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!