This lecture is slightly mis-titled. This will really be the origin. Tomorrow I'll deal with the decline and then the revival. So the origin is going to deal with the three greatest personalities of the early Austrian school, all of whom were knighted.
That is, all of whom were royalty. Well, not royalty, but part of the aristocracy. Karl Menger dropped a von when he was a teenager. Eugen von Bombaverk was a Ritter, which is a higher level of nobility, is what I was trying to say.
They were all nobles. And Friedrich Freiherr von Wieser was in the lower nobility. So they were all nobles. What's interesting about the Austrian school is that all three individuals that comprising the core of the early Austrian school were working really in some sense towards the same goal, though Wieser veered off.
But when I first came across the Austrian school in college in the history of economic thought course, my professor was extremely enthusiastic, even though he wasn't an Austrian himself, about the school. He said this is one of the first times in the history of intellectual development, or the history of ideas, that three such prominent thinkers self-consciously attempted to develop the same research project, research program. Let me start with one point, and that is that Karl Menger is the founder of the school. Now, Karl Menger was one of the original marginalist revolutionaries.
That is, he is one of the three individuals that were credited with overthrowing classical economics. Now, that's slightly inaccurate in two ways. Number one, he did much more than participate in the marginal revolution. And number two, his mission was not to overthrow classical economics, but to complete classical economics.
The classical economists had done a great deal in developing price theory. That is, the law of supply and demand. At least in the short run, they saw it as determining price. They considered this, to some extent, a universally valid law.
They also used this law to great effect in destroying the schemes of the early utopian socialists. And Mises always stresses that point. And they developed a theory of calculated action that focused on the business decision maker. So it wasn't a complete theory of human action, but it was a theory of calculated action.
They pointed out that prices guided production. And they focused on the businessman. And what they did was point out the following, that in the short run, if the demand for a product goes up, for example, if the demand for jam cars goes up, that's probably a fantasy at this point. What would occur is that there would be a much greater profit.
Let's say the demand for larger automobiles goes up. There would be much larger profits suddenly in the automobile industry, in the production of larger automobiles. Prices would increase as demand increased, exceeding cost of production. So the so-called normal return to production would be exceeded, according to the classical school, when there was an increase in demand.
That would increase production of that particular good. That is, other entrepreneurs or other capitalists, the classical school didn't distinguish between the capitalist and the entrepreneur. Other capitalists would invest their funds in producing larger automobiles, which would increase the supply of these larger automobiles. That would draw resources away from other areas of the economy, including, let's say, the production of smaller automobiles.
And that would bring about a reallocation of resources. So monetary calculation, the comparison of prices and costs, the calculation or computation of profits and losses, directed production. So the Austrians did see this as an extremely important accomplishment of classical economics, that and the short run theory of supply. Where the classical economists went wrong was to talk about goods as if they were abstract classes.
And they had a problem then. Their value theory was the problem. The value theory is what should underlie any good theory of price. It should support it, and it should logically lead to the theory of price that you're propounding.
That was not the case in the classical school. What the classical school did was talk about iron or diamonds or automobiles in what Menger called abstract classes, not in concrete units. When they did that, they were unable to arrive at an explanation of how human beings valued these goods. And they were caught in a paradox, the so-called paradox of value.
That is to say, the classical economists looked around and they said, bread, the abstract class, is much more important to sustaining human life than diamonds. Its use value, as they called it, is therefore much greater than the use value of diamonds. Diamonds really go toward satisfying wants for aesthetic pleasure or for ostentation, but they certainly aren't crucial to human beings sustaining their lives. So why is it then that diamonds have a higher exchange value on the market than bread does per unit of weight, per pound of diamonds?
A pound of diamonds is much more costly to purchase than a pound of bread. Well, they never answered that question. They said, well, we're not going to worry about use value. Anything that is a good, yes, it is true, has a use value.
Economics is only interested in explaining exchange value, that is, the prices of goods on the market. So we're just going to forget about use value. So they didn't attempt to solve the paradox of value. What Menger saw was that you needed to solve the paradox of value to have a consistent price theory.
Unfortunately, the classical school also did the same thing with distribution theory. They didn't attempt to explain the wages or how wages were determined for a particular scientist or for a particular worker or for a particular piece of equipment. They talked about the distribution of shares to capital in general, to labor in general, and to natural resources in general. This wasn't really even economics.
This was just more metaphysical speculation. So that was another problem with the classical school. And this led to really a final problem. They pointed out that, yes, applying demand, changes applying demand, determine price in the short run.
But in the long run, there had to be something else. Otherwise, their theory was hanging air. It wasn't grounded in human action. These prices were just there.
The capitalists were reacting to the changes in prices in the short run. Now, as capitalists changed resource allocation, as prices changed, prices tended towards their long run level, which according to the classical school, was a level determined by the cost of production, at least to some classical economists, or to the number of hours of labor embodied in the product. So in some sense, in the long run, value was inherent in the product. It wasn't the relationship between the human mind and a thing in the real world or a service in the real world.
It was inherent in the product. Almost like, as one commentator pointed out, the amount of value in a product was determined by the amount that the laborer sweat on the product. The harder it was to produce the product, the higher its cost of production, and therefore the higher its price. This is how they got around the paradox of value, and they explained that diamonds had a higher price because it was much more difficult, in terms of labor or in terms of, or more expensive in terms of cost of production, to bring diamonds to the surface, cut them, polish them, and turn them into jewelry, than it is to raise wheat and refine it into flour and bake it into bread.
That's why diamonds were more expensive. So they had a schizophrenic price theory. Menger wanted to heal that division in price theory and he wanted to ground the whole theory of economics itself, and I'll give you some quotes, in the striving of human beings to satisfy their wants. One last problem with the classical school was that they also were schizophrenic in terms of explaining how certain goods were priced versus other goods.
For example, goods that could not be reproduced, goods like the da Vinci painting or sculpture, antiques, and so on, since they could not be reproduced, their value never tended towards their cost of production. Who would ever know their cost of production in terms of the hours of labor or the cost it took the da Vinci to paint something? On the other hand, reproducible goods like bread and diamonds did have a cost of production. So they had an inconsistent or a non-integrated price theory for two different classes of goods.
So let me then talk a little about Menger. Menger was indeed the founder of the Austrian school of economics proper. He really did create the system of value and price theory that constitutes the core of Austrian economic theory. He also originated and consistently applied what we might call the praxeological method for pursuing research in economics.
So that in its method and in its core price theory, Austrian economics has always been, and it will remain in the future, Mengerian economics. And this was recognized by a number of very prominent historians of thought. For example, Schumpeter wrote, Menger is nobody's pupil and what he created stands. This is the middle of the 1920s, over 50 years after Menger wrote.
Menger's theory of value, price, and distribution is the best we have up to now, unquote. Mises wrote, what is known as the Austrian school of economics started in 1871 when Karl Menger published a slender volume on the entitled Principles of Economics. Until the end of the 70s, there was no Austrian school. There was only Karl Menger.
Finally, Hayek. Hayek said, the Austrian school's fundamental ideas belong fully and wholly to Karl Menger. What is common to the members of the Austrian school and constitutes their peculiarity, what constitutes their peculiarity and provided the foundation for their contributions, is the acceptance of the teaching of Karl Menger. And as I point out, Menger was motivated by a specific aim.
That aim was of establishing a causal link between the subjective values underlying the choices of consumers, which the classical school ignored, and the objective market prices used in the economic calculations of businessmen, as I said, veered off or departed from Menger's original project and attempted to build, to use marginal utility, but to build on it a theory of the economy that was in some sense a verbal general equilibrium theory, in which he could explain how social welfare could be maximized. So he had a quantitative view of marginal utility that was more or less absent in Menger and Böhm-Bawerk, although they sometimes latched into a quantitative view of utility. They mainly avoided it. Wieser embraced it wholeheartedly.
I'll talk about that later on. Let me just give you some quotes from Wieser just to show you the project that he was embarked on. This is in the preface of his seminal work, The Principles of Economics. He writes, I have devoted special attention to the investigation of the causal connections, note the word causal, between economic phenomena involving products and the corresponding agents of production, not only for the purpose of establishing a price theory based upon reality, also note that term, and placing all price phenomena, including interest, wages, ground rent, etc., together under one unified point, but also because of the important insights we thereby gain into many other economic processes heretofore completely misunderstood.
In other words, he basically said that if you have a solid foundation for economics and you deduce a consistent theory, then you can apply it to all the issues that economists are interested in. You didn't need a separate theory of distribution like the classical school did, and a separate theory of pricing. In his notes that he wrote to himself when he was beginning to work on the book, he wrote, Man himself is the beginning and the end of every economy, which statements like that appear in Bastiat. He also points out that our science is a theory of a human being's ability to deal with his wants.
All things are subject, this is a separate quote, that actually is in his notes, the first quote. Once again, this shows a very strong influence of the French school and the German price theorists that developed today's theory. This whole focus on wants, on human striving for wants. Now the very first line of his treatise, or it's actually not a treatise, it's his principles, says all things are subject to the law of cause and effect.
The very first line, he rejected the mutual determination, the mechanical mutual determination of economic quantities, which leaves out human beings, and which was the project of one of the other marginalist revolutionaries, Walras. Also, Wieser was also someone who more or less followed Walras in this respect, rather than Menger. Finally, let me just give you the last quote here. It doesn't negate quantities.
What we're saying is that the quantities that emerge in the market economy are caused purely by subjective valuations of human beings. In other words, in Walras, for example, there are all these given data, including quantities of various resources and so on. And these quantities are placed into a system of simultaneous equations. And all of them, and the results, the equilibrium price and quantities that come out of that, that come out of the data, are mutually determined.
Or they're mutually determined one another. And in fact, here we show that Menger was not a radical subjectivist, as some Austrians have claimed. Menger recognized that there was both objective and subjective aspects to the economic process. And that the chain of causality ran from subjective wants, and this is something he got from Bastiat, through the real world, that is, man put forth efforts to produce things, to transform resources in the objective world, according to technological recipes, into goods that would be more useful and that would satisfy his wants.
So in other words, man's motive was subjective, to satisfy his wants. His actions on the best means to satisfy those wants were also subjective. But the middle link was objective. He had to produce goods and services.
He had to transform elements, existing elements of his environment, into such a way that they satisfied his wants. So causality ran both ways. It ran from human wants to the effort to produce, and it ran back the other way. Once those things were produced, it satisfied the goods that were produced, or the cause of the satisfaction of human wants.
Human wants were the cause of the production of the goods. So he says, one's own person, moreover, and any of its states, he's talking about subjective states of satisfaction, are linked in this great universal structure of relationships. It is impossible to conceive of a change of one's person from one state to another in any way other than one subject to the law of causality. If, therefore, one passes from a state of need to a state in which the need is satisfied, sufficient causes for this change must exist.
There must be forces operating within one's organism that remedy the disturbed state, or there must be external things acting upon it that by their nature are capable of producing the state we call satisfaction of our needs. So recently, my wife got a new car, and that disturbed me a little bit because I didn't have a new car. And I suddenly felt a want for a new car. And I went and looked around.
I convinced her that I needed it. And I like American cars. I like GM cars. And I got a Grand Prix.
I work hard. I do extra things and earn extra money. And I produce extra effort and produce the means of purchasing that car. And I got a Grand Prix Competition Series GM, which is a very fast car.
It's black. It's really cool looking. So that assuaged my disturbed state. That material thing satisfied my want.
And that's, I'm being frivolous, but I'm joking. But in some sense, I'm being frivolous about it. But that's true. That's the way all of us perceive the striving to satisfy our wants with real things.
Now, Israel Kirzner, who I've discussed this with, claims that Menger was more subjectivist than that. He would fight me on this. And he would claim, well, this is more Bombauer. But this is a quote from Menger.
So let me talk a little bit more about Menger and how he went about reconstructing economics. And then I'll talk about Bombauer. Well, the first thing that Menger did was to develop, actually to improve on, a theory of goods. One of the great things about the German economists of the 19th century was that they started almost all of their treatises with what was called the theory of goods.
This is another response to those who claimed that the early Austrian school, or at least Menger, was radically subjectivist. Well, if you're radically subjectivist, you don't start off with all things are subject to the law of cause and effect. And you don't start your treatise with a theory of goods. According to Menger, for a thing to be a good, or in his words, for a thing to have goods character, four criteria had to be met.
One, there had to be a human need. Secondly, such properties as render the thing capable of being brought into causal connection with the satisfaction of this need. That is, the car must have certain properties that I perceive as satisfying my need. Thirdly, there must be human knowledge of this causal connection.
And fourth, the command of the thing, you must have command of the item, sufficient to direct it to the satisfaction of the need. Now let me explain what I mean here with the fourth criterion. I need a sunny day. I need the sun to be shining to have a good time at the Mets game.
So that's, to have the good of watching a Mets game, which this year it is a good. You have to have the sun out. You can't have rain. But I have no control over the sun.
So if the sun doesn't come out, then the Mets game loses the quality of being a good. Even if it's drizzling and they're playing and I don't like the rain, I'm not going to go. It's no longer good to me. Because of the fourth criterion being missing.
Even though the other three are present. Now Mises pointed out that there was a problem with Menger's four criteria. He said, look, Menger says that properties must objectively exist that bring the thing into causal connection with the satisfaction of the need. And that there must be human knowledge of this causal connection.
But what Mises pointed out was that there has to be an opinion by the subject that the goodwill or the thing will satisfy the need. That is, ex ante, people do something because they believe their need will be satisfied. They undertake some sort of a production activity or they purchase a good. However, ex post, after the fact, they may be wrong.
There can be error. So you can combine those two into simply, or restate them as the human need, the opinion that the thing in question will satisfy that need, and control or command over the thing. In other words, you must have control in the sense that you can use the thing to actually satisfy your needs. Now Menger asked the following question.
Given that we know what goods are, the problem then becomes, how do we actually value a good? Before we can even talk about individuals valuing a good, you must keep in mind that before individuals will strive to obtain a good, there must be an insufficiency of it. Now Menger used the word economic good versus free good. Mises said, well, if a thing is freely available like air, we never even spend any effort or time or attention on attempting to obtain air in a normal situation.
Therefore, air isn't even a good at all. It's bad to call it a free good. It's simply a general condition of human welfare. Mises used that terminology.
But let's stick with Menger's terminology. Menger said that for a thing to be an economic good means that there has to be an insufficient quantity to satisfy all human wants for we have the fictional Robinson Crusoe on an island who has been stranded and has very little resources at his disposal. What, how will he act if we economize these resources? And not only that, how will he determine the value of the resources?
Now let me just take A here. Let's say that Robinson Crusoe has a certain finite amount of grain, okay. Sacks of grain, you think of wheat or corn or whatever it is. And he has 20 different wants for each sack of grain.
So notice what Menger is doing here is talking about concrete units. He's not talking about wheat in general, what's the value of wheat in general. If Robinson Crusoe had more than 20 units or 20 sacks of grain, grain would no longer be an economic good. He wouldn't worry about it.
There'd be more than enough to satisfy all of his wants, assuming there's only 20 wants for grain. But let's say he has 5 units, okay. And he ranks them in the following order. The first sack, the most important use would be to bake bread for sustaining his life.
The second would be, that would just keep him alive for a year until the next year. The second use would be to bake bread for maintaining his health and vitality and allowing him to strive after satisfactory of other wants. The third would be used for seed for next year's harvest so he could live another year. The fourth would vary his diet.
He'd ferment it and turn it into whiskey, produce whiskey. The fifth, he'd use it to domesticate and feed farm animals, which would yield him meat, dairy and poultry products in addition to the bread. Now he has 5 sacks. That's the scale of wants in the case of the importance of the uses of each one of those sacks.
Now he asks this question, okay. First of all, what is the value of any given sack? Well, what we do know is that every sack is interchangeable. Since every sack of wheat is identical with every other sack, they have to have equal value.
But yet they serve very differently valued wants. How do we determine the value? Is it the value of the most important want? Is it some average value, maybe the third want?
Well, this is where Menger's brilliance comes in. Now, other writers before Menger in the German tradition I followed say, and even in the French school, had come close to the notion of marginal utility, but they didn't ask the right question. And they didn't realize that marginal utility pervades human life. The question is this.
If a fox or some other animal broke in and let's say consumed the second sack, what want would go unfulfilled? Well obviously, because human beings economize, we say we want to satisfy the most important want, the want that would go unfulfilled is the fifth want, the least important want that could be satisfied by the current supply. So the satisfaction from the lowest valued want that's satisfied or capable of being satisfied by the available supply becomes the marginal utility, utility being satisfaction, the satisfaction of the last want. So what Menger points out then was, each sack was valued according to its marginal utility.
Each one had a value equal to the satisfaction from eating meat, having milk and eggs and dairy products over the course of the year. Why? Because that was what Menger called the dependent utility. No matter which sack is lost, he loses the satisfaction from the lowest valued want.
So this is the theory of marginal utility. Now what he pointed out was that then, therefore, the value of a good depends on its marginal utility, which as I'll show you in a moment, resolves the paradox of value. But note something. If indeed he lost one of the sacks, what would happen to the marginal utility and therefore the value of each of the sacks of grain?
They would go up. They would be higher. He would now be reduced to a supply of four and now a higher value would depend on the grain, on the sack of grain, and that is the whiskey, the satisfaction from whiskey. If he lost another sack of grain, a second one, he would lose that utility.
So the law then becomes, the law of marginal utility is, the greater the number of units of a good an individual possesses, the lower its marginal utility and therefore the lower its value. Or to put it another way, as the supply of good increases, its value decreases because its marginal utility decreases. And that can be stated conversely. The fewer the units of a good, the higher the marginal utility and therefore the higher the value of the good.
And now we have the resolution, as Menger went on to show us, of the paradox of value. The reason why in a normal situation diamonds have a higher value, which is reflected in its market price, than bread per unit, is precisely because diamonds are much more scarce than water in the normal situation. If you place someone in a desert who has not had water in three days and has a perfect gem, let's say the purple diamond that Kobe Bryant bought for his wife, an $8 million purple diamond in order to make up for his infidelity, you would give that diamond up for a quart of water. Why?
Because water is so scarce in the desert and such that the marginal utility of water in the desert is higher than the marginal utility of the diamond. Why? Because the want that's being satisfied by water is to keep you alive for another three days. Let me just make this a little bit more complicated, slightly.
Let's say that there's a farmer who possesses three horses and two cows. Now these are different goods and the horses are interchangeable among themselves and the cows are interchangeable. That is, they're identical within the group of horses and within the group of cows. Notice that the farmer would use the first two horses to plow his field.
The first cow serves the third want, which is to provide milk for the farm family. And the fourth provides additional milk that could be turned into cheese and butter. And the third horse, the second cow, does... And the third horse provides pleasure riding.
And that's how he values these various goods or satisfactions. The question then becomes, which is the more valuable animal for this farmer? Well, according to Menger, you don't look at the top, you don't have to know the horse is the most important. It's not.
You simply ask the question, if the barn is burning and you can only save four animals, which four would you save? Obviously two horses and two cows. Why? Because horses have a lower value.
The marginal utility of horses are lower. Now, if that horse is perishes, the horse, then suddenly notice the marginal utility of horses increases to the second satisfaction and therefore the horse becomes a more important animal. So you never look at the top. You look at the lowest valued satisfaction that is served by a unit of a good.
Okay. So we resolve that paradox. And very quickly, let me mention something else that he did, or actually two other points that I think are important to discuss. What he also did was to come up with what he called orders of goods.
He pointed out that, okay, marginal utility and people's scales of wants determine the value of first-order goods. Those are the consumer goods. What determines the value of the goods that produce those consumer goods? Let's say we're talking about bread.
Okay. Bread is the value of bread is determined by the marginal utility of bread to the actual consumers. But what about the flour, ovens, and baker's labor, baker's labor, that go to producing that bread? That's the second-order good.
Well, what Menger pointed out was that their value reflects the value of the bread whose production they cause. So he has this causality. The final good, the consumer good, causes satisfaction, but the second-order good, the baker's labor, the ovens, and so on, causes the production of the first-order good, which in turn causes satisfaction. So whereas production goes from the resources that are further and further away from the consumers down towards consumers, value travels upward.
Okay. What about the third-order good? The mill, the wheat, the miller's labor that goes to producing the flour that is used in the second-order industries, or above that, the farm labor, the farm tools, the farm animals that are used to produce the wheat, and so on. What Menger pointed out was that there was a theory of imputation, that value was imputed backwards, okay, as opposed to the classical school, which claimed that the value of a diamond resulted from the fact that it was very expensive to produce a diamond.
That is, that the labor of the jeweler, that the labor of the diamond workers, that the cost of the diamond mine, all of these things had a high value, therefore diamonds had a high value. Menger said, no, that's not true, it's the exact opposite. The only reason why diamond mines have value at all is because people value diamonds so highly. The marginal utility of diamonds are very, very high to individuals.
So that, for example, and I always give this example to my class, if you saw the marvelous movie Witness, which takes place in the Amish country in southeastern Pennsylvania, the Amish are also called the plain people, and they don't wear any sort of jewelry. They don't even have buttons on their clothing. They wear black, all black, and they wear hooks because they believe even buttons show vanity. Well, what if all Americans adopted Amish values?
What would happen to the value of diamonds, the marginal utility of diamonds? They would drop to nothing, okay? In which case, what would happen to the wages paid to skilled jewelers and gem cutters? They would drop to zero.
What would happen to diamond mines, leaving aside the industrial use of diamonds? Suddenly diamond mines, the stock of diamond mines would fall to zero, okay? So Menger turned the classical school on its head and showed that, in two atoms of hydrogen and one atom of oxygen. If you're missing the one oxygen atom, you can't get water.
You can't produce water. Mold production is not like production of a chemical. Mold production, most things can be produced using different combinations of factors. He saw that back then.
And what he said was the following. He says, what would happen if out of the 1,000 pounds of fertilizer, 100 pounds were taken away? All other things equal, with the same amount of forces and plows and labor and so on. He says, well, there would be a reduction in the output.
It would go, let's say, from 100 bushels of wheat, or let's say produced per year, 1,000, 1,000 bushels of wheat, let's say, to 950 bushels of wheat because of the reduction of fertilizer. So Menger said was that the marginal product, the additional product that that last 100 pounds of fertilizer added gave the value to the fertilizer. So whatever value he attached to 50 bushels of wheat is the value of the 100 pounds of fertilizer. And he didn't take it as far as the market economy, but let's assume each bushel of wheat was, let's say, $3 a bushel and there was a reduction in output of 50 bushels.
That's $150. He'd be willing to pay up to $150 because that would be the loss of his revenue to purchase 100 additional pounds of fertilizer. So that's what Menger actually gave us the hint on how to solve the problem of pricing factors of production. What about von Bawerk?
Well, two important points about von Bawerk. One is that he, well, the one that he's known for is that he came up with the theory of capital and interest that was based on subjective values. That was based on people's time preferences. Now, it was adulterated with other factors, but basically he came up with the notion of time preference.
That is, if I were to ask you to lend me $10,000 and you completely trusted me, there was no question that I would default, and that I would pay you back in one year. I'll give you an IOU for, let's say, $10,000 in one year's time. Okay? Well, would you give me that for a firm promise, firm guarantee that I pay you back?
Would you give me $10,000 today in exchange for $10,000 a year from now? No one would. Why? Because in the interim, you'd be giving up the satisfaction from that $10,000.
That's the notion of time preference. What von Bawerk pointed out was that future satisfactions have lower value than present satisfaction. A future sum of money has dollar for dollar a lower value than a present sum of money. So, therefore, if I offered you $11,000 future dollars for $10,000 future dollars today, you're not exploiting me by taking $11,000 a year from now for $10,000 today.
In fact, that reflects the fact that future dollars have a lower value than present dollars because in making a loan to me, you forego all the satisfactions that you could have attained for that year. What von Bawerk pointed out was that this is not only true in the loan market, but it's true when a capitalist invests in the structure of production. And he used the orders of goods that Menger used. And he called it the stages of production.
So, if it takes me five years to build a car, okay? Then, or let's say, I'm in the assembly stage of an automobile. And I know that I could produce a certain number of automobiles that will yield me a million dollars one year from now. Would I be willing to pay the workers, and let's forget about the raw materials and so on, let's just assume the workers.
Would I be willing to pay the workers the full $1 million? Well, of course not. No one else would. The workers' value would be bid up to a level which reflected the time preferences in society.
So, if there was about a 10% time preference on average in society, if people preferred goods today to goods a year from now by about a 10%, then the total amount of wages paid to workers would be 10% less than $1 million. That is, about $900,000. So, capitalists would pay about $900,000 at the beginning of the process, let's assume they paid them right at the beginning, and in return, they would get the capital goods that the laborers worked on for the year. And at the end of the year, the capital goods would be finished automobiles, which the capitalists would then turn around and sell for a million dollars.
He would get about, let's say, an 11% return on a $900,000 investment. So, far from being exploitative, what the capitalist does, the capitalist function in a market society, is to remove the burden of waiting for income from the workers. Think about workers that want to engage in a five-year process, okay? They want to produce bread from scratch.
Well, if you think about it, before you can even produce bread, okay, you must have the wheat. Where's the flour, you know, the wheat before that. And before that, you must have the farm tools. And before that, you must have the iron ore.
So, it might take five years to produce bread. Now, let's say the workers could produce bread that would sell for $500,000, okay? As a group. And let's assume there's no capitalists.
They have to wait five years for that income, okay? Now, how would they go about doing that? They would have to save up consumer goods in advance. Or they would have to save up money in advance that would see them over that five-year period.
However, if there's a capitalist there who's already done the saving and the capitalist invests the money, in fact, it would be a series of capitalists if it were one going different stages. They pay the workers every two weeks or every week or whatever it is. So the workers don't have to wait for the five years until they get paid. They get paid every week or two.
And they're willing then to take less than their marginal revenue product, less than the revenue they add to the final output. That revenue is discounted, as in the case of the auto workers, by the interest rate. So every year they get a certain salary that's, let's say, 5% per year less than they could have gotten if they were willing among themselves to produce a good and wait five years for the income. That's the return to the capitalist.
It's not exploitative, as Marx claimed. Even though the capitalist sat back and did nothing. Or even hired the manager to claim, just sat in his chair and was, in Marx's term, or Randian, or Keynes' term, a rentee, someone who just collects, clips coupons from bonds from investing, and lives on that. The capitalist has done something.
At some point in the past, that person who has become the capitalist was a saver first, was someone who abstained from consumption, and may not have been even particularly rich, but abstained from consumption in the present and accumulated a certain capital that he then advanced to the workers before the product was ready for sale. And I mentioned also, not only did the capitalist investors or capitalist entrepreneurs remove the burden of waiting, also, as we see in the case every day of firms that lose money, in the case of GM, for example, or in the case of IBM, which in 1990, 1991, IBM lost $13 billion in those two years. Did any of the workers not get paid during those two years for the product that they worked on for IBM? Who lost the $13 billion?
Did the workers lose a penny? No. They were paid. They may have lost their jobs after the fact, but for the product they produced that was not worth the cost of producing, they still got their full pay.
So even though Bommaver didn't quite go that far, okay, Mises and Rothbard did, we see that the capitalist entrepreneur also removed the burden of uncertainty and payment from the workers. Okay? All right, so that was Bommaver's first important contribution. It's much broader than that.
He actually developed, in fact, what Murray Rothbard has called Austrian macroeconomics. He developed a version of an overall economy much before Keynes discovered macroeconomics in 1936, quote, unquote. One other thing that he did, I want to just point out very quickly, is take Menger's theory of marginal utility much further and develop the theory of pricing that people really still don't realize, even Austrians, is different from the supply and demand analysis that we learn in our textbooks. Even though it was in terms of supply and demand, it was much richer.
And let me show you this very quickly. Okay. It's interesting, if you look at Mises' human action, there's hardly any discussion of basic price theory. In his chapter on prices, there's a lot on how factors of production are priced and a lot later on on how monopoly prices are formed, but there's only about a page and a half or something on actual prices.
And he basically says, well, everyone knows by now that the prices are determined by the marginal pairs. Okay. This analysis of marginal pairs that was developed by Bomaver. I think it's one of the most important underrated contributions.
Also one of the reasons why people like, for example, Israel Kirzner and others think, though Israel Kirzner isn't as at fault as Lachmann, who claim that Bomaver is some sort of an objectivist and isn't a true Austrian. Okay, that's nonsense once we go through this example. I'll give you my pointer a maximum buying price of 213, then the price would have to be less than 213 because otherwise he would come into the market. Okay.
Okay. So that's the upper limit. What about the lower limit? The lower limit has to be set by either the higher of the first unsuccessful buyer, okay, v6, or the last successful seller.
In this case, v6 has the higher price, and in this case, therefore, the limit is between 210 and 250. And let me just give you that in a more formal way. Simply, the upper limit of equilibrium price range, in this case, it's between those two prices, is determined by the lower of the minimum price of the first unsuccessful seller and the maximum price of the last unsuccessful buyer. or the last successful buyer, excuse me.
The lower limit is determined by the higher of the minimum price of the last successful seller and the maximum price of the first unsuccessful buyer. In this case, the marginal pair that actually determines it are those two, but it can be either. In either case, it could be one or the other depending on which, and you can look at these examples in the book. The reason why I bring this up is because this means that it is subjective values, and subjective values alone, and I'll put up a few quotes by von Bawerk, that determines prices.
And he says the following. He says, of all the results we've attained in this chapter, and that's the chapter in which he has this horse market, the one that is by far of greatest import is the fact that all influences which function in the determination of price have been resolved into subjective valuations and a rational appraisal of their functioning. And he goes on and says, and I do really believe we have here hit upon the simplest and most natural and indeed the most productive manner of conceiving exchange and price. I refer to the pricing process as a result derived from all the valuations that are present in society.
And then he goes on and says, I do not advance this as a metaphorical analogy, but as living reality, that in every market at every moment in time it is people's subjective valuations of buyers and sellers that determine the prices. So that, for example, when you go into a supermarket and you walk out with, let's say, two six-packs of beer, two pounds of steak, five potatoes, and no more and no less, what does that mean? That means that you have purchased up to the point where the last unit of each good just exceeds the price that you're paying for it, so that you're benefiting. And on the other hand, the seller, in return, is receiving a price that he prefers to each unit of those goods.
Then von Bawerk, in another passage, says, the syllog of vacuousness and unsatisfying vagueness and the coribda of an equally unsatisfying erroneousness. He says, it is now my opinion that the problem finds complete organization and solution if we introduce into the traditional frame the simple thought that price is completely and entirely the product of man's subjective valuations. Finally, he says, and this is important, he says, prices are the result of the momentary market situation and we are beginning by regarding as a constant quantity the stocks of finished products which constitute the supply. That is, at any moment, Murray Rothbard emphasizes this, at any moment there is always a certain amount of goods on the market in inventory.
That's why we don't draw upward sloping cost of production curves, marginal cost curves, as do the mainstream economists. At any moment in time, the only cost of selling a good that's in stock is speculation on whether you can get a higher price in the future. And that's the only reason why supply curves might slope upward. He goes on to say, however, they are only momentarily constant, becoming a variable quantity as time goes on and as production continually keeps adding to their stocks.
He's answering Marshall there. Marshall and others claim that the Austrian school only explained the value of goods that were readily available, only explained their prices. But that's all there are at any moment in time. They're simply exchange of goods that already exist.
But beyond that, and the second thing, what he's saying is that because you have a structure of production that is integrated and is continually giving us outputs of new goods and services, those markets are created and recreated. So new stocks are continuously falling off of the market. But just because of that dynamic fact doesn't mean that the analysis of a given moment isn't the correct analysis. It always is the correct analysis.
It's not the long-run upward sloping supply curve, which is based on long-run cost of production, that's relevant to price theory. It's always the momentary supply and the momentary demand, which depends on people's values. And something else that's interesting, which I'm working on now, and it's in von Bawerk, and I realize now it's in many other economists, including Henry Hazlitt, mainstream economists, when they say that the demand increases, they think, well, the demand increases. At any given price, people will buy more.
They'll spend more on the good. So the demand curve shifts to the right. That's not the way von Bawerk, or, for example, Hazlitt, or even people closely like Rothbard, talk about it. This whole idea that an increase in demand means an increase in spending on goods.
People don't just have extra money and want to spend it on goods. What actually happens is that if there's an increase in demand, it means that— and von Bawerk was very, very specific—that if there's an increase in the demand for a good, it means that people now value the good more in relation to money than they did before. They're always comparing the good to the marginal utility of the good to the marginal utility of money. Which means that what we talk about, it's much more accurate to say the demand curve shifts upward or the demand curve shifts downward.
And when you talk like that, spending is no longer important. Spending falls out of the whole thing. Spending is what happens after you've decided that the good is more important than you thought it was before, in which case you'll buy more units if there's a given supply. You want to buy more units.
You value it higher. That's very important because that actually now bears on monetary theory. When we say, if the government increases the amount of money in the economy, there will be more spending. Well, it means that's telling the people who still have more money and say, hey, I have more money.
I'm going to spend more. No, that's not what happens. von Bawerk actually says that if people have more money, then the value of money will fall in relation to goods and the demand curve for goods will go up. On the other hand, if an individual has less money, then he will value money, the marginal utility of money will rise, and therefore the value of the money on the market will be higher, which means that the demand curve, because you're giving money away, the demand curve will fall.
So demand curves fall and rise. They don't move to the right or the left. Saying move to the right or the left really, as I'm beginning to realize in the last year, causes problems in monetary theory. It completely blows the monitors out of the water.
I'm writing a paper I'll give later here at the meetings later this summer on that. Okay, I'd rather take some questions. We'll get to Visor. Visor is only a few things that I can say, and I'll say more about it tomorrow.
Visor accepted marginal utility, but for the most part departed from Menger and von Bawerk and attempted to formulate a general equilibrium system of the economy, which was more realistic than that of Walras. And there's various points at which he tried to bring in realistic data into the system. But there's no doubt if you read through his treatise on social economics, his early treatise on natural value, that he started from a communist economy in which one line controls everything and tried to treat that economy in the same way that an individual economizes in his household economy. And he believed that just as the individual can tell if he's better off by rearranging resources, so too could that be done for the economy as a whole.
But when you talk about different individuals, you're talking about adding up utilities. So what he did, and he did introduce a very small free equation system in which he tried to solve the problem of imputation. In other words, he didn't accept the view of Menger that you can figure out the value of factors of production by figuring out their marginal product by subtracting. He didn't like that.
He wanted to impute it through a mathematical process. And he actually comes out, and I'll read this tomorrow, he says something like, these equations are solved every day by the market. Well, I don't see anybody solving any equations in the market. I just see buying and selling.
And he did it for a time. So I'll stop there, and I'll take any questions. Yes? Can you discuss the last thing in the long run?
I'm curious, how does Jevons and Zaslavich fit in there? Jevons, I think, is better than Walras. He wrote his treatise earlier than Walras, the same year Menger wrote his, 1871. And he did try to rehabilitate the French school.
He did have a notion of causality, but he quantified utility. He drew cardinal utility curves. Whatever was good in Jevons' system was rescued by Wicksteed. The best stuff was taken out of it.
And I'll put it this way, it's all in Wicksteed. Whatever's good in Jevons is in Wicksteed. And Jevons is good. But he did take things in a mathematical direction, not as thoroughly as Walras.
He also, since his book was really only an introduction to economics, just bargaining meaning two people bargaining. So he sort of is the author of a bargaining theory in some sense. And I think in the economy of the state says that nothing worthwhile has been done on bargaining since Baumol in 1962 in the economy of the state. Now I haven't thought about developing this marginal pairs in any deeper.
Now there's an article that John Egger, an Austrian, who's also at South Royalton, sent me, which he... on marginal pairs that got me thinking about this, which he got into the Journal of Economic Education back in '99. I have a copy of that article if you want to look at it. It looks a little bit more detail.
He claims that Baumol makes a mistake, which I don't see in this. But anyway, that he didn't quite get the marginal pairs right, which I don't think is quite right. But anyway, you know, there hasn't been anything written on the marginal pairs in a long time, and then Egger's article is great, just to have some talk about that. I always thought it that way when I was teaching undergraduates.
Now the MBA students, you know, they don't want to hear about marginal pairs. I mean, that's, you know, why do we have to go through all of this? But Egger tells me that he does teach MBA students this stuff and that they are interested in it. So, well, now I may introduce this and say, look, this is a better way.
One thing I did want to point out is that Baumol doesn't reject regular supply and demand theory. What he says is that, he says, when buyers and sellers make continuously changing valuations, upward or downward. Notice he's talking about upward and downward as the case may be. And these valuations represent offers to buy or sell partial quantities of a market good, there's a special predilection for depicting them by means of continuously ascending or descending curves and for indicating by the points of intersection the price situation which competitive offers based on those valuations are in the process of developing.
Now he says this is unobjectionable. He goes on to say, he says, however, he says, I still find it questionable whether with its resulting presentation, with its resulting unavoidable suppression of any personal point of view, this method of presentation is really capable of completely supplanting and making superfluous a description by running commentary of the determination price. By running commentary of the determination, he means looking at the buyers, looking at the sellers, showing the maximum buying prices and the minimum selling prices and focusing on the marginal pairs. He's saying there's nothing wrong with drawing these curves and he does at one point, but that it's too mechanical.
It doesn't show you the subjective valuations interacting to determine the price. He admits that it's easy to do it that way and in some cases heuristically it's better to have a supply and demand curve so students can follow along and so on, and that this becomes cumbersome. It does become cumbersome when you're talking about a lot of people. But he thinks that this should be the first introduction to price, the first price theory.
Okay, any other questions, comments? Baumol says something similar to that. How about the loose use of terminology to refer to markets and government and property rights and nebulous sorts of things? It's kind of objected at.
You have to remember the real reality behind the scene. It's okay to use it loosely, but you have to remember that there's an hardcore reality behind it. Right, that's very important. People think that, often say that Baumol was verbose or prolix, saying in too many words what he could have said in a few words.
But I think he's very, very careful and I like the way he writes. He's clear. You take a long time to make a point, but when he makes the point, you know it. And if you go through that chapter with the marginal pairs, he changes everything around to show you how, if people's...
one criticism of this was by certain economists, Edgworth in particular and some others. Well, you know, you're saying only the marginal pairs affect the market. But that's actually, it actually is not true, okay, that only the marginal pairs determine the price. It's everybody's valuations in the market that determine price.
It's simply everybody's valuations determine where the marginal pair is. The marginal pair is determined by, if you change the number of sellers and buyers, you're going to change the marginal pair. Baumol admits it in the second edition or third edition, says, okay, I wasn't as clear on that. So, be careful with the way you state it.
Marginal pairs alone don't determine price, okay? It's the marginal pairs that are determined by all the subjective valuations of the buyers and the sellers. If you have fewer sellers or sellers with different valuations, the marginal pairs themselves are going to change. But it is ultimately the limits.
They establish the limits. The existing system or situation establishes the limits of the price. And, of course, where you have numerous people in the market, the marginal pairs become down to just the marginal pair, okay? That is, the person who just values, the buyer who just values the good more than the quantity of money and the seller who just values the quantity of money less or more, quantity of money as receiving more than the good he's giving up.
So you get one point, okay? You don't get a range. And I think Baumol actually shows that, too, that you can get a point, not a range. Okay, yes.
Thank you.