition of his mentor, Cannan, and other economists associated with the prewar London School of Economics, Hutt's overriding concern throughout his long and productive career was to demonstrate the practical implications of sound economic theory for enhancing the material and other benefits of a market society, and to do so in language readily intelligible to the educated citizen. The fact that Hutt's writings are occasionally peppered with quirky and unconventional usages and terminology does not detract from the resounding success of this endeavor.
The theme that characterizes and unifies all of Hutt's works is the explication, defense, and application of the proposition that rivalrous competition among profit-seeking entrepreneurs operating in a free-market economy, where all prices, including wage rates, are competitively and noncoercively determined, insures the full utilization of scarce resources in a manner that is continually and strictly in accord with anticipated consumer preferences.
In the 1930s, Hutt coined the term "consumer sovereignty" to denote the concept according to which, in the market economy, the production decisions of entrepreneurs are rigidly governed by the freely expressed spending decisions of consumers.Hutt, W.H. 1990. Economists and the Public: A Study of Competition and Opinion. 2nd ed. New Brunswick, NJ: Transaction Publishers. The term "price coordination" Hutt applied to identifying the outcome of the market process by which the prices of scarce resources, including labor, are ultimately determined by the competitive bidding of entrepreneurs on the basis of their forecasts of the future prices of consumer goods.Hutt, W.H. 1963. Keynesianism—Retrospect and Prospect: A Critical Restatement of Basic Economic Principles. Chicago: Henry Regnery Company.
When the prices of productive inputs are thus coordinated with prices of entrepreneurially planned outputs, the result is "full employment" of available resources and the allocation of each resource among the most value productive of its prospective uses. With respect to the labor market, this means that everyone who is willing to work at prevailing wage rates can more or less readily find a job that maximizes the monetary value of his or her labor services.
Hutt utilized this analysis of market pricing and resource allocation to explain the consequences of various interventions into competitive labor markets by governments and labor unions. In a classic work originally published in 1930, Hutt demolished two long-standing myths about the labor market that were tirelessly propagated by late-19th-century socialists and trade unionists, and accepted even by market-oriented economists.Hutt, W.H. 1975. The Theory of Collective Bargaining. These involved the assertion that "collective bargaining," compelled by law or induced by the threat of legally sanctioned union coercion, was necessary in the case of labor, because the competitive market process placed the laborer at a disadvantage vis-à-vis the capitalist employer and/or generated a wide margin of indeterminacy for the price of labor.
In a later work, Hutt rigorously demonstrated that, contrary to prevailing belief, collective bargaining, or "the strike-threat system" as he labeled it, cannot succeed in increasing the aggregate income share of labor at the expense of the share of capital.Hutt, The Strike-Threat System. Rather, as Hutt showed, the wage gains of unionized laborers come at the expense of nonunion workers and consumers in general.
Nonunion workers suffer a decrease in their incomes because some of the laborers who lose jobs in those industries where collective bargaining forces wage rates above market-clearing levels will swell labor supplies and drive wage rates down in nonunionized industries and occupations. Consumers, including union members, experience an erosion of their real incomes, as consumer goods become more scarce and expensive in response to the increased unemployment in unionized sectors of the economy, and to the diversion of labor to less-productive employments in nonunion industries.
Capital is misallocated, and consumer sovereignty and satisfaction further impaired, as investors seek to inure themselves against strike-threat exploitation by reducing their investment in unionized industries and changing the form of their remaining investments to less-productive assets that may be quickly and easily converted to uses outside unionized industries in the event of a strike-induced rise in costs.
In another important application of economic analysis, Hutt explained how the South African apartheid system developed as a system of legal privileges bestowed by an interventionist government on Communist-oriented, white labor unions, who wished to protect and augment their wage rates by restricting competition from lower-skilled, nonwhite workers.Hutt, W.H. 1964. The Economics of the Colour Bar: A Study of the Economic Origins and Consequences of Racial Segregation in South Africa. New York: Transatlantic Arts. Hutt argued that, had laissez-faire capitalism prevailed and debarred government from coercively intervening on the side of the unions, competition among entrepreneurs seeking to cut costs and maximize profits would have integrated the South African labor force and generated a peaceful, multiracial society.
Hutt was a lifelong, insightful critic of Keynes and of Keynesian economics in all of its variations. To Hutt the fundamental and fatal flaw of Keynesianism was that it completely ignores the coordinating function of the market's pricing process. In 1939, Hutt published a work in which he exhaustively identified and categorized the diverse kinds of resource idleness that could arise in a market economy.Hutt, W.H. 1977. The Theory of Idle Resources.
Hutt argued that persistent mass unemployment, such as that during the 1930s, is not a result of a failure of "aggregate demand" in the private sector, as Keynes had claimed in the General Theory in 1936, but of government and union disruption of the market's price-coordination mechanism. Entrepreneurial incentives to employ labor and produce goods were seriously diminished by price rigidities introduced into the economy as a result of legislation mandating minimum wages, compulsory collective bargaining, unemployment insurance, and cartelization and price fixing in manufacturing and agriculture. By preventing the swift competitive adjustment of resource prices to product prices that had declined as a result of monetary deflation and the public's scramble for liquidity, these legislated price rigidities were responsible for the unrelenting nature of the Great Depression.
Hutt explained that the apparent success of the Keynesian policy of stimulating a depressed economy via increasing "aggregate demand" through deficit spending financed by money creation is attributable solely to the fact that such a policy temporarily inflates product prices relative to incorrect and downwardly inflexible resource prices and brings about a crude type of price coordination.Hutt, W.H. 1963. Keynesianism—Retrospect and Prospect, pp. 68–75. However, anticipating the modern rational-expectations position, Hutt argued that once labor unions and other legally privileged groups of resource owners come to anticipate the regular recurrence of such inflationary episodes and to adjust their selling prices accordingly, even the temporary coordinating effect of Keynesian fine tuning is lost and all that results is inflationary recession or stagflation.Hutt, Keynesianism—Retrospect and Prospect. pp. 407–20.
The coping stone of Hutt's economic thought is his restatement of Say's Law, a central doctrine of prewar macroeconomic theorizing, whose meaning and importance had been almost completely obscured by the Keynesian Revolution.Hutt, A Rehabilitation of Say's Law. In Hutt's reformulation, Say's Law refers to the truth that, when all inputs and outputs are coordinatively priced, the supply of any particular thing constitutes a demand for a noncompeting good. This implies that it is never an insufficiency of demand but a "withholding" of supply, due to pricing assets or services above market-clearing levels, that depresses economic activity.
Ah, the greens. They're not just treehuggers anymore. They've been browbeating us to recycle, eat soy, save energy, drive less, ride the bus, and a thousand other ways to "act local" for many years now, writes Tyler A. Watts.
This audio Mises Daily is narrated by Gennady Stolyarov II.
Ah, the greens. They're not just treehuggers anymore. They've been browbeating us to recycle, eat soy, save energy, drive less, ride the bus, and a thousand other ways to "act local" for many years now. Now they've even got a hip new huckster on the big screen: "No Impact Man," your conductor on a first-class guilt trip to ecoland. Despite the massive popularity of their cause, I don't think they're satisfied. They want to control us. If we don't watch out, these people hell-bent on saving the planet are going to end up micromanaging our daily lives.
The idea of sustainability itself sounds pretty benign — it merely implies that people ought to be forward thinking, prudent, and thrifty in their use of economic resources. And I'm OK with this basic idea — on the surface, it sounds like simple wisdom, in league with similarly bland and benevolent values like responsibility and generosity.
But deep down, there's something unsettling about the basic premise of sustainability. Sustainability advocates — let's call them "sustainists" — are damning in their fervor, poise, and rhetoric. Their ideology is pregnant with an accusation that the way things currently are is somehow unsustainable. There's an alarmism here which essentially claims, "there's a crisis, it's your fault for being ignorant, irrational, and greedy. You must do as we say to fix it, or we'll all die."
This alarmist crusade, which underlies the sustainability movement, should rankle people with an economic understanding of the world. A basic tenet of economics is that markets are self-correcting and orderly; prices indicate resource constraints and guide people in economizing on their use. Prices change as underlying supply and demand conditions change, inducing appropriate adjustments in consumption and production patterns. Prices channel the profit motive — a natural aspect of the human condition — into productive and innovative activities. In short, prices work.
Sustainists are either ignorant or in denial of this basic lesson. Either way, we economists have our work cut out for us.
The Sustainists' LamentThe gist of the problem, as the sustainists see it, is that people are using resources irresponsibly — either using them up too fast, using too much of them, or using them in a way that will have negative long-term ramifications. In brief, sustainists disapprove of other peoples' actions, and are taking steps to correct their wayward brethren.
Because these wasteful others, through either ignorance, laziness, or stubbornness, will not wake up and adopt sustainable practices on their own, sustainists see the need for a self-conscious effort — organized campaigns, eco–guilt trips, and yes, even laws — to correct this misuse of resources. We need to change our patterns of action; we need a motivating force beyond mere "economic self-interest" (i.e., the profit motive). Sustainability, then, has become a full-fledged crusade to "save the planet," and if you're not part of the solution, you're surely part of the problem.
Let's interpret this through the lens of economics. Sustainability arguments fall under one of two broad categories: (1) the nonrenewable resources argument that the supplies of certain important resources are shrinking; by the time people realize this it will be "too late" — resource shortages will strain the capitalist economies to the breaking point; (2) the climate-change argument that there are large, though delayed, negative externalities to current patterns of resource use.[1]
Whatever their type, sustainability arguments invoke market failure. Indeed, the very practices cited as unsustainable arise on the free market. Therefore some outside corrective, whether aggressive moral suasion or economic regulation, is needed to prevent the impending catastrophe of unsustainable resource use.
Are Prices Not Sufficient?I don't want to dwell on the particulars of the sustainability movement. There are dozens of manifestations, from green building to organic farming to mandatory recycling to decarbonization — indeed, the sustainability bandwagon (which of course is painted green and powered by renewable energy) seems infinitely expandable to include every industry and interest group under the sun. Instead, I want to draw out the essential implications of the sustainability movement.
The sustainability movement is an assault on economics. It claims at its core that prices don't operate through time to direct consumption and production decisions in a sustainable way. A lesson in basic economics should suffice to defend against the sustainists' attack.
Prices arise in the market economy as a concomitant of mutually beneficial exchange. People want things that improve their lives — we call this value. Some valuable things are more scarce than others; take the classic case of water and diamonds. In absolute terms, water is more valuable than diamonds: you don't need diamonds to live.
Yet water is, pound for pound, far cheaper. Why? Although it's valuable, it is also relatively abundant; in many parts of the world, it literally does fall from the sky. The price of any good reflects this combination of value and scarcity. We're willing to pay more for valuable things as they become relatively scarce (e.g., oil); and we needn't pay as much for valuable things as they become more abundant (e.g., grain).
Likewise, as scarce things lose their value, people are no longer willing to pay for them (e.g., typewriters), and people must pay more for scarce things that suddenly become sought after (e.g., vintage Michael Jackson records). The awesome thing about prices is that they seamlessly convey this combination of facts about an item's value (demand) and it's scarcity (supply). Prices, of course, are subject to change — prices of certain goods fluctuate every day. But this is a good thing; discernable trends in prices over time indicate relative changes in the "market fundamentals" of supply and demand.
In this sense, prices reliably guide individuals, both consumers and producers, toward a rational use of resources. Savvy consumers listen to the prices; a rising price trend tells them to cut back on that particular item, and a falling price tells them to go ahead and use a little more of it. The same basic logic applies on the production side.
Entrepreneurs, driven by the profit motive, are like bloodhounds sniffing out these price trends in search of profit opportunities — chances to create value through exchange. If the price of a good trends strongly upwards over time (indicating it has become scarcer and/or more valuable), they rush to find cheaper substitutes. The cheaper the substitutes, the higher the profits to be had, especially if you're the first to market. If prices trend downwards over time (indicating that the resource is becoming more abundant relative to its usefulness), entrepreneurs devote their efforts elsewhere.
The general outcome of these economic processes is captured by the statement "prices coordinate."[2] In other words, the price system acts as an "invisible hand,"[3] guiding people — both consumers and producers — in their economic actions. The real beauty of this free-market price system is that it brings about its own kind of sustainability. This is not so much sustainability in the use of particular resources — for particular goods fall in and out of favor according to supply and demand factors — but sustainability of high economic growth and high standards of living in the economically developed, capitalist economies.
Take, as an example, the transition in the market for interior illumination: tallow candles were replaced by whale-oil lamps, which were replaced by kerosene lamps, which were replaced by incandescent bulbs powered by electricity. There was no social or political pressure needed to accomplish this evolution; there was no "peak whale oil" movement, no kerosene conservationists, no sustainability crusade of yore. All it took was a functional price system, combined with the ever-present entrepreneurial drive for profits under a competitive, free-market order.
Likewise, in our time as sustainists and other worrywarts fret about resource depletion, the price system remains functional, quietly yet assuredly guiding individuals to economize on resources, search out profitable substitutes, and anticipate future trends. All this happens without preaching, without crusades, and without activism.
Is the Sustainability Crusade Sustainable?How long will sustainists be able to beat their drum, simultaneously trumpeting their greener-than-thou self-image and attempting, with varying degrees of coercion, to make the rest of us act "sustainable" too? With the global warming scare losing credibility by the day, the likelihood of sustainists being able to claim even a moral victory is fading.[4] Barring the earth melting down from a little bit of smoke, I'm not too worried about sustainists having much of a long-run impact.
Hardcore sustainists are asking for a radically disruptive change from the natural order of the free-market economy. They're asking us to forego wealth and embrace privation in the name of their cause.[5] Although citizens of the Western democracies have seemingly become easy marks for anything green, we will only go so far toward saving the planet, especially when it becomes apparent that sustainability requires a march toward poverty and a deeply regimented and regulated society (and that the planet's not really in peril, after all).
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"A lesson in basic economics should suffice to defend against the sustainists' attack."Also, and perhaps more importantly, people in developing countries will be increasingly turned off by the sustainists' demands for sacrifice. Having just arrived at the high living standards that long-term capitalist development yields, my sense is that they will turn a cold shoulder to the idea of ratcheting down their development.
The current resurgence of the classical-liberal tradition in economics will also reduce the appeal of sustainability. The idea of imposed or centrally planned sustainability will crumble under the realization that the spontaneous order wrought by the invisible hand of the free-market price system is amazingly sustainable in and of itself. Add to the mix the hardships of the current recession, and it won't be long before enough people, even sustainist crusaders come crawling back, box of chocolates in hand, to the free-market economy.
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Notes[1] The "peak oil" movement is a species of the first argument.
[2] This a key theme of the works of F.A. Hayek; see, for instance, the classic essay, "The Use of Knowledge in Society."
[3] For the quote in its original context, see Adam Smith's Wealth of Nations, book IV section 2.9.
[4] To be fair, I should note that, as far as it constitutes an externality-based market failure argument, the idea of man-made global warming is consistent with sound economic theory. The burden of proof in this case, though, rests on those sustainists who genuinely believe that there are disastrous long-term externalities in store from man-made global warming. As my favorite radio host would say, "color me skeptical."
[5] For examples of the economic sacrifices that hardcore sustainists seek to impose, see here, here, and here.
[Excerpted from Human Action, Scholar's Edition, pp. 423–425]
The deliberations of the individuals which determine their conduct with regard to money are based on their knowledge concerning the prices of the immediate past. If they lacked this knowledge, they would not be in a position to decide what the appropriate height of their cash holdings should be and how much they should spend for the acquisition of various goods.
A medium of exchange without a past is unthinkable. Nothing can enter into the function of a medium of exchange which was not already previously an economic good to which people assigned exchange value already before it was demanded as such a medium.
But the purchasing power handed down from the immediate past is modified by today's demand for and supply of money. Human action is always providing for the future, be it sometimes only the future of the impending hour. He who buys, buys for future consumption and production.
As far as he believes that the future will differ from the present and the past, he modifies his valuation and appraisement. This is no less true with regard to money than it is with regard to all vendible goods. In this sense we may say that today's exchange value of money is an anticipation of tomorrow's exchange value.
The basis of all judgments concerning money is its purchasing power as it was in the immediate past. But as far as cash-induced changes in purchasing power are expected, a second factor enters the scene, the anticipation of these changes.
He who believes that the prices of the goods in which he takes an interest will rise buys more of them than he would have bought in the absence of this belief; accordingly he restricts his cash holding. He who believes that prices will drop restricts his purchases and thus enlarges his cash holding.
As long as such speculative anticipations are limited to some commodities, they do not bring about a general tendency toward changes in cash holding. But it is different if people believe that they are on the eve of big cash-induced changes in purchasing power. When they expect that the money prices of all goods will rise or fall, they expand or restrict their purchases.
These attitudes strengthen and accelerate the expected tendencies considerably. This goes on until the point is reached beyond which no further changes in the purchasing power of money are expected. Only then does the inclination to buy or to sell stop and do people begin again to increase or to decrease their cash holdings.
But if once public opinion is convinced that the increase in the quantity of money will continue and never come to an end, and that consequently the prices of all commodities and services will not cease to rise, everybody becomes eager to buy as much as possible and to restrict his cash holding to a minimum size. For under these circumstances the regular costs incurred by holding cash are increased by the losses caused by the progressive fall in purchasing power. The advantages of holding cash must be paid for by sacrifices which are deemed unreasonably burdensome.
This phenomenon was, in the great European inflations of the '20s, called flight into real goods (Flucht in die Sachwerte) or crack-up boom (Katastrophenhausse). The mathematical economists are at a loss to comprehend the causal relation between the increase in the quantity of money and what they call "velocity of circulation."
The characteristic mark of the phenomenon is that the increase in the quantity of money causes a fall in the demand for money. The tendency toward a fall in purchasing power as generated by the increased supply of money is intensified by the general propensity to restrict cash holdings which it brings about. Eventually a point is reached where the prices at which people would be prepared to part with "real" goods discount to such an extent the expected progress in the fall of purchasing power that nobody has a sufficient amount of cash at hand to pay them.
The monetary system breaks down; all transactions in the money concerned cease; a panic makes its purchasing power vanish altogether. People return either to barter or to the use of another kind of money.
The course of a progressing inflation is this: At the beginning the inflow of additional money makes the prices of some commodities and services rise; other prices rise later. The price rise affects the various commodities and services, as has been shown, at different dates and to a different extent.
This first stage of the inflationary process may last for many years. While it lasts, the prices of many goods and services are not yet adjusted to the altered money relation. There are still people in the country who have not yet become aware of the fact that they are confronted with a price revolution which will finally result in a considerable rise of all prices, although the extent of this rise will not be the same in the various commodities and services.
These people still believe that prices one day will drop. Waiting for this day, they restrict their purchases and concomitantly increase their cash holdings. As long as such ideas are still held by public opinion, it is not yet too late for the government to abandon its inflationary policy.
But then, finally, the masses wake up. They become suddenly aware of the fact that inflation is a deliberate policy and will go on endlessly. A breakdown occurs. The crack-up boom appears. Everybody is anxious to swap his money against "real" goods, no matter whether he needs them or not, no matter how much money he has to pay for them.
Within a very short time, within a few weeks or even days, the things which were used as money are no longer used as media of exchange. They become scrap paper. Nobody wants to give away anything against them.
It was this that happened with the Continental currency in America in 1781, with the French mandats territoriaux in 1796, and with the German Mark in 1923. It will happen again whenever the same conditions appear. If a thing has to be used as a medium of exchange, public opinion must not believe that the quantity of this thing will increase beyond all bounds. Inflation is a policy that cannot last forever.
This article is excerpted from Human Action, Scholar's Edition, pp. 423–425.]
In an attempt to control the aggregate healthcare costs that will be shouldered by taxpayers under his proposed system, President Obama has pushed increased reliance on preventive carefor all eligible Americans. His argument is that, because preventive care is normally much less expensive than later surgeries, increased use of these earlier, preemptive treatments will entail radical cost savings. As with many of the president's healthcare promises, this argument falls apart under rigorous examination.
The Economics of PreventionThe logic behind increased preventive care is simple; if an individual knows he will be afflicted with some serious and expensive malady, say a heart attack, it is typically much less expensive for him to undergo preventive procedures, in this case the insertion of vascular stents. In such a case, not only is the patient likely to save money and possibly prolong his life, but he also removes the anxiety of knowing he is at high risk for heart failure.
Preventive treatment, then, will only be purchased when it removes serious anticipated future risks, either of higher treatment costs or of serious pain or death. Any surgery requires the curtailment of other forms of consumption, so consumers will prefer to abstain from preventive care unless they know they are at high risk of high future financial or physical costs. The unregulated consumer, in an extreme example, would never purchase a surgery to prevent the prospect of future ingrown hairs.
For every disease or affliction, there is an interval of risk over which preventive care justifies its price and thus will likely be purchased. Consumers who expect that they are at extremely low risk for heart failure will almost certainly not purchase vascular stents because they believe their risk of dying of heart failure is so low that the value of preventing it is practically worthless to them.
On the other hand, there are those individuals — for example, the morbidly obese and those who have already suffered multiple heart attacks — who are almost certain to die of a heart attack. For these unfortunate consumers, the risk of death is already so certain that preventive surgery may be worthless.
There are some methods of preventive care which can almost certainly avert the risk of dying of an affliction, and for these procedures, even those extremely high-risk patients will likely decide the surgery is worth its price. The "risk threshold" for preventive care is decided on by individuals and their doctors, but like all economic decisions is influenced by price; more expensive treatments are less likely to be purchased by marginally risky consumers.
Not All Hearts Are Created EqualIf the president's plan were applied only to cholesterol-clogged patients, it is quite clear that the preventive care would save money and lead to a positive health outcome. However, this is not a victory for Mr. Obama's plan. Patients such as these are likely to pay for preventive care with or without a government mandate or subsidy. No "cost savings" occur by compelling a group of high-risk patients to do what they already would have. In fact, any subsidies to such a group actually increase taxpayers' health burden.
"No 'cost savings' occur by compelling a group of high-risk patients to do what they already would have."It is absolutely paramount to remember in our analysis that American patients are not homogeneous mannequins smoothly distributed over one or two physical variables along a bell curve or any other type of graph. Each individual consumer is an acting, reasoning human being with a unique set of uncertain health risks and, more importantly, unique desires and risk tolerances.
The reality is that many people are at no price-justifying risk for dying early of any disease. This, for the a priori economic thinker, explains what the president believes is Americans' underutilization of preventive care: if more people had reason to believe that preventive care is worth its price, they would of course already be purchasing it. Rather, for the majority of Americans, vascular stents and other preventive treatments are simply not worth the requisite time, money, and physical invasion.
Mandating or even subsidizing preventive care for these individuals does not eliminate very many expensive late-term surgeries in the future, and thus would clearly not result in any such cost savings for the taxpayer. In fact, it is easy to see that subsidizing new preventive surgeries will result in increased costs to taxpayers.
Worse still, providing subsidies for these new and unmerited preventive surgeries not only costs tax dollars, but also comes at a cost to what mainstream economists refer to as "social welfare," because increased vascular stent consumption necessarily entails decreased consumption of another good or service.
Furthermore, the market for preventive care is also far from homogeneous. For many diseases or maladies, there are multiple methods of prevention, which each hold different potential costs and benefits for each patient. Some methods of preventive care, such as our example of vascular stents, entail a decision on the quantity of the procedure — how many blood vessels will be stented — with a diminishing marginal benefit to each additional unit of care. To expect Obama's proposed healthcare bureaucracies to calculate the cost-cutting level of subsidy for each individual method of preventive care is absurd. Instead, preventive decisions should be left to specialized doctors and their patients.
Even if we grant that Obama's health bureaucracies will somehow be able to effectively target individual patients along the "risk thresholds" for subsidized preventive treatments, it is still unclear that this will decrease aggregate financial costs. For any net cost savings to occur, we must also assume that these consumers sometimes forgo preventive care, even though it would ultimately be more cost-effective for every individual lumped into that class to pursue the preventive treatments in question. Only under these conditions would Obama's proposal serve its purpose.
"American patients are not homogeneous mannequins."However, this simple pursuit of lower aggregate spending over time is a weak justification for suppressing individual choice. Acting Man does not consume in the interests of possibly minimizing the total costs of some abstract statistical class in which he's included by regulators.
In reality, an individual health consumer chooses to consume or abstain from preventive care according to his subjective appraisal of the value of the possible extra length or quality of life he may receive as a result of the preventive care against the value of the consumption made possible by abstaining from the preventive care.
He makes this decision while taking into consideration his medically determined risk of harm from the malady and his personal tolerance for that risk. Such an intimate decision, which weighs the value of extra months or years of life and the quality of life gained or sacrificed, all while accounting for risk tolerance, literally cannot be made by budget-balancing government employees.
What about Individual Costs?Obama's proposal for subsidized prevention would not only increase aggregate healthcare spending by funding unmerited preventive treatments, but would also increase the per-unit prices of those treatments. The economics here are simple subsidy economics; a subsidy for any service will decrease the effective price of that service to the consumer, increasing demand for that service along any market price. Holding supply constant, this increased demand will increase the market price for that service.
For the Obama cost plan, this is a second Achilles' heel; the greater the subsidy granted, the greater the increase in market price will be, because consumers will face a smaller and smaller portion of any treatment's real price. They will thus choose to consume more and more unmerited preventive procedures, increasing the prices of those frivolous treatments. As the price of general preventive care rises, the public will of course expect greater and greater subsidies for their treatments.
The tragic end result of this experiment will be the political need for the health bureaucracy to subsidize a higher portion of the soaring prices of a greater number of preventive treatments. To argue that this represents lower aggregate costs is pure nonsense and should be dismissed as such.
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ConclusionWhile increasing preventive care to cut long-term costs may seem logical at first, it is clear to see that government-mandated treatment cannot possibly lead to a more cost-effective balance between preventive treatment and future treatment.
Furthermore, we can see that any subsidy for preventive care will massively increase costs for the individual and, under Obama's plan, for the taxpayer. From these conclusions, it is obvious that only individual patients armed with the advice of their doctors can be trusted to make cost-effective decisions regarding their preferred method of care.
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The demand for a medium of exchange is the composite of two partial demands: the intention to use it in consumption and production and the intention to use it as a medium of exchange, writes Ludwig von Mises (1881–1973).
This audio Mises Daily is narrated by Jeff Riggenbach.
Athens, Georgia, is widely considered to be impoverished. A "living wage" is usually the result of a local government effort to increase the legally permissible wage above the state or federally mandated minimum wage in that area.
Many residents of Athens have been trying to implement a living wage in the community for some time. These efforts are largely supported by the faculty, staff, and students at the University of Georgia, in Athens. Focusing on some of the least-skilled workers, I show why the living wage would not have any positive impact on the poor in Athens and why a higher mandated wage could further impoverish them.
There are plenty of people who can tell you the "benefits" of a living wage. Of course, these benefits are very shallow and short-term. A deeper economic and social analysis demonstrates the appalling costs of such regulation.
As with all government regulations, the most significant problem with living-wage legislation would be the unforeseen consequences, in this case unemployment. Many would say that unemployment levels do not increase very much when living-wage laws are enacted, but looking at general employment numbers does little for determining the effects on the poor.
Take, for instance, current unemployment statistics in Georgia. Unemployment in the state has hovered between 3.4 and 6.5 percent over the past decade.[1] These rates are deemed acceptable by our government and it is unlikely that they are much affected by the minimum wage. Additionally, based on other states' experiences, one would not anticipate a large change in the unemployment rate due to living-wage legislation.
However, I contend that the small magnitude of changes in the general unemployment rate does not justify a living wage because it does not represent its impact on the poor. Poor people make up a small fraction of the people counted by employment measures.
The overwhelming majority of Americans in the workforce are not directly affected by living-wage laws. Their jobs are safe because they are worth significantly more to their employers than any (current) mandated wages. If we want to discuss the effects of the living wage among the poor, we must consider only the poor in our statistics.
Let us consider some of the less-employable American workers: teenagers. Teenagers are generally worth lower wages than any other age group in society, due to their immaturity and lack of experience. Indeed, it stands to reason that people are worth the least in the first job they ever take. Typically, the best teenage workers' wages will increase during the first few years. Most, however, will not see any significant wage increases until they finish school or move into full-time work.
The unemployment rate is measured as a percentage: people who want work but cannot find it are divided into the total number of people who want work, including those who are actively in the workforce. According to US Department of Labor statistics, American teenagers experienced an unemployment rate of 15.7 percent in 2007. (Note that this low figure was during the Fed-fueled boom).[2] This is one group of people who truly are affected by living-wage legislation. A change in the generally reported unemployment rates does not reflect the changes many poor (or less-skilled/inexperienced) people feel.
This number would be very susceptible to a change in mandated minimum wages because so many teenagers are already worth barely more than the current minimum wage in terms of productivity per hour. Whether it is poor teenagers or other unskilled groups, higher wage laws are only going to decrease their opportunities to find work and improve job skills.
Clearly, some people are going to be adversely affected by a living wage. One could argue from a standpoint of liberty (formerly an American ideal), that laws adversely affecting some groups should not be enacted, but we will only look at the economic impacts of such legislation here.
The data show that the people most likely to be affected by living-wage legislation are black, teenage males. This group had a national unemployment rate of 33.8 percent in 2007. When the data are broken down for black males aged 16 and 17, the unemployment rate is in excess of 40 percent.
These numbers are staggering, and they would only get worse with a living wage. Some teenagers would not even have the option of work because the value of their marginal revenue would not equal their new, higher wage cost.
So, what happens to these people who are left jobless? Well, they still need money and something to do during the day.
Not surprisingly, crime rates are highest among those in their late teens and early twenties. The Georgia Bureau of Investigation cites young people, aged 17–21, as perpetrating 23.4 percent of the crimes in the state.[3]
It is no coincidence that those who cannot find work tend to find things that get them into trouble to fill their time. I argue that enactment of a living wage would only put more young people on the streets rather than in jobs where they can learn skills that will serve them well in the future.
Not only is this lack of work bad for young people and other low-skilled workers, but it also hurts the local economy. Due to the higher mandated wage, jobs that are not worth this wage will no longer be performed legally in the community. Trash pickup, general cleaning, inexpensive food preparation, farming, and many other tasks would be either neglected or moved to places with lower wage costs.
This general lack of production would not be due to people's lack of desire to do the work, but to government's intervention, which would keep the tasks from being done on the grounds that their monetary value doesn't fit with the social agenda. It may seem desirable to keep people from working for too little money, but keeping people who want those jobs out of work is both an attack on liberty and a mistake in economics.
If we compare life in a city to life on a deserted island, then we can better understand the repercussions of not allowing our least-skilled laborers to work for what they are worth. Take, for example, ten people shipwrecked on an island, with no expectation of a rescue anytime soon.
Let us say that one is too old to work, three are children, and the other six are capable adults. We assume that the six adults and the three children will work to build and maintain shelters, find and deliver clean water, and locate and cook food for all ten people.
Now suppose that three of the adults start businesses in which each takes care of one of the main tasks on the island. They each hire one other adult and one child to help accomplish their daily tasks. The children are probably not excited about the amount of resources allotted to them as pay, but they know that it is the best offer they have (better than surviving alone) and so they choose to continue working for meager portions.
Now, what would happen if we implemented a living wage on the island? Let's say the group votes that two of the children are not getting enough food and benefits from the work they do.
Now, the two youngest and least-skilled kids are no longer allowed to work because they are not getting paid enough. By choosing to participate in the working program on the island, the kids themselves were saying that they were better off working with the group than being by themselves, and that they can benefit from group trade. However the group decided the deal is not good enough, so they prevented the kids from working.
"By choosing to participate in the working program on the island, the kids themselves were saying that they were better off working."It seems asinine not to let people work when they are trying to survive on a deserted island, just because they do not produce as much as others. Yet, when it comes to a city, many people quickly assume that others should not work for less than some guaranteed wage.
I propose that the standard of living is higher for the people of a city (or deserted island) who let as many persons work as want to, than in a community that eliminates jobs that do not seem particularly enticing. The absence of a living wage does not require the undue work of any one person; it just protects the rights of those least-skilled people who want to work, while providing services that increase everyone's standard of living, including the workers' own.
Now let us look at the island two years later. There are two possibilities. One is that two children have not worked for the past two years because they were not considered productive enough. They ran around the island, playing games and living off the labor of the seven workers. They have not gained any job skills or experience to make them more valuable citizens on the island.
The other possibility is that the children were allowed to work for the previous two years. Not only have they matured, but they have also developed much-needed job skills in their given tasks. Perhaps, by working, they have created more efficient methods for delivering their goods and services. Perhaps they have learned how to do their respective bosses' jobs and are ready to take over should something happen to that person. At the very least, they have contributed two years of production that has increased the standard of living for everyone on the island.
I use the island illustration to show that even basic economics demonstrates problems with mandated wages. Another argument, presented by Lew Rockwell, deals with the optimal level of wages. If eight dollars an hour is good, then why would we not require twenty or even one hundred dollars an hour as a living wage? These numbers sound absurd, but the economics that makes them unthinkable is the same economics that makes even a "low" living wage an inefficient option.[4]
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Standards of living do not increase with wages, but rather with production. Society needs people to produce at any wage, and then prices will reflect the wages being earned for a given task. Once we look at the living-wage law from the point of view of someone who loses his or her job (as opposed to someone who gets a raise), we see its ugly side.
Ultimately, a living wage in Athens (or anywhere) will actually hurt the poor rather than helping them. It will decrease production, increase counterproductive activity for the least skilled, and increase prices for the entire population. Cities like Athens should encourage work instead, by minimizing regulations on labor and allowing everyone's standard of living to increase with unadulterated production.
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Notes[1] Economagic, "Economic Time Series Page," October 29, 2008.
[2] U.S. Department of Labor, "Employment Status of the Civilian Noninstitutional Population by Age, Sex, and Race," October 29, 2008.
[3] Georgia Bureau of Investigation, "Crime Statistics," November 6, 2008.
[4] Rockwell, Llewellyn H. Jr., "The Bridge of Asses," Ludwig Von Mises Institute, October 2, 2003.
Money is the thing which serves as the generally accepted and commonly used medium of exchange. All the other functions which people ascribe to money are merely particular aspects of its primary and sole function, writes Ludwig von Mises (1881–1973).
This audio Mises Daily is narrated by Jeff Riggenbach.
What Determines the Price of Gold?The outlooks of gold analysts are diverse. After reading the latest WGC report, Mineweb is bullish: "Gold demand tops US$100 billion and mine supply remains under threat." John Nadler, however, is bearish, citing the expected "additional 400–500 tonnes per annum" that will result from the exploration boom of the last few years. Tom Barlow even asks, "Are we running out of gold?"
I choose these examples not to pick on these authors. I could have just as easily chosen a hundred other examples: the vast majority of analysts who cover the gold market focus on mine supply as one of the main drivers of gold-price forecasts. I use these examples only to illustrate the ubiquity of this view.[1] However, while analysts need something to analyze — and the mining industry provides many analytical complexities — ultimately, their efforts are wasted. Mine supply has very little influence on the price of gold.
Anyone who agrees that the gold trade is a market would accept the premise that the price depends on supply and demand. Where most analysts go wrong is to analyze gold using what I will call the consumption model. This model counts the current year's mine production plus scrap (and, in some versions, central-bank sales) as supply, and the current year's purchases of jewelry, coins, bars, and industrial gold as demand.
Gold and the Consumption ModelThe consumption model is good way to forecast the price of a commodity that meets two conditions:
it is destructively consumed (or spoils), and
the annual production of the commodity is large in relation to existing, above-ground stockpiles.
Oil is a good example of a commodity that meets these conditions. It is refined and then irreversibly combusted. The oil price must enable the market to clear more-or-less current production with current consumption, buffered only by the oil sitting on tankers and in underground reserves. Reserves cannot do not hold more than a few months' supply, due to the high rate of oil consumption in relation to the storage capacity.
The consumption model does not explain price formation of a commodity where the two conditions are not met, because owners of the existing stocks own much more of the commodity than the producers bring to market. Consequently, they have far more influence over the price than do producers. Gold is the best example of such a commodity: gold is not consumed; people buy it in order to hold it; gold has the largest ratio of stock to annual production of any commodity.
In fact, it is estimated that nearly all of the gold ever mined in human history still exists. This supply grows by only 1 to 2 percent on an annual basis; or, if we look at the ratio from the other side, approximately 50–100 times the annual mine production is held in stockpiles.[2]
The consumption model would hold true if each year's gold were segregated into its own market, with no arbitrage from previous years' markets. But this is not the case: everyone who is buying, selling, and holding forms a single, integrated market. A buyer doesn't care whether he receives gold mined within the past year.[3] Gold miners are competing with all of the holders of gold stockpiles when they sell. Contrary to the consumption model, the price of gold does clear the supply of recently mined gold against coin buyers; it clears all buyers against all sellers and holders. The amount of gold available at any price depends largely on the preferences of existing gold owners, because they own most of the gold.
Looking at the supply side of the market, each ounce in someone's stockpile is for sale at some price. The offered price of each ounce is distinct from that of each other ounce, because each gold owner has a minimum selling price, or "reservation price," for each one of their ounces. The demand for gold comes from holders of fiat money who demand gold by offering some quantity of money for it. In the same way that every ounce of gold is for sale at some price, every dollar would be sold if a sufficient volume of goods were offered in exchange. While some dollar owners are not interested in owning gold at any price, those who are interested have a maximum buying price for each ounce that they might purchase. You can think of their buying prices for gold ounces as their reservation price for holding dollars.
How the Price of Gold Is FormedRothbard provides a detailed, bottom-up analysis of price formation in a market like this. I will demonstrate his model with a sequence of diagrams that show how the dollar price of gold is formed. As a first step, suppose that while gold trading had been suspended for some time, the preferences of some of the gold owners and nonowners changed. Thus, when the market opens, some of them wish to buy while others wish to sell.
Rothbard constructs supply and demand curves using the reservation prices of the individual buyers and sellers. The supply curve at each price is the total amount of gold ounces for sale by all gold owners at or above that price. The demand curve at each price is the total amount gold ounces that could be purchased with the dollars offered at that price (or below that price). The market-clearing price is that point where supply and demand are balanced.
Figure 1: Before TradingWhen trading opened, the market participants would converge on market-clearing price. Once a price had been established, all of the buyers offering at or above that price would buy, and the all of the sellers asking at or below that price would sell. Trading would continue until no one wanted to exchange gold for dollars or dollars for gold. At that point in time, the market will have cleared. Supply and demand curves would be as they are in Figure 2.
After trading, everyone has adjusted gold and dollar balances to their preferred levels. The market would show two quoted prices for gold: the best bid and the best offer. The best bid is the price offered by the marginal nonbuyer of gold, and the best offer is the price asked by the marginal nonseller of gold. More trading could occur only if a buyer increased their bid price, or a seller decreased their ask price, for at least one ounce.
Figure 2: After TradingSuppose that, from this new starting point, one gold owner lowered his asking price for one of his ounces below the best offer of the most marginal seller. A trade would then take place between the gold owner and the marginal seller. What would the situation be after the trade? The same as before, except that the best bid and best offer prices might be different. The new prices would depend on the reservation price of the buyer of the single ounce. If his reservation price were above the best bid but below that of the next most marginal seller, then the new buyer would become the marginal seller and would set the best offer price. But his reservation price might be much higher — enough to make another one of the existing gold owners the new marginal seller.
The miner is different from other gold owners in that he produces gold, while the other owners bought their gold. But from a price-formation standpoint, it doesn't matter how or where it came from; the miner can choose a reservation price, or not. Most miners do not have a reservation price; they sell at market.[4]
The gold analysts and I agree that, in a market, the marginal buyer and seller set the prices. It is also true that the miner is always a marginal seller because they sell at market. However, the entire population of suppliers and demanders must be considered in order to identify who the marginal buyers are and the price where the trades take place. All of the demanders influence the price through their decision not to offer a higher price. All of the (nonmine) suppliers influence the price through their decision not to ask for a lower price. To sell at market means to sell at the price set largely by those buyers and sellers who do have reservation prices. The problem with the consumption model is that it ignores the influence of the majority of sellers on the price.
How does the presence of sellers selling at market affect the price? The miner's presence affects the supply curve as shown in Figure 3.
Figure 3: Mine and Nonmine Supply Some trades will take place below what was the best bid before the miner entered the market, as shown in Figure 4.
Figure 4: Mining and SupplyOnce the miner has sold his stocks, we are back to the situation shown in Figure 2. What was the freshly mined gold is part of the new buyer's stockpile. There will be a new bid and ask price, which will take into account the reservation price of the person who bought the miner's gold. We cannot say what the new bid and ask will be: either could be above or below the price before the miner sold.
Some ObjectionsNow that I've explained how the price of gold is determined in the market, I will look at two of the objections I have received when I have presented the ideas above:
Mine supply is the only supply available to the market, because gold investors are primarily of the buy-and-hold mindset.If gold buyers typically have long holding periods, then is gold like oil that was burned or corn that was eaten? Is it gone forever and not part of the market?
Every asset is for sale at some price. While many small gold coin and bar buyers have a reservation price that is more than $10 above today's price, they do have a reservation price. There is a point at which other assets (stocks or bonds) or consumption goods (cars or houses) would start to look more attractive than holding the marginal ounce of gold. There can be no doubt that a good many gold owners would become sellers at $5,000, $10,000, or $100,000 per ounce.
Existing stocks of gold don't affect the price because they are not for sale at the current price.On closer examination, this is not really an argument: it is only a restatement of the definition of price. A price in a cleared market is that quantity of money below which nothing is offered for sale. While this is true, it does not provide any information about what the price will be. As discussed above, the price at which the first mined ounce is sold is set by the marginal nonseller and nonbuyers of gold.
Suppose, for example, that all of the gold owners had a reservation price of $5,000 or higher per ounce, with the buy prices of people holding dollars remaining where they are now. If that were the case, then once miners had sold their gold, gold would be offered at around $5,000 per ounce.
Conclusion$20 $14
While mining doesn't have much impact on the gold price, the reverse is not true: the gold price has significant influence on the mining industry. The economics of mining explains this. The cost of getting the gold out of the ground is sensitive to several factors, including the grade of the deposit, its depth below the surface, proximity to refining infrastructure, the cost of energy, the cost of labor, and other variables. The marginal cost of mining more gold above current production rises rather sharply. It would not be profitable for the gold-mining industry to increase production enough to have much impact on the total gold supply during any given year.
The consumption model of gold pricing ignores the influence of the majority of sellers on the price of gold. It counts only a minority of the sellers. The consumption model does include "scrap sales" (sales by those sellers whose reservation price was low enough to result in a sale). But the suppliers who did not sell outnumber those who did — by a large margin — and the selling price of those who did sell was primarily determined by those who did not.
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Notes[1] The sole exception that I can think of is a report from Credit Agricole, authored by Paul Mylchreest.
[2] You must register with the World Gold Council to download their supply and demand data. For a comprehensive set of statistics, including the total above-ground stockpiles, see Gold Market Knowledge.
[3] The time window of one year is entirely arbitrary — why not one week?
[4] Some miners sell at a predetermined price because they have entered into hedging contracts. This price could be above or below the market. Other miners (though very few) do have a reservation price. These miners stockpile gold if it is above their reservation price.
[April 1955]
The Republican president of the United States believes that no person should be allowed or required to work for less than 90 cents an hour. The Democratic governor of New York urges raising the minimum wage to $1.25 from its present level of 75 cents.
Except for such differences in detail, fixing a minimum wage by law has come to be a bipartisan project. That may indicate good politics — but it is no assurance that a minimum wage law will accomplish what is claimed for it.
Beginning with the truism that "the laborer is worthy of his hire," proponents of the minimum wage interpret it to mean that anyone who works thereby establishes a valid claim against his employer, or against society, for a wage sufficient to assure an adequate standard of living. Though it may be difficult to say precisely what constitutes an adequate standard of living, the opinion is widely held that such a standard lies somewhere between the prevailing extremes of wealth and of poverty; underlying this opinion is the assumption the poor are poor because the rich are rich; that is, that employers exploit their employees.
It is supposed that employers withhold as much as they can of what the workers have produced — that the so-called "wages fund" is not fully disbursed as wages — and that this is a crime against workers in particular and society in general. And if crime is being committed, it is the duty of government to intervene; hence, a minimum wage law.
If this theory is correct, how is the injustice of inequality, or exploitation, done away with by a minimum wage as low as 90 cents or $1.25 an hour? If the compulsory equalization of wealth is a proper means to a better society, why shouldn't the minimum wage be at least $5 an hour?
The answer, of course, is that the minimum wage theory does not square with experience. The reason is that work, as such, is not something scarce and useful to human beings. Sheer effort is not one of the things men will buy in the market place.
The goods and services produced by workmen are the things valued, regardless of how much or how little labor went into their creation. If a horse can pull ten times as many cabbages to market as a man can, who in his right mind would hire a man instead of a horse for that job?
But if the horse is hired, should the cabbage-mover then be required to pay ten men to sit by and watch the operation? That would be a logical development, according to the minimum wage theory that human labor is the only thing of value to society.
That theory is wrong because horsepower also has value, as tools are valuable, and scientific knowledge, and a great many other things besides direct physical labor. How valuable? Why, just as valuable as producers and consumers jointly determine in the market place.
There is no such thing as a "wages fund" in the minds of individual buyers and sellers who bargain with one another. The money a man owns, or the property it symbolizes, may be offered in exchange for labor — a service — or it may be offered in exchange for other property.
The fund, if one chooses to call the earnings and savings of individuals a fund, cannot be paid solely and exclusively to labor. Some of it must go as a return for the use of tools and capital, or else there will soon be none of those savings which create job opportunities and which help to improve the productivity of the laborer.
Unemployment of the Least CapableA dictator, it is true, can arbitrarily declare human labor to be the only thing of value in the world; and he can set a minimum or a maximum wage, or just fix prices. But he cannot enforce his dictates because they run contrary to the rules of human behavior.
As long as men harbor their own distinctive sense of values, there is no way of predetermining the price they will pay for what they want. That is set in the market place, whether it is legal or "black."
A $5 minimum wage is indeed ridiculous, not because $5 is the wrong amount, but because it is ridiculous to try to set a minimum wage at any level. It doesn't work. And it is an injustice to the people it is supposed to help — the less productive and less fortunate members of society.
If a minimum wage is set high enough to have any effect, that effect must be a closing of the market to those persons least capable of earning a living. For the minimum wage denies such persons the right to offer their services for what they are worth. The law says in effect, "If you are not worth the legal minimum wage, you are not worth anything."
This, of course, is arbitrariness of the very worst kind. It is difficult to visualize a greater injustice than this among supposedly civilized human beings — the strong ganging up to deprive the weak of their limited means of helping themselves.
Setting a minimum wage, below which no man may sell his services, is like setting a floor price for potatoes. The higher the floor price, the less demand there will be for potatoes. Those growers of potatoes who are least skilled in the arts of production will have been forced out of the market arbitrarily. And so will those buyers who can least afford to pay the price for potatoes.
If government intervenes to support the market at the floor price, then these two groups — the poorest producers and the poorest consumers — become the wards of the government, each dependent on a subsidy for survival. The government assumes the obligation, by means of unemployment compensation, to support those who were either directly or indirectly forced out of productive employment. The higher the minimum wage level, the more unemployment there must be.
Denying a man the right to offer his services, by fixing the minimum wage at more than his services are worth, is to deprive him of a market for the only thing in the world he could have justified as his own. But that is not the end of the evil of the minimum wage. Those unused productive powers are lost, and society is poorer because of it.
And if there is this kind of restraint upon the available supply of goods and services in the world, who suffers first and most? Why, the victims are those least able to pay the price for even the barest essentials of life!
Lessons of the DepressionThe inhuman consequences of the minimum wage idea were shown up during the great Depression of the thirties. Labor unions, which had been gaining membership steadily during the twenties, were so bound to a philosophy of ever-rising wage rates that they could not adjust to a changed market situation, even though such rigidity forced many of their own members to join the ranks of the jobless.
Equally well-meaning businessmen, lured by the promises of the National Industrial Recovery Act, pledged themselves to codes which would not let prices or wage rates find their proper level. Though most of the minimum wage legislation did not come until later in the thirties, the early years of the Depression were nonetheless marked by government compulsions along the lines of the minimum wage idea.
And the direct consequence of this organized coercive interference with the free market was a prolonged and unnecessary period of hardship for people who sought to earn a living. The "experts" on social problems speak glibly of the free market and open competition as forms of barbarism. They describe the individual bargaining process of price and wage determination as an outmoded application of "the law of the jungle."
But the basic law of the jungle is that might makes right; differences of opinion are subject to settlement by violence or compulsion. Perhaps the most significant departure human beings have ever made from jungle law is in the direction of a reasoned and deliberate tolerance for individuality — a mutual respect for both inherited and cultivated characteristics which make each of us different from every other person.
In the economic or material sense, this tolerance and respect for the rights of one another is reflected in the concept of private ownership and control of property. It allows and encourages exchange of goods and services among those who have something to offer and are willing to trade.
It is true that such voluntary exchange serves the self-interest of everyone involved. But that is no reason for referring to the competitive market process as though it were an evil example of the law of the jungle. Voluntary exchange rejects rather than follows the rule that might makes right.
The rule of the market is that personal choice is right, up to the point that such choice begins to injure an innocent person. This is quite the opposite of jungle warfare which considers weak and relatively defenseless individuals to be fair game for the strong and cunning.
There is one big humanitarian reason for adherence to the market method of voluntary exchange, and that reason is the desire to act charitably toward those less fortunate than oneself. They are the ones who would not survive the rigors of the jungle and who would end up most permanently enslaved in any politically regulated society.
The one great blessing of the market economy is that it encourages every individual to develop his talents, however limited they might be. And it assures each a full measure of value for the much or the little that he has to contribute to the satisfaction of human needs. Thus does a free society inevitably out-produce any other kind, creating more useful things the very abundance of which is the poor man's assurance of a chance for survival.
$15 $12
Buy 10 to 100, save $3 each.There are sound reasons why some men should earn more for their efforts than do others — why skilled labor should be worth more than unskilled — why the successful manager of a business should receive more than any of his employees. Human beings are not all alike, in either capacities or desires.
Prices and wages as determined in a free market, unrigged by political intervention, are the best means of insuring the production and equitable distribution of the goods and services all men seek. Those who have most clearly proved their productive capacity are rewarded accordingly through the voluntary acts of their fellow men in the market place. This is the signal to produce even more, and it is the incentive which attracts other men to lead more useful and productive lives. A compulsory minimum wage, at any level, can only add to the hazards of the jungle.
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This article was originally published as "Inhumanity of the Minimum Wage" in The Freeman, April 1955.
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European politicians want to achieve broadband access for all. They think that this is a panacea and could even drive Europe out of the current economic situation. In fact, the European Commission "considers it of the greatest importance that, within the European Union, key services such as e-communications are widely available to citizens and businesses, independently of their geographical location, and at an affordable price and specified quality."[1]
Current regulation is failing to achieve this goal. So, politicians are looking for new ideas to push forward their vision for society. There is one proposal that has been in the making for some time, but which has only recently gained momentum due to the impulse of the UK government. It consists of including broadband service as part of the scope of the universal service obligations.
In the wake of liberalization, universal service obligations were introduced to safeguard the concept of reasonable access at an affordable price, irrespective of income levels and geographic location. Originally, these obligations were related to telecommunication services and, in most cases, still are.
If broadband services are considered universal service, one or more operators will be obliged to provide these services at reasonable and geographically uniform prices. In this way, the proponents think that broadband access for all will be achieved. Of course, there is no surer way of achieving the opposite effect.
The Provision of Broadband Services in the Unhampered MarketWhen analyzing policy options, Austrian economics begins by elucidating the operation of a free market. As Ludwig von Mises writes, "Only at a later stage, having exhausted everything which can be learned from the study of this imaginary construction, does it turn to the study of the various problems raised by interference with the market on the part of governments."[2]
In a free market, there is no imbalance between demand and supply. This means that every consumer who is ready to pay the price will be able to obtain their desired product. In a free market, there are no shortages. All demand is satisfied, and there is no need to impose an obligation of forced sales.
The price of the product tends to be the cost of production plus the going rate of profit for the capital invested.[3] If prices exceed the costs by more than this amount, there is a tendency toward expanded production and lower prices. This process is driven by entrepreneurs in search of profits.
Applied to broadband access, this implies that every consumer who values the service more than its price would be able to buy it and thus have broadband access. Because of this, the goal of extending broadband access would be accomplished. In fact, this goal is always accomplished in a free market.
Of course, the question about the affordability of the price remains. It has just been stated that the price will tend toward the cost of production plus the going rate of profit for investments. Nothing, then, can be said about its affordability in absolute terms. In fact, the affordability of the price will depend on the preferences of the individuals and their subjective valuations of the goods. What is affordable to one individual may not be so to another.
However, the market process of discovery is also at work. Market prices provide information to entrepreneurs on the valuation of resources and on the consequent opportunities for profit. The existence of profits in the broadband industry are a sign to entrepreneurs that they should drive resources toward providing broadband access in those areas where prices allow it.
As a result, new ways of providing broadband access would be discovered — for example, new technologies or new applications of existing ones — or of increasing the efficacy of its use. It is not possible to predict which new ideas the discovery market process would uncover. However, what can be said is that:
It would drive down the price toward the cost of production plus the going rate of profits.
It may well find cheaper ways of providing the service, thus driving down the costs of production — and, in turn, the price of the service.
Due to the law of diminishing marginal utility, a lower price for broadband access will (ceteris paribus) make it desirable to more individuals. In fact, the market process of discovery will make broadband access affordable to more and more individuals over time, achieving an increase in both the extension and affordability of the service.
In summary, a free market achieves, automatically, a universal extension of service to those users willing to pay its price. Moreover, it assures that this price will tend toward the cost of production plus the going rate of profits. Finally, it unleashes the market process of discovery, so that new technologies and uses drive down the costs of production, increase the quality and variety of the service, or do both things.
Imposing a "Reasonable" PriceHowever, policy makers often think that the unhampered market price is not affordable, or they grow impatient while the market process evolves. In those cases, they may be tempted to impose a presumed "affordable" price on the assumption that it will quicken the extension of the service. This is precisely the proposal of the UK government with respect to broadband access.
Of course, the first question is defining what is considered a "reasonable" or "affordable" price. As was shown above, there is no abstract, absolute level of affordability, apart from giving the service for free. What is considered affordable for some individuals — according to their particular rankings of values — is not so for others.
Thus, policy makers find themselves confronted with the insurmountable task of determining a price outside of the market. No matter what reasons are invoked to claim that the established prices are fair, reasonable, or affordable, they are always arbitrary. The only fair, nonarbitrary price in the market is the one at which both buyer and seller freely choose to make the interchange.[4]
However, this problem has proven to be of no concern for policy makers, who nevertheless come up with an "affordable" price — according to their own criteria. Once the affordable price is set, one of two things can happen:
The affordable price is above the unhampered market price. In this case, there are no consequences for the market.
The affordable price is below the unhampered market price. In this case, a genuine price control is in place, and the theory of price control is at work.[5]
For broadband access in Europe, the most likely outcome of intervention would be that the regulated price will be above unhampered market prices in some geographical areas and below them in other areas. This is due largely to the influence that features such as population density,[6] income levels,[7] and the nature of the territory have in affecting the cost of providing telecommunication services. This is widely recognized by the industry and its regulators.[8]
The theory of price control tells us that, in those geographic areas where the regulated price is below the unhampered market price (that is, high-cost areas), no operator will voluntarily provide the service. Instead, the government will need to impose sales obligations if it wants to stick to its original goal.
This is not enough to guarantee the desired effect — that is, that of all who demand broadband access having it at the affordable price. Demand exceeds supply, which leads to shortages in the provision for high-cost areas.
Thus, the next step would be rationing in high-cost areas. In any case, the theory of price control shows that the government must ultimately resort to central planning in order to attain broadband access at affordable prices in all geographical areas.
If the government is not willing or able to intervene further in the market, then the shortages will remain in place. Shortages under price controls disrupt production.[9] Among the consequences of shortages, the most important for broadband access would likely be the reduction of quality and service, the increase of maintenance and replacement costs, and delays in production.
There is still another effect resulting from the imposition of a "reasonable" price below market prices: the stifling of the market process of discovery. According to Kirzner's theory, regulation may inhibit desirable discovery processes which the market might have generated.[10]
Specifically, the imposition of an affordable price will restrict supply of broadband access from operators competing in other geographical areas. But not only that: it will also inhibit the discovery of wholly unknown sources of supply (like new technologies) and hinder activities as yet unforeseen. The regulated price disincentivizes entrepreneurial activity that could lead to innovative — and probably cheaper — ways of providing broadband access.
It is now clear that the imposition of broadband price affordability is incompatible with the extension of the service. Lack of profitability makes forced sales necessary — at least in high-cost areas — as the theory of price control predicts. If the government is not ready to enact central planning to support its goal, shortages will occur. Not every individual who is willing to pay the price will have access to broadband, and quality and service will suffer. Moreover, the market process of discovery will be stifled, and no entrepreneur will have the profit incentive to look for cheaper ways of providing the service, so that costs will actually remain higher than they otherwise would in a free market.
ConclusionThe only way to guarantee extension of broadband service in an efficient way is to avoid any intervention in the market. Only the free market guarantees that all demand is satisfied, and that the price is the minimum realizable without confiscating wealth from some individuals in favor of others. In addition, the free market allows the full working of the market process of discovery, which fuels dynamic efficiency, increases innovation, and can eventually lead to lower (and thus more affordable) prices.
$15 $14
According to the theory of price control, the imposition of affordable prices would make inevitable the imposition of forced sales for broadband access in high-cost areas. If the government is not ready to intervene continuously, shortages will develop in those areas, and the objective of extension of broadband access will be impaired.
In summary, the inclusion of broadband access in the universal service obligation will not only fail to achieve extension of broadband access, but will also fall short of the extension that would otherwise be attained under free market conditions.
But, then, what else could be expected from a government that is about to re-nationalize the telecommunication network after twenty-five years of liberalization?[11]
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Notes[1] European Commission, Communication from the Commission to the European Parliament, The Council, The European Economic and Social Committee, and the Committee of the Regions: On the Second Periodic Review of the Scope of Universal Service in Electronic Communications Networks and Services in Accordance with Article 15 Of Directive 2002/22/EC (COM, 2008), 572 Final, Setpember 9, 2008.
[2] Ludwig von Mises, Human Action (Auburn: Ludwig von Mises Institute, 1998), p. 239.
[3] George Reisman, Capitalism (Jameson Books, 1990), ch. 6.
[4] Laurence Vance, "The Myth of the Just Price," Mises Daily, March 31, 2008.
[5] Ludwig von Mises, "Theory of Price Control," in A Critique of Interventionism (Arlington House, 1977).
[6] See, for instance, Johannes Bauer, Jung Hyun Kim, and Steven Wildman, "Broadband Uptake in OECD Countries: Policy Lessons from Comparative Statistical Analysis" (paper presented at the 31st Research Conference on Communication, Information, and Internet Policy, Arlington, Virginia, September 19–21, 2003).
[7] Kenneth Flamm, "The Role of Economics, Demographics and State Policy in Broadband Availability" (paper presented at the PURC/London Business School Conference on The Future of Broadband: Wired and Wireless, 2005, Gainesville, Florida, February 24, 2005).
[8] For example, in the recent ERG Common Position on Geographic Aspects of Market Analysis: "NRAs should also be aware that the underlying costs may (or are even likely to) differ between geographic areas and that a cost oriented price for a particular geographic area may be different than an averaged cost oriented price for a national market."
[9] For an exhaustive description of these consequences, see Reisman, ch. 7.
[10] Israel Kirzner, "The Perils of Regulation: A Market Process Approach" in Austrian Economics: A Reader, Champions of Freedom, Ludwig von Mises Lectures Series, Volume 18, ed. Richard Ebeling, (Hillsdale College Press, 1991), pp. 618–654.
[11] See Richard Wray and Ashley Seager, "'Doomsday' Plan to Renationalize BT," The Observer, February 15, 2009. For a theoretical explanation based on the theory of price control, see Fernando Herrera-Gonzalez, "Europe's Internet Troubles," Mises Daily, December 4, 2007.
The government's initial step in attempting to create a government-run healthcare monopoly has been to propose a law that would eventually drive the private health insurance industry out of existence. Additional taxes and mandated costs are to be imposed on health insurance companies, while a government-run "health insurance" bureaucracy will be created, ostensibly to "compete" with the private companies. The hoped-for end result is one big government monopoly which, like all government monopolies, will operate with all the efficiency of the post office and all the charm and compassion of the IRS.
Of course, it would be difficult to compete with a rival who has all of his capital and operating costs paid out of tax dollars. Whenever government "competes" with the private sector, it makes sure that the competition is grossly unfair, piling costly regulation after regulation, and tax after tax on the private companies while exempting itself from all of them. This is why the "government-sponsored enterprises" Fannie Mae and Freddie Mac were so profitable for so many years. It is also why so many abysmally performing "public" schools remain in existence for decades despite their utter failure at educating children.
America's Healthcare Future?Some years ago, the Nobel-laureate economist Milton Friedman studied the history of healthcare supply in America. In a 1992 study published by the Hoover Institution, entitled "Input and Output in Health Care," Friedman noted that 56 percent of all hospitals in America were privately owned and for-profit in 1910. After 60 years of subsidies for government-run hospitals, the number had fallen to about 10 percent. It took decades, but by the early 1990s government had taken over almost the entire hospital industry. That small portion of the industry that remains for-profit is regulated in an extraordinarily heavy way by federal, state and local governments so that many (perhaps most) of the decisions made by hospital administrators have to do with regulatory compliance as opposed to patient/customer service in pursuit of profit. It is profit, of course, that is necessary for private-sector hospitals to have the wherewithal to pay for healthcare.
Friedman's key conclusion was that, as with all governmental bureaucratic systems, government-owned or -controlled healthcare created a situation whereby increased "inputs," such as expenditures on equipment, infrastructure, and the salaries of medical professionals, actually led to decreased "outputs" in terms of the quantity of medical care. For example, while medical expenditures rose by 224 percent from 1965–1989, the number of hospital beds per 1,000 population fell by 44 percent and the number of beds occupied declined by 15 percent. Also during this time of almost complete governmental domination of the hospital industry (1944–1989), costs per patient-day rose almost 24-fold after inflation is taken into account.
The more money that has been spent on government-run healthcare, the less healthcare we have gotten. This kind of result is generally true of all government bureaucracies because of the absence of any market feedback mechanism. Since there are no profits in an accounting sense, by definition, in government, there is no mechanism for rewarding good performance and penalizing bad performance. In fact, in all government enterprises, exactly the opposite is true: bad performance (failure to achieve ostensible goals, or satisfy "customers") is typically rewarded with larger budgets. Failure to educate children leads to more money for government schools. Failure to reduce poverty leads to larger budgets for welfare state bureaucracies. This is guaranteed to happen with healthcare socialism as well.
Costs always explode whenever the government gets involved, and governments always lie about it. In 1970 the government forecast that the hospital insurance (HI) portion of Medicare would be "only" $2.9 billion annually. Since the actual expenditures were $5.3 billion, this was a 79 percent underestimate of cost. In 1980 the government forecast $5.5 billion in HI expenditures; actual expenditures were more than four times that amount — $25.6 billion. This bureaucratic cost explosion led the government to enact 23 new taxes in the first 30 years of Medicare. (See Ron Hamoway, "The Genesis and Development of Medicare," in Roger Feldman, ed., American Health Care, Independent Institute, 2000, pp. 15-86). The Obama administration's claim that a government takeover of healthcare will somehow magically reduce costs is not to be taken seriously. Government never, ever, reduces the cost of doing anything.
All government-run healthcare monopolies, whether they are in Canada, the UK, or Cuba, experience an explosion of both cost and demand — since healthcare is "free." Socialized healthcare is not really free, of course; the true cost is merely hidden, since it is paid for by taxes.
Whenever anything has a zero explicit price associated with it, consumer demand will increase substantially, and healthcare is no exception. At the same time, bureaucratic bungling will guarantee gross inefficiencies that will get worse and worse each year. As costs get out of control and begin to embarrass those who have promised all Americans a free healthcare lunch, the politicians will do what all governments do and impose price controls, probably under some euphemism such as "global budget controls."
Price controls, or laws that force prices down below market-clearing levels (where supply and demand are coordinated), artificially stimulate the amount demanded by consumers while reducing supply by making it unprofitable to supply as much as previously. The result of increased demand and reduced supply is shortages. Non-price rationing becomes necessary. This means that government bureaucrats, not individuals and their doctors, inevitably determine who will get medical treatment and who will not, what kind of medical technology will be available, how many doctors there will be, and so forth.
All countries that have adopted socialized healthcare have suffered from the disease of price-control-induced shortages. If a Canadian, for instance, suffers third-degree burns in an automobile crash and is in need of reconstructive plastic surgery, the average waiting time for treatment is more than 19 weeks, or nearly five months. The waiting time for orthopaedic surgery is also almost five months; for neurosurgery it's three full months; and it is even more than a month for heart surgery (see The Fraser Institute publication, Waiting Your Turn: Hospital Waiting Lists in Canada). Think about that one: if your doctor discovers that your arteries are clogged, you must wait in line for more than a month, with death by heart attack an imminent possibility. That's why so many Canadians travel to the United States for healthcare.
All the major American newspapers seem to have become nothing more than cheerleaders for the Obama administration, so it is difficult to find much in the way of current stories about the debacle of nationalized healthcare in Canada. But if one goes back a few years, the information is much more plentiful. A January 16, 2000, New York Times article entitled "Full Hospitals Make Canadians Wait and Look South," by James Brooke, provided some good examples of how Canadian price controls have created serious shortage problems.
A 58-year-old grandmother awaited open-heart surgery in a Montreal hospital hallway with 66 other patients as electric doors opened and closed all night long, bringing in drafts from sub-zero weather. She was on a five-year waiting list for her heart surgery.
In Toronto, 23 of the city's 25 hospitals turned away ambulances in a single day because of a shortage of doctors.
In Vancouver, ambulances have been "stacked up" for hours while heart attack victims wait in them before being properly taken care of.
At least 1,000 Canadian doctors and many thousands of Canadian nurses have migrated to the United States to avoid price controls on their salaries.
Wrote Mr. Brooke, "Few Canadians would recommend their system as a model for export."
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Canadian price-control-induced shortages also manifest themselves in scarce access to medical technology. Per capita, the United States has eight times more MRI machines, seven times more radiation therapy units for cancer treatment, six times more lithotripsy units, and three times more open-heart surgery units. There are more MRI scanners in Washington state, population five million, than in all of Canada, with a population of more than 30 million (See John Goodman and Gerald Musgrave, Patient Power).
In the UK as well — thanks to nationalization, price controls, and government rationing of healthcare — thousands of people die needlessly every year because of shortages of kidney dialysis machines, pediatric intensive care units, pacemakers, and even x-ray machines. This is America's future, if "ObamaCare" becomes a reality.
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It might be asserted that labor unions, in exacting higher wage rates on the free market, are achieving monopoly prices. However, it is not true that a union wage rate could ever be called a monopoly price. For the characteristic of the monopolist is precisely that he monopolizes a factor or commodity. To obtain a monopoly price, he sells only part of his supply and withholds selling the other part, because selling a lower quantity raises the price on an inelastic demand curve. It is the unique characteristic of labor in a free society, however, that it cannot be monopolized. Each individual is a self-owner and cannot be owned by another individual or group. Therefore, in the labor field, no one man or group can own the total supply and withhold part of it from the market. Each man owns himself.
A monopolist's action is always limited by loss of revenue from the withheld supply. But in the case of labor unions, this limitation does not apply. Since each man owns himself, the "withheld" suppliers are different people from the ones getting the increased income. If a union, in one way or another, achieves a higher price than its members could command by individual sales, its action is not checked by the loss of revenue suffered by the "withheld" laborers. If a union achieves a higher wage, some laborers are earning a higher price, while others are excluded from the market and lose the revenue they would have obtained.
These discharged workers are the main losers in this procedure. Since the union represents the remaining workers, it does not have to concern itself, as the monopolist would, with the fate of these workers. At best, they must shift to some other — nonunionized — industry.
The trouble is, however, that the workers are less suited to the new industry. Their having been in the now-unionized industry implies that their worth in that industry was higher than in the industry to which they must shift; consequently, their wage rate is now lower. Moreover, their entry into the other industry depresses the wage rates of the workers already there.
Consequently, at best, a union can achieve a higher, restrictionist wage rate for its members only at the expense of lowering the wage rates of all other workers in the economy. Production efforts in the economy are also distorted. But, in addition, the wider the scope of union activity and restrictionism in the economy, the more difficult it will be for workers to shift their locations and occupations to find nonunionized havens in which to work. And more and more the tendency will be for the displaced workers to remain permanently or quasi-permanently unemployed, eager to work but unable to find nonrestricted opportunities for employment. The greater the scope of unionism, the more a permanent mass of unemployment will tend to develop.
Unions try as hard as they can to plug all the "loopholes" of nonunionism, to close all the escape hatches where the dispossessed workmen can find jobs. This is termed "ending the unfair competition of nonunion, low-wage labor." A universal union control and restrictionism would mean permanent mass unemployment, growing ever greater in proportion to the degree that the union exacted its restrictions.
It is a common myth that only the old-style "craft" unions, which deliberately restrict their occupational group to highly skilled trades with relatively few numbers, can restrict the supply of labor. They often maintain stringent standards of membership and numerous devices to cut down the supply of labor entering the trade. This direct restriction of supply doubtless makes it easier to obtain higher wage rates for the remaining workers. But it is highly misleading to believe that the newer-style "industrial" unions do not restrict supply. The fact that they welcome as many members in an industry as possible cloaks their restrictionist policy.
Unemployment by DecreeThe crucial point is that the unions insist on a minimum wage rate higher than what would be achieved for the given labor factor without the union. By doing so, they necessarily cut the number of men whom the employer can hire. Ergo, the consequence of their policy is to restrict the supply of labor, while at the same time they can piously maintain that they are inclusive and democratic, in contrast to the snobbish "aristocrats" of craft unionism.
In fact, the consequences of industrial unionism are more devastating than those of craft unionism. For the craft unions — being small in scope — displace and lower the wages of only a few workers. The industrial unions, larger and more inclusive, depress wages and displace workers on a large scale and, what is even more important, can cause permanent mass unemployment.
The unemployment and the misemployment of labor, caused by restrictionist wage rates, need not always be directly visible. Thus, an industry might be particularly profitable and prosperous, either as a result of a rise in consumer demand for the product or from a cost-lowering innovation in the productive process. In the absence of unions, the industry would expand and hire more workers in response to the new market conditions. But if a union imposes a restrictionist wage rate, it may not cause the unemployment of any current workers in the industry; it may, instead, simply prevent the industry from expanding in response to the requirements of consumer demand and the conditions of the market. Here, in short, the union destroys potential jobs in the making and imposes a misallocation of production by preventing expansion. It is true that, without the union, the industry will bid up wage rates in the process of expansion; but if unions impose a higher wage rate at the beginning, the expansion will not occur.
Why Workers AgreeSome opponents of unionism go to the extreme of maintaining that unions can never be free-market phenomena and are always "monopolistic" or coercive institutions. Although this might be true in actual practice, it is not necessarily true. It is very possible that labor unions might arise on the free market and even gain restrictionist wage rates.
How can unions achieve restrictionist wage rates on the free market? The answer can be found by considering the displaced workers. The key problem is this: Why do the workers let themselves be displaced by the union's minimum wage scale? Since they were willing to work for less before, why do they now meekly agree to being fired and looking for a poorer-paying job? Why do some remain content to continue in a quasi-permanent pocket of unemployment in an industry, waiting to be hired at the excessively high rate? The only answer, in the absence of coercion, is that they have adopted on a commandingly high place on their value scales the goal of not undercutting union wage rates. Unions, naturally, are most anxious to persuade workers, both union and nonunion, as well as the general public, to believe strongly in the sinfulness of undercutting union wage rates.
This is shown most clearly in those situations where union members refuse to continue working for a firm at a wage rate below a certain minimum (or on other terms of employment). This situation is known as a strike. The most curious thing about a strike is that the unions have been able to spread the belief throughout society that the striking members are still "really" working for the company even when they are deliberately and proudly refusing to do so. The natural answer of the employer, of course, is to turn somewhere else and to hire laborers who are willing to work on the terms offered. Yet unions have been remarkably successful in spreading the idea through society that anyone who accepts such an offer — the "strikebreaker" — is the lowest form of human life.
To the extent, then, that nonunion workers feel ashamed or guilty about "strikebreaking" or other forms of undercutting union-proclaimed wage scales, the displaced or unemployed workers agree to their own fate. These workers, in effect, are being displaced to poorer and less satisfying jobs voluntarily, and remain unemployed for long stretches of time voluntarily. It is voluntary because that is the consequence of their voluntary acceptance of the mystique of "not crossing the picket line" or of not being a strikebreaker.
There are undoubtedly countless numbers of workers who do not realize that their refusal to cross a picket line, their "sticking to the union," may result in their losing their jobs and remaining unemployed.
When the People LearnAs for the unions, the consequences of their activity, when discovered (for example, displacement or unemployment for oneself or others), will be considered unfortunate by most people. Therefore, it is certain that when knowledge of these consequences becomes widespread, far fewer people will be "pro-union" or hostile to "nonunion" competitors.
Such conclusions will be reinforced when people learn of another consequence of trade union activity: that a restrictionist wage raises costs of production for the firms in the industry. This means that the marginal firms in the industry, the ones whose entrepreneurs earn only a bare rent, will be driven out of business, for their costs have risen above their most profitable price on the market — the price that had already been attained. Their ejection from the market and the general rise of average costs in the industry signify a general fall in productivity and output, and hence a loss to the consumers. Displacement and unemployment, of course, also impair the general standard of living of the consumers.
Unions have had other important economic consequences. Unions are not producing organizations; they do not work for capitalists to improve production. Rather they attempt to persuade workers that they can better their lot at the expense of the employer. Consequently, they invariably attempt as much as possible to establish work rules that hinder management's directives. These work rules amount to preventing management from arranging workers and equipment as it sees fit. In other words, instead of agreeing to submit to the work orders of management in exchange for his pay, the workers now set up not only minimum wages, but also work rules without which they refuse to work.
Everyone LosesThe effect of these rules is to lower the marginal productivity of all union workers. The lowering of marginal value-product schedules has a two-fold result:
it itself establishes a restrictionist wage scale with its various consequences, for the marginal value product has fallen while the union insists that the wage rate remain the same; and
consumers lose by a general lowering of productivity and living standards.
Restrictive work rules therefore also lower output. All this is perfectly consistent with a society of individual sovereignty, however, provided always that no force is employed by the union.
To advocate coercive abolition of these work rules would imply literal enslavement of the workers to the dictates of consumers. But, once again, it is certain that knowledge of these various consequences of union activity would greatly weaken the voluntary adherence of many workers and others to the mystique of unionism.
Unions, therefore, are theoretically compatible with the existence of a purely free market. In actual fact, however, it is evident to any competent observer that unions acquire almost all their power through the wielding of force, specifically force against strikebreakers and against the property of employers. An implicit license to unions to commit violence against strikebreakers is practically universal. Police commonly either remain "neutral" when strikebreakers are molested or else blame the strikebreakers for "provoking" the attacks upon them. Certainly, few pretend that the institution of mass picketing by unions is simply a method of advertising the fact of a strike to anyone passing by.
When unions are permitted to resort to violence, the state or other enforcing agency has implicitly delegated this power to the unions. The unions, then, have become "private states."
Murray Rothbard's writing always displayed the clarity of a first-rate mind, but it is listening to him teach that reveals the humor, the wit, the sheer fun of experiencing his genius.Frustrating the MarketWe have investigated the consequences of unions achieving restrictionist prices. This is not to imply, however, that unions always achieve such prices in collective bargaining. Indeed, because unions do not own workers and therefore do not sell their labor, the collective bargaining of unions is an artificial replacement for the smooth workings of "individual bargaining" on the labor market. Whereas wage rates on the nonunion labor market will always tend toward equilibrium in a smooth and harmonious manner, its replacement by collective bargaining leaves the negotiators with little or no rudder, with little guidance on what the proper wage rates would be.
Even with both sides trying to find the market rate, neither of the parties to the bargain could be sure that a given wage agreement is too high, too low, or approximately correct. Almost invariably, furthermore, the union is not trying to discover the market rate, but to impose various arbitrary "principles" of wage determination, such as "keeping up with the cost of living," a "living wage," the "going rate" for comparable labor in other firms or industries, an annual average "productivity" increase, "fair differentials," and so forth.
This article originally appeared under the title "Restrictionist Pricing of Labor" in The Freeman, May 1963, pp. 11–16.
Good WillMonopoly of DemandConsumption as Affected by Monopoly PricesPrice Discrimination on the Part of the SellerPrice Discrimination on the Part of the BuyerThe Connexity of PricesPrices and IncomePrices and ProductionThe Chimera of Nonmarket Prices[This article is excerpted from chapter 16 of Human Action. Robert Murphy has written a study guide for this chapter, available in HTML and PDF.This article follows "Chapter XVI. Prices, Part 2."]
- Good WillIt must be emphasized again that the market is peopled by men who are not omniscient and have only a more or less defective knowledge of prevailing conditions.
The buyer must always rely upon the trustworthiness of the seller. Even in the purchase of producers' goods the buyer, although as a rule an expert in the field, depends to some extent on the reliability of the seller. This is still more the case on the market for consumers' goods. Here the seller for the most part excels the buyer in technological and commercial insight. The salesman's task is not simply to sell what the customer is asking for. He must often advise the customer how to choose the merchandise which can best satisfy his needs. The retailer is not only a vendor; he is also a friendly helper. The public does not heedlessly patronize every shop. If possible, a man prefers a store or a brand with which he himself or trustworthy friends have had good experience in the past.
Good will is the renown a business acquires on account of past achievements. It implies the expectation that the bearer of the good will in the future will live up to his earlier standards. Good will is not a phenomenon appearing only in business relations. It is present in all social relations. It determines a person's choice of his spouse and of his friends and his voting for a candidate in elections. Catallactics, of course, deals only with commercial good will.
It does not matter whether the good will is based on real achievements and merits or whether it is only a product of imagination and fallacious ideas. What counts in human action is not truth as it may appear to an omniscient being, but the opinions of people liable to error. There are some instances in which customers are prepared to pay a higher price for a special brand of a compound although the branded article does not differ in its physical and chemical structure from another cheaper product. Experts may deem such conduct unreasonable. But no man can acquire expertness in all fields which are relevant for his choices. He cannot entirely avoid substituting confidence in men for knowledge of the true state of affairs. The regular customer does not always select the article or the service, but the purveyor whom he trusts. He pays a premium to those whom he considers reliable.
The role which good will plays on the market does not impair or restrict competition. Everybody is free to acquire good will, and every bearer of good will can lose good will once acquired. Many reformers, impelled by their bias for paternal government, advocate authoritarian grade labeling as a substitute for trademarks. They would be right if rulers and bureaucrats were endowed with omniscience and perfect impartiality. But as officeholders are not free from human weakness, the realization of such plans would merely substitute the defects of government appointees for those of individual citizens. One does not make a man happier by preventing him from discriminating between a brand of cigarettes or canned food he prefers and another brand he likes less.
The acquisition of good will requires not only honesty and zeal in attending to the customers, but no less money expenditure. It takes time until a firm has acquired a steady clientele. In the interval it must often put up with losses against which it balances expected later profits.
From the point of view of the seller good will is, as it were, a necessary factor of production. It is appraised accordingly. It does not matter that as a rule the money equivalent of the good will does not appear in book entries and balance sheets. If a business is sold, a price is paid for the good will provided it is possible to transfer it to the acquirer.
It is consequently a problem of catallactics to investigate the nature of this peculiar thing called good will. In this scrutiny we must distinguish three different cases.
Case 1. The good will gives to the seller the opportunity to sell at monopoly prices or to discriminate among various classes of buyers. This does not differ from other instances of monopoly prices or price discrimination.
Case 2. The good will gives to the seller merely the opportunity to sell at prices corresponding to those which his competitors attain. If he had no good will, he would not sell at all or only by cutting prices. Good will is for him no less necessary than the business premises, the keeping of a well-assorted stock of merchandise and the hiring of skilled helpers. The costs incurred by the acquisition of good will play the same role as any other business expenses. They must be defrayed in the same way by an excess of total proceeds over total costs.
Case 3. The seller enjoys within a limited circle of staunch patrons such a brilliant reputation that he can sell to them at higher prices than those paid to his less renowned competitors. However, these prices are not monopoly prices. They are not the result of a deliberate policy aiming at a restriction in total sales for the sake of raising total net proceeds. It may be that the seller has no opportunity whatsoever to sell a larger quantity, as is the case for example, with a doctor who is busy to the limit of his powers although he charges more than his less popular colleagues. It may also be that the expansion of sales would require additional capital investment and that the seller either lacks this capital or believes that he has a more profitable employment for it. What prevents an expansion of output and of the quantity of merchandise or services offered for sale is not a purposive action on the part of the seller, but the state of the market.
As the misinterpretation of these facts has generated a whole mythology of "imperfect competition" and "monopolistic competition," it is necessary to enter into a more detailed scrutiny of the considerations of an entrepreneur who is weighing the pros and cons of an expansion of his business.
Expansion of a production aggregate, and no less increasing production from partial utilization of such an aggregate to full capacity production, require additional capital investment which is reasonable only if there is no more profitable investment available.Expenditure for additional advertising also means additional input of capital. It does not matter whether the entrepreneur is rich enough to invest his own funds or whether he would have to borrow the funds needed. Also that part of an entrepreneur's own capital which is not employed in his firm is not "idle." It is utilized somewhere in the framework of the economic system. In order to be employed for the expansion of the business concerned these funds must be withdrawn from their present employment.Cash holding, even if it exceeds the customary amount and is called "hoarding," is a variety of employing funds available. Under the prevailing state of the market the actor considers cash holding the most appropriate employment of a part of his assets. The entrepreneur will only embark upon this change of investment if he expects from it an increase in his net returns. In addition there are other doubts which may check the propensity to expand a prospering enterprise even if the market situation seems to offer propitious chances. The entrepreneur may mistrust his own ability to manage a bigger outfit successfully. He may also be frightened by the example provided by once prosperous enterprises for which expansion resulted in failure.
A businessman who, thanks to his splendid good will, is in a position to sell at higher prices than less renowned competitors, could, of course, renounce his advantage and reduce his prices to the level of his competitors. Like every seller of commodities or of labor he could abstain from taking fullest advantage of the state of the market and sell at a price at which demand exceeds supply. In doing so he would be making presents to some people. The donees would be those who could buy at this lowered price. Others, although ready to buy at the same price, would have to go away emptyhanded because the supply was not sufficient.
The restriction of the quantity of every article produced and offered for sale is always the outcome of the decisions of entrepreneurs intent upon reaping the highest possible profit and avoiding losses. The characteristic mark of monopoly prices is not to be seen in the fact that the entrepreneurs did not produce more of the article concerned and thus did not bring about a fall in its price. Neither is it to be seen in the fact that complementary factors of production remain unused although their fuller employment would have lowered the price of the product. The only relevant question is whether or not the restriction of production is the outcome of the action of the — monopolistic — owner of a supply of goods and services who withholds a part of this supply in order to attain higher prices for the rest. The characteristic feature of monopoly prices is the monopolist's defiance of the wishes of the consumers. A competitive price for copper means that the final price of copper tends toward a point at which the deposits are exploited to the extent permitted by the prices of the required nonspecific complementary factors of production; the marginal mine does not yield mining rent. The consumers are getting as much copper as they themselves determine by the prices they allow for copper and all other commodities. A monopoly price of copper means that the deposits of copper are utilized only to a smaller degree because this is more advantageous to the owners; capital and labor which, if the supremacy of the consumers were not infringed, would have been employed for the production of additional copper, are employed for the production of other articles for which the demand of the consumers is less intense. The interests of the owners of the copper deposits take precedence over those of the consumers. The available resources of copper are not employed according to the wishes and plans of the public.
Profits are, of course, also the outcome of a discrepancy between the wishes of the consumers and the actions of the entrepreneurs. If the entrepreneurs had had in the past better foresight of the present state of the market, no profits and losses would have emerged. Their competition would have already adjusted in the past — due allowance being made for time preference — the prices of the complementary factors of production to the present prices of the products. But this statement cannot brush away the fundamental difference between profits and monopoly gains. The entrepreneur profits to the extent he has succeeded in serving the consumers better than other people have done. The monopolist reaps monopoly gains through impairing the satisfaction of the consumers.
- Monopoly of DemandMonopoly prices can emerge only from a monopoly of supply. A monopoly of demand does not bring about a market situation different from that under not monopolized demand. The monopolistic buyer — whether he is an individual or a group of individuals acting in concert — cannot reap a specific gain corresponding to the monopoly gains of monopolistic sellers. If he restricts demand, he will buy at a lower price. But then the quantity bought will drop too.
In the same way in which governments restrict competition in order to improve the position of privileged sellers, they can also restrict competition for the benefit of privileged buyers. Again and again governments have put an embargo on the export of certain commodities. Thus by excluding foreign buyers they have aimed at lowering the domestic price. But such a lower price is not a counterpart of monopoly prices.
What is commonly dealt with as monopoly of demand are certain phenomena of the determination of prices for specific complementary factors of production.
The production of one unit of the commodity m requires, besides the employment of various nonspecific factors, the employment of one unit of each of the two absolutely specific factors a and b. Neither a nor b can be replaced by any other factor; on the other hand a is of no use when not combined with b and vice versa. The available supply of a by far exceeds the available supply of b. It is therefore not possible for the owners of a to attain any price for a. The demand for a always lags behind the supply; a is not an economic good. If a is a mineral deposit the extraction of which requires the use of capital and labor, the ownership of the deposits does not yield a royalty. There is no mining rent.
But if the owners of a form a cartel, they can turn the tables. They can restrict the supply of a offered for sale to such a fraction that the supply of b exceeds the supply of a. Now a becomes an economic good for which prices are paid while the price of b dwindles to zero. If then the owners of b react by forming a cartel too, a price struggle develops between the two monopolistic combines about the outcome of which catallactics can make no statements. As has already been pointed out, the pricing process does not bring about a uniquely determined result in cases in which more than one of the factors of production required is of an absolutely specific character.
It does not matter whether or not the market situation is such that the factors a and b together could be sold at monopoly prices. It does not make any difference whether the price for a lot including one unit of both a and b is a monopoly price or a competitive price.
Thus what is sometimes viewed as a monopoly of demand turns out to be a monopoly of supply formed under particular conditions. The sellers of a and of b are intent upon selling at monopoly prices without regard to the question whether or not the price of m can become a monopoly price. What alone matters for them is to obtain as great a share as possible of the joint price which the buyers are ready to pay for a and b together. The case does not indicate any feature which would make it permissible to apply to it the term monopoly of demand. This mode of expression becomes understandable, however, if one takes into account the accidental features marking the contest between the two groups. If the owners of a (or b) are at the same time the entrepreneurs conducting the processing of m, their cartel takes on the outward appearance of a monopoly of demand. But this personal union combining two separate catallactic functions does not alter the essential issue; what is at stake is the settlement of affairs between two groups of monopolistic sellers.
Our example fits, mutatis mutandis, the case in which a and b can also be employed for purposes other than the production of m, provided these other employments only yield smaller returns.
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Consumption as Affected by Monopoly PricesThe individual consumer may react to monopoly prices in different ways.
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Notwithstanding the rise in price, the individual consumer does not restrict his purchases of the monopolized article. He prefers to restrict the purchase of other goods. (If all consumers were to react in this way, the competitive price would have already risen to the height of the monopoly price.)
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The consumer restricts his purchase of the monopolized article to such an extent that he does not spend for it more than he would have spent — for the purchase of a larger quantity — under the competitive price. (If all people were to react in this way, the seller would not get more under the monopoly price than he did under the competitive price; he would not derive any gain by deviating from the competitive price.)
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The consumer restricts his purchase of the monopolized commodity to such an extent that he spends less for it than he would have spent under the competitive price; he buys with the money thus saved goods which he would not have bought otherwise. (If all people were to react in this way, the seller would harm his interests by substituting a higher price for the competitive price; no monopoly price could emerge. Only a benefactor who wanted to wean his fellow men from the consumption of pernicious drugs would in this case raise the price of the article concerned above the competitive level.)
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The consumer spends more for the monopolized commodity than he would have spent under the competitive price and acquires only a smaller quantity of it.
However the consumer may react, his satisfaction appears to be impaired from the viewpoint of his own valuations. He is not so well served under monopoly prices as under competitive prices. The monopoly gain of the seller is borne by a monopoly deprivation of the buyer. Even if some consumers (as in case 3) acquire goods which they would not have bought in the absence of the monopoly price, their satisfaction is lower than it would have been under a different state of prices. Capital and labor which are withdrawn from the production of products which drops on account of the monopolistic restriction of the supply of one of the complementary factors required for their production, are employed for the production of other things which would otherwise not have been produced. But the consumers value these other things less.
Yet there is an exception to this general rule that monopoly prices benefit the seller and harm the buyer and infringe the supremacy of the consumers' interests. If on a competitive market one of the complementary factors, namely f, needed for the production of the consumers' good g, does not attain any price at all, although the production of f requires various expenditures and consumers are ready to pay for the consumers' good g a price which makes its production profitable on a competitive market, the monopoly price for f becomes a necessary requirement for the production of g. It is this idea that people advance in favor of patent and copyright legislation. If inventors and authors were not in a position to make money by inventing and writing, they would be prevented from devoting their time to these activities and from defraying the costs involved. The public would not derive any advantage from the absence of monopoly prices for f. It would, on the contrary, miss the satisfaction it could derive from the acquisition of g.See below, pp. 676–677.
Many people are alarmed by the reckless use of the deposits of minerals and oil which cannot be replaced. Our contemporaries, they say, squander an exhaustible stock without any regard for the coming generations. We are consuming our own birthright and that of the future. Now these complaints make little sense. We do not know whether later ages will still rely upon the same raw materials on which we depend today. It is true that the exhaustion of the oil deposits and even those of coal is progressing at a quick rate. But it is very likely that in a hundred or five hundred years people will resort to other methods of producing heat and power. Nobody knows whether we, in being less profligate with these deposits, would not deprive ourselves without any advantage to men of the twenty-first or of the twenty-fourth centuries. It is vain to provide for the needs of ages the technological abilities of which we cannot even dream.
But it is contradictory if the same people who lament the depletion of some natural resources are no less vehement in indicting monopolistic restraint in their present-day exploitation. The effect of monopoly prices of mercury is certainly a slowing down of the rate of depletion. In the eyes of those frightened by the aspect of a future scarcity of mercury this effect must appear highly desirable.
Economics in unmasking such contradictions does not aim at a "justification" of monopoly prices for oil, minerals, and ore. Economics has neither the task of justifying nor of condemning. It has merely to scrutinize the effects of all modes of human action. It does not enter the arena in which friends and foes of monopoly prices are intent upon pleading their causes.
Both sides in this heated controversy resort to fallacious arguments. The antimonopoly party is wrong in attributing to every monopoly the power to impair the situation of the buyers by restricting supply and bringing about monopoly prices. It is no less wrong in assuming that there prevails within a market economy, not hampered and sabotaged by government interference, a general tendency toward the formation of monopoly. It is a grotesque distortion of the true state of affairs to speak of monopoly capitalism instead of monopoly interventionism and of private cartels instead of government-made cartels. Monopoly prices would be limited to some minerals which can be mined in only a few places and to the field of local limited-space monopolies if the government were not intent upon fostering them.
Murphy's Guide to MisesThe promonopoly party is wrong in crediting to the cartels the economies of big-scale production. Monopolistic concentration of production in one hand, they say, as a rule reduces average costs of production and thus increases the amount of capital and labor available for additional production. However, no cartel is needed in order to eliminate the plants producing at higher costs. Competition on the free market achieves this effect in the absence of any monopoly and of any monopoly prices. It is, on the contrary, often the purpose of government-sponsored cartelization to preserve the existence of plants and farms which the free market would force to discontinue operations precisely because they are producing at too high costs of production. The free market would have eliminated, for example, the submarginal farms and preserved only those for which production pays under the prevailing market price. But the New Deal preferred a different arrangement. It forced all farmers to a proportional restriction of output. It raised by its monopolistic policy the price of agricultural products to such a height that production became reasonable again on submarginal soil.
No less erroneous are the conclusions derived from a confusion of the economies of product standardization and monopoly. If men asked only for one standard type of a definite commodity, production could be arranged in a more economical way and costs would be lowered accordingly. But if people were to behave in such a manner, standardization and the corresponding cost reduction would emerge also in the absence of monopoly. If, on the other hand, one forces the consumers to be content with one standard type only, one does not increase their satisfaction; one impairs it. A dictator may deem the conduct of the consumers rather foolish. Why should not women be dressed in uniforms like soldiers? Why should they be so crazy about individually fashioned clothes? He may be right from the point of view of his own value judgments. But the trouble is that valuation is personal, individual, and arbitrary. The democracy of the market consists in the fact that people themselves make their choices and that no dictator has the power to force them to submit to his value judgments.
- Price Discrimination on the Part of the SellerBoth competitive prices and monopoly prices are the same for all buyers. There prevails on the market a permanent tendency to eliminate all discrepancies in prices for the same commodity or service. Although the valuations of the buyers and the intensity of their demand as effective on the market are different, they pay the same prices. The wealthy man does not pay more for bread than the less wealthy man, although he would be ready to pay a higher price if he could not buy it cheaper. The enthusiast who would rather restrict his consumption of food than miss a performance of a Beethoven symphony pays no more for admission than a man for whom music is merely a pastime and who would not care for the concert if he could attend it only by renouncing his desire for some trifles. The difference between the price one must pay for a good and the highest amount one would be prepared to pay for it has sometimes been called consumers' surplus.Cf. A. Marshall, Principles of Economics (8th ed. London, 1930), pp. 124127.
But there can appear on the market conditions which make it possible for the seller to discriminate between the buyers. He can sell a commodity or a service at different prices to different buyers. He can obtain prices which may sometimes even rise to the point at which the whole consumers' surplus of a buyer disappears. Two conditions must coincide in order to make price discrimination advantageous to the seller.
The first condition is that those buying at a cheaper price are not in a position to resell the commodity or the service to people to whom the discriminating seller sells only at a higher price. If such reselling cannot be prevented, the first seller's intention would be thwarted. The second condition is that the public does not react in such a way that the total net proceeds of the seller lag behind the total net proceeds he would obtain under price uniformity. This second condition is always present under conditions which would make it advantageous to a seller to substitute monopoly prices for competitive prices. But it can also appear under a market situation which would not bring about monopoly gains. For price discrimination does not enjoin upon the seller the necessity of restricting the amount sold. He does not lose any buyer completely; he must merely take into account that some buyers may restrict the amount of their purchases. But as a rule he has the opportunity to sell the remainder of his supply to people who would not have bought at all or would have bought only smaller quantities if they had had to pay the uniform competitive price.
Consequently the configuration of production costs plays no role in the considerations of the discriminating seller. Production costs are not affected as the total amount produced and sold remains unaltered.
The most common case of price discrimination is that of physicians. A doctor who can perform 80 treatments in a week and charges $3 for each treatment is fully employed by attending to 30 patients and makes $240 a week. If he charges the 10 wealthiest patients, who together consume 50 treatments, $4 instead of $3, they will consume only 40 treatments. The doctor sells the remaining 10 treatments at $2 each to patients who would not have expended $3 for his professional services. Then his weekly proceeds rise to $270.
As price discrimination is practiced by the seller only if it is more advantageous to him than selling at a uniform price, it is obvious that it results in an alteration of consumption and the allocation of factors of production to various employments. The outcome of discrimination is always that the total amount expended for the acquisition of the good concerned increases. The buyers must provide for their excess expenditure by cutting down other purchases. As it is very unlikely that those benefited by price discrimination will spend their gains for the purchase of the same goods as those the other people no longer buy in the same quantity, changes in the market data and in production become unavoidable.
In the above example the 10 wealthiest patients are damaged; they pay $4 for a service for which they used to pay only $3. But it is not only the doctor who derives advantage from the discrimination; the patients whom he charges $2 are benefited too. It is true they must provide the doctor's fees by renouncing other satisfactions. However, they value these other satisfactions less than that conveyed to them by the doctor's treatment. Their degree of contentment attained is increased.
For a full comprehension of price discrimination it is well to remember that, under the division of labor, competition among those eager to acquire the same product does not necessarily impair the individual competitor's position. The competitors' interests are antagonistic only with regard to the services rendered by the complementary nature-given factors of production. This inescapable natural antagonism is superseded by the advantages derived from the division of labor. As far as average costs of production can be reduced by bigscale production, competition among those eager to acquire the same commodity brings about an improvement in the individual competitor's situation. The fact that not only a few people but a great number are eager to acquire the commodity c makes it possible to manufacture it in cost-saving processes; then even people with modest means can afford it. In the same way it can sometimes happen that price discrimination renders the satisfaction of a need possible which would have remained unsatisfied in its absence.
There live in a city p lovers of music, each of whom would be prepared to spend $2 for the recital of a virtuoso. But such a concert requires an expenditure greater than 2 p dollars and can therefore not be arranged. But if discrimination of admission fees is possible and among the p friends of music n are ready to spend $4, the recital becomes feasible, provided that the amount 2 (n + p) dollars is sufficient. Then n people spend $4 each and (p − n) people $2 each for the admission and forego the satisfaction of the least urgent need they would have satisfied if they had not preferred to attend the recital. Each person in the audience fares better than he would have if the unfeasibility of price discrimination had prevented the performance. It is to the interest of the organizers to enlarge the audience to the point at which the admission of additional customers involves higher costs than the fees they are ready to spend.
Things would be different if the recital would have been arranged in spite of the fact that none of those admitted paid more than $2. Then price discrimination would have impaired the satisfaction of those who are charged $4.
The most common practices in selling admission tickets for artistic performances and railroad tickets at different rates are not the outcome of price discrimination in the catallactical sense of the term. He who pays a higher rate gets something appreciated more than he who pays less. He gets a better seat, a more comfortable traveling opportunity, and so on. Genuine price discrimination is present in the case of physicians who, although attending to each patient with the same care, charge the wealthier clients more than the less wealthy. It is present in the case of railroads charging more for the shipping of goods the transportation of which adds more to their value than for others although the costs incurred by the railroad are the same. It is obvious that both the doctor and the railroad can practice discrimination only within the limits fixed by the opportunity given to the patient and the shipper to find another solution of their problems more to their own advantage. But this refers to one of the two conditions required for the emergence of price discrimination.
It would be idle to point out a state of affairs in which price discrimination could be practiced by all sellers of all kinds of commodities and services. It is more important to establish the fact that within a market economy not sabotaged by government interference the conditions required for price discrimination are so rare that it can fairly be called an exceptional phenomenon.
- Price Discrimination on the Part of the BuyerWhile monopoly prices and monopoly gains cannot be realized to the advantage of a monopolistic buyer, the case is different with price discrimination. There is only one condition required for the emergence of price discrimination on the part of a monopolistic buyer on a free market, namely, crass ignorance of the state of the market on the part of the sellers. As such ignorance is unlikely to last for any length of time, price discrimination can only be practiced if the government interferes.
The Swiss Government has established a government owned and operated trade monopoly for cereals. It buys cereals at world-market prices on foreign markets and at higher prices from domestic farmers. In domestic purchases it pays a higher price to farmers producing at higher costs on the rocky soil of the mountain districts and a lower price — although still higher than the world-market price — to the farmers tilling more fertile land.
- The Connexity of PricesIf a definite process of production brings about the products p and q simultaneously, the entrepreneurial decisions and actions are directed by weighing the sum of the anticipated prices of p and q. The prices of p and q are particularly connected with one another as changes in the demand for p (or for q) generate changes in the supply of q (or of p). The mutual relation of the prices of p and q can be called connexity of production. The businessman calls p (or q) a by-product of q (or p).
The production of the consumers' good z requires the employment of the factors p and q, the production of p the employment of the factors a and b, and the production of q the employment of the factors c and d. Then changes in the supply of p (or of q) bring about changes in the demand for q (or for p). It does not matter whether the process of producing z out of p and q is accomplished by the same enterprises which produce p out of a and b and q out of c and d, or by entrepreneurs financially independent of one another, or by the consumers themselves as a preliminary step in their consuming. The prices of p and q are particularly connected with one another because p is useless or of a smaller utility without q and vice versa. The mutual relation of the prices of p and q can be called connexity of consumption.
If the services rendered by a commodity b can be substituted, even though in a not perfectly satisfactory way, for those rendered by another commodity a, a change in the price of one of them affects the price of the other too. The mutual relation of the prices of a and b can be called connexity of substitution.
Connexity of production, connexity of consumption, and connexity of substitution are particular connexities of the prices of a limited number of commodities. From these particular connexities one must distinguish the general connexity of the prices of all goods and services. This general connexity is the outcome of the fact that for every kind of want-satisfaction, besides various more or less specific factors, one scarce factor is required which, in spite of the differences in its qualitative power to produce, can, within the limits precisely defined above,Cf. above, pp. 133–135. be called a nonspecific factor — namely, labor.
Within a hypothetical world in which all factors of production are absolutely specific, human action would operate in a multiplicity of fields of want-satisfaction independent of one another. What links together in our actual world the various fields of want-satisfaction is the existence of a great many nonspecific factors, suitable to be employed for the attainment of various ends and to be substituted in some degree for one another. The fact that one factor, labor, is on the one hand required for every kind of production and on the other hand is, within the limits defined, nonspecific, brings about the general connexity of all human activities. It integrates the pricing process into a whole in which all gears work on one another. It makes the market a concatenation of mutually interdependent phenomena.
It would be absurd to look upon a definite price as if it were an isolated object in itself. A price is expressive of the position which acting men attach to a thing under the present state of their efforts to remove uneasiness. It does not indicate a relationship to something unchanging, but merely the instantaneous position in a kaleidoscopically changing assemblage. In this collection of things considered valuable by the value judgments of acting men each particle's place is interrelated with those of all other particles. What is called a price is always a relationship within an integrated system which is the composite effect of human valuations.
- Prices and IncomeA market price is a real historical phenomenon, the quantitative ratio at which at a definite place and at a definite date two individuals exchanged definite quantities of two definite goods. It refers to the special conditions of the concrete act of exchange. It is ultimately determined by the value judgments of the individuals involved. It is not derived from the general price structure or from the structure of the prices of a special class of commodities or services. What is called the price structure is an abstract notion derived from a multiplicity of individual concrete prices. The market does not generate prices of land or motorcars in general nor wage rates in general, but prices for a certain piece of land and for a certain car and wage rates for a performance of a certain kind. It does not make any difference for the pricing process to what class the things exchanged are to be assigned from any point of view. However they may differ in other regards, in the very act of exchange they are nothing but commodities, i.e., things valued on account of their power to remove felt uneasiness.
The market does not create or determine incomes. It is not a process of income formation. If the owner of a piece of land and the worker husband the physical resources concerned, the land and the man will renew and preserve their power to render services; the agricultural and urban land for a practically indefinite period, the man for a number of years. If the market situation for these factors of production does not deteriorate, it will be possible in the future too to attain a price for their productive employment. Land and working power can be considered as sources of income if they are dealt with as such, that is, if their capacity to produce is not prematurely exhausted by reckless exploitation. It is provident restraint in the use of factors of production, not their natural and physical properties, which convert them into somewhat durable sources of income. There is in nature no such thing as a stream of income. Income is a category of action; it is the outcome of careful economizing of scarce factors. This is still more obvious in the case of capital goods. The produced factors of production are not permanent. Although some of them may have a life of many years, all of them eventually become useless through wear and tear, sometimes even by the mere passing of time. They become durable sources of income only if their owners treat them as such. Capital can be preserved as a source of income if the consumption of its products, market conditions remaining unchanged, is restricted in such a way as not to impair the replacement of the worn out parts.
Changes in the market data can frustrate every endeavor to perpetuate a source of income. Industrial equipment becomes obsolete if demand changes or if it is superseded by something better. Land becomes useless if more fertile soil is made accessible in sufficient quantities. Expertness and skill for the performance of special kinds of work lose their remunerativeness when new fashions or new methods of production narrow the opportunity for their employment. The success of any provision for the uncertain future depends on the correctness of the anticipations which guided it. No income can be made safe against changes not adequately foreseen.
Neither is the pricing process a form of distribution. As has been pointed out already, there is nothing in the market economy to which the notion of distribution could be applied.
- Prices and ProductionThe pricing process directs production into those channels in which it best serves the wishes of the consumers as manifested on the market. Only in the case of monopoly prices have the monopolists the power to divert production, within a limited range, from this line into other lines to their own benefit.
The prices determine which of the factors of production should be employed and which should be left unused. The specific factors of production are employed only if there is no more valuable employment available for the complementary nonspecific factors. There are technological recipes, land, and nonconvertible capital goods whose capacity to produce remains unused because their employment would mean a waste of the scarcest of all factors, labor. While under the conditions present in our world there cannot be in the long run unemployment of labor in a free labor market, unused capacity of land and of inconvertible industrial equipment is a regular phenomenon.
It is nonsense to lament the fact of unused capacity. The unused capacity of equipment made obsolete by technological improvement is a landmark of material progress. It would be a blessing if the establishment of durable peace would render munitions plants unused or if the discovery of an efficient method of preventing and curing tuberculosis would render obsolete sanatoria for the treatment of people affected by this evil. It would be sensible to deplore the lack of provision, in the past which resulted in malinvestment of capital goods. Yet, men are not infallible. A certain amount of malinvestment is unavoidable. What has to be done is to shun policies like credit expansion which artificially foster malinvestment.
Modern technology could easily grow oranges and grapes in hothouses in the arctic and subarctic countries. Everybody would call such a venture lunacy. But it is essentially the same to preserve the growing of cereals in rocky mountain valleys by tariffs and other devices of protectionism while elsewhere there is plenty of fallow fertile land. The difference is merely one of degree.
The inhabitants of the Swiss Jura prefer to manufacture watches instead of growing wheat. Watchmaking is for them the cheapest way to acquire wheat. On the other hand the growing of wheat is the cheapest way for the Canadian farmer to acquire watches. The fact that the inhabitants of the Jura do not grow wheat and the Canadians do not manufacture watches is not more worthy of notice than the fact that tailors do not make their shoes and shoemakers do not make their clothes.
- The Chimera of Nonmarket PricesPrices are a market phenomenon. They are generated by the market process and are the pith of the market economy. There is no such thing as prices outside the market. Prices cannot be constructed synthetically, as it were. They are the resultant of a certain constellation of market data, of actions and reactions of the members of a market society. It is vain to meditate what prices would have been if some of their determinants had been different. Such fantastic designs are not more sensible than whimsical speculations about what the course of history would have been if Napoleon had been killed in the battle of Arcole or if Lincoln had ordered Major Anderson to withdraw from Fort Sumter.
It is no less vain to ponder on what prices ought to be. Everybody is pleased if the prices of things he wants to buy drop and the prices of the things he wants to sell rise. In expressing such wishes a man is sincere if he admits that his point of view is personal. It is another question whether, from his personal point of view, he would be well advised to prompt the government to use its power of coercion and oppression to interfere with the market's price structure. It will be shown in the sixth part of this book what the inescapable consequences of such a policy of interventionism must be.
But one deludes oneself or practices deception if one calls such wishes and arbitrary value judgments the voice of objective truth. In human action nothing counts but the various individuals' desires for the attainment of ends. With regard to the choice of these ends there is no question of truth; all that matters is value. Value judgments are necessarily always subjective, whether they are passed by one man only or by many men, by a blockhead, a professor, or a statesman.
Any price determined on a market is the necessary outgrowth of the interplay of the forces operating, that is, demand and supply. Whatever the market situation which generated this price may be, with regard to it the price is always adequate, genuine, and real. It cannot be higher if no bidder ready to offer a higher price turns up, and it cannot be lower if no seller ready to deliver at a lower price turns up. Only the appearance of such people ready to buy or to sell can alter prices.
Economics analyzes the market process which generates commodity prices, wage rates, and interest rates. It does not develop formulas which would enable anybody to compute a "correct" price different from that established on the market by the interaction of buyers and sellers.
At the bottom of many efforts to determine nonmarket prices is the confused and contradictory notion of real costs. If costs were a real thing, i.e., a quantity independent of personal value judgments and objectively discernible and measurable, it would be possible for a disinterested arbiter to determine their height and thus the correct price. There is no need to dwell any longer on the absurdity of this idea. Costs are a phenomenon of valuation. Costs are the value attached to the most valuable want-satisfaction which remains unsatisfied because the means required for its satisfaction are employed for that want-satisfaction the cost of which we are dealing with. The attainment of an excess of the value of the product over the costs, a profit, is the goal of every production effort. Profit is the pay-off of successful action. It cannot be defined without reference to valuation. It is a phenomenon of valuation and has no direct relation to physical and other phenomena of the external world.
Economic analysis cannot help reducing all items of cost to value judgments. The socialists and interventionists call entrepreneurial profit, interest on capital, and rent of land "unearned" because they consider that only the toil and trouble of the worker is real and worthy of being rewarded. However, reality does not reward toil and trouble. If toil and trouble is expended according to well-conceived plans, its outcome increases the means available for want-satisfaction. Whatever some people may consider as just and fair, the only relevant question is always the same. What alone matters is which system of social organization is better suited to attain those ends for which people are ready to expend toil and trouble. The question is market economy, or socialism? There is no third solution. The notion of a market economy with nonmarket prices is absurd. The very idea of cost prices is unrealizable. Even if the cost price formula is applied only to entrepreneurial profits, it paralyzes the market. If commodities and services are to be sold below the price the market would have determined for them, supply always lags behind demand. Then the market can neither determine what should or should not be produced, nor to whom the commodities and services should go. Chaos results.
This refers also to monopoly prices. It is reasonable to abstain from all policies which could result in the emergence of monopoly prices. But whether monopoly prices are brought about by such promonopoly government policies or in spite of the absence of such policies, no alleged "fact finding" and no armchair speculation can discover another price at which demand and supply would become equal. The failure of all experiments to find a satisfactory solution for the limited-space monopoly of public utilities clearly proves this truth.
It is the very essence of prices that they are the offshoot of the actions of individuals and groups of individuals acting on their own behalf. The catallactic concept of exchange ratios and prices precludes anything that is the effect of actions of a central authority, of people resorting to violence and threats in the name of society or the state or of an armed pressure group. In declaring that it is not the business of the government to determine prices, we do not step beyond the borders of logical thinking. A government can no more determine prices than a goose can lay hen's eggs.
We can think of a social system in which there are no prices at all, and we can think of government decrees which aim at fixing prices at a height different from that which the market would determine. It is one of the tasks of economics to study the problems implied. However, precisely because we want to examine these problems it is necessary clearly to distinguish between prices and government decrees. Prices are by definition determined by peoples' buying and selling or abstention from buying and selling. They must not be confused with fiats issued by governments or other agencies enforcing their orders by an apparatus of coercion and compulsion.In order not to confuse the reader by the introduction of too many new terms, we shall keep to the widespread usage of calling such fiats prices, interest rates, wage rates decreed and enforced by governments or other agencies of compulsion (e.g., labor unions). But one must never lose sight of the fundamental difference between the market phenomena of prices, wages, and interest rates on the one hand, and the legal phenomena of maximum or minimum prices, wages, and interest rates, designed to nullify these market phenomena, on the other hand.
This article is excerpted from chapter 16 of Human Action. Robert Murphy has written a study guide for this chapter, available in HTML and PDF.This article follows "Chapter XVI. Prices, Part 2."
[This article is excerpted from chapter 16 of Human Action. Robert Murphy has written a study guide for this chapter, available in HTML and PDF.This article follows "Chapter XVI. Prices, Part 1."]
Competitive prices are the outcome of a complete adjustment of the sellers to the demand of the consumers. Under the competitive price the whole supply available is sold, and the specific factors of production are employed to the extent permitted by the prices of the nonspecific complementary factors. No part of a supply available is permanently withheld from the market, and the marginal unit of specific factors of production employed does not yield any net proceed. The whole economic process is conducted for the benefit of the consumers. There is no conflict between the interests of the buyers and those of the sellers, between the interests of the producers and those of the consumers. The owners of the various commodities are not in a position to divert consumption and production from the lines enjoined by the state of supply of goods and services of all orders and the state of technological knowledge.
Every single seller would see his own proceeds increased if a fall in the supply at the disposal of his competitors were to increase the price at which he himself could sell his own supply. But on a competitive market he is not in a position to bring about this outcome. Except for a privilege derived from government interference with business he must submit to the state of the market as it is.
The entrepreneur in his entrepreneurial capacity is always subject to the full supremacy of the consumers. It is different with the owners of vendible goods and factors of production and, of course, with the entrepreneurs in their capacity as owners of such goods and factors. Under certain conditions they fare better by restricting supply and selling it at a higher price per unit. The prices thus determined, the monopoly prices, are an infringement of the supremacy of the consumers and the democracy of the market.
The special conditions and circumstances required for the emergence of monopoly prices and their catallactic features are:
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There must prevail a monopoly of supply. The whole supply of the monopolized commodity is controlled by a single seller or a group of sellers acting in concert. The monopolist — whether one individual or a group of individuals — is in a position to restrict the supply offered for sale or employed for production in order to raise the price per unit sold and need not fear that his plan will be fruitrated by interference on the part of other sellers of the same commodity.
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Either the monopolist is not in a position to discriminate among the buyers or he voluntarily abstains from such discrimination.Price discrimination is dealt with below, PP. 385–388.
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The reaction of the buying public to the rise in prices beyond the potential competitive price, the fall in demand, is not such as to render the proceeds resulting from total sales at any price exceeding the competitive price smaller than total proceeds resulting from total sales at the competitive price. Hence it is superfluous to enter into sophisticated disquisitions concerning what must be considered the mark of the sameness of an article. It is not necessary to raise the question whether all neckties are to be called specimens of the same article or whether one should distinguish them with regard to fabric, color, and pattern. An academic delimitation of various articles is useless. The only point that counts is the way in which the buyers react to the rise in prices. For the theory of monopoly price it is irrelevant to observe that every necktie manufacturer turns out different articles and to call each of them a monopolist. Catallactics does not deal with monopoly as such but with monopoly prices. A seller of neckties which are different from those offered for sale by other people could attain monopoly prices only if the buyers did not react to any rise in prices in such a way as to make such a rise disadvantageous for him.
Monopoly is a prerequisite for the emergence of monopoly prices, but it is not the only prerequisite. There is a further condition required, namely a certain shape of the demand curve. The mere existence of monopoly does not mean anything. The publisher of a copyright book is a monopolist. But he may not be able to sell a single copy, no matter how low the price he asks. Not every price at which a monopolist sells a monopolized commodity is a monopoly price. Monopoly prices are only prices at which it is more advantageous for the monopolist to restrict the total amount to be sold than to expand his sales to the limit which a competitive market would allow. They are the outcome of a deliberate design tending toward a restriction of trade.
In calling the monopolist's conduct deliberate, it is not meant to suggest that he compares the monopoly price he is asking with the competitive price which a hypothetical nonmonopolized market would have determined. It is only the economist who contrasts the monopoly price with the potential competitive price. In the deliberations of the monopolist who has already got his monopolistic position, the competitive price plays no role at all. Like every other seller he wants to realize the highest price attainable. It is only the state of the market as conditioned by his monopolistic position on the one hand and the conduct of the buyers on the other that results in the emergence of monopoly prices.
- It is a fundamental mistake to assume that there is a third category of prices which are neither monopoly prices nor competitive prices. If we disregard the problem of price discrimination to be dealt with later, a definite price is either a competitive price or a monopoly price. The assertions to the contrary are due to the erroneous belief that competition is not free or perfect unless everybody is in a position to present himself as a seller of a definite commodity.
The available supply of every commodity is limited. If it were not scarce with regard to the demand of the public, the thing in question would not be considered an economic good, and no price would be paid for it. It is therefore misleading to apply the concept of monopoly in such a way as to make it cover the entire field of economic goods. Mere limitation of supply is the source of economic value and of all prices paid; as such it is not yet sufficient to generate monopoly prices.Cf. the refutation of the misleading extension of the concept of monopoly by Richard T. Ely, Monopolies and Trusts (New York, 1906), pp. 1–36.
The term monopolistic or imperfect competition is applied today to the cases in which there are some differences in the products of different producers and sellers. This means that almost all consumers' goods are included in the class of monopolized goods. However, the only question relevant in the study of the determination of prices is whether these differences can be used by the seller for a scheme of deliberate restriction of supply for the sake of increasing his total net proceeds. Only if this is possible and put into effect, can monopoly prices emerge as differentiated from competitive prices. It may be true that every seller has a clientele which prefers his brand to those of his competitors and would not stop buying it even if the price were higher. But the problem for the seller is whether the number of such people is great enough to overcompensate the reduction of total sales which the abstention from buying on the part of other people would bring about. Only if this is the case, can he consider the substitution of monopoly prices for competitive prices advantageous.
The confusion which led to the idea of imperfect or monopolistic competition stems from a misinterpretation of the term control of supply. Every producer of every product has his share in controlling the supply of all commodities offered for sale. If he had produced more a, he would have increased supply and brought about a tendency toward a lower price. But the question is why he did not produce more of a. Was he in restricting his production of a to the amount of p intent upon complying to the best of his abilities with the wishes of the consumers? Or was he intent upon defying the orders of the consumers for his own advantage? In the first case he did not produce more of a, because increasing the quantity of a beyond p would have withdrawn scarce factors of production from other branches in which they would have been employed for the satisfaction of more urgent needs of the consumers. He does not produce p + r, but merely p, because such an increase would have rendered his business unprofitable or less profitable, while there are still other more profitable employments available for capital investment. In the second case he did not produce r, because it was more advantageous for him to leave a part of the available supply of a monopolized specific factor of production m unused. If m were not monopolized by him, it would have been impossible for him to expect any advantage from restricting his production of a. His competitors would have filled the gap and he would not have been in a position to ask higher prices.
In dealing with monopoly prices we must always search for the monopolized factor m. If no such factor is in the case, no monopoly prices can emerge. The first requirement for monopoly prices is the existence of a monopolized good. If no quantity of such a good m is withheld, there is no opportunity for an entrepreneur to substitute monopoly prices for competitive prices.
Entrepreneurial profit has nothing at all to do with monopoly. If an entrepreneur is in a position to sell at monopoly prices, he owes this advantage to his monopoly with regard to a monopolized factor m. He earns the specific monopoly gain from his ownership of m, not from his specific entrepreneurial activities.
Let us assume that an accident cuts a city's electrical supply for several days and forces the residents to resort to candlelight only. The price of candles rises to s; at this price the whole supply available is sold out. The stores selling candles reap a high profit in selling their whole supply at s. But it could happen that the storekeepers combine in order to withhold a part of their stock from the market and to sell the rest at a price s + t. While s would have been the competitive price, s + t is a monopoly price. The surplus earned by the storekeepers at the price s + t over the proceeds they would have earned when selling at s only is their specific monopoly gain.
It is immaterial in what way the storekeepers bring about the restriction of the supply offered for sale. The physical destruction of a part of the supply available is the classical case of monopolistic action. Only a short time ago it was practiced by the Brazilian government in burning large quantities of coffee. But the same effect can be attained by leaving a part of the supply unused.
While there constantly prevails a tendency to make profits disappear, the specific monopoly gain is a permanent phenomenon and can disappear only with a change in the market data. While profits are incompatible with the imaginary construction of the evenly rotating economy, monopoly prices and specific monopoly gains are not.
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The competitive price is determined by the state of the market. There prevails on a competitive market a tendency toward the disappearance of differences in prices and the establishment of a uniform price. With regard to monopoly prices things are different. If it is possible for the seller to increase his net proceeds by restricting sales and increasing prices per unit sold, then as a rule there are several monopoly prices which satisfy this condition. As a rule one of these monopoly prices yields the highest net proceeds. But it may also happen that various monopoly prices are equally advantageous to the monopolist. We may call this monopoly price or these monopoly prices most advantageous to the monopolist the optimum monopoly price or the optimum monopoly prices.
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The monopolist does not know beforehand in what way the consumers will react to a rise in prices. He must resort to trial and error in his endeavors to find out whether the monopolized good can be sold to his advantage at any price exceeding the competitive price and, if this is so, which of various possible monopoly prices is the optimum monopoly price or one of the optimum monopoly prices. This is in practice much more difficult than the economist assumes when, in drawing demand curves, he ascribes perfect foresight to the monopolist. We must therefore list as a special condition required for the appearance of monopoly prices the monopolist's ability to discover such prices.
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A special case is provided by the incomplete monopoly. The greater part of the total supply available is owned by the monopolist; the rest is owned by one or several men who are not prepared to cooperate with the monopolist in a scheme for restricting sales and bringing about monopoly prices. However, the reluctance of these outsiders does not prevent the establishment of monopoly prices if the portion pt controlled by the monopolist is large enough when compared with the sum of the outsiders' portions p2. Let us assume that the whole supply (p=p1 + p2) can be sold at the price c per unit and a supply of p−z at the monopoly price d. If d (pt − z) is higher than c p1, it is to the advantage of the monopolist to embark upon a monopolistic restriction of his sales, no matter what the conduct of the outsiders may be. They may go on selling at the price c or they may raise their prices up to the maximum of d. The only point that counts is that the outsiders are not willing to put up with a reduction in the quantity which they themselves are selling. The whole reduction required must be borne by the owner of p1. This influences his plans and will as a rule result in the emergence of a monopoly price which is different from that which would have been established under complete monopoly.It is obvious that an incomplete monopoly scheme is bound to collapse if the outsiders come into a position to expand their sales.
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Duopoly and oligopoly are not special varieties of monopoly prices, but merely a variety of the methods applied for the establishment of a monopoly price. Two or several men own the whole supply. They all are prepared to sell at monopoly prices and to restrict their total sales accordingly. But for some reason they do not want to act in concert. Each of them goes his own way without any formal or tacit agreement with his competitors. But each of them knows also that his rivals are intent upon a monopolistic restriction of their sales in order to reap higher prices per unit and specific monopoly gains. Each of them watches carefully the conduct of his rivals and tries to adjust his own plans to their actions. A succession of moves and countermoves, a mutual outwitting results, the outcome of which depends on the personal cunning of the adverse parties. The duopolists and oligopolists have two objectives in mind: to find out the monopoly price most advantageous to the sellers on the one hand and to shift as much as possible of the burden of restricting the amount of sales to their rivals. Precisely because they do not agree with regard to the quotas of the reduced amount of sales to be allotted to each party, they do not act in concert as the members of a cartel do.
One must not confuse duopoly and oligopoly with the incomplete monopoly or with competition aiming at the establishment of monopoly. In the case of incomplete monopoly only the monopolistic group is prepared to restrict its sales in order to make a monopoly price prevail; the other sellers decline to restrict their sales. But duopolists and oligopolists are ready to withhold a part of their supply from the market. In the case of price slashing one group A plans to attain full monopoly or incomplete monopoly by forcing all or most of its competitors, the B's, to go out of business. It cuts prices to a level which makes selling ruinous to its more vulnerable competitors. A may also incur losses by selling at this low rate; but it is in a position to undergo such losses for a longer time than the others and it is confident that it will make good for them later by ample monopoly gains. This process has nothing to do with monopoly prices. It is a scheme for the attainment of a monopoly position.
One may wonder whether duopoly and oligopoly are of practical significance. As a rule the parties concerned will come to at least a tacit understanding concerning their quotas of the reduced amount of sales.
- The monopolized good by whose partial withholding from the market the monopoly prices are made to prevail can be either a good of the lowest order or a good of a higher order, a factor of production. It may consist in the control of the technological knowledge required for production, the "recipe." Such recipes are as a rule free goods as their ability to produce definite effects is unlimited. They can become economic goods only if they are monopolized and their use is restricted. Any price paid for the services rendered by a recipe is always a monopoly price. It is immaterial whether the restriction of a recipe's use is made possible by institutional conditions — such as patents and copyright laws — or by the fact that a formula is kept secret and other people fail to guess it.
The complementary factor of production the monopolization of which can result in the establishment of monopoly prices may also consist in a man's opportunity to make his cooperation in the production of a good known to consumers who attribute to this cooperation a special significance. This opportunity may be given either by the nature of the commodities or services in question or by institutional provisions such as protection of trademarks. The reasons why the consumers value the contribution of a man or a firm so highly are manifold. They may be: special confidence placed on the individual or firm concerned on account of previous experience;Cf. below, pp. 376–380, on good will. merely baseless prejudice or error; snobbishness; magic or metaphysical prepossessions whose groundlessness is ridiculed by more reasonable people. A drug marked by a trademark may not differ in its chemical structure and its physiological efficacy from other compounds not marked with the same label. However, if the buyers attach a special significance to this label and are ready to pay higher prices for the product marked with it, the seller can, provided the configuration of demand is propitious, reap monopoly prices.
The monopoly which enables the monopolist to restrict the amount offered without counteraction on the part of other people can consist in the greater productivity of a factor which he has at his disposal as against the lower productivity of the corresponding factor at the disposal of his potential competitors. If the margin between the higher productivity of his supply of the monopolized factor and that of his potential competitors is broad enough for the emergence of a monopoly price, a situation results which we may call margin monopoly.The use of this term "margin monopoly" is, like that of any other, quite optional. It would be vain to object that every other monopoly which results in monopoly prices could also be called a margin monopoly.
Let us illustrate margin monopoly by referring to its most frequent instance in present-day conditions, the power of a protective tariff to generate a monopoly price under special circumstances. Atlantis puts a tariff t on the importation of each unit of the commodity p the world market price of which is s. If domestic consumption of p in Atlantis at the price s + t is a and domestic production of p is b, b being smaller than a, then the costs of the marginal dealer are s + t. The domestic plants are in a position to sell their total output at the price s + t. The tariff is effective and offers to domestic business the incentive to expand the production of p from b to a quantity slightly smaller than a. But if b is greater than a, things are different. If we assume that b is so large that even at the price s domestic consumption lags behind it and the surplus must be exported and sold abroad, the imposition of a tariff does not affect the price of p. Both the domestic and the world market price of p remain unchanged. However the tariff, in discriminating between domestic and foreign production of p, accords to the domestic plants a privilege which can be used for a monopolistic combine, provided certain further conditions are present. If it is possible to find within the margin between s + t and s a monopoly price, it becomes lucrative for the domestic enterprises to form a cartel. The cartel sells in the home market of Atlantis at a monopoly price and disposes of the surplus abroad at the world market price. Of course, as the quantity of p offered at the world market increases as a consequence of the restriction of the quantity sold in Atlantis, the world market price drops from s to s1. It is therefore a further requirement for the emergence of the domestic monopoly price that the total restriction in proceeds resulting from this fall in the world market price is not so great as to absorb the whole monopoly gain of the domestic cartel.
In the long run such a national cartel cannot preserve its monopolistic position if entrance into its branch of production is free to newcomers. The monopolized factor the services of which the cartel restricts (as far as the domestic market is concerned) for the sake of monopoly prices is a geographical condition which can easily be duplicated by every new investor who establishes a new plant within the borders of Atlantis. Under modern industrial conditions, the characteristic feature of which is steady technological progress, the latest plant will as a rule be more efficient than the older plants and produce at lower average costs. The incentive to prospective newcomers is therefore twofold. It consists not only in the monopoly gain of the cartel members, but also in the possibility of outstripping them by lower costs of production.
Here again institutions come to the aid of the old firms that form the cartel. The patents give them a legal monopoly which nobody may infringe. Of course, only some of their production processes may be protected by patents. But a competitor who is prevented from resorting to these processes and to the production of the articles concerned may be handicapped in such a serious way that he cannot consider entrance into the field of the cartelized industry.
The owner of a patent enjoys a legal monopoly which, other conditions being propitious, can be used for the attainment of monopoly prices. Beyond the field covered by the patent itself a patent may render auxiliary services in the establishment and preservation of margin monopoly where the primary institutional conditions for the emergence of such a monopoly prevail.
We may assume that some world cartels would exist even in the absence of any government interference which provides for other commodities the indispensable conditions required for the construction of a monopolistic combine. There are some commodities, e.g., diamonds and mercury, the supply of which is by nature limited to a few sources. The owners of these resources can easily be united for concerted action. But such cartels would play only a minor role in the setting of world production. Their economic significance would be rather small. The important place that cartels occupy in our time is an outcome of the interventionist policies adopted by the governments of all countries. The great monopoly problem mankind has to face today is not an outgrowth of the operation of the market economy. It is a product of purposive action on the part of governments. It is not one of the evils inherent in capitalism as the demagogues trumpet. It is, on the contrary, the fruit of policies hostile to capitalism and intent upon sabotaging and destroying its operation.
The classical country of the cartels was Germany. In the last decades of the nineteenth century the German Reich embarked upon a vast scheme of Sozialpolitik. The idea was to raise the income and the standard of living of the wage-earners by various measures of what is called prolabor legislation, by the much glorified Bismarck plan of social security, and by labor-union pressure and compulsion for the attainment of higher wage rates. The advocates of this policy defied the warnings of the economists. There is no such thing as economic law, they announced. The Hohenzollern Empire which had defeated the Emperors of Austria and of France and before which the nations of the world trembled was above any law. Its will was the supreme canon.
In stark reality the Sozialpolitik raised costs of production within Germany. Every progress of the alleged prolabor legislation and every successful strike disarranged industrial conditions to the disadvantage of the German enterprises. It made it harder for them to outdo foreign competitors for whom the domestic events of Germany did not raise costs of production. If the Germans had been in a position to renounce the export of manufactures and to produce only for the domestic market, the tariff could have sheltered the German plants against the intensified competition of foreign business. They would have been in a position to reap higher prices. What the wage earner would have profited from the achievements of the legislature and the unions, would have been absorbed by the higher prices he would have had to pay for the articles he bought. Real wage rates would have risen only to the extent the entrepreneurs could improve technological procedures and thereby increase the productivity of labor. The tariff would have rendered the Sozialpolitik harmless in preventing a spread of unemployment.
But Germany is, and was already at the time Bismarck inaugurated his prolabor policy, a predominantly industrial country. Its plants exported a considerable part of their total output. These exports enabled the Germans to import the foodstuffs and raw materials they could not grow in their own country, comparatively overpopulated and poorly endowed with natural resources as it was. As has been pointed out above, such a surplus production renders a protective tariff ineffective. Only cartels could free Germany from the catastrophic consequences of its "progressive" prolabor policies. The cartels charged monopoly prices at home and sold abroad at cheaper prices. The cartels are the necessary accompaniment and upshot of a "progressive" labor policy as far as it affects industries dependent on foreign markets. The cartels do not, of course, safeguard for the wage earners the illusory social gains which the labor politicians and the union leaders promise them. There is no means of raising wage rates for all those eager to earn wages above the height determined by the productivity of each kind of labor. What the cartels achieved was merely to counterbalance the apparent gains in nominal wage rates by corresponding increases in domestic commodity prices. But the most disastrous effect of minimum wage rates, permanent mass unemployment, was at first avoided.
Germany was not the first country that resorted to "prolabor" legislation and gave its labor unions a free hand to enforce minimum wage rates. Other countries had preceded Germany in this respect. But the oppositon which these policies had encountered on the part of economists, reasonable statesmen, and businessmen had for many years put a check upon the progress of these destructive methods of government. For the most part their alleged benefits did not grant the wage earners more than they had already won, without any interference on the part of the government, by the technological improvements which never cease under capitalism. When in some cases the government had gone a little farther, the propulsive evolution of business in a very short time made things even. But in later years, especially after the end of the First World War, all other nations adopted for their labor policies the thorough methods of the Germans. Again the cartel had to supplement the "prolabor" policies in order to conceal their futility and to postpone for a time their manifest fiasco.
With all industries which cannot content themselves with the domestic market and are intent upon selling a part of their output abroad the function of the tariff, in this age of government interference with business, is to enable the establishment of domestic monopoly prices. Whatever the purpose and the effects of tariffs may have been in the past, as soon as an exporting country embarks upon measures designed to increase the revenues of the wage earners or the farmers above the potential market rates, it must foster schemes which result in domestic monopoly prices for the commodities concerned. A national government's might is limited to the territory subject to its sovereignty. It has the power to raise domestic costs of production. It does not have the power to force foreigners to pay correspondingly higher prices for the products. If exports are not to be discontinued, they must be subsidized. The subsidy can be paid openly by the treasury or its burden can be imposed upon the consumers by the cartel's monopoly prices.
The advocates of government interference with business ascribe to the "State" the power to benefit certain groups within the framework of the market by a mere fiat. In fact this power is the government's power to foster monopolistic combines. The monopoly gains are the funds out of which the "social gains" are financed. As far as these monopoly gains do not suffice, the various measures of interventionism immediately paralyze the operation of the market; mass unemployment, depression, and capital consumption appear. This explains the eagerness of all contemporary governments to foster monopoly in all those sectors of the market which are in some way or other connected with export trade.
If a government does not or cannot succeed in attaining its monopolistic aims indirectly, it resorts to direct action. In the field of coal and potash the Imperial Government of Germany established compulsory cartels. The American New Deal was prevented by the opposition of business from organizing the nation's great industries on an obligatory cartel basis. It succeeded better in some vital branches of farming with measures designed to restrict output for the sake of monopoly prices. A long series of agreements concluded between the world's most prominent governments aimed at the establishment of world-market monopoly prices for various raw materials and foodstuffs.A collection of these agreements was published in 1943 by the International Labor Office under the title Intergovernmental Commodity Control Agreements. It is the avowed purpose of the United Nations to continue these plans.
It is necessary to view this promonopoly policy of the contemporary governments as a uniform phenomenon in order to discern the reasons which motivated it. From the catallactic point of view these monopolies are not uniform. The contractual cartels into which entrepreneurs enter in taking advantage of the incentive offered by protective tariffs are instances of margin monopoly. Where the government directly fosters monopoly prices we are faced with instances of license monopoly. The factor of production by the restriction of the use of which the monopoly price is brought about is the license which the laws make a requisite for supplying the consumers.
Such licenses may be granted in different ways:
An unlimited license is granted to practically every applicant. This amounts to a state of affairs under which no license at all is required.
Licenses are granted only to selected applicants. Competition is restricted. However, monopoly prices can emerge only if the licensees act in concert and the configuration of demand is propitious.
There is only one licensee. The licensee, e.g., the holder of a patent or a copyright, is a monopolist. If the configuration of the demand is propitious and if the licensee wants to reap monopoly gains, he can ask monopoly prices.
The licenses granted are limited. They confer upon the licensee only the right to produce or to sell a definite quantity, in order to prevent him from disarranging the authority's scheme. The authority itself directs the establishment of monopoly prices.
Finally there are the instances in which a government establishes a monopoly for fiscal purposes. The monopoly gains go to the treasury. Many European governments have instituted tobacco monopolies. Others have monopolized salt, matches, telegraph and telephone service, broadcasting, and so on. Without exception every country has a government monopoly of the postal service.
- Margin monopoly need not always owe its appearance to an institutional factor such as tariffs. It can also be produced by sufficient differences in the fertility or productivity of some factors of production.
It has already been said that it is a serious blunder to speak of a land monopoly and to refer to monopoly prices and monopoly gains in explaining the prices of agricultural products and the rent of land. As far as history is confronted with instances of monopoly prices for agricultural products, it was license monopoly fostered by government decree. However the acknowledgment of these facts does not mean that differences in the fertility of the soil could never bring about monopoly prices. If the difference between the fertility of the poorest soil still tilled and the richest fallow fields available for an expansion of production were so great as to enable the owners of the already exploited soil to find an advantageous monopoly price within this margin, they could consider restricting production by concerted action in order to reap monopoly prices. But it is a fact that physical conditions in agriculture do not comply with these requirements. It is precisely on account of this fact that farmers longing for monopoly prices do not resort to spontaneous action but ask for the interference of governments.
In various branches of mining conditions are often more propitious for the emergence of monopoly prices based on margin monopoly.
- It has been asserted again and again that the economies of big-scale production have generated a tendency toward monopoly prices in the processing industries. Such a monopoly would be called in our terminology a margin monopoly.
Before entering into a discussion of this topic one must clarify the role an increase or decrease in the unit's average cost of production plays in the considerations of a monopolist searching for the most advantageous monopoly price. We consider a case in which the owner of a monopolized complementary factor of production, e.g., a patent, at the same time manufactures the product p. If the average cost of production of one unit of p, without any regard to the patent, decreases with the increase in the quantity produced, the monopolist must weigh this against the gains expected from the restriction of output. If on the other hand cost of production per unit decreases with the restriction of total production, the incentive to embark upon monopolistic restraint is augmented. It is obvious that the mere fact that big-scale production tends as a rule to lower average costs of production is in itself not a factor driving toward the emergence of monopoly prices. It is rather a checking factor.
What those who blame the economies of big-scale production for the spread of monopoly prices are trying to say is that the higher efficiency of big-scale production makes it difficult or even impossible for small-scale plants to compete successfully. A big-scale plant could, they believe, resort to monopoly prices with impunity because small business is not in a position to challenge its monopoly. Now, it is certainly true that in many branches of the processing industries it would be foolish to enter the market with the high-cost products of small, inadequate plants. A modern cotton mill does not need to fear the competition of old-fashioned distaffs; its rivals are other more or less adequately equipped mills. But this does not mean that it enjoys the opportunity of selling at monopoly prices. There is competition between big businesses too. If monopoly prices prevail in the sale of the products of big-size business, the reasons are either patents or monopoly in the ownership of mines or other sources of raw material or cartels based on tariffs.
One must not confuse the notions of monopoly and of monopoly prices. Mere monopoly as such is catallactically of no importance if it does not result in monopoly prices. Monopoly prices are consequential only because they are the outcome of a conduct of business defying the supremacy of the consumers and substituting the private interests of the monopolist for those of the public. They are the only instance in the operation of a market economy in which the distinction between production for profit and production for use could to some extent be made if one were prepared to disregard the fact that monopoly gains have nothing at all to do with profits proper. They are not a part of what catallactics can call profits; they are an increase in the price earned from the sale of the services rendered by some factors of production, some of these factors being physical factors, some of them merely institutional. If the entrepreneurs and capitalists in the absence of a monopoly price constellation abstain from expanding production in a certain branch of industry because the opportunities offered to them in other branches are more attractive, they do not act in defiance of the wants of the consumers. On the contrary, they follow precisely the line indicated by the demand as expressed on the market.
The political bias which has obfuscated the discussion of the monopoly problem has neglected to pay attention to the essential issues involved. In dealing with every case of monopoly prices one must first of all raise the question of what obstacles restrain people from challenging the monopolists. In answering this question one discovers the role played in the emergence of monopoly prices by institutional factors. It is nonsense to speak of conspiracy with regard to the deals between American firms and German cartels. If an American wanted to manufacture an article protected by a patent owned by Germans, he was compelled by the American law to come to an arrangement with German business.
- A special case is what may be called the failure monopoly.
In the past capitalists invested funds in a plant designed for the production of the article p. Later events proved the investment a failure. The prices which can be obtained in selling p are so low that the capital invested in the plant's inconvertible equipment does not yield a return. It is lost. However, these prices are high enough to yield a reasonable return for the variable capital to be employed for the current production of p. If the irrevocable loss of the capital invested in the inconvertible equipment is written off on the books and all corresponding alterations are made in the accounts, the reduced capital working in the conduct of the business is by and large so profitable that it would be a new mistake to stop production altogether. The plant works at full capacity producing the quantity q of p and selling the unit at the price s.
But conditions may be such that it is possible for the enterprise to reap a monopoly gain by restricting output to q/2 and selling the unit of p at the price 3 s. Then the capital invested in the inconvertible equipment no longer appears completely lost. It yields a modest return, namely, the monopoly gain.
This enterprise now sells at monopoly prices and reaps monopoly gains although the total capital invested yields little when compared with what the investors would have earned if they had invested in other lines of business. The enterprise withholds from the market the services which the unused production capacity of its durable equipment could render and fares better than it would by producing at full capacity. It defies the orders of the public. The public would have been in a better position if the investors had avoided the mistake of immobilizing a part of their capital in the production of p. They would, of course, not get any p. But they would instead obtain those articles which they miss now because the capital required for their production has been wasted in the construction of an aggregate for the production of p. However, as things are now after this irreparable fault has been committed, they want to get more of p and are ready to pay for it what is now its potential competitive market price, namely, s. They do not approve, as conditions are now, the action of the enterprise in withholding an amount of variable capital from employment for the production of p. This amount certainly does not remain unused. It goes into other lines of business and produces there something else, namely, m. But as conditions are now, the consumers would prefer an increase of the available quantity of p to an increase in the available quantity of m. The proof is that in the absence of a monopolistic restriction of the capacity for the production of p, as it is under given conditions, the profitability of a production of the quantity q of s would be such that it would pay better than an increase in the quantity of the article m produced.
There are two distinctive features of this case. First, the monopoly prices paid by the buyers are still lower than the total cost of production of p would be if full account is taken of the whole input of the investors. Second, the monopoly gains of the firm are so small that they do not make the total venture appear a good investment. It remains malinvestment. It is precisely this fact that constitutes the monopolistic position of the firm. No outsider wants to enter its field of entrepreneurial activity because the production of p results in losses.
Failure monopoly is by no means a merely academic construction. It is, for instance, actual today in the case of some railroad companies. But one must guard against the mistake of interpreting every instance of unused production capacity as a failure monopoly. Even in the absence of monopoly it may be more profitable to employ variable capital for other purposes instead of expanding a firm's production to the limit fixed by the capacity of its durable inconvertible equipment; then the output restriction complies precisely with the state of the competitive market and the wishes of the public.
- Local monopolies are, as a rule, of institutional origin. But there are also local monopolies which originate out of conditions of the unhampered market. Often the institutional monopoly is designed to deal with a monopoly which came into existence or would be likely to come into existence without any authoritarian interference with the market.
A catallactic classification of local monopolies must distinguish three groups: margin monopoly, limited-space monopoly and license monopoly.
A local margin monopoly is characterized by the fact that the barrier preventing outsiders from competing on the local market and breaking the monopoly of the local sellers is the comparative height of transportation costs. No tariffs are needed to grant limited protection to a firm which owns all the adjacent natural resources required for the production of bricks against the competition of far distant tile works. The costs of transportation provide them with a margin in which, the configuration of demand being propitious, an advantageous monopoly price can be found.
So far local margin monopolies do not differ catallactically from other instances of margin monopoly. What distinguishes them and makes it necessary to deal with them in a special way is their relation to the rent of urban land on the one hand and their relation to city development on the other.
Let us assume that an area A offering favorable conditions for the aggregation of an increasing urban population is subject to monopoly prices for building materials. Consequently building costs are higher than they would be in the absence of such a monopoly. But there is no reason for those weighing the pros and cons of choosing the location of their homes and their workshops in A to pay higher prices for the purchase or the renting of such houses and workshops. These prices are determined on the one hand by the corresponding prices in other areas and on the other by the advantages which settling in A offers when compared with settling somewhere else. The higher expenditure required for construction does not affect these prices; its incidence falls upon the yield of land. The burden of the monopoly gains of the sellers of building materials falls on the owners of the urban soil. These gains absorb proceeds which in their absence would go to these owners. Even in the — not very likely — case that the demand for houses and workshops is such as to make it possible for the owners of the land to attain monopoly prices in selling and leasing, the monopoly prices of the building materials would affect only the proceeds of the landowners, not the prices to be paid by the buyers or tenants.
The fact that the burden of the monopoly gains reverts to the price of urban employment of the land does not mean that it does not check the growth of the city. It postpones the employment of the peripheral land for the expansion of the urban settlement. The instant at which it becomes advantageous for the owner of a piece of suburban land to withdraw it from agricultural or other nonurban employment and to use it for urban development appears at a later date.
Now arresting a city's development is a two-edged action. Its usefulness for the monopolist is ambiguous. He cannot know whether future conditions will be such as to attract more people to A, the only market for his products. One of the attractions a city offers to newcomers is its bigness, the multitude of its population. Industry and commerce tend toward centers. If the monopolist's action delays the growth of the urban community, it may direct the stream toward other places. An opportunity may be missed which never comes back. Greater proceeds in the future may be sacrificed to comparatively small short-run gains.
It is therefore at least questionable whether the owner of a local margin monopoly in the long run serves his own interests well by embarking upon selling at monopoly prices. It would often be more advantageous for him to discriminate between the various buyers. He could sell at higher prices for construction projects in the central parts of the city and at lower prices for such projects in peripheral districts. The range of local margin monopoly is more restricted than is generally assumed.
Limited-space monopoly is the outcome of the fact that physical conditions restrict the field of operation in such a way that only one or a few enterprises can enter it. Monopoly emerges when there is only one enterprise in the field or when the few operating enterprises combine for concerted action.
It is sometimes possible for two competing trolley companies to operate in the same streets of a city. There were instances in which two or even more companies shared in supplying the residents of an area with gas, electricity, and telephone service. But even in such exceptional cases there is hardly any real competition. Conditions suggest to the rivals that they combine at least tacitly. The narrowness of the space results, one way or another, in monopoly.
In practice limited-space monopoly is closely connected with license monopoly. It is practically impossible to enter the field without an understanding with the local authorities controlling the streets and their subsoil. Even in the absence of laws requiring a franchise for the establishment of public utility services, it would be necessary for the enterprises to come to an agreement with the municipal authorities. Whether or not such agreements are to be legally described as franchises is unimportant.
Monopoly, of course, need not result in monopoly prices. It depends on the special data of each case whether or not a monopolistic public utility company could resort to monopoly prices. But there are certainly cases in which it can. It may be that the company is ill-advised in choosing a monopoly-price policy and that it would better serve its long-run interests by lower prices. But there is no guarantee that a monopolist will find out what is most advantageous for him.
One must realize that limited-space monopoly may often result in monopoly prices. In this case we are confronted with a situation in which the market process does not accomplish its democratic function.About the significance of this fact see below, pp. 676–678.
Private enterprise is very unpopular with our contemporaries. Private ownership of the means of production is especially disliked in those fields in which limited-space monopoly emerges even if the company does not charge monopoly prices and even if its business yields only small profits or results in losses. A "public utility" company is in the eyes of the interventionist and socialist politicians a public enemy. The voters approve of any evil inflicted upon it by the authorities. It is generally assumed that these enterprises should be nationalized or municipalized. Monopoly gains, it is said, must never go to private citizens. They should go to the public funds exclusively.
The outcome of the municipalization and nationalization policies of the last decades was almost without exception financial failure, poor service, and political corruption. Blinded by their anticapitalistic prejudices people condone poor service and corruption and for a long time did not bother about the financial failure. However, this failure is one of the factors which contributed to the emergence of the present-day crisis of interventionism.See below, pp. 851–853.
- It is customary to characterize traditional labor-union policies as monopolistic schemes aiming at the substitution of monopoly wage rates for competitive wage rates. However, as a rule labor unions do not aim at monopoly wage rates. A union is intent upon restricting competition on its own sector of the labor market in order to raise its wage rates. But restriction of competition and monopoly price policy must not be confused. The characteristic feature of monopoly prices is the fact that the sale of only a part p of the total supply P available nets higher proceeds than the sale of P. The monopolist earns a monopoly gain by withholding P − p from the market. It is not the height of this gain that marks the monopoly price situation as such, but the purposive action of the monopolists in bringing it about. The monopolist is concerned with the employment of the whole stock available. He is equally interested in every fraction of this stock. If a part of it remains unused, it is his loss. Nonetheless he chooses to have a part unused because under the prevailing configuration of demand it is more advantageous for him to proceed in this way. It is the peculiar state of the market that motivates his decision. The monopoly which is one of the two indispensable conditions of the emergence of monopoly prices may be — and is as a rule — the product of an institutional interference with the market data. But these external forces do not directly result in monopoly prices. Only if a second requirement is fulfilled is the opportunity for monopolistic action set.
It is different in the case of simple supply restriction. Here the authors of the restriction are not concerned with what may happen to the part of the supply they bar from access to the market. The fate of the people who own this part does not matter to them. they are looking only at that part of the supply which remains on the market. Monopolistic action is advantageous for the monopolist only if total net proceeds at a monopoly price exceed total net proceeds at the potential competitive price. Restrictive action is always advantageous for the privileged group and disadvantageous for those whom it excludes from the market. It always raises the price per unit and therefore the total net proceeds of the privileged group. The losses of the excluded group are not taken into account.
It may happen that the benefits which the privileged group derives from the restriction of competition are much more lucrative for them than any imaginable monopoly price policy could be. But this is another question. It does not blot out the catallactic differences between these two modes of action.
Murphy's Guide to MisesThe prevailing labor-union policies are restrictive and not monopoly price policies. The unions are intent upon restricting the supply of labor in their field without bothering about the fate of those excluded. They have succeeded in every comparatively underpopulated country in erecting immigration barriers. Thus they preserve their comparatively high wage rates. The excluded foreign workers are forced to stay in their countries in which the marginal productivity of labor, and consequently wage rates, are lower. The tendency toward an equalization of wage rates which prevails under free mobility of labor from country to country is paralyzed. On the domestic market the unions do not tolerate the competition of nonunionized workers and admit only a restricted number to union membership. Those not admitted must go into less remunerative jobs or must remain unemployed. The unions are not interested in the fate of these people.
Even if a union takes over the responsibility for its unemployed members and pays them, out of the contributions of its employed members, unemployment doles not lower than the earnings of the employed members, its action is not a monopoly price policy. For the unemployed union members are not the only people wronged by the union's policy of substituting higher rates for the potential lower market rates. The interests of those excluded from membership are not taken into account.
The Mathematical Treatment of the Theory of Monopoly PricesMathematical economists have paid special attention to the theory of monopoly prices. It looks as if monopoly prices would be a chapter of catallactics for which mathematical treatment is more appropriate than it is for other chapters of catallactics. However, the services which mathematics can render in this field are rather poor too.
With regard to competitive prices mathematics cannot give more than a mathematical description of various states of equilibrium and of conditions in the imaginary construction of the evenly rotating economy. It cannot say anything about the actions which would finally establish these equilibria and this evenly rotating system if no further changes in the data were to occur.
In the theory of monopoly prices mathematics comes a little nearer to the reality of action. It shows how the monopolist could find out the optimum monopoly price provided he had at his disposal all the data required. But the monopolist does not know the shape of the curve of demand. What he knows is only points at which the curves of demand and supply intersected one another in the past. He is therefore not in a position to make use of the mathematical formulas in order to discover whether there is any monopoly price for his monopolized article and, if so, which of various monopoly prices is the optimum price. The mathematical and graphical disquisitions are therefore no less futile in this sector of action than in any other sector. But, at least, they schematize the deliberations of the monopolist and do not, as in the case of competitive prices, satisfy themselves in describing a merely auxiliary construction of theoretical analysis which does not play a role in real action.
Contemporary mathematical economists have confused the study of monopoly prices. They consider the monopolist not as the seller of a monopolized commodity, but as an entreprenuer and producer. However, it is necessary to distinguish the monopoly gain clearly from entrepreneurial profit. Monopoly gains can only be reaped by the seller of a commodity or a service. An entrepreneur can reap them only in his capacity as seller of a monopolized commodity, not in his entrepreneurial capacity. The advantages and disadvantages which may result from the fall or rise in cost of production per unit with increasing total production, increase or diminish the monopolist's total net proceeds and influence his conduct. But the catallactic treatment of monopoly prices must not forget that the specific monopoly gain stems, with due allowance made to the configuration of demand, only from the monopoly of a commodity or a right. It is this alone which affords to the monopolist the opportunity to restrict supply without fear that other people can frustrate his action by expanding the quantity they offer for sale. Attempts to define the conditions required for the emergence of monopoly prices by resorting to the configuration of production costs are vain.
It is misleading to describe the market situation resulting in competitive prices by declaring that the individual producer could sell at the market price also a greater quantity than what he really sells. This is true only when two special conditions are fulfilled: the producer concerned, A, is not the marginal producer, and expanding production does not require additional costs which cannot be recovered in selling the additional quantity of products. Then A's expansion forces the marginal producer to discontinue production; the supply offered for sale remains unchanged. The characteristic mark of the competitive price as distinguished from the monopoly price is that the former is the outcome of a situation under which the owners of goods and services of all orders are compelled to serve best the wishes of the consumers. On a competitive market there is no such thing as a price policy of the sellers. They have no alternative other than to sell as much as they can at the highest price offered to them. But the monopolist fares better by withholding from the market a part of the supply at his disposal in order to make specific monopoly gains.
This article is excerpted from chapter 16 of Human Action. Robert Murphy has written a study guide for this chapter, available in HTML and PDF.This article follows "Chapter XVI. Prices, Part 1."
For the enemies of freedom in general , and of the economy in particular, the recent crash has been the occasion to re-assert that markets in general, and financial ones in particular, are inherently unstable — and thus dangerous — because they are driven by irrational behaviors such as the "mimetic effect," which, according to many experts and politicians, explains how Wall Street booms and then busts.
The idea, put a little simplistically, is this: when one investor speculates on the rise of a financial asset, he bids up its price, thus enticing more investors to speculate on its rise; they, in their turn, bid up its price, thus inflating a frantic speculative bubble that totally disconnects the market value of the financial asset from the real value of the underlying real asset.
This notion of speculation as a (temporary) "self-fulfilling prophecy" does not withstand even a thirty-second rational examination.
First, it does not even meet the formal requirements of a logical explanation.
Indeed, if the "mimetic effect" were true, every buying of a financial asset by an investor should lead to an exuberant rise in its price. This theory offers no criterion explaining why some speculations lead to bubbles and why others do not.
Second, if the instigator of the mimetic speculation initiates a bad speculation, he should be losing money. The problem, in fact, is not so much the "mimetic effect" in and of itself. Carl Menger, for instance, explained how money was established thanks to imitative behavior in which market participants follow the path opened by successful pioneers.
Three ProblemsThere are 3 problems to address in accounting for any speculative bubble:
There is a lag in time between the bad speculation and the financial losses that reveal it. The "mimetic effect" does not account for this.If the prices of certain financial assets are to be greatly inflated, it must be because investors anticipate great profits. Now, what, except a sudden and collective mania, explains such exuberance?How is a speculative bubble fed? Where do investors get the limitless means they waste in irrational ventures?In order to solve these three problems and get a rational explanation of the formation of speculative bubbles in financial markets, let's examine two cases.
First Case: The Misallocation of CapitalIn this first case, we consider investors as financial intermediaries with capital limited to actual savings. In this scenario, it is not only plausible but even necessary that some investors make bad investments, thus misallocating capital to low- and even negative-return assets.
This answers problem 2: because of uncertainty, speculation will happen to be deceptive. However, under such conditions, individual imperfect information concerning the future state of the economy is the only reason for false expectation.
Speculating on an asset and buying some of it, an investor can entice fellow market participants to join in his fate. However, the supply of capital being limited to net savings, from one period to another, the supply of funds which can be misallocated is strictly limited; and, since the return on investment will increase in the assets from which they are taken, the simple pursuit of profit will both reveal and correct the malinvestment.
Second Case: Credit ExpansionWhat happens when financial intermediaries have access to actual savings and newly created credit funds?
As explained by the Austrian business-cycle theory, newly created funds imply a decrease in interest rates. This decrease will have various effects on various financial assets, and thus on their relative prices.
Generally speaking, all future goods appear cheaper, and more profitable, than they really are — considering the real interest rate. But they appear even more so according to parameters such as the position of their underlying real assets in the structure of production, the period of production of their products, their durability, or the risk entailed in their offering.
As a consequence, we have here a reason for a collective error, since the manipulation of interest rates makes it appear more profitable to all investors to invest in certain assets.
And we also have an answer to the question concerning the origin of the flow of funds invested in these particularly interest-rate-sensitive and risky financial assets: the newly created credit.
Finally, the hypothesis of a monetary expansion also explains the time lag between the bad speculation on those assets and the losses they imply. Because of the injection of new liquidities in the economy, the structure of prices is loosened and, just like the structure of production, becomes distended. Misallocated funds do not have to be taken from other assets, and their overinvestment in sensitive and risky assets can go on up to the point to which their illusory rise in profitability is superior to that of less interest-rate-sensitive and risky investments.
Thus, speculative error can go on at no cost as long as that limit is not reached.
In fact, there are two other limits. First, the rate of interest tends to rise to its real value, undermining the pseudoprofitability of the real assets underlying sensitive and risky assets. Thus, new credit has to be created constantly.
Second, the injection of liquidity will have to be stopped at some point, or else hyperinflation will take place.
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The "mimetic-effect" explanation of speculative bubbles fails to distinguish between two radically different cases: on the one hand, the misallocation of a limited supply of savings by financial-market participants; on the other hand, the investment of a supply of funds superior to actual savings, i.e., of artificial credit created by a deceptively low rate of interest.
Only the latter can lead to speculative bubbles.
A good explanation of a phenomenon, such as the formation of speculative bubbles on financial markets, demonstrates itself in that it also explains bad explanations: verum index sui et falsi.
What then is the so-called "mimetic effect," really? When new liquidities are injected in a financial system, asset prices vary. They do so differently, according to various parameters, and only step by step. The "mimetic effect" does not reveal the intrinsic irrationality of speculation: it is nothing but the process by which artificial credit is being channeled, through a distorted price structure, to interest-rate-sensitive and risky assets.
If there is a mimetic behavior, it is the one of central bankers who constantly inflate the money supply in order to re-inflate bubbles and "stabilize" financial markets.
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I was the teaching assistant for a course on the theory of property rights during the fall semester of 2002. We spent quite a bit of time discussing rent control, various rent-control cases, and the legal principles that informed judicial decisions surrounding rent-control cases.
One of these principles was an aversion to "windfall" profits. Windfall profits occur when an entrepreneur enjoys profits in excess of what he expected, usually as the result of a drastic change in market conditions.
People often point to the run-up in gas prices — some gas stations were charging over $3 a gallon — after the September 11 attacks as an example of firms enjoying windfall profits. The price per gallon is higher than the cost per gallon. This, it is argued, is unfair, especially when an entrepreneur/business owner enjoys profits that he doesn't have to "work" for.
We often discussed this in terms of what was called the rate-setting equation, in which the court set prices according to the formula
rate = operating cost + reasonable return
This ignores two things. First, the definition of "reasonable" is arbitrary. Second, expected prices determine the costs an entrepreneur is willing to incur. As a rule, people don't incur costs and engage in arbitrary productive activity irrespective of expected benefits. In short, the price one expects to receive for a product — say a gallon of gasoline — determines the prices he is willing to pay for factors of production, how he will produce the product, and the quantity he is willing to supply. Prices are not cost determined.
To better illustrate this principle, suppose you are a cotton buyer in 1860s England. Two boatloads of cotton arrive, one from the United States and the other from Egypt. Let's assume that Egyptian cotton and American cotton are perfect substitutes. As a merchant, do you care at all what it costs your suppliers to produce their wares? Suppose you're the one trying to sell the American cotton. Do your costs of production influence the price at which you agree to sell the cotton? At this point, all of your costs are sunk. (Economists are fond of the phrase "sunk costs are sunk," which is to say that there is no way to recover them.) As such, these costs shouldn't factor into your asking price.
Let's return to our discussion of windfall profits as it relates to rent-controlled apartments. The in-class examples concerned rent-control ordinances in Cambridge, MA and Berkeley, CA, which are reportedly nice places to live and where the demand for housing is stronger than in most parts of the country. The "windfall profits" rationale for rent control works as follows: suppose you've owned an apartment complex in Cambridge for 50 years. The apartments cost you $450 a month to maintain, and you can rent them out for $500 a month for a monthly profit of $50 each. Suppose now that the demand for Cambridge apartments skyrockets, and you can now charge $1,000 a month for the exact same apartment. The rent controllers maintain that it isn't fair that you can now enjoy such higher rents without really changing the product you offer or "working for it." Since people supposedly aren't entitled to what they don't "work for," the rent controllers step in and cap rental prices at $500 a month. Everyone should be happy because you're still earning a "reasonable" profit on each apartment, consumers are still able to get cheap apartments, and the Cambridge housing stock has not diminished.
Henry Hazlitt sums up the standard argument for rent control as follows:
Rent control is initially imposed on the argument that the supply of housing is not "elastic" — i.e., that a housing shortage cannot be immediately made up, no matter how high rents are allowed to rise. Therefore, it is contended, the government, by forbidding increases in rents, protects tenants from extortion and exploitation without doing any real harm to landlords and without discouraging new construction. (Economics in One Lesson, p. 111)
As the great proto-Austrian economist Frederic Bastiat points out, however, we should never merely take account of that which is seen. We must also consider that which is not seen — the hidden effects of a policy like rent control. And there is plenty that is not seen in the case of rent control.
First, there are the standard problems associated with holding prices below the market-clearing price, all of which are taken out of an everyday "Principles of Microeconomics" textbook. Queuing (people waiting in line for the good, in this case, apartments) and nonprice competition will set in. People will try to get apartments by making bribes or other side payments. Landlords may let their property deteriorate. Landlords may withdraw from the housing market and convert their apartments to offices. Et cetera.
But this is only the tip of the iceberg. Let's consider the normative issue first. In this situation, rent controllers objected to windfall profits for the landlord. But what of the renter who has the good fortune to secure for $500 an apartment for which someone else would gladly pay $1,000? This is just as much a windfall as anything else. Moreover, the rent-control board either consigns the second renter to the winds of fate — he will, in all likelihood, be banished to a waiting list — or shuts him out of the housing market altogether because his willingness to pay is not allowed to manifest itself through the market process.
Moreover, rent control distorts the structure of production by nullifying the valuable signaling role of profits. High profits induce others to enter a market. In this case, high profits signal that there is quite a bit of money to be made in the Cambridge housing market. One of the fundamental precepts of economics is that people respond to incentives; something has to induce people to engage in productive activity (supplying apartments, in this case). They don't just do so ad hoc. It may very well be that some people are willing to absorb heavy losses to supply cheap, high-quality apartments out of their compassion for the hardscrabble lives of Harvard, MIT, and Berkeley students and faculty who are trying to eke out a living in the unforgiving world that is academe.
Of course, what motivates most people is the prospect of being able to do more of the things they like, whether it is consuming Coca-Cola, alleviating third-world poverty, or reading economics articles. Regardless, wealth helps. Therefore, the prospect of increasing one's wealth is quite often the driving force that motivates behavior.
Let's look at who wins and who loses. The rent control board certainly wins; passing additional rent control measures usually solidifies their employment. Incumbent tenants and those lucky enough to get a cheap apartment win because they get a good at a price below that which would clear the market. People pushing for rent control "win" in the sense that they get to feel good about striking a blow for justice.
Let's look at what Henry Hazlitt had to say about attempts to hold prices below their market-clearing levels in his classic Economics in One Lesson:
Now we cannot hold the price of any commodity below its market level without in time bringing about two consequences. The first is to increase the demand for that commodity. Because the commodity is cheaper, people are both tempted to buy, and can afford to buy, more of it. The second consequence is to reduce the supply of that commodity. Because people buy more, the accumulated supply is more quickly taken from the shelves of merchants. But in addition to this, production of that commodity is discouraged. Profit margins are reduced or wiped out. The marginal producers are driven out of business. Even the most efficient producers may be called upon to turn out their product at a loss.
He continues:
If we did nothing else, therefore, the consequence of fixing a maximum price for a particular commodity would be to bring about a shortage of that commodity. But that is precisely the opposite of what government regulators originally wanted to do. For it is the very commodities selected for maximum price-fixing that the regulators most want to keep in abundant supply. But when they limit the wages and the profits of those who make these commodities … they discourage the production of the price-controlled necessities while they relatively stimulate the production of less essential goods.
And this is the consequence of the state attempting to control the price of any good. It is often objected that "necessities" such as food, housing, education, and health care are too important to be left to the wiles and whimsies of the market.
The reader may have seen a bumper sticker reading "health care is a right, not a privilege." This certainly makes for convenient political rhetoric, but when we get past the newspaper headlines, we see that we're dealing with issues of mind-boggling complexity.
The principles by which market forces allocate resources aren't particularly difficult to grasp. People agree to exchange because they expect to be better off as a result, and those who are willing to pay the most generally get their desired quantity of a good in question. So the market's mechanisms for allocating resources aren't that mysterious.
We run into problems when we start talking about a good being a "right" that should be provided by someone (presumably the state) irrespective of market forces or one's ability to pay. The most apparent problems arise when we start to consider exactly what the concept of a "good" entails.
Goods are extremely specific things. They are characterized by definite physical, spatial, and temporal characteristics — in other words, we're concerned with the "what, where, and when" of a good. For example, suppose I have an ice cream cone after lunch. The good "ice cream" is characterized by certain physical properties (it's a soft, cold substance of a particular chemical composition), certain spatial properties (in all likelihood, it's at our local Kroger), and certain temporal properties (after dinner).
While it isn't hard to wrap our minds around the goods-character of ice cream, serious difficulties become apparent when we start to think about more abstract classes of goods such as "health care" or "housing." First, "health care" and "housing" are descriptors used to classify broad arrays of goods and services that are very costly to measure and may not be interchangeable. If we go back to ice cream for a second, we see that one vanilla ice cream cone is usually a perfect substitute for another. Moreover, it's easy to substitute chocolate for vanilla, gelato for ice cream, and waffle cones for sugar cones. It isn't easy to substitute the services of a urologist for the services of a gynecologist (for example).
So what are we talking about when we talk about "health care?" Do we mean brain surgery? Do we mean basic physicians' services? Do we mean aspirin?
Similarly, what are we talking about when we talk about "housing?" Basic shelter might consist of a lean-to or a mud hut. Do we mean penthouses in midtown Manhattan? Most so-called progressives would say that the "housing crisis" is characterized by a shortage of "adequate" housing, but who is to decide what is "adequate?" My wife and I have a three-bedroom house. On some margins, this is more than adequate. On some margins, though, it is inadequate. I'd like to have a bigger desk, but the guest room is too small. We don't have space for another couch in the living room, but it would be nice. Do we have a right to all of this at someone else's expense?
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Market prices turn incomprehensibly complex relationships into very simple ones. Government policy does the opposite. It turns the simple into the extraordinarily complex, and, as Ludwig von Mises has argued in various places, government intervention in one aspect of the economy will displace resources, change prices, and likely lead to calls for government intervention in other areas of the economy. Establishing the boundaries and definitions of what constitutes "just" and "unjust" outcomes presents one set of problems, and measuring the valuable attributes of the goods and services that are to be regulated or subsidized presents another. At the very least, these problems should cause us to view government intervention with a skeptical eye.
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There is an epidemic of bankruptcies: Circuit City, Sharper Image, Goody's, Gottschalk's, Comp USA, Levitz Furniture, Chrysler, GM. Not to mention all the local businesses that don't make the news when they close up shop. And the rash of corporate bustouts is far from over according to consulting firm Bain & Company, who predicts nearly 100 large ($100 million or more in assets) corporate bankruptcies by next year.
We're in a period of severe losses — a cluster of errors, as Murray Rothbard described it — with thirty-seven banks having failed already this year, and many more to come.
But as gruesome as the economic news sounds, Rothbard explained that this is the recovery.
The liquidation of unsound businesses, the "idle capacity" of the malinvested plant, and the "frictional" unemployment of original factors that must suddenly and en masse shift to lower stages of production — these are the chief hallmarks of the depression stage.
Many would like the boom to continue "where the inflationary gains are visible and the losses hidden and obscure," Rothbard wrote. "This boom euphoria is heightened by the capital consumption that inflation promotes through illusory accounting profits."
But the boom is where the trouble happens — when resources are directed into malinvestments and distortions occur — and trouble we've had this past decade with a Capital T. The M-2 money supply increased 53% since year 2001, while at the same time total bank loans doubled and bank real-estate loans increased over 150%. The mistakes of bad entrepreneurs have been hidden, employment was directed to wasteful and unneeded occupations, unsound projects were built and business risk was ignored.
"The boom produces impoverishment," wrote Ludwig von Mises in Human Action.
But still more disastrous are the moral ravages. It makes people despondent and dispirited. The more optimistic they were under the illusory prosperity of the boom, the greater is their despair and their feeling of frustration. The individual is always ready to ascribe his good luck to his own efficiency and to take it as a well-deserved reward for his talent, application and probity. But reverses of fortune he always charges to other people, and most of all to the absurdity of social and political institutions. He does not blame the authorities for having fostered the boom. He reviles them for the inevitable collapse.
Many bankers continue to contend that their banks are sound, protesting that they didn't make any subprime loans like those big Wall Street banks. But the cluster of errors doesn't contain itself to one asset. Houses don't suddenly appear. First, land is purchased. Then that land must be entitled — permission from local government must be obtained to build what the owner wants on the property. This is a lengthy process than can in the best case take months and in the worst cases take decades. Infrastructure improvements are then made and finally houses can be constructed.
So, low interest rates spur consumers and investors to buy houses — in some cases creating housing shortages and exploding prices, which, in turn, cause developers to buy land and begin the lengthy development process just described. After money supply increases by way of credit expansion, businesses malinvest by "overinvesting in higher-stage and durable production processes," Rothbard explained in Man, Economy and State.
Real-estate developers by and large use debt financing every step of the way from when they buy the land to when they start construction. In the past, banks traditionally shied away from making land loans. But as the market overheated, more and more banks got in the land-loan business. Land lending is inherently risky because land doesn't produce income and gaining government approvals in a timely manner is often problematic: land is many months from being converted to a use that is salable to the typical consumer. Lending for the construction is the least risky, but still the homes must be sold to pay off the loan.
Guaranty Bank of Austin recently demolished 16 new and partially built homes in Victorville, California. The cost of finishing the development exceeded what they could sell the homes for despite four of the homes already being complete. In early 2008, these homes were selling for $280,000 to $350,000 in the bedroom community 50 miles from LA.
The Victorville demolition is one of the most dramatic ends to a bad bet made during the housing boom, but abandoned developments have become an all-too-common sight in California. Nearly 250 residential developments totaling 9,389 homes have been halted across the state, according to one research firm.
And the residential meltdown is nowhere close to being over. There is reportedly a million-house overhang in the market nationwide. But misguided attempts by government are keeping home prices from correcting to affordable levels. "If an investor could purchase a home and rent it out for close to breakeven," real-estate broker Mike Morgan writes in Barron's, "we might be getting close to the bottom. But we are nowhere close to that level in most critical markets."
Morgan points to a California program that offers a $10,000 tax credit for buyers of new homes. Thus, encouraging the building of redundant houses, at the same time homes are being bulldozed in Victorville. The annual sales pace is 300,000 homes, yet 500,000 new homes are being started that will just add to a bloated inventory.
"All of this government intervention will only spawn new malinvestments and later depressions."What Morgan calls the back half of the residential-real-estate hurricane will destroy bank balance sheets. "Our experience with banks' selling REOs is they realize about 50% — 75% of what they initially think they will get," explains Morgan.
But the current crisis doesn't end with residential real estate. Commercial-real-estate developers follow roof tops. When they see homes being built, they forecast that those homeowners will need places to shop and places to work — so the residential-construction boom inevitably leads to a commercial-property boom: office and industrial buildings as well as shopping centers. All those new homeowners will need to buy everything from groceries to garden hoses. Plus, new title company, mortgage loan, construction, and other real-estate-dependent jobs are created, meaning more office and industrial space will be required.
And lenders were there to embrace their developer customers' dreams and supply the credit. Commercial mortgages and construction loans exploded in the boom years. "Tiny cap rates, feckless lending and willful ignorance were par for the course in those years when the market could hardly seem to walk a straight line," writes Grant's Interest Rate Observer.
But with the finding of new tenants difficult and the rash of bankruptcies of current renters, commercial-property values are plunging. The Moody's/REAL Commercial Property Price Index has fallen over 21 percent since it peaked in October 2007. And the folks at Deutsche Bank see price declines of 35 to 45 percent and maybe more in commercial property, due to the large number of loans coming due between now and 2012 that will not be able to be refinanced. Not only are loan delinquency rates up and rents down, but the go-go years of aggressive loan underwriting are gone. The interest-only, high-loan-to-value-ratio loans that drove capitalization (cap) rates to the five percent range are history. Property buyers who are required to put more money down will offer significantly less for the same net operating income to achieve the required return on investment.
"Volume [of real-estate transactions] in the Americas has fallen hardest with the first quarter 2009 sales down 84% year-over-year and 56% from the fourth quarter of 2008," according to REAL Capital Analytics.
This spells further trouble for the small community banks that make up just 28% of the banking industry's total assets but are responsible for about 60% of the nation's commercial-real-estate lending.
So while many bankers contend their institutions are sound, bank attorney Gerald Blanchard told US Banker, "Across the U.S. right now there are still a fair number of community and regional banks with significant problems."
"There are banks in the sunbelt and other areas sitting on developed lots — lots that have been bulldozed, wired, and paved but not built on — worth 15 to 20 cents on the dollar," Blanchard says. "Those institutions with heavy investments are suffering big losses and big hits to capital. So yes, we will continue to see failures." Blanchard went on to say that newer banks will not be lending to builders and depending on brokered deposits to grow their banks, as they did in the boom.
A contraction of credit and liquidation of assets is exactly what would complete this recovery. Failing real-estate prices, business failures, and high unemployment signal that the economy is desperately trying to heal but the Fed is fighting valiantly to re-inflate, increasing its balance sheet 140% just to generate a 14% increase in the M-1 money supply. The folks at Grant's estimate the federal response to the current downturn to be 12 greater than that to the Great Depression, which prolonged that recovery for a decade.
However, all of this government intervention will only spawn new malinvestments and later depressions. "It should be clear that any governmental interference with the depression process can only prolong it," explained Rothbard "thus making things worse from almost everyone's point of view." Further delay of the readjustments will only lengthen the depression, postponing complete recovery indefinitely.
"The larger the scope of malinvestment and error in the boom," predicted Rothbard, "the greater and longer the task of readjustment in the depression." Government intervention on all levels guarantees that this will be a very long, bumpy recovery.
"The overexpansion of the strip-club business is yet another malinvestment created by the Federal Reserve's monetary creation."Strip clubs are the ultimate boom-time creation. After all, the business model rests on masses of men overpaying for cocktails while overpaying lithesome young women to bump and grind on their laps — all of this after paying an exorbitant charge just to enter the building.
Prior to the great boom of the past decade, the jiggle business was localized. Politically unpopular, zoning for such establishments is confined to industrial areas, tucked away from mom and the kids. Financing to build such businesses was hard to come by as many bank boards frowned upon the morals of the operation, turning a blind eye to the abundant cash flows. Publicly traded strip-club operators were unheard of.
Of course given their unpopularity with local do-gooders, entrepreneurs who are able to open an adult business become ongoing targets for extortion by local politicians. Since the government tightly controls how many can open — and the rules when they do — adult business owners are often forced to bribe city officials first to gain approvals to open their businesses, and then to remain open.
Such was the case in one of the most fertile fields for the stripping business, Las Vegas. As home-equity-rich Americans were flooding Sin City after the shock of 9/11 wore off, and Federal Reserve liquidity was making testosterone-filled young men feel like the good times would never end and money was for wasting, strip club owner Mike Galardi operated a small hole-in-the-wall money machine called Cheetahs. But with the town booming, he wanted to expand his feline-themed empire. But he wasn't the only one. Everyone wanted to build a big club in Las Vegas. Convention traffic was soaring, gaming win was growing by leaps and bounds, and more casino properties were planned for the Strip. Las Vegas was just getting started and the big-box strip-club race was on. The 70,000-square-foot Sapphire Gentlemen's Club was underway right behind Circus Circus, as was the large, ornate Treasures, located across I-15 from Palace Station. So many others were trying to open clubs that a moratorium was placed on new applications.
With approvals for his 25,000-square-foot Jaguars club hard to obtain, Galardi made a few hundred thousand dollars in gifts and cash payments to county commissioners to get Jaguars started and keep county inspectors off his back. Ultimately three Clark County commissioners, as well as Galardi, would go to prison in a political corruption case known as G-Sting.
Of course Galardi was only doing what he had to do. In his book, The Ethics of Liberty, Murray Rothbard explained that there
is nothing illegitimate about the briber, but there is much that is illegitimate about the bribee, the taker of the bribe. Legally, there should be a property right to pay a bribe, but not to take one.
Former Galardi employee and friend Rich Buonantony told the San Diego Union-Tribune newspaper,
[Galardi] was giving hundreds of thousands of dollars, and do you think it was easy to remember giving five grand here and 10 grand there? It was nothing for him to give money. People looked at Mike Galardi like he was an ATM machine.
Those "people" Buonantony referred to were politicians.
But now that the boom has turned bust, business has flattened for strip clubs. The 25,000-square-foot club that forever changed the lives of Galardi and three commissioners is now owned by the publicly traded Rick's Cabaret International Inc. Eric Langan, the man who took over Rick's in 1998, ramped up the company's growth in 2005 and now it owns 19 clubs around the country. Quite a story for a guy who sold his baseball card collection to finance his first club, "I just jumped in," says Langan. "With cold beer and some naked girls, it's pretty easy to make money."
With that initial $24,000 investment, Langan's first club measured 1,600 square feet. Now, as he told BBook.com, some of his clubs have dressing-room areas measuring more than three times that space. Back in 1999 Rick's was trading for less than a buck a share on NASDAQ but by December of 2007, with his shares trading for $27 — more than the price of a lap dance — Langan's goal became to own 50 clubs in three to five years. He bought a 47,000-square-foot club in Miami for $25 million, a 25,000-square-foot Dallas club for $9.5 million and he paid $18.7 million for the former Jaguars in Las Vegas. Rick's balance sheet is now showing the strain. At September 30, 2006, liabilities totaled less than $17 million. Now with business sagging along with the asset values of the clubs, the company's debts have soared to almost $72 million.
"With cold beer and some naked girls, it's pretty easy to make money."And the company has encountered expenses that Langan likely didn't include in his pro forma when analyzing his company's Las Vegas purchase. Cab drivers in Sin City have always collected bounties for delivering passengers to various businesses — especially strip clubs. But the price has soared in recent months as business has soured.
When a lot of loose cash is floating around, lawyers start taking interest. Attorney Al Marquis has filed a lawsuit to stop cabbies from being paid for delivering customers, thinking that it's bad for Vegas.
The problem with paying for the delivery of customers is that it's been escalating in recent years. It has begun to substantially alter the conduct of lots of different parties from hosts and doormen at casinos; to individual cab and limo drivers; to tourists getting diverted over their objection.
To regain market share, Rick's Las Vegas hiked cabby payouts to $100 per head which led to an increase in monthly sales to $1.9 million in April, according to the Wall Street Journal. However, $1 million of that went to cabbies and the club lost money for the month. "You gotta remember, in our industry it's all about the girls. So he who has the girls has the customers, and he who has the customers has the girls," Lagan philosophized during a recent investor conference call. "So it's really a chicken and egg and which came first. The trick is keeping the girls and the customers on a platform…. The guys will always go where the girls are."
What Lagan didn't say is that the girls are important because they pay to work. So, beyond the drinks and the cover charges and in some cases expensive meals, strip-club cash flow depends first and foremost on entertainers paying to entertain. Back in the Las Vegas boom days it was $50 per shift (depending upon the time of day) and $75 or $100 during convention weeks. On top of that, dancers are expected to tip the disc jockeys, floormen, and house mothers.
But the current bust means too many dancers are chasing too few laps in too much square footage. "For an industry often thought to be recession proof," the Wall Street Journal's Kris Hudson writes, "the transition has been sobering." Rick's stock is trading below $7 and publicly traded rival VCG Holding Corp. is trading at $2.40, a decline of 83% from its peak.
And investors are not the only ones getting hammered by the softness in the bump-and-grind industry. The entertainers themselves are shaking their moneymakers for much less these days. Buffy, who plies her trade at Rick's in Las Vegas told the Wall Street Journal that she is making only a quarter of what she did during the boom. However, that beats the mortgage business for Sara, who gave up making loans in the bay area, for stimulating conventioneers in her g-string at the Sapphire Gentlemen's Club. Reportedly, "a laid-off paralegal, a laid-off fashion designer, a Bank of America banker, a former paralegal and two Los Angles real estate agents" have changed careers despite the lower returns to be had working in 8-inch heels. However, anyone who has spent time in strip clubs will tell you that obtaining reliable personal information from entertainers is problematic.
The overexpansion of the strip-club business is yet another malinvestment created by the Federal Reserve's monetary creation. As F.A. Hayek has explained, profits made through stock market or real estate appreciation in terms of money, "which do not correspond to any proportional increase of capital beyond the amount which is required to reproduce the equivalent of current income, are not income, and their use for consumption purposes must lead to a destruction of capital."
The wealth that strip-club patrons and strip-club moguls thought they had to throw around was but an illusion, and the reality is sobering for the entertainers, cabbies, politicians, and others who have been riding the strip-club boom.
The real threat to humanity comes from governments growing ever more powerful in the name of fighting climate change. Whether you are a "denier" or whether you think carbon dioxide emissions need to be sharply reduced very quickly, you should be extremely skeptical of the process now unfolding in Washington. This isn't about saving the planet; it's about money and power, writes Robert P. Murphy.
This audio Mises Daily is narrated by Floy Lilley.