Patterico's Pontifications

9/1/2015

“Human Action” and Robert Murphy’s “Choice,” Part 11: Indirect Exchange and Money

Filed under: Economics,General,Human Action and Choice — Patterico @ 7:30 am

This is Part 11 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.” Like previous posts, this post is 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.

This is one of the longest chapters in the book, and I think it’s the toughest post in the series (at least so far). Some paragraphs may need to be read twice, or perhaps you should just read them more slowly than you’d normally read a blog post. But I think the concepts are among the most fascinating. You should learn something today.

INDIRECT EXCHANGE

Murphy begins by explaining the difference between direct and indirect exchange. We have explored simple examples of direct exchange before, in post 7 (trading one flavor of ice cream for another) and post 10 (selling ice cream for money). Let me illustrate indirect exchange while sticking with the ice cream example.

Say Milton has chocolate, but wants vanilla. Murray has vanilla, but wants strawberry. Ludwig has strawberry, but wants chocolate. No two of these men can trade with one another and have both sides directly obtain they want. But any two of the three can trade directly, and thereby have one side get what they want directly, and have the other side obtain what he needs to successfully trade with the third party. The party that uses the first transaction to get what he needs for a second transaction is engaged in indirect exchange.

For example, if Milton trades his chococate for Murray’s vanilla, Milton is immediately happy, because he wanted vanilla. Murray, exchanging his vanilla for chocolate, is not happy yet — because Murray wanted strawberry, and he has chocolate. But now Murray can go to Ludwig, and exchange strawberry for chocolate. After two transactions, everyone’s happy.

Here, Murray used strawberry ice cream as a medium of exchange. Trading something of value for strawberry did not satisfy Murray immediately, but using that strawberry ice cream as a medium of exchange allowed Murray to get what he wanted.

THE ORIGINS OF MONEY

Carl Menger, the father of Austrian economics, explained that money got its start with this sort of indirect exchange. People recognized that they could not always trade goods directly. But they also realized that if they could trade their goods or services in return for a widely accepted medium of exchange, they could get what they wanted.

Menger explained that money must of necessity emerge in this way. His was not a historical analysis, as there are no clear records of how this happened; rather, he argued from economic logic. Money could not have emerged because a wise ruler said: “everyone should start accepting these shiny rocks” (or pieces of metal, or whatever) “in return for the valuable stuff they have.” It seems very unlikely that people would have signed onto such a bizarre-sounding plan. And if a wise ruler had managed to pull this off, how would he know how many shiny rocks people should have to exchange for one sheep? for three cows? for one day’s labor picking crops? and so forth.

No: instead people started trading for things that they knew would be widely accepted, because they were useful commodities on their own. In some societies the initial medium of exchange was tobacco. It has been cocoa beans at times. (I explained the origins of money more fully in May 2014, and for a fuller description, I refer you to that post, but here we will just summarize it.) But over time, people gravitated towards previous metals like gold and silver, because they had the properties you would expect from a medium of exchange: they were recognizable, scarce, liquid, divisible, durable, easily stored, and transportable. The general idea, however, is that money was a commodity — and it cannot logically emerge any other way. (Gold is thus a “commodity money” — as contrasted with fiat money, which is money simply because government declares it to have value.)

Now comes the fun part — that I think is going to upset some of you, because it may run counter to the conventional way you have likely thought about money for most of your life. (Why “fun”? Well, where’s the fun if I’m not challenging your ingrained beliefs a little bit?)

ANALYZING MONEY USING SUPPLY AND DEMAND

Mises’s great insight into money (one of them, anyway) is that money is a good that is demanded by people, just as they demand any other good. It’s not just what’s left after you get through satisfying your other demands. It’s something you demand just as you demand traditional goods or services. Money is demanded, not so we can consume it (obviously), but because we can hold it, and it provides a flow of services to the person who holds it.

If you view money as a good, there are immediately some problems that need to be addressed. For one, how do you value it? Oranges might be said to be worth $2 per pound. Bicycles might be $200 each. What is money “worth”? The answer is: the reciprocal of all the goods and services it could purchase. If oranges are $1 for a half pound, then $1 is worth a half pound of oranges. If bicycles are $200, then $1 is worth 1/200 of a bicycle. Etc.

Viewing money in this way helps you to understand general price fluctuations as a function of the demand for money. If the price of money goes up (because the demand for money goes up), then the price of all these other goods goes down. When people demand money more, prices fall. Put another way, money’s purchasing power rises. Like any other good, as its price goes up, people will hold less of it, because they can get more for it. (As a side note — and this is my own observation, not endorsed by Murphy — this is why deflation is not worrisome. As people hoard money, it becomes more valuable, and naturally people will want to exchange it for goods, since they can buy more with it.)

By contrast, when money’s purchasing power (or price) falls, prices of other goods go up. This is what is typically thought of as “inflation” (price inflation, or rising prices) — and it is a function of money losing its purchasing power. Put another way, the price of money is falling, which is often a side effect of expansion of the money supply — the marginal utility of extra units of money decreases as the supply available increases.

Ultimately, then, the purchasing power of money is a function of the demand for money. (Remember, Mises liked to explain the economy in terms of demand.) The purchasing power of money throughout the economy adjusts so that the total quantity of money demanded by all people (taking into account what they would have to exchange to get it) equals the total amount of money in existence. (This is the same thing that happens with goods and services: the quantity of a good in an unhampered market economy tends towards the level equal to the total amount demanded at the market clearing price.)

Viewing money as a good collapses the artificial distinction between microeconomics and macroeconomics. It allows Austrian economists to analyze the macro economy according to the common-sense principles (incentives and purposeful behavior) that govern decisions on the individual level.

THE REGRESSION THEOREM

Other problems come to mind, however. Remember, we have said all value is subjective. How can we use subjective value theory to explain the value of money without engaging in circular logic? Before Mises, explanations of the purchasing power of money seemed to travel in a circle: money can buy stuff because people demand it . . . and people demand money it because it can buy stuff.

Mises introduced the time element to break the circle. He explained that money’s purchasing power today is based on people’s expectations of what money’s purchasing power will be in the future. We’re no longer explaining money’s current purchasing power by reference to money’s current purchasing power, but rather by referring to the purchasing power we expect it will have in the future. This evaluation of the future is crucially aided by knowledge of what money was worth in the recent past.

You might say: that breaks the logical circle, but it leads us into a another problem: of infinite regress. If today’s purchasing power is based on yesterday’s expectations, and yesterday’s purchasing power was based on the previous day’s expectations, where did the original purchasing power come from? That’s where Menger’s explanation of the origin of money, described above, comes in. Mises said all money started as commodity money, like gold. Mises called this the “regression theorem.” At some point in the past, the community was in a situation of direct exchange (as opposed to indirect exchange) and this explains the origin of the purchasing power of money.

Mises argued that, if everyone in the world suddenly forgot tomorrow what the prices had been for everything in the past, people could reconstruct the process of comparing the relative values of different goods or services (a Ferrari is worth more than an orange), but nobody would know what a “dollar” is worth anymore. This is why Mises says that money — a medium of exchange — must begin as an economic good for which people assign an exchange value. People who have commonly used nothing but fiat money in their lives may have a hard time accepting this. But there is no fiat currency in existence whose value can’t be traced backwards in time to a commodity money. (This may help explain why people are having such a hard time determining a stable value for Bitcoin. Murphy acknowledges in a footnote that Misesians are still debating whether Bitcoin can escape the logic of the regression theorem.)

THE NON-NEUTRALITY OF MONEY

Mises also argued that money is not “neutral.” As noted, many economists would explain prices through the examples of a barter system, and throw in money as an afterthought. Mises did not. One effect of this view is Mises’s views on the effects of new money entering the economy. Many people seem to assume that if you double the stockpile of money, prices will double and purchasing power will halve, but otherwise people’s relative economic positions will remain constant. First, it’s not so neat and mathematical as that — but more importantly, money enters the economy in different places, and the people who get to use it before the prices rise are benefited. So, during QE, for example, large investment banks received the new money injected in the economy first, and benefited at the expense of others.

Another Mises tenet was that the currently available quantity of money is sufficient. Many people assume that, as the population rises, it is necessary to expand the money supply to forestall that horrible bogeyman called “deflation.” Mises emphatically disagreed. Doubling the money supply does not make people richer, and halving it does not make people poorer.

THE GOLD STANDARD

Mises was also a fan of the gold standard, seeing it as a critical bulwark against government power — as important as a written constitution or bill of rights. (I hesitate to use the words “gold standard” in a post, as it is almost certain that the comment section will fixate on it, making arguments that have nothing to do with the points made in the post. Still, this is part of the chapter.) Mises did not want governments to have the power to take action (even war) without the political accountability that comes with raising the money for the government action through taxation or borrowing. Simply inflating the currency allows governments to pretend that the government action costs them nothing.

The gold standard sets an automatic brake on inflation. If countries tried to inflate their currency, gold would flow out of the country as the government would be forced to redeem the inflated currency for gold. The money supply would have to shrink (or, if you were insistent on inflating, you could just pull a Richard Nixon and kill the gold standard — the “to hell with everything” strategy — leading to the price inflation we saw in the 1970s).

This mechanism also keeps foreign trade in balance; if more Americans bought British products than vice versa, they would have to buy pounds to do so. The surfeit of dollars chasing pounds would cause pounds to increase in value relative to dollars. But the gold standard would keep this from getting out of control, because if the value of a dollar became too low vis-a-vis the pound (meaning it took more dollars to buy a pound), gold owners could simply sell gold to England, buy U.S. dollars with the pounds, exchange those dollars for gold in the U.S., and end up with more gold than they started with. The net effect is that gold would flow out of the U.S., causing U.S. prices to fall, which would cause the British to buy more American goods, bringing everything back into balance. This mechanism has been understood since the days of Hume and Ricardo.

THE MEANING OF “INFLATION”

Finally, Mises was very clear that we should use the term “inflation” to refer to the quantity of money, and not the rise in prices that an increased quantity of money causes. (In a slight concession to the widespread use of the term to refer to the latter concept, Murphy uses “price inflation” to refer to the rise in prices, and “monetary inflation” to refer to an expansion in the money supply, which is what Mises insisted inflation really means.) Mises reasoned: “It is impossible to fight a policy which you cannot name.” (Shades of Ted Cruz talking about radical Islamic terrorism!) The root cause of price inflation is monetary inflation, and if we call rising prices “inflation,” we are then left without a term to describe what the real problem really is.

That was a bear of a chapter; possibly the toughest one in the book. I may give you a few days to reflect on this one before moving ahead with the next post.

8/31/2015

“Human Action” and Robert Murphy’s “Choice,” Part 10: Where Prices Come From

Filed under: Economics,General,Human Action and Choice — Patterico @ 7:48 am

This is Part 10 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.” Like previous posts, this post is 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.

This is another meaty chapter.

In explaining how the prices of consumer goods are determined, Murphy relies on preference rankings similar to the ones we used in post number 7, which gave examples of preference rankings in ice cream.

In that post, we showed that one person (Milton) who had two scoops of vanilla ice cream, but preferred one scoop of chocolate, could profitably trade with someone (Murray) who had one scoop of chocolate, but preferred two scoops of vanilla. Then if a third person comes along (Ludwig) who also has a scoop of chocolate, and is willing to settle for one scoop of vanilla instead of two, Milton will trade with Ludwig and not Murray. (See post 7 for a fuller discussion.)

If you substitute dollars for scoops of one of the flavors of ice cream (for example, vanilla), you can see how prices are determined. Murray will sell his scoop of chocolate for $2. Ludwig will sell his for $1. The market clearing price becomes $1.

The valuation is still subjective even though money has been introduced. As for the issue of why people would want little green pieces of paper (dollars) instead of scoops of ice cream, we can, of course, answer that by saying that people expect to be able to use those little green pieces of paper to obtain other things they want. Why this should be so, however, is a topic for a future post.

Mises distinguishes between valuation and appraisement. Valuation, according to Murphy, is “the significance that an individual places on a good or service because of its ability to confer happiness or utility on the individual.” Appraisement “assesses the amount of money for which a good or service can be sold.” Each influences the other, but they are separate concepts.

The next point is very subtle but worth understanding, because it was important to Mises, and misunderstood by even famous economists such as Joseph Schumpeter. For a single actor, the subject of valuation of a higher-order good depends on his own subjective valuation of the consumer good it helps produce. In a market economy, by contrast, the prices of higher-order producer goods are ultimately determined both by consumer preferences and by entrepreneurs — who appraise the prices of producer and consumer goods using economic calculation. Mises’s concern is that we always keep in mind the key role of the entrepreneur in allocating resources to produce consumer goods. This is a task that entrepreneurs do using economic calculation, which works only in a free market economy with accurate price signals.

Why was this important to Mises? Because if you ignore the key role of accurate price signals as used by entrepreneurs, then you might get fooled into thinking socialism is viable. More on this in a future post.

Murphy now stops to mention two “complications” that arise in assessing the role entrepreneurs play in determining the prices of the factors of production.

One is the ever-looming issue of time preference — the idea that people tend to prefer having their desires satisfied now, and not in the future. As entrepreneurs bid on the factors of production, they must remember that goods are always more valuable today than in the future. Thus, entrepreneurs always have to charge a mark-up. Because, even if you set aside the risks taken by entrepreneurs in trying to predict what consumers will value in the uncertain future, they also generally must use capital. Thus, they must contend with the fact that production takes time — and this means that capitalists’ investments in the production process must be recouped and then some, to make it worth their while to put the capital up for use by the entrepreneurs.

Also, Murphy notes that entrepreneurs choose to buy inputs according to anticipated marginal productivity — similar to the way consumers buy consumer goods according to the marginal utility they expect to receive from successive units of those goods in the production process. The only difference is the inclusion of the factor of the entrepreneur’s appraisement. The entrepreneur appraises how much extra revenue a producer good will bring in, and purchases (and thus appraises the value of) those producer goods accordingly. This applies to labor too. If you think an extra worker will bring in more money, you hire him. (Shockingly, this means a higher minimum wage could mean fewer workers hired on the margin!)

THE ROLE OF SUPPLY: Standard economics textbooks tend to mechanically portray prices as intersections of supply and demand curves. Now, Austrians don’t reject out of hand the role played by supply. Obviously scarcity affects your demand decisions on the margin; recall the example of water and diamonds offered in post 4:

[A]s the supply of a good increases, the marginal utility of the good decreases, and vice versa. You pay less for water than diamonds because there is plenty of water (currently) to satisfy our most critical desires, like satisfying thirst. If there were so little water that you had to pay $10,000 (more than you’d pay for a small diamond), just to get a drink and not die of thirst, you’d pay it (if you had the money).

But Murphy notes that Austrians tend to portray prices as fixed by subjective demand rather than by “objective cost” or by supply. Consumers determine demand for consumer goods, and entrepreneurs “sit on the demand side” for producer goods. The reason to emphasize the demand, Murphy says, is to keep in the forefront of one’s mind that subjective demand drives the whole process. To the extent that “supply” sits on one side of a transaction, it is really demand . . . reversed. What we call “supply” in a traditional transaction is really someone demanding money, and willing to exchange a good or service in exchange for money.

Put simply, the reason demand is king is because demand is what creates value to begin with. Without subjective demand for a good, it is worthless.

Murphy notes that, while creating consumer goods is a process, at the time of the exchange, “suppliers” have usually sunk their costs in the particular item being offered. They then have to get the best deal for the goods they have created, based on demand for those goods. Demand will also affect their decisions going forward, including whether to produce the same goods, how many to produce, and what to charge for them.

These are difficult concepts, and I hope I have summarized them accurately. Tomorrow, we address Mises’s brilliant insights regarding money, and how it is not a mere afterthought grafted onto the barter economy. Challenging stuff, but very worthwhile. Stick with it!

8/30/2015

“Human Action” and Robert Murphy’s “Choice,” Part 9: Defining and Studying the Market Economy

Filed under: Economics,Human Action and Choice — Patterico @ 12:56 am

This is Part 9 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.” Like previous posts, this post is 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.

Mises describes the market economy as a “process” — as “the social system of the division of labor under private ownership of the means of production.” It is the way individuals coordinate their activities voluntarily, acting on their own behalf, but aiming to satisfy others’ needs as well as their own.

Mises studies what would happen in a pure market economy even though no such economy actually exists. Some criticize this as unrealistic, but any policy proposal requires one to conduct a thought experiment about how things would be, if one’s proposal were accepted. This is no different.

We must now classify different people in the economy and the money they receive for what they provide. Workers provide labor and receive wages. Landowners and capitalists provide similar things as one another, and both receive interest. (While land, or natural resources, is not man-made, it is similar to man-made capital in that it provides entrepreneurs a head-start in time in the production process. More on this later.) Entrepreneurs adjust the factors of production in anticipation of the future, and receive profits when their foresight is accurate.

More definitions: Capital is the market value of assets minus the market value of liabilities. Income is the amount of consumption that can occur without reducing capital. Saving is the difference between income and consumption.

Mises was very clear that in a capitalist economy, the consumer is sovereign. The notion that everything is controlled by guys with white mustaches and top hats carrying around giant sacks with dollar signs on them (thanks to Tom Woods for the image) is a socialist fabrication. According to Mises, a businessman may be at the helm of the ship, but he has to obey the captain’s orders — and: “The captain is the consumer.”

Neither the entrepreneurs nor the farmers nor the capitalists determine what has to be produced. The consumers do that. If a businessman does not strictly obey the orders of the public as they are conveyed to him by the structure of market prices, he suffers losses, he goes bankrupt, and is thus removed from his eminent position at the helm. Other men who did better in satisfying the demand of the consumers replace him.

The steering by consumers is not always explicit, of course — but it happens nonetheless. Murphy gives as an example two entrepreneurs, a jeweler and a house builder. The jeweler makes pretty and affordable jewelry with gold, while the builder makes houses that are lined with gold inside and out, in the manner of European kings, making the prices of his houses astronomical. If people buy the jewelry, but reject the houses as too expensive, this means the consumer has steered the use of gold into jewelry rather than house-building. It’s not that the consumer explicitly told these entrepreneurs to use gold for one purpose, and not to use it for another . . . but in effect the consumer did communicate that message, through his decision to buy jewelry, but not absurdly priced houses.

In this way, price signals allow entrepreneurs to direct the economy’s resources in such a manner that they best satisfy the preferences of the consuming public. Rather than having government make arbitrary decisions, people vote with their dollars. There is, in this process, a deep connection between economic freedom and political liberty. Mises said:

No government and no civil law can guarantee and bring about freedom otherwise than by supporting and defending the fundamental institutions of the market economy.

This is critical, and I believe it with every fiber of my being. There is no political liberty without economic freedom.

Competition is what gives market actors freedom within the market economy. Workers who feel exploited can work elsewhere. Consumers who don’t like the product can buy elsewhere. (Try doing that with government!) But competition is a process, and while a snapshot at any given time may cause one to believe incorrectly that there is no competition, because one firm has a large market share, that is usually shown to be wrong over time. As long as government does not impose barriers to entry, lack of competition is an indication that the current goods and services are being provided at an adequate price. Meanwhile, any industry that appears to be a dominant and overbearing force is either a) a product of government, and/or b) faces extinction when technology finds a new way to accomplish the same goal in a better, cheaper way.

The railroads seemed like a monopoly at one point, Mises noted — and indeed, the lack of competition at one point in time showed that there was really no reason for other firms to invest in more rail lines, when the existing ones were sufficient. But this did not prevent the invention of the automobile or the airplane.

Next, we consider what Murphy calls “the vexing issue of (in)equality.” Murphy explains that “inequality of income and wealth is an unavoidable feature of a market economy.” If there are 100 people, and two are singers, and 98 are fans, the 98 may be willing to work a little harder to give money to one of the singers. The 98 fans may be willing to work a lot harder to give a lot more money to the other singer. This will result in the singer who makes the most people happy gaining a greater income and having more wealth — but if you changed this system, it would prevent or negate voluntary transfers, and might have an effect on the satisfaction of the consumers.

Once the critical role of monetary calculation in allocating resources is understood, it becomes clear that governmental redistribution of income impairs economic calculation and the proper distribution of scarce resources. Price signals are distorted and the consumer is less satisfied.

Another implication of monetary calculation is that the most efficient allocation of resources (satisfying the most people) can happen only in the pure market economy. Government cannot allocate resources efficiently, because the profit motive is alien to government bureaucracy. Bureaucratic management is different from profit management, not just in incentives. Bureaucracy need not convince consumers to voluntarily part with their money, and can (unlike businesses) prevent competition. Thus, the forces that make resource allocation efficient in the market economy are utterly absent in bureaucracy.

Enough for today. We’re over halfway done with the book! I hope this made sense. These are central concepts that show why the market is better than governments in allocating resources. Tomorrow, we’ll discuss how prices are formed on the market.

8/29/2015

“Human Action” and Robert Murphy’s “Choice,” Part 8: What Monetary Calculation Can and Can’t Do

Filed under: Economics,General,Human Action and Choice — Patterico @ 1:11 am

This is Part 8 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.” (At the end of this short post, we’ll be about halfway home!) Like previous posts, this post is a summary of a summary. If you’re intrigued by what I discuss here, you’d do well to buy and read Murphy’s book.

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.

Yesterday we introduced the concept of monetary (or economic) calculation. Today we’ll look a little bit more at that important concept, and talk about what it can, and cannot, do. Chapter 8 is a short chapter — and after the lengthy exercise we put the reader through yesterday, I am happy to do a shorter post today.

Although Murphy labels his chapter as being about what economic calculation can and cannot do, it seems to be principally about what it cannot do. Murphy starts by reminding us that a balance sheet (the key document in monetary calculation) seems so very precise . . . yet it is full of predictions about an uncertain future. You include, as an item of depreciation, 1/10 of the cost of a capital good expected to last 10 years . . . but for all you know, it will crap out tomorrow. You list your accounts receivable as an asset . . . but one of the businesses that owes you might go bankrupt next week, leaving you to receive pennies on the dollar.

Entrepreneurship is about predicting an uncertain future. Monetary calculation aids in this endeavor greatly — to the point where Goethe described double-entry bookkeeping as “one of the finest inventions of the human mind.” But no activity that involves predictions about the future can ever be exact.

Another point that I consider very important: remember that in Part 1 I said (in a comment) that

one thing I find very attractive about Mises and Austrian economics is that it is so much more realistic than classical economics, because it treats human beings as human beings.

In Chapter 8, Murphy makes the point that, according to the Austrian school in general, and Mises in particular, it is not assumed to be true “that people in a market economy are just out to make money.” The great thing about Mises’s broad view of “human action” is that it does not judge between people’s ends or desires — and in particular, it does not require that the desired goal be a goal to make more money. The altruism of a Mother Teresa is every bit as compatible with Mises’s theories of “human action” as are a CEO’s mass firing of employees to boost the bottom line. So economic calculation is not the be-all and end-all of the Austrian school, by a long-shot — and to me, that makes it the most realistic economic school of thought in existence.

By contrast, classical economics all too often reduces people to stick figures in a graph, robotically “maximizing utility under constraint.”

That’s it! See, I told you this would be a short post! Tomorrow, we act much more ambitiously, tackling the economics of the market society, beginning with defining and studying the market economy. Hope you’re enjoying the posts. See you tomorrow.

8/28/2015

“Human Action” and Robert Murphy’s “Choice,” Part 7: The Importance of Monetary Calculation

Filed under: Economics,General,Human Action and Choice — Patterico @ 12:01 am

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:

MURRAY’S PREFERENCES

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:

MILTON’S PREFERENCES

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:

LUDWIG’S PREFERENCES

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.

8/27/2015

“Human Action” and Robert Murphy’s “Choice,” Part 6: The Importance of Ideas and Reason

Filed under: Economics,General,Human Action and Choice — Patterico @ 12:02 am

This is Part 6 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, this is a summary of a summary. Blog life.

The idea here is to popularize and spread the word about Austrian economics and educate the public. (Several of you have bought Murphy’s book, and that is very pleasing to me. Some have even started reading Mises himself, which is fantastic!) 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.

Chapter 6 is a chapter devoted to summarizing Mises’s views on the importance of ideas in history. As Keynes said, most men are “the slaves of some defunct economist.” How ironic that quote is to the Austrian economist! — who watches governments haplessly careen from one absurd Keynesian “solution” to another, always prescribing the most counterproductive “cure” imaginable to the given diagnosed economic disease. The Austrian watches countries in a “bust” try to “fix” everything with huge infusions of cash and lowering of interest rates. The Austrian sees these actions as insane — like using trepanation to cure headaches, lobotomies to cure depression, or cigarettes to cure asthma. The Austrian longs for the day when the basics of economics are widely understood by policymakers, as real human suffering will thereby be alleviated to a previously unheard-of extent.

Mises literally believed that using reason “to grasp the advantages of social cooperation” (to use Murphy’s phrase) is the key to preventing the collapse of society.

Murphy spends much of chapter 6 drawing contrasts between Mises’s Austrian economics and other economic philosophies, such as Marxism and logical positivism.

The contrast with Marxism might sound like it would require a long explanation, but for now Mises (and Murphy) are concerned mainly with showing that Marx believed society molded men’s ideas, while Mises believed that ideas molded society. Other stark differences between Austrian economics and Marxism/socialism, such as Mises’s famous explication of the “socialist calculation problem” (also discussed by Hayek) will be reserved for future posts.

Probably the most interesting contrast is that between Mises and the logical positivists asserted that statements about economics lacked value unless they could be “verified.” This contrast, to me, appears related to Murphy’s final topic of the chapter: the notion that economics cannot be a “science” unless it makes testable predictions. Although Murphy separates the sections, I will discuss them together in this post.

Here, Murphy contrasts Mises with another well-respected economist (and a Patterico favorite): Milton Friedman. It turns out that Friedman and Mises are severely at odds with one another on the notion of economics as a “science” — and whether the correctness of economic principles depends upon those principles being validated by real-world data.

At this point the reader may be uneasy. We’re taking issue with Milton Friedman and rejecting the notion of using real-world data to validate our principles? Surely we are on shaky ground here! The fact that I know you are thinking this, to me, means I need to spend a little extra time on this final point.

This reminds us of Murphy’s analogy to geometry in Chapter 3 (see post number three in this series). As I summarized it in that post:

We do not derive the Pythagorean theorem by building 500 right triangles and measuring the angles and the sides. The proof of the theorem does not depend on experimentation. The proof is within us — it is simply a logical chain of thoughts that we need to reflect on.

Murphy quotes Mises on this point in chapter 6. Mises argued that while the Pythagorean theorem could be considered a “tautology” in the sense that “its deduction results in an analytic judgment,” that does not mean it is to be discounted:

Nonetheless nobody would contend that geometry in general and the theorem of Pythagoras in particular do not enlarge our knowledge. Congition from purely deductive reasoning is also creative and opens for our mind access to previously barred spheres. . . . It is its vocation to tender manifest and obvious what was hidden and unknown before.

Mises makes an analogy here to the quantity theory of money (the cornerstone of which he elsewhere modestly defined as “the idea that a connection exists between variations in the value of money on the one hand and variations in the relations between the demand for money and the supply of it on the other hand” — Theory of Money and Credit, p. 130) and says that it is like the Pythagorean theorem:

The quantity theory does not add to our knowledge anything which is not virtually contained in the concept of money. It transforms, develops, and unfolds; it only analyzes and is therefore tautological like the theorem of Pythagoras in relation to the concept of the rectangular [right] triangle. However, nobody would deny the cognitive value of the quantity theory. To a mind not enlightened by economic reasoning it remains unknown. A long line of abortive attempts to solve the problems concerned shows that it was certainly not easy to attain the present state of knowledge.

In chapter 6, Murphy gives us a hypothetical in which aliens visit Earth. We might not expect them to already know things that are purely a matter of human convention — such as the idea that a “bachelor” is someone without a wife. But we would expect that they would know geometry. And (if they engage in specialization and trade) we would expect that they would know economic principles like marginal utility theory. And if the aliens didn’t know geometry, or economic principles, we would expect that they would be grateful to learn these things — and that they would recognize their inherent truth.

Murphy quotes Friedman as disdaining an economic theory based on “a structure of tautologies” as being nothing but “disguised mathematics” if it cannot predict action in the real world. Let me quote Murphy at length in response:

From the starting point that humans act, the economist could logically deduce — thereby forming a tautology, it’s true — that individuals have subjective preferences with ordinal rankings, that choices come with opportunity costs, and that the value of second-order capital goods is dependent on the value of the first-order consumer goods that the individual believes they have the technological power to produce. Say what one will about these types of statements, they are clearly within the realm of economics and are not merely “disguised mathematics.” Although they have not been derived by reference to empirical observation, thinking through these tautologies definitely aids acting individuals as they navigate the real world. Logical, deductive economics as championed by Ludwig von Mises is not mere word games.

That’s how Murphy ends his chapter, and it’s a good way to end this blog post. We’re about 1/3 of the way through the project so far. Keep reading and sharing!

8/26/2015

“Human Action” and Robert Murphy’s “Choice,” Part 5: The Division of Labor

Filed under: Economics,General,Human Action and Choice — Patterico @ 7:45 am

This is Part 5 of my ongoing 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” — so you’re reading a summary of a summary. Hey, it’s a blog. Short and concise is what we do.

The idea of this series of 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.

Chapter 5 is a meaty chapter, but an important one. It revolves around the critical concept of the division of labor, which Mises saw as the foundation of all human society, and the reason that we have achieved whatever prosperity we have achieved. The importance of the division of labor, then, cannot be overstated. Understanding the division of labor allows one to spot economic fallacies all over — whether the fallacy is the so-called benefits of buying “local,” or the notion that a nation benefits its citizens by imposing trade barriers, or by preventing jobs from being exported overseas.

If every household tried to be completely and utterly self-sufficient, civilization would collapse. One of the key reasons we have the standard of living we have is because people specialize in particular tasks. The advantages of doing so are numerous. People don’t waste time switching between tasks. Automation is promoted because it makes sense to invest in machines. This is turn gives rise to economies of scale, which leads to tremendous savings. Many tasks require a minimum threshold of workers to accomplish them. And of course the division of labor allows people to use their natural aptitude to its greatest extent, or to acquire a special aptitude through experience.

But the benefits of the division of labor apply regardless of differing aptitude, as economist David Ricardo showed in the early 1800s with his explication of the principle of comparative advantage. This is critical to understand, and destroys the argument for tariffs and other protectionist measures. The notion is this: even if you are better than me at both tasks A and B, together we are more productive if you specialize in one task, and I specialize in the other. Namely, one should specialize in the task in which their advantage is most pronounced.

Murphy gives an example to illustrate the point. Say a store owner (Marcia) is better than the hired help (John) at everything. Store owner Marcia can convince someone to buy an item in 15 minutes, while it takes hired help John two hours to accomplish the same result. Marcia can tidy up the store at closing time in half an hour, while the hapless John takes an hour to do the same. The store owner Marcia is better than the hired help John at both tasks, but Marcia has the greatest comparative advantage in selling, since she can sell eight times as fast as John, and can tidy up only twice as fast. So at closing time, Marcia should concentrate on selling and let John do all the tidying up. She will make far more money this way than she would if she and John did not specialize. You can run any similar experiment with actual numbers and you will see that the math always works out in favor of specialization.

The division of labor is (of course) of no use without the ability to trade and cooperate. This, to Mises, was central. Again: Mises goes so far as to describe as the very foundation of human civilization the fact that humans are more productive when they act in concert with each other — as long as they are able to recognize that fact. Thus Mises rejects the naively sunny view that altruism is the fundamental underpinning of society — but he also rejects social Darwinism, in which stronger people dominate weaker ones for the good of humanity.

Finally, Mises posits that the highest productivity can occur only in a free market. While a command economy can enjoy the benefits of the division of the labor, those benefits will pale in comparison to the fruits of a truly free market. Future chapters (and posts) will illustrate this further.

8/25/2015

“Human Action” and Robert Murphy’s “Choice,” Part 4: Rounding Out the Basics

Filed under: Economics,General,Human Action and Choice — Patterico @ 12:01 am

This is Part 4 of my ongoing 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” — so you’re reading a summary of a summary . . . which sounds about right for a blog post, no?

The idea of this series of posts is to popularize and spread the word about Austrian economics and educate the public. 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.

In this post, we will be defining some terms, which is an exercise that is critical to any future discussion. We will also learn a concept that separates Austrian economics from classical economics: the heterogeneity of capital. Unlike classical economists, Austrians do not view capital as one large lump. They see the capital structure as composed of different types of capital, some geared towards longer-term goals than others. As we will see later, this more accurate view of capital has staggering implications for the business cycle. Based on my reading, it seems to me that this concept is utterly foreign to classical economics, and allows Austrians to better understand the effect of changes in the monetary supply and interest rates.

In keeping with the Austrian desire to explicate universally applicable concepts, we simplify everything to a desert island, with a hypothetical Robinson Crusoe, trying to manage his environment. This sort of approach drives the Paul Krugmans of the world crazy, but it helps illustrate universal concepts that apply to any human actor.

The key insight is to classify goods as “lower-order” or “higher-order” based on how close they are in the production process to satisfying a consumer’s desire. Lower-order goods are the closest to satisfying a desire. In particular, consumer goods are goods that directly satisfy a desire. For example, Robinson Crusoe is hungry, and eats a coconut sitting on the ground. The coconut is a consumer good, or “first-order” good, because it directly satisfies Crusoe’s needs. It is the lowest-order good possible.

Goods used to produce consumer goods are producer goods. A “second-order” good is used to directly produce a consumer good. A branch that Crusoe uses to get a coconut from a tree is a second-order producer good. If Crusoe uses a rock with a sharp point to help him saw off a branch (a second-order good), then the rock is a third-order producer good. As so forth.

In a complex economy, there are numerous orders of producer goods — and the higher-order they are, the further removed they are from directly satisfying a consumer’s needs. Mined iron ore is a very high-order producer good indeed, far removed from directly satisfying the consumer. The oven in a bakery is a lower-order producer good, because it is closer in the production process to delivering a muffin to the customer.

We will see in future posts that this division of producer goods into lower-order and higher-order goods — the “heterogeneity of capital” — is central to understanding the Austrian perspective. It allows Austrians to make insights regarding the business cycle that are simply beyond the reach of classical economists.

More definitions: Natural resources and labor are also classified as producer goods, and capital goods are factors of production created by people.

Any action is an exchange — even without a second person — because of opportunity cost. When you act, you exchange your chance to take action a at that moment, for a chance to take action b instead.

Action also must take place in time — and action implies that the actor is uncertain about the future. If he were certain of the future, why bother acting?

Getting a bit more complex now, we round out Chapter Four with a discussion of two related concepts: 1) the law of diminishing marginal utility, and 2) the law of diminishing returns.

THE LAW OF DIMINISHING MARGINAL UTILITY

The idea that people make economic decisions “on the margin” was a key insight of economists working in the 1870s, and this concept remains central to all economics today. The idea is that, when evaluating preferences, you don’t really compare one good versus another — you compare successive units of one good to successive units of another.

You always use the first unit of a good to satisfy your most important need or desire. Successive units are devoted to less important desires. This means that successive units are not worth as much to you. This is the law of diminishing marginal utility.

For example, if you lacked running water, and had to buy bottled water for all your water needs, you might put the first bottle to use in satisfying your thirst. The second might be used to bathe yourself. The third might be used for cleaning dishes, and the fourth to give your dog water. Maybe the fifth will be stored in the garage in case the store runs out of water. That first bottle is worth more to you than the fourth or fifth.

Just as obviously, as the supply of a good increases, the marginal utility of the good decreases, and vice versa. You pay less for water than diamonds because there is plenty of water (currently) to satisfy our most critical desires, like satisfying thirst. If there were so little water that you had to pay $10,000 (more than you’d pay for a small diamond), just to get a drink and not die of thirst, you’d pay it (if you had the money).

Murphy has all kinds of interesting examples that flesh out these concepts, which is one reason that reading his book is superior to reading a blog post summary of it.

THE LAW OF DIMINISHING RETURNS

Our last concept for the chapter is probably the most complex: the law of diminishing returns. Imagine you are producing something using two scarce resources: A and B. If you fix the amount of one of these variables (A), then there is a maximum amount of output per additional unit of B. In other words, you might get more total output by adding more B, but at a certain point that output will be less per unit B, meaning that adding additional units of B may not be justified (depending on the circumstances).

I told you it’s complex. We need an example to make it concrete.

In Murphy’s example, A is an industrial strength dishwasher at a restaurant, and B is a variable number of workers using the machine. Murphy has a chart assuming one machine (A) and then showing the number of dishes washed as you add more workers (B). I’m going to take the liberty of reproducing his chart here — and I hope he’s OK with that. (If he’s not, I’ll take it down.)

Screen Shot 2015-08-23 at 12.26.58 PM

As you can see, as you add workers, the number of dishes washed increases, to a point. 1 worker can wash 100 dishes. 2 can wash 300. 5 can wash 1000. The absolute number keeps going up, until you add the tenth worker, who is just in the way and actually reduces the total number of dishes washed.

But there is an upper limit to the number of dishes washed per worker: 210, achieved when there are three workers.

This is the law of diminishing returns.

Murphy notes that, during busy times, a manager may wish to employ more than three workers even though the number of dishes washed per worker goes down — simply because it may be critical to get, say, 1000 dishes washed per hour.

We are now finished with the chapters explicating the basic concepts of human action. In post 5, we will move on to action within the framework of society, and expound on the division of labor — one of the most important concepts in all of economics.

8/24/2015

“Human Action” and Robert Murphy’s “Choice,” Part 3: Theory vs. History

Filed under: Economics,General,Human Action and Choice — Patterico @ 12:05 am

This is Part 3 of my ongoing series of posts summarizing Bob Murphy’s excellent book Choice: Cooperation, Enterprise, and Human Action — which itself is a summary of Ludwig von Mises’s classic treatise “Human Action.” The idea of this series of posts is to popularize and spread the word about Austrian economics and educate the public. Part 1 is here. Part 2 is here. Feel free to read them first if you’re just getting started. They’re actually very simple posts, making very simple points — as we are still in foundational mode.

Also, 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. Also, let me be clear: any errors in these summaries are mine and not Murphy’s. I am restating his points in my language, and that opens up the possibility of inaccuracy. Should that happen, blame me, not him.

One of the things that the Paul Krugmans of the world mock about Austrian economics is that they claim it is too abstract and has no relationship to the real world. After all, as I explained in previous posts, Mises sees economics as a discipline that derives universal truths from deductive reasoning that has nothing to do with experimentation. Mises tells us that everything we need to know about economics is within us. All we need to do is think about these principles and understand what logically follows from our conclusions. How can that teach us anything about the real world (the Krugman types ask)?!?!

Here, Murphy makes the analogy to geometry. We do not derive the Pythagorean theorem by building 500 right triangles and measuring the angles and the sides. The proof of the theorem does not depend on experimentation. The proof is within us — it is simply a logical chain of thoughts that we need to reflect on.

How can economics be compared to that?? Isn’t economics a discipline depending on endlessly random and changing variables that can never be predicted?

Mises says that’s wrong. According to Mises, there are certain laws of human action that we can derive logically — just as we logically derived yesterday that human action requires a mind, preferences that are ordinal and not cardinal, and a desire to affect the future.

Economics is not physics. Economics does not set up a hypothesis about what will happen in reality if one conducts a controlled experiment in which x does specified action y to object z. In economics, as conceived by Mises, there is nothing to “test.” It is an a priori discipline. Mises did not reject the study of data. But he did reject the notion that principles of economics depend upon on the outcome of data from controlled experiments.

Murphy, in his book, offers a compelling defense of this approach, by challenging the hypothetical classical economist to come up with precepts that demonstrate what it means to “think like an economist.” Murphy quite rationally guesses that even a classical economist would say things like this:

  • “There’s no such thing as a free lunch.”
  • “People make decisions on the margin.” [Editor’s note: we’ll get into what this means in a future post. The simplest way to illustrate the concept for now is with this observation: the hundredth bite of steak may not be as appealing as the first bite.]
  • “Trade is a positive-sum game.” [Editor’s note: socialists and Democrats forget this one all. the. time.]

Pretty much every honest economist would agree with these concepts. But why? Because 100,000 controlled experiments have been run to demonstrate whether free lunches exist? No. These are not observations we think are true because we conduct experiments. They are simply inherent in the process of “thinking like an economist.” These are truths that we know, from being a human being and reflecting on the nature of humans and how they act.

Also important is to distinguish economics — an analysis of human action — from economic history, which is a very different discipline. Again: Mises did not reject the concept of collecting economic data per se. Murphy notes that Mises and his student Friedrich Hayek founded the Austrian Institute for Business Cycle Research in 1927. (Mises predicted that the monetary expansion of the 1920s was going to result in a giant crash, just as followers of Austrian economics like Ron Paul predicted, in the early 2000s, a huge crash from the Fed’s cutting of interest rates — while folks like Paul Krugman were explicitly calling for a housing bubble; no joke!). So: no, Mises did not reject the study of economic data. He just refused to call it “economics.” He just believed that study fell under the category of “economic history.”

So if you think geometry is irrelevant to the “real world” because its truths do not depend on empirical observations or experimental verification, feel free to reject Austrian economics on the same basis. Otherwise, you are compelled to grapple with each grippingly inescapable conclusion on its own . . . even as it follows inexorably from the previous one.

Murphy rounds out the chapter with this observation:

“Subjective Value Theory” Is an Objective Theorem in Misesian Economics

Other than learning the building blocks of Austrian economics, one of the main concepts you might learn from this post (if you are unfamiliar with the concept, which many people are) is the concept of “subjective value theory.” The idea here is that the market price of any good, or service (or stock, or bond) does not depend upon anything objective. The price simply reflects the subjective perspective of consumers in the market. This is not a uniquely Austrian insight, as far as I know; I believe it is universally accepted by all honest economists these days.

And I think the insight is very valuable. I once had someone say to me: “I heard the stock market lost hundreds of millions of dollars in value yesterday. My question is: where did it go?” Before I learned “subjective value theory” I was utterly at a loss. Where had it gone? I had no idea.

Now I know: it didn’t go anywhere. Yesterday, all the people forming the consumers in the stock market collectively thought these stocks were worth x. Today, they think it’s worth x . . . minus a few hundred million dollars. It’s completely subjective.

Again (and I could be wrong here), but while this is a core Austrian concept — and was discovered by the earliest known major Austrian economist, Carl Menger — it was also discovered by others at about the same time . . . and is now (I believe) fairly well universally recognized by all economists, both Austrian and classical.

The point made by Murphy is not to explicate the concept (which is, I submit, an important concept), but rather to note that, within Mises’s framework, this “theory” is not really a “theory” in the way we typically use the term. It’s more like an objective theorem, the way the Pythagorean theorem is a truism and not a “theory.”

Again: economic truths like these just are. They can’t be proven right or wrong by experimentation. They are just there: truths to be discovered through reflection.

Enough for today. Tomorrow we’ll define some more concepts and get into the concepts of diminishing marginal utility (a core economic concept) as well as the central role that time plays in the Austrian vision.

I hope you’re enjoying this. Real economics is one of the most important disciplines you can learn.

8/23/2015

“Human Action” and Robert Murphy’s “Choice,” Part 2: What Is Action?

Filed under: Economics,General,Human Action and Choice — Patterico @ 10:31 am

This is Part 2 of my ongoing series of posts summarizing Bob Murphy’s excellent book Choice: Cooperation, Enterprise, and Human Action. The idea is to popularize and spread the word about Austrian economics and educate the public. Part 1 is here.

So what do we mean when we say economists study “human action”? First, the action must be purposeful behavior; reflex actions do not count, for example. It can even be inaction. Rush fans will recognize the quote: “if you choose not to decide, you still have made a choice.” Right?

Remember yesterday, I said: “Mises thought of economics as a deductive discipline, in which one divines, through analysis and reflection, the fundamentals of why humans act, and derives the necessary logical implications of these fundamentals using a deductive and logical chain of reasoning.” So what can we deduce from purposeful behavior?

Well, some of these are going to seem obvious. But it’s still necessary to state them — because it’s all foundational for what comes in the future.

First, obviously, if there is human action, then there must be a mind behind it. Human action is different from the mindless falling of a rock that we see in physics. Second, the actor must have goals, or preferences, in taking an action.

So far, pretty obvious. Here is another implication that is perhaps less obvious, but is very important: preferences are subjective and not objective. A related concept is that preferences are ordinal and not cardinal.

OK, I’m going to have to explain this one.

Cardinal numbers are “counting numbers” that measure things in units. In the equation 2+2=4, the numbers two and four are cardinal numbers.

“Ordinal” numbers arrange things in a series. Joe is first in line. Chocolate is my 4th favorite flavor of ice cream. (It’s actually my favorite; this is a theoretical discussion!) These preferences can’t be measured in units. I can say chocolate is my fourth favorite flavor, and vanilla is my third favorite. But I can’t measure the difference between these preferences in units. I can’t coherently say I prefer vanilla three times as much as chocolate. More importantly, there is no way to compare, in units, one person’s preference to another’s. You can’t say “Murray likes Buicks twice as much as Joe does.” (You can say Murray is willing to spend twice as much on a Buick as Joe is, but that’s a separate discussion for a separate day.)

The bottom line is: preferences are ordinal and not cardinal. You prefer one good or service to another, but — just like Frank is a better friend to you than Pete — this can’t be expressed in units (cardinal numbers).

Finally, an acting man believes he can influence the future. This is a better way of expressing the concept at issue than saying “man acts rationally” — because the word “rational” is a term that is loaded with connotations not used by Mises. For example, Murphy argues that to Mises, a rain dance is a “rational” act. Why? Because the person doing the dance has a goal (making it rain) and is engaged in action that is directed towards achieving that end.

The fact that we know the action will not accomplish the purpose does not mean the action is not “human action” (or “rational” as Mises uses the term). That’s why I like Murphy’s formulation that the man engaged in “human action” must believe that he can influence the future. This way, we can avoid judgments about whether that action is based on correct information, or whether it actually will achieve the purpose he believes it will achieve.

That summarizes Chapter 2, and is enough for today. Remember, we are still in foundational mode. Tomorrow, we will address the issue of Mises’s economics being an a priori discipline.

UPDATE: Let me say, as I should have at the outset, that any errors in these summaries are mine and not Murphy’s. I am restating his points in my language, and that opens up the possibility of inaccuracy. Should that happen, blame me, not him.

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