This is Part 7 of a 17-part series of posts summarizing Bob Murphy’s indispensable book Choice: Cooperation, Enterprise, and Human Action. Murphy’s book is itself is a summary of Ludwig von Mises’s classic treatise “Human Action.” As a result, you are reading a summary of a summary.
The purpose of these posts is to popularize and spread the word about Austrian economics and educate the public. Rather than list all the previous parts, I have created a category for all these posts, called “Human Action and Choice,” so that all these posts can be read (in reverse order) with a single click. Note well: any errors in these summaries are mine and not Murphy’s.
We are now moving into the section of the book titled “Economic Calculation” and begin with a chapter on the importance of monetary calculation.
In an earlier post, we emphasized that preference rankings in human action are ordinal, not cardinal. You can say you prefer chocolate ice cream to vanilla, but you can’t assign a number of units to each: it makes no sense to say “I prefer chocolate ice cream three times as much as vanilla.” More importantly, you can’t compare the intensity of your preferences to the intensity of another individual’s preferences. But I told you that there was a subtlety involving buying goods with money that would come up in a future post. This is that post.
With the introduction of money, for the first time arithmetical operations can be applied to economic affairs. The importance of money to the workings of the free market can’t be overstated. Having price signals determined by the market and communicated in units of money allows society to allocate resources in the most efficient manner possible. Without money, and without prices set by a free market, this cannot happen — because (as previously noted) in a barter system one can only look to ordinal preference rankings which cannot be expressed in units. (As we will later see, this is the central reason that Mises said socialism could not work — his famous “socialist calculation problem,” which will merit its own post.)
Before we get to money, we must explain how “barter prices” emerge in a world without money, based on ordinal preference rankings. (These are my examples and not Murphy’s. Although they are loosely based on his examples, don’t blame him.)
Assume there is a fellow named Murray whose ordinal ice cream preferences line up this way:
1. Two scoops of vanilla
2. One scoop of chocolate (Murray possesses this)
3. One scoop of vanilla
#1 is his top preference. #2 is his second, and #3 is his last choice.
Clearly, Murray would trade his scoop of chocolate for two scoops of vanilla, but not for one.
Now, pretend a fellow named Milton has this ice cream preference rank:
1. One scoop of chocolate
2. Two scoops of vanilla (Milton possesses this)
3. One scoop of vanilla (obviously Milton possesses this too; if he has two, he necessarily has one)
Milton would trade two scoops of vanilla for one scoop of chocolate. We know that Murray would trade his own scoop of chocolate for two scoops of vanilla. So we can see that these two folks can do a direct trade — and both will be better off.
Now say there is a third guy, Ludwig, whose ice cream preference is as follows:
1. Two scoops of vanilla
2. One scoop of vanilla
3. One scoop of chocolate (Ludwig possesses this)
Now, Murray and Ludwig both have a scoop of chocolate, which Milton wants. But Ludwig has set a cheaper price. He will accept just one scoop of vanilla for a scoop of chocolate — while Murray is demanding two scoops of vanilla.
Milton, with his two scoops of vanilla, would rather trade with Ludwig, who will take only one of Milton’s two scoops of vanilla, as opposed to Murray, who insists on getting two scoops of vanilla in return for his one scoop of chocolate.
In this way, adding more people to the market helps establish an equilibrium barter price for the scoop of chocolate: namely, one scoop of vanilla, the lowest price that a vendor of chocolate scoops will demand.
Note well: we never once had to say anything like “Milton gets twice as much pleasure from chocolate as he does from vanilla” or anything of the sort.
Also note that we never once talked about how difficult it is to create or obtain one scoop of chocolate vs. one scoop of vanilla. From the time of Adam Smith there was something called the “labor theory of value” which posited that prices depend upon the cost of the inputs. This fallacy led directly to the fallacy that the laborer, and not the capitalist, was the person who imbued goods with their true value, and thus “deserves” the fruits of that production. You can easily see that, while the labor theory of value was taken as true by Adam Smith, it was seized upon by Karl Marx, and is still implicit in many of the complaints of socialists like Bernie Sanders.
Whenever someone like Bernie Sanders complains that McDonald’s workers are getting paid too little, their implicit argument is that the workers are the ones who are really adding value to the business, while the people running the company are just fat cats putting in cash and watching the profits roll in. When they refuse to give those profits to the workers, they are exploiting the workers, who really give the business its value. This exploitation theory is Marxism 101.
But once you understand that value is subjective, then you understand that the person who contributes the most to an enterprise is the entrepreneur, who correctly foresees what consumers will want. The entrepreneur who predicts the advent of streaming video like Netflix will add far more value to his company than all the sweat of workers tirelessly toiling away to build new Blockbuster outlets that are going to go out of business.
Getting back to ice cream: the creation of barter prices wowed economists so much that they treated money as an afterthought: as a kind of neutral factor that served as a kind of stand-in for the equilibrium barter prices that are reached through the operation of trades like those described above, following from simple ordinal preference rankings. This, Mises warned, was a huge mistake — and his recognition of that fact amounted to one of his key insights. (We’ll discuss this in later posts. The hint I’ll offer here, which will be elaborated on later, is that money is a good with its own demand and supply issues.)
For now, it is enough to understand (with subtleties to be added later) that money serves as the basis of economic calculation, which is the central device that allows man to determine how to most efficiently allocate his resources. You might not need monetary calculation (though it helps) to decide it actually makes more sense to grow oranges in Florida and ship them to Montana, rather than try to grow them in Montana. But without monetary calculation, how can a businessman decide how many oranges to grow? whether to ship them by truck or by plane? how many retail outlets should distribute them? and so forth.
To make complex determinations like this, you could never rely on something like the equilibrium barter prices such as we demonstrated above with our ice cream examples. There are just too many elements in the calculation: how much is a plane ride worth, compared to a truck shipment, compared to a box to put your oranges in, compared to a tractor to plow your grove, compared to an hour of labor offered by a retailer to sell your oranges . . . and so on? Without monetary calculation, this sort of analysis cannot possibly be done. It is just too complicated.
And (again jumping ahead), this is why a socialist economy, without real price signals, cannot possibly succeed.
With that observation, we have come full circle for this post, which has been a longer one, but (I hope) very satisfying and informative. Tomorrow we will further explore what economic calculation can do — and cannot do.