An Introduction to
Economic Reasoning

David Gordon

Ludwig von Mises Institute
518 West Magnolia Avenue
Auburn, Alabama 36832-4528

Copyright © 2000 Ludwig von Mises Institute. All rights reserved.
Published by the Ludwig von Mises Institute, 518 West Magnolia Avenue, Auburn,
Alabama 36832-4528. (www.mises.org)
ISBN: 0-945466-28-5

D

edicated to
Quintin E. and Marian L. Ward,with deepest gratitude.

AcknowledgementsI

am first of all indebted to Mr. and Mrs. Quintin E. Ward, whose
generous support made this book possible. Mr. Ward’s career andachievements exemplify the free market in action.
For very helpful comments on the manuscript, Ithank Hans
Hoppe, Jeffrey Herbener, Joseph Salerno, and Mark Thornton.
They bear no responsibility for any remaining mistakes.
At the Mises Institute, Judy Thommesen and Kathy White handled editorial work in the manuscript with great skill. I thank Mises
Institute Member Richard Perry for preparing the index. Pat
Barnett, as always, was a constant source of encouragement. She
also provided me with helpful comments and corrections. The president of the Mises Institute, Lew Rockwell, not only commissioned
the project: he nudged it along through gentle prodding. To all ofthese, many thanks.

Table of Contents
INTRODUCTION................................................................................i
1

THE METHOD OF ECONOMICS..........................................................1

2

ACTION AND PREFERENCE, PART 1................................................15

3

ACTION AND PREFERENCE, PART 2................................................35

4

DEMAND AND SUPPLY...................................................................55

5

THE LABOR THEORY OF VALUE......................................................83

6

PRICE CONTROLS........................................................................103

7

MINIMUM WAGES AND WAGE CONTROL.......................................1178

MONEY, PART 1..........................................................................131

9

MONEY, PART 2..........................................................................147

10

THE GOLD STANDARD.................................................................161
CONCLUSION..............................................................................175
GLOSSARY..................................................................................177
RECOMMENDED READINGS.........................................................185
INDEX........................................................................................187

Introduction
WHY STUDY ECONOMICS?

W

hy, indeed? A good short answer is that you can’t get awayfrom it. Almost everything you do involves economics. Why
do people have to earn a living? Why do some people—heavyweight boxers, rock stars, and movie producers, for example—earn
vastly more than bus drivers or policemen? What determines theprice of a Big Mac, or, for that matter, a Mack truck? Whenever you
have to deal with money or prices, you are talking about economics. To paraphrase Monsieur Jourdain, a character in a play by theseventeenth-century French writer Molière, you have been speaking economics all your life.
But granted the pervasiveness of economics questions, why
study them systematically? After all, we are all governed by the lawof gravity—try jumping off a cliff sometime if you don’t think so—
but does it follow that we have to study physics?
If people don’t understand the basic laws of economics, we areheaded for disaster. You don’t have to understand much physics toknow why it’s not a good idea to jump off a cliff; but an economy
that runs well depends on enough people grasping some simple
truths about how the price system works.
As we’ll see throughout this book, a sound economy depends onallowing people to act freely. If politicians interfere with the freemarket, or attempt to replace it entirely with socialism, we are in fortrouble.
ix

x An Introduction to Economic Reasoning

And some people are always tempted to do this. They think thatby one or another hare-brained scheme, they can promote theirown welfare. Unless you understand the key elements of economics, you may fall for some of these ideas. If people do so, the economy will suffer or collapse altogether; and we may lose our freedom
as well. A little time spent learning economics will help you to avoid
a great deal of trouble later.

WHY YOU WILL ENJOY ECONOMICS
Thomas Carlyle, a famous British writer of the nineteenth century, once called economics “the dismal science.” But, if economics
is studied in the right way, it’s a lot of fun. This may surprise you, if
you have ever looked at a college textbook on economics. Most
textbooks have so many equations in them that they look like a railroad timetable.
We won’t be doing that here. This book contains no complicated math. But at this point you have probably thought of an objection. Even if this book doesn’t have complicated math, this is notenough to make studying it fun. After all, English grammar doesn’t
use math either, but most students don’t rank it among the mostenjoyable subjects in their school careers.
Rather, the main reason economics is fun is this:You don’t have to accept anything as true justbecause the book says so, or your teacher tells you.
Everything in economics is (or should be) a matterof reason and evidence.
As you know, this is not true for many subjects
you study. Suppose, for example, you read in yourhistory textbook: “Franklin Roosevelt saved theUnited States from revolution by reforming capitalism.” (We assume that you are not a student in aschool so “progressive” that you don’t study histoFranklin D. Rooseveltry.)Introduction xi

How are you to know whether the statement about Roosevelt istrue? You have to accept what the text (or your teacher) tells you.
Only in college courses (and sometimes not even there) will you
find out why historians make the claims they do.
Sometimes this can lead to trouble. What if the textbook iswrong? For example, the claim about Roosevelt just given is completely mistaken. Roosevelt’s New Deal measures were disastrous.
You may end up “knowing” things that just aren’t true.
Is the solution not to believe what your teachers tell you? No,(or at least not always)—then you couldn’t learn history at all.
There is simply so much to learn that you have to start somewhere.
Only after you have learned a great deal will you be in a position tounderstand why historians make the statements they do.
You will encounter the same thing when you study science.
Why is “the sun is millions of miles distant from the earth” true, but“the moon is made of green cheese” false? You won’t be able to findout unless you accept (at least temporarily) a great many otherstatements just on faith. This situation can sometimes lead to frustration. You must learn things without understanding why they aretrue. Wouldn’t it be great to study a subject in which you don’t haveto do this?
But haven’t we already gotten into trouble? Why should you
believe the claim this book made about Roosevelt? (That is, theclaim that it is false that FDR saved capitalism.) Are you being
asked to accept this on faith? Not at all. By the end of the book, youwill understand why the economic policies that Roosevelt followed
could not work.

WHAT IS ECONOMICS?
So far, there is a major gap in our chapter. We’ve predicted thatyou will like economics, because you don’t have to rely on authority.

xii An Introduction to Economic Reasoning

But we have neglected to tell you what economics is. Has the ostensible subject of this book been forgotten?
As you can guess, the answer is no. An explanation of method isessential to understand economics, as we propose to do here. In one
sense, it’s obvious what economics is about; topics such as prices,
wages, production, banking, inflation, the business cycle, etc., readily come to mind. One way to proceed would be to make a list ofthese, and similar topics, and then tell something about each one.
This “method,” if it can be called that, was actually used bysome economists in the nineteenth and twentieth centuries. In
Europe, these economists were called historicists; in the UnitedStates, institutionalists. As you may imagine, economics done thisway is unsystematic: it isn’t at all a matter of applying deductive reasoning. In historicist economics, you do have to take practicallyeverything on the book’s say-so. “Economists” such as Gustav
Schmoller, Werner Sombart, and Thorstein Veblen, who belonged
to these schools, very rarely engaged in deductive reasoning. Their
attitude was “Take down what I give you or get out!”
The economics followed in this book is that of the Austrian
School, founded by Carl Menger in the nineteenth century and

Gustav Schmoller
1838–1917

Werner Sombart
1863–1941

Thorstein Veblen
1857–1929

Introduction xiii

Carl Menger
1840–1921

Ludwig von Mises
1881–1973

Murray N. Rothbard
1926–1995

continued in the twentieth century preeminently by Ludwig vonMises and Murray Rothbard. Rather than take economics to be aloosely-put-together list of topics, it is characterized by a strictlydeductive approach.
Austrian economists start from a single principle, the “action
axiom”—all men act. From this axiom, and a few added assumptions, we will attempt to deduce significant truths about all of the
topics mentioned in the previous paragraphs but one. You will be
the judge of our success. But before we can see how Austrian economics proceeds, we must first explain deduction.
1.

When is it reasonable to accept judgments, “just because
the book says so?”2.

See whether you can find out why Carlyle called economics “the dismal science.”?

Chapter 1
The Method of Economics
DEDUCTIVE METHOD

I

n economics, we operate with deductive logic. (Bertrand Russell,a twentieth-century English philosopher, once said that there are
two kinds of logic, deductive and bad.)
Deductive logic is a tool of amazing power. Given a true statement, we can, by using deduction, obtain other true statementsfrom it. These new statements not only are true—their truth isguaranteed! If the statements we started with are true, then ourconclusions are also true.
Let’s look at a few examples:• ALL COMMUNISTS ARE TWO-HEADED MONSTERS• KARL MARX WAS A COMMUNIST• THEREFORE, KARL MARX WAS A TWO-HEADED MONSTER

Does the conclusion, “Karl Marx was a two-headed monster,”follow from the premises (the statements it was deduced from)? Yes,
it does. Then, if the premises are true, so is the conclusion.
Have we proved that Karl Marx was a two-headed monster?
Not so fast. All we know is that if the premises are true, then so is
the conclusion. Unless both premises are in fact true, we can’t claimthat they show the conclusion to be true.
12 An Introduction to Economic Reasoning

What good is logic, then? Well, let’s go over the basic point
again. We know that whenever the premises are true, the conclusion is true. An argument in which the conclusion is correctlydeduced from the premises is called a valid argument. If we can(somehow) arrive at true premises, then we are guaranteed true
conclusions. And, as you will discover in this book, sometimes
obvious truths can have very startling consequences.
But this raises a further question. What are the rules for correct
inference, and how do we know these rules are true? Are we back toaccepting things just because the book says so? Again, not at all.
The discipline that studies the rules of valid reasoning is logic.
In this book, we won’t be studying these laws in a systematic way.
But the rules of inference we’ll be using are very simple, commonsense ones. You will be able to see right away that they are right.
Let’s look at the example just presented. The first, or major,
premise, can be diagrammed like this:TWO-HEADED MONSTERSCOMMUNISTS

Similarly, we can diagram the second premise:

COMMUNISTSKARL MARX

Chapter 1: The Method of Economics 3

And then the conclusion:

TWO-HEADED MONSTERS
KARL MARXThe inference rule we are using is: If class a is included in classb, and class b is included in class c, then class a is included in class c.
You can see, just by thinking about it, that this rule is correct.

1.

How would you argue with someone who refused to accept
the rule of inference given in this section?

2.

The basic rules of logic were first discussed in detail by
the Greek philosopher Aristotle (384–322 B.C.). Try tofind out something about his life. Who was his teacher?
Who was his most famous student?

?

THE LAWS OF LOGIC
Now, we are going to dig a little deeper. Aristotle asked an
important question. Why are the inference rules of logic true? Hethought that there are three laws that provide a foundation for all
logical truth.
These laws are sometimes called laws of thought, but this is amisnomer. According to Aristotle, these laws govern reality. The
three laws are the following:4 An Introduction to Economic Reasoning

1.

A = A: The Law of Identity2.

Not (A and not A): The Law of Non-Contradiction

3.

A or not A: The Law of Excluded Middle

We only have time to give a very brief account of these here.
The Law of Identity means, as Bishop Joseph Butler put it, that “athing is what it is.” It’s hard to state this in a form that doesn’t repeat
the principle. If you don’t yet get it, some example might help: If
this book is boring, then this book is boring. If roses are red, thenroses are red. If roses are yellow, then roses are yellow. What would
be simpler?
The Law of Non-Contradiction is equally easy to grasp. Let’s
use the same set of examples as before, suitably modified. If thisbook is boring, then it is not the case that this book is not boring.
If roses are red, then it is not the case that roses are not red. If roses
are yellow . . . (you fill in the rest).
The hardest of the three laws for students to get is the third
one. Suppose we take any two contradictory properties, e.g., redand not red (to get the contradictory of a property by negating it).
Anything must be either red or not red. Thus, the number five is
not red. Rudolph the Red-Nosed Reindeer’s nose is red. The Gross
National Product is not red. Anything whatever is either one or theother of any set of contradictory qualities.

?

1.

Can something be both red and not red?

2.

Some philosophers have denied that these laws are always
true. Marxists say, e.g., that everything is constantly
changing; therefore, the Law of Identity isn’t true. Why isthis objection based on a misunderstanding of the Law of
Identity?

Chapter 1: The Method of Economics 5

VALIDITY CONTINUED
We now know that if you start with true premises, you will
arrive at a true conclusion. A valid argument transmits truth fromthe premises to the conclusion. What happens if one of the premises is false? Does this make the conclusion false? Not necessarily.
All our rule says is that true premises transmit truth: it says nothing
about how premises and conclusion are related with a false premise.
In the example already used, the major premise is false. It’s not
the case that all communists are two-headed monsters. The conclusion is also false: Marx was not a two-headed monster. But this pattern by no means always holds true. Let’s look at another example:• ALL SCORPIONS ARE DEMOCRATS• HILLARY CLINTON IS A SCORPION• THEREFORE, HILLARY CLINTON IS A DEMOCRATBoth the premises are false. (Perhaps the falsity of the second
premise is arguable!) But the conclusion is true: Hillary Clinton isa Democrat! How can this be?
By now, you should know the answer. The conclusion is true,
but the premises don’t make it true. These premises do not transmit truth, since they are false. Just to make things absolutely clear,
all the premises must be true for truth to be transmitted. One false
premise prevents the rule from applying.
Notice that the rule requires both true premises and a valid
argument. This example does not meet our requirement:• SOME TEXANS ARE TALL
• SOME TALL PEOPLE ARE DEMOCRATS• SOME TEXANS ARE DEMOCRATS

6 An Introduction to Economic Reasoning

This argument is invalid: the conclusion does not follow fromthe premises. Can you see why? Let’s resort to diagrams again:
The first premise:

TALL PEOPLETEXANS

The first premise says that the classes of tall people and Texansintersect, or have some members in common. It does not say thatthe class of Texans is included in the class of tall people. (Can you
give the premise for which this is the correct diagram?)

TALL PEOPLETEXANS

Similarly, the second premise looks like this:TALL PEOPLE

DEMOCRATS

It states that these two classes, tall people and Democrats, intersect.
You can now see why the conclusion does not follow. The conclusion, some Texans are Democrats, looks like this:Chapter 1: The Method of Economics 7

DEMOCRATSTEXANS

Our premises allow this to be true, but they don’t require it.
This is also consistent with our premises:

DEMOCRATSTEXANS

Both premises will be true, and the conclusion turns out to befalse. Can you see how this is possible? Once again, use of a diagram
will help. Suppose this was the situation:

TALL PEOPLE
DEMOCRATSTEXANS

Here, both of our premises are represented. The diagramshows that some Texans are tall, and also that some tall people are
Democrats. But, in this state of affairs, no Texans are Democrats.
The tall people who are Texans are different tall people from those
who are Democrats.
In fact, of course, both of the premises are true; and so, is theconclusion. Lyndon Baines Johnson, whom most of you won’t
recall, was both. (If you do remember LBJ, what are you doing stillin school?) Even though premises and conclusions are both true,
the premises do not transmit their truth to the conclusion, since theargument is invalid.

8 An Introduction to Economic Reasoning

Can true premises in an invalid argument lead to a false conclusion? Certainly.
• ALL AUSTRIAN ECONOMISTS SUPPORT THE SUBJECTIVE THEORYOF VALUE• NO AUSTRIAN ECONOMIST LIVED BEFORE THE NINETEENTH
CENTURY• THEREFORE, NO SUPPORTER OF THE SUBJECTIVE THEORY OF
VALUE LIVED BEFORE THE NINETEENTH CENTURY

As we shall see later in this book, both of the premises are true,
but the conclusion is false.

?

1.

Diagram the argument just given. Show why the conclusion does not follow.

2.

Given examples of (a) valid arguments with true premises;(b) valid arguments with at least one false premise; (c)invalid arguments with at least one false premise; (d)invalid arguments with true premises. Must any of thesetypes always lead to a false conclusion?

STILL MORE ON VALIDITY
Fortunately, we have only one more rule to cover about transmission of truth. In a valid argument, if the conclusion is false, thenat least one of the premises must be false. A valid argument transmits the falsity of the conclusion to at least one premise. Onceagain, an example:• MINIMUM WAGE RATES LEAD TO UNEMPLOYMENT

Chapter 1: The Method of Economics 9• LUDWIG VON MISES FAVORED MINIMUM WAGE RATES• THEREFORE, MISES FAVORED A GOVERNMENT POLICY THATLEADS TO UNEMPLOYMENT

Here, the conclusion is false: how false you will discover later inthe book. But the argument is valid. Then, our rule tells us that atleast one of the premises is false. In this case, it is the second premise. Mises, who is one of this book’s heroes, opposed minimum
wage laws. But the first premise is true; and by the end of the book,
you will be able to explain why. Thus, our rule does not say that ina valid argument with a false conclusion, both premises are false. It
says that at least one is false. And if in fact just one premise is false,
the rule doesn’t tell us which one it is.

1.

Show, using diagrams, that the argument about Mises isvalid.

2.

Give examples of a valid argument with a false conclusionthat has (a) one false premise and one true premise; (b)two false premises.

3.

Suppose you have an invalid argument with a false conclusion. What can you tell about the truth of the premises?

?

DEDUCTION EXTENDED
The type of argument that we have been discussing so far iscalled a categorical syllogism. It has two premises, both statements of(alleged) fact, and a conclusion. But not all valid arguments take thisform: it was discussed here because you can easily grasp what validity means if you take examples of this kind. But premises can also be10 An Introduction to Economic Reasoning

hypothetical. For example, the statement: “If wishes were dollars,Social Security would be financially sound” does not claim either
that wishes are dollars or that Social Security is financially sound.
All that the statement claims is that if wishes were dollars, thenSocial Security would be sound. A syllogism can have either one or
two hypothetical premises.

?

1.

Give examples of syllogisms with (a) one and (b) two hypothetical premises.

2.

Can you show how to convert a hypothetical premise intoa categorical one? That is, show how an “if-then” statement can be changed into another statement about a matter of fact. If you can answer this, you will have no difficulty getting an “A” in the course. In fact, you are probably in the wrong class.

DEDUCTION FURTHER EXTENDED
We have just a little bit more technical machinery to getthrough. Unfortunately, this is the most difficult section of thechapter. Fortunately, it isn’t very long. Some premises are stronger
than mere factual claims. Let’s return to a variant of an old friend:“Some communists are two-headed monsters.” This (false) premisedoes not say that some communists have to be two-headed monsters, i.e., that they couldn’t possibly be anything else. It just saysthat they are in fact two-headed monsters.
Contrast this statement with the following: “No one can be his
own father.” This does not just say that no one is in fact his own
father: it makes the stronger claim that no one possibly could be his
own father. No matter how we change features of the actual world,Chapter 1: The Method of Economics 11

this statement is always true. It’s part of the nature of being a father
that you can’t be your own father.
Necessarily true propositions (but not the one about fathers)
play an important part in economics, and you would be well-advised
to reread the preceding paragraph carefully. (Instructors should
police students at this point to make sure students understand whata necessary proposition is. If necessary, mild electric shocks may be
administered.)
Now for the hard part: In a categorical syllogism, one that does
not contain necessarily true premises, the conclusion need not itself
be necessarily true, even though it follows of necessity from thepremises. Got that? Let’s have another look. Consider this case:• SOME ECONOMISTS ARE STUPID• NO AUSTRIAN ECONOMISTS ARE STUPID• THEREFORE, SOME ECONOMISTS ARE NOT AUSTRIAN

The initial premise is (alas!) true. The truth of the second
premise is a matter for discussion. But neither premise is necessary:it could have turned out, however unlikely, that all economists areintelligent. And though difficult to conceive of, it might have been
the case that there are stupid Austrian economists. And the conclusion is also not necessarily true. All economists might have turned
out to be Austrian economists. (Austrian economics is the foundation for this book. See page 19 for an explanation.)
Nevertheless, the conclusion necessarily follows from thepremises. If the premises are true, then it must be the case that theconclusion is true. Given our two premises, it must be the case thatsome economists are not Austrians.
Then why is it wrong to say that the conclusion is necessary? If
it must be the case that some economists are not Austrians, isn’t thisjust what it means to say that, necessarily, some economists are not

12

An Introduction to Economic Reasoning

Austrians? Yes; but, remember we are not asserting that it must be
the case that some economists are not Austrians. We are saying that
if the premises are true, then some economists are not Austrians.
One more complication, and then we are out of the woods (atleast for now). A syllogism with two premises that are not necessarily true can turn out to have a conclusion that is necessarily true. All
that we’ve been trying to show is that it does not have to turn out
this way. Here is an example of a valid syllogism with two non-necessary premises. (The technical term for “non-necessary” is “contingent.”)• SOME FATHERS ARE PROFESSIONAL FOOTBALL PLAYERS• ALL PROFESSIONAL FOOTBALL PLAYERS ARE MALE
• SOME FATHERS ARE MALE

Although the conclusion follows from two contingent premises, it itself is necessarily true. (Why? Because it follows directlyfrom the necessarily true “All fathers are male.” There is a complication here [having to do with “existential import”] that we canignore. Some logicians don’t think “All fathers are male” entails“some fathers are male.” Why not? In their view, “all fathers aremale” means “if x is a father, x is male.” This does not entail that
there are any fathers. But “some fathers . . .” does entail that there arefathers. See, I told you we should ignore this.)
We’re now over the hard part. It was important to look at necessary propositions, as they play a key role in economics.
And there is one further extension we need to look at. Not all
valid deductive arguments are syllogistic. Putting that into English,
a valid argument doesn’t have to have two premises. Suppose westart with this premise: “All socialists are subversives.” From this,we may at once deduce: “All fatheaded socialists are fatheaded subversives.” No intermediate premises are needed.

Chapter 1: The Method of Economics

This sort of immediate inference is very important in economics, especially of the Austrian variety. We often are given a concept
and then required to deduce various features of it that follow
immediately. As we shall see, the concept of “action” is the mostimportant one we use in economics. Much of economics consists ofdeducing what follows from the concept of action, and a good dealof this inference is immediate rather than syllogistic.

1.

How can you find out if a statement is necessarily true?

2.

If a statement is necessarily true, do you need to test it tofind out whether it is true?

?

ECONOMICS VS. MATHEMATICS
But if economics proceeds strictly by logic, so that you don’t
have to accept statements on authority, doesn’t this mean that economics is really mathematical, after all? In math, you operate
through proof. Suppose x = 5. Then, 2x = 10. (Don’t worry, this is
the toughest math in the book.) 2x = 10 is true because it follows
from applying the rule if you multiply one side of an equation by
two, you must multiply the other side by two also. You arrive at theconclusion, 2x = 10, because that is what the rule tells you to do.
Economics also uses proof, but the way it proceeds often differsfrom mathematical proofs. In math, to reiterate, you operate by
fixed rules on certain symbols. Once you know the rule, you can fillin the blank here with almost no thought: x = 5, 2x = ____. It’s analmost mechanical process. But this isn’t always the case in economics.

13

14

An Introduction to Economic Reasoning

Let’s return to immediate inference. In the last section, we gave
an example of a valid immediate inference. Let’s look at an inference that on the surface looks similar:• ALL SOCIALISTS FAVOR SUBVERSION• THEREFORE, ALL RUSSIAN SOCIALISTS FAVOR RUSSIANSUBVERSION

Here, the conclusion is false. The truth of the premise is consistent with the falsity of the conclusion. Suppose some Russiansocialists wish to overthrow the Bulgarian government, rather thantheir own. If so, the premise might be true, but the conclusion would
be false.
But how do we know this? No mechanical rule will tell us which
immediate inferences work, and which do not. We simply have to
use our judgment; and this is often true for non-immediate inference as well.

?

1.

How do we know the rules of mathematics arecorrect?

2.

Would it be a good idea to use symbolic logic in economics, if economics relies on immediate inferences?

3.

Is it always best to begin by “defining your terms”? Why or
why not?

4.

Deduction only tells us what we already “know.” Howmight a supporter of the deductive approach reply?

Chapter 2
Action and PreferencePart I

A

fter getting through Chapter 1, you may have wondered: what
does all of this have to do with economics? In this chapter, we’ll
find out. What we are going to attempt is to apply the deductive
method in order to build up a science of economics. Remember, if
we carry out this task correctly, we will have achieved something
remarkable. Given a true starting point, our conclusions must be
true.
This at once raises a key issue. What should be chosen as thestarting point? To pick the wrong initial premise threatens disaster.
Suppose, for example, we started with this premise: “The economic value of a good consists of the labor necessary to make it.” This
statement, as we’ll soon discover, is false. Anything we deduce fromit, then, is not guaranteed to be true. Our conclusions may be true,
but they won’t be true because they follow from our starting point.
It’s easy to think of true propositions that we might start with—that isn’t the problem. “2 + 2 = 4” is, unarguably, true; so is “SomeU.S. presidents have been big spenders.” The hard part is to arrive
at a true proposition that will lead to significant results. Fortunately,
through the genius of the Austrian economist Ludwig von Mises,
this problem has been solved.

THE ACTION AXIOM
The fundamental principle of economics can be stated in two
words: man acts. Most of the rest of this book will endeavor to clarify
17

18

An Introduction to Economic Reasoning

what this axiom means, and to draw out its implications. Our firstquestion is obvious: what is an act? Incidentally, “man” in the axiomof course refers to both men and women. “Man” is a general termthat means “human beings.” This is perfectly acceptable English
usage, in spite of the absurd posturing of the “politically correct.”
Feel perfectly free to substitute “human beings” for “man” in theaxiom, if you are so inclined; I can’t help it if you cave in before asilly political fashion.
But I digress. What is an action? It is easier to give examples
than to offer a watertight definition. Reading a book, voting forclass president, doing your homework, and playing soccer are all
actions. (If you have the misfortune to attend a progressive school,
look up “homework” in the dictionary.) Any conscious behavior
counts as action—an action is anything that you do on purpose.

?

1.

“The action axiom is trivial. Everybody knows it’s true. It’s
like ‘a red light means stop’; nothing interesting follows
from it.” What’s wrong with this argument?

2.

List some other basic terms besides “action” that are
hard to define exactly, even though everybody knows what
they mean.

3.

“Unless we define our terms, we can’t think accurately. It
isn’t enough, then, to have an approximate idea of what
‘action’ means. We need an exact definition.” Is this lineof thought correct? Why or why not? Use your answer tothe preceding question to help you with this one.

ACTION
It’s important to note a basic distinction here. Not everythingthat happens to a person counts as an action: an action must be
done deliberately. While you are reading this, your pulse is beating

Chapter 2: Action and Preference, Part 1(I hope). But this is not something that you have decided to do: it isa process that goes on automatically in your body. Reading, ofcourse, is an action. You don’t read just by having a newspaper page
put in front of you; you have to decide to do it; and, while you’rereading, the process is under your conscious control.
Some actions don’t require much conscious control. For mostpeople, walking takes place without having to think explicitly about
each step. You don’t say to yourself, “Left foot, right foot; now left
again, etc.,” you just walk. Nevertheless, the process is under yourconscious control. Imagine what it would be like if things were different. Suppose you suddenly found your legs moving by themselves, and your efforts to will them to stop failed. Then you wouldn’t be acting, although your body would be moving.

1.

Are nervous tics actions? Sleepwalking? Epileptic fits?

2.

“Walking isn’t really an action. Walking just consists ofother actions, such as moving your legs.” What’s wrong
with this argument?

Normally, an action includes some physical movements of the
body. When you walk, your legs move; when you read, your eyes
are constantly shifting focus. Some “actions” don’t seem to involve
physical movement, e.g., thinking. (There are all sorts of things
going on in your brain when you think, but are these thinking
itself? Could thinking take place altogether apart from any physicalentity? Fortunately, we don’t have to solve these issues here.)
But the actions we’ll be concerned with in economics do, forthe most part, involve physical movements; examples include buying, selling, investing, and laboring. We’ll take thinking for our

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An Introduction to Economic Reasoning

purposes as part of action, rather than as a separate act itself. (Note,however, that ordinary usage includes “acts of thought.”)
Not all outward actions, however, do involve physical movement. Suppose you are thinking about going for a walk. You decide
not to; you find appealing the remark of R.M. Hutchins:“Whenever I feel like exercise, I lie down until the feeling goesaway.” You still act; in this context, staying put is an action.
There are even a few cases in which you can do something
besides waiting or staying put without any physical movement taking place. Imagine that you are a member of Congress. A resolution
has been proposed to increase taxes by 50 percent. The Speaker
announces: “All those in favor, please stand; opposed, remain seated.” Since you have, by the time of your election, finished studying
this book, you understand why taxation is theft. You decide to vote“no”; and, following the Speaker’s instructions, you remain seated.
You haven’t moved; but you have voted, just as much as if, ignorantof sound economics, you had stood up. To reiterate, though, mostof the actions that we’ll be studying do involve physical movement.

IS THE AXIOM TRUE?
Well, we have our initial axiom; and the next step appears obvious. As promised, we must deduce conclusions about economics
from it. But something has been left out. Recall, we must have atrue initial premise in order to be sure that the conclusions we draw
from it are true. So far, all that I have done is to state the axiom, andsay a few things about it. But is it true? Unless it is, we’re in trouble, for the reason already stated.
Fortunately, the problem is easily solved. Isn’t it obvious thatthe axiom is true? When I explained the axiom, I deliberately
picked examples such as walking and reading that we all do. You
wouldn’t be reading these words now, unless you were acting. Once
you think about “man acts” you will see that it is silly to doubt it. (IfChapter 2: Action and Preference, Part 1

you think about the axiom but don’t see that it’s obviously true, you
would be probably better off to drop economics and take up sociology instead.)
The action axiom, then, is a common-sense truth. And this isenough to get the science of economics going. In this respect, economics differs from chemistry, biology, and (most of) physics. In
these sciences, we usually need to experiment in order to find thingsout. It isn’t an obvious, common-sense truth that a molecule ofwater is composed of two hydrogen atoms and one oxygen atom.
This was something scientists discovered only by careful testing.
Not everything in the physical sciences rests on experiment.
The ancient Greeks identified a body in the sky which they called“Hesperus,” the Morning Star. They picked out another body,“Phosphorus,” the Evening Star. Careful observation showed thatthe two bodies are identical. “The Morning Star is the Evening
Star” is part of astronomy, but it didn’t require experiment to establish. Nevertheless, it isn’t a common-sense truth: careful observation was needed to discover it.
In the physical sciences, you can sometimes get the wrong
results if you rely on common sense. What could be more obvious,
for example, than the fact that the sun moves round the earth. “Ofcourse the Earth is stationary. Use your eyes!” a character in one ofGeorge Bernard Shaw’s plays remarks. But in fact (or so at least
modern astronomers tell us) the earth is moving at an enormous
rate of speed. Common sense does not inform us of this, and common-sense observations don’t refute it. “If the earth were moving,
we’d all fall off” is not a good reason to doubt that the earth moves.
This suggests a problem. If, in the physical sciences, commonsense observations can turn out to be false, why not in economics as
well? Perhaps the action axiom, however apparent its truth, will one
day be shown false. Have we started down a false trail?
You will be glad to know that we haven’t. Why do commonsense judgments about the physical world sometimes turn out to be
mistaken? This involves difficult issues in the philosophy of science;

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An Introduction to Economic Reasoning

but, basically, the answer is straightforward. In the physical world,
there is an underlying level of things not directly open to observation. Common sense can tell you how the world is on the surface:it does not disclose the world’s inner structure.
But human action isn’t like that. There is no underlying levelfor human action, in the same way that there is for the physicalworld: What you see is what you get. Since we act ourselves, we
grasp the nature of action directly. We don’t have to guess at the
inner structure of thought. Physical objects consist of atoms, butthere aren’t “atoms of thought.”

1.

“Yes, there are too ‘atoms of thought’! The brain has an
inner structure, just like any other physical object. And
the mind is the brain. Therefore, there are atoms ofthought.” Evaluate this objection. (If you can show what’s
wrong with it, you’re a ringer.)

2.

Look up Newton’s first law of motion. How does this contradict common sense?

?

You might think that economists would be glad to have a common-sense foundation for their discipline. But some of them arenot. In contrast to the Austrian School, which fully accepts the
deductive approach, many economists think that it is unscientific torely purely on deduction. Deduction plays an important role in economics, no doubt; but premises ought not to be accepted justbecause they are held “self-evident.” Rather, what is important is
the conclusions which these premises imply. These must be subject
to test. Whether the premises are self-evident or even true matterslittle; only predictions count. As we shall see, Austrians reject thisview.

Chapter 2: Action and Preference, Part 1

23

A basic principle of economics, one we’ll be studying soon, is thelaw of demand. Instead of showing how this law follows deductively
from common-sense principles, some economists have conductedsurveys to find out whether the law holds. They ignore the fact that,
if the law has been correctly deduced, it rests on a much firmer basis
than conjectures derived from polls.

MORE ABOUT ACTION
Now that we know the action axiom is true, we can return tothe main business of deducing theorems from it. There isn’t anything difficult or unusual in doing this: using a common-sense pointof view, we shall look at the concept of action and see what we get.
For one thing, every action has a goal or purpose. Why, forexample, are you now reading this page? Because you want to findout what we’re attempting to communicate. (Why you want to dothat is of course another question.) Again, when you walk across theclassroom, you do so in order to arrive at your destination: you want
to go from Point A to Point B. (Back in the Dark Ages when I went
to school, I would have used the example of walking to school: butof course no one would do so odd a thing today.)And what in turn follows from your having a goal? Obviously,
you haven’t already obtained the goal: otherwise, there would be noneed to act. If you were already at Point B, there would be no needto move there. (Indeed, you couldn’t move there. You might staythere, but that would be a different action.)
But a goal by itself does not suffice for an action. Let us returnto the case of moving from Point A to Point B. It is such a thrillingexample that one can hardly do otherwise. Suppose you are now at
Point A. You would like to be at Point B, but you have no idea how
to get there. (“It’s all the way across the room! What am I supposed
to do?”) You so far haven’t done anything. In order to act, you must
do something to get what you want. You must, in other words, use

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An Introduction to Economic Reasoning

means to achieve your goal. In this case, of course, walking acrossthe room is the means to obtain your goal of being at Point B.

?

1.

Give a few examples of acts that you have done. Identify
the ends and means in each.

2.

Here is a difficult problem we won’t be able to cover in thisbook that you might like to try your hand at: In order toobtain an end, you have to use means. But using means toachieve an end is itself an action. In walking across theroom, e.g., I move my legs in a certain way. But, if using
the means is an action, doesn’t that action require the useof a further means? If so, doesn’t an infinite regress
result? How, then, can action take place at all? (If you findthis question unintelligible, feel perfectly free to ignore it.
Better yet, ask your teacher if he can answer it.)

We now understand the basic structure of an action: the use ofmeans to obtain an end. In turn, the question arises, what can we
deduce from this? (You can begin to see how economics develops:
from what we already know, we attempt to deduce more and more.)
What must be true if there are ends and means?
Suppose you thought that, regardless of anything you did or
didn’t do now, you would wind up at Point B. Then, it would bepointless for you to start walking. Why walk if you are going to getthere anyway? (Assume that walking won’t get you there faster thandoing nothing.) Or, suppose you thought your legs would startmoving automatically. There would again be no point to setting
yourself deliberately to move them. In order to act, then, you mustbelieve that obtaining the goal is, at least in part, up to you.
Sometimes this point is put in this way: it is a condition ofaction that the future is uncertain. But this can be misleading. It
may just mean exactly what was said before; in order to act, youChapter 2: Action and Preference, Part 1

can’t believe that your goal will come about regardless of what you
do. If so, of course, fine.
But “the future is uncertain” may suggest something else.
Perhaps what is intended is that in order to act, you must not knowwhat is going to happen. (I think, in fact, that this is the more natural reading of “the future is uncertain.”)But this is a much stronger claim, and we have not at all provedthat this is a necessary condition of action. Can you see why it’s astronger claim? Well, the first claim, the one that we have argued
for, is that in order to act, you must not know that the goal will
come about, regardless of what you do. The new claim is that inorder to act, you must not know that the goal will come about. The“regardless of what you do” clause has been dropped. And so far, at
any rate, no justification has been offered for doing so.
In fact, the stronger claim is false. Sometimes (though notalways) we do know our goal will come about; and our knowing thisis consistent with our acting to obtain the goal. How is this possible? Suppose you know that if you walk across the room, you will
arrive at Point B. You also know that you are going to walk acrossthe room. Then, why can’t it be true that you know now that you
are going to be at Point B? If you do know this, then in this respect
the future is not uncertain. Don’t say in response that there must be
something wrong with the argument, because the future is uncertain. This is just the issue in dispute.
This may sound like much ado over a very small point. (Perhaps
it sounds like this because it is much ado about a small point.) But
we have emphasized it because the very idea of the future makes
many economists go into a panic. They think that because humanaction is oriented toward the future, it is what they call “radicallyuncertain.” Actors, in their view, know next to nothing at all about
what the results of their actions will be. As you can imagine, economists with this view are rather limited in what they can say: there
isn’t much room for a science of economics if one’s only message is

25

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An Introduction to Economic Reasoningthat actors are ignorant. It is important, then, not to fall for the“radical uncertainty” line.

?

1.

List something about the future that you know.

2.

“We don’t really know the future. Suppose I think I knowthat I’ll have ice cream for breakfast tomorrow. I always
have ice cream for breakfast, and I’m a creature of habit,
so my claim to knowledge appears well-grounded. But it isfalse. After all, I might change my mind; or I might die during the night, or untold other things might happen. Thus,
I don’t really know that I’ll have ice cream tomorrow; andthe future is indeed radically uncertain.” Evaluate.

Enough about “radical uncertainty.” Let’s return to the structureof action. We have just learned that in order to act, you must notbelieve that your goal will be achieved, regardless of what you do.
Can you think of a closely related belief that, if you had it, would
prevent you from acting? You must not believe that your goal will
fail to be achieved, regardless of what you do. Suppose we would
like to be the next King of England. The job pays well, and it’s fun
having people bow to you. I believe, however, that nothing that I
can do can in any way secure my goal: I’m just not eligible to be
king, absent an unimaginable change in the Law of Succession to
the Crown. My goal will thus lead to no action.

PREFERENCE AND UTILITY
An action, then, uses means to achieve an end. What follows
from the fact that you are pursuing a certain end? Obviously, youwant that end: you prefer having it to having something else. We
return once again to our never-failing source of excitement—the
move across the classroom from Point A to Point B. If you move

Chapter 2: Action and Preference, Part 1

from A to B, would you rather stay at A or be at B? Even a graduate of a progressive elementary school should be able to cope withthis one. You would rather be located at B; otherwise, you wouldn’t
move there. Another way of putting the point is that when you act,
you think you’ll be better off after you obtain your goal than you
would have been without it.
Economists like technical terms; so instead of saying that when
you act, you think that you will be better off, they usually say thatyou think your utility or welfare will increase by acting. It is crucial
for your understanding economics to realize that this is just a
restatement of the previous point; we haven’t added anything new
by the claim that in acting, you think your level of utility will
increase. All you have said (to go over the point once more) is thatyou prefer getting your goal to not getting it.
Why are we pounding you over the head with this? Because
there is a mistake that is very easy to make here. Some people thinkthat whenever you act, you are trying to maximize pleasure and minimize pain. What does this mean? There are some feelings or sensations that people tend to like; imagine how you would feel, forexample, if you were right now eating a banana split instead ofstudying the concept of utility. Or imagine how you would feel if
you saw the person you most hate in the world carried away in a flying saucer.
Other feelings of course, most people try to avoid. Very few
people seek out red-hot stoves to touch; and not many would emulate King Enrique el Impotente of Castile, the father of Queen
Isabella, in seeking out the smell of burning leather.
According to psychological hedonists or egoists, who hold theview about action just described, maximizing pleasure and minimizing pain are our only real goals. All actions, on this view, aremeans (ultimately) to increase pleasurable sensations or decrease
painful ones. If we move from Point A to Point B (surprise!), we doso because we think being at Point B will better serve our happiness.

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An Introduction to Economic Reasoning

There are other forms of hedonism that view the goal of action insomewhat different ways, but this form (“crude” or “hardline” psychological hedonism) is sufficient for our purposes.

UTILITY AND WELFARE
Having explained what psychological hedonism is, we are now
ready to deal with the mistake about utility and welfare to which I
earlier referred. When we say in economics that an actor thinks thatobtaining his goal will increase his utility, we are not—repeat not—committing ourselves to psychological hedonism. By this point you
should be able to explain what an increase in utility means in economics. All that we are saying, as economists, is that an actor
prefers securing his goal to not obtaining it. “Utility” and “welfare”
do not designate particular ends, such as sensations of various kinds,
to which our ordinary goals are means.
It is a fallacy to take welfare and utility as if they did designate
particular sensations. Economists who do so think of utility as a
substance that we always attempt to increase. We are, on this view,always saying to ourselves, “More utility!”

Jeremy Bentham
1748–1832

John Stuart Mill
1806–1873

Chapter 2: Action and Preference, Part 1

But why is the position a fallacy? I believe that psychologicalhedonism is mistaken, but I certainly have not shown that it is. The
problem with the theory, for our purposes, does not lie in its(alleged) falsity. Rather, it does not follow from the concept ofaction. It is a psychological hypothesis about how people act. It has
no place in the deductive science of economics we are attempting toconstruct.
1.

Does psychological hedonism strike you as a plausible
theory? How would you explain actions that aim to help
other people, using this theory?

2.

Does maximizing pleasure always lead to the same actions
as minimizing pain?

3.

Some philosophers, e.g., Jeremy Bentham and John StuartMill, adopted utilitarianism as an ethical theory. They heldthat one should try to maximize the happiness of as many
people as possible (“The greatest happiness of the greatest number”). Do you think that utilitarianism is a true
theory of ethics?

Once more we return to the concept of action. Each of us, in
acting, aims to achieve a goal by the use of means. We must decide
what means will best secure our ends. How can I get to Point B?
Should I walk? run? drive? Questions about choice of means constantly confront us.
And choice is not confined to questions of means. The Danish
philosopher Søren Kierkegaard said that purity of heart is to will
one thing. Perhaps he is right; but in fact people have many different ends at which they aim. We must choose not only between various means to achieve a goal, but also among goals. Will you spend
the next hour studying economics? Eating ice cream? (If I were you,
I would pick the latter.)

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An Introduction to Economic Reasoning

One further complication. We not only choose between goals,
and choose which means to use to obtain a given goal. Many means
can be used to help achieve more than one end; we must decide
which end each versatile means will serve. This economics textbook
might be put to use as a doorstop: is this a good use of it, given yourends? Suppose that the textbook would make a better doorstop thanthe bust of your great-aunt that now reposes useless in your attic.
You may decide to put your great-aunt’s head to use at the door,
even though it is inferior to the textbook as a doorstop, if you wish
to use the textbook for some other purpose.
Action, then, involves complex choices among both goals andmeans. I hope that you have noticed something about this proposition that differs from the points about action we have previously
made. It doesn’t follow from the action axiom. Do you see why not?
It is perfectly consistent with the axiom that each person engage in
only one action, with a fixed set of means. (Remember the legendof Sisyphus, who spent his life pushing a rock up a mountain?)
Stop! Hasn’t something gone wrong? We are supposed to be
developing a deductive science of economics, but we have introduced propositions that don’t follow from the axiom. What is to be
done? Must we give up economics as a deductive discipline?
Not at all. Economics is still deductive; but we must introduce
a few extra principles besides the action axiom. Once we admit
these, we can then proceed in the same deductive fashion as we haveso far done. Only now we have more premises to work with.
The extra principles that we now need are these: (1) People
have a variety of goals; and (2) There are a variety of resources ormeans by which people can pursue these goals. But how do weknow these principles are true? You will recall (and if you don’t yourteacher will remind you) the big problem we discussed at the startof this chapter. If we don’t start with true principles, then we haveno guarantee of the truth of what is deduced from them. How, then,do we know that our extra principles are true?

Chapter 2: Action and Preference, Part 1

Some Austrian economists would contend that I have taken awrong turn in the last few paragraphs. We could understand theaction axiom in a broader sense. “Action,” in this extended sense,
necessarily involves a variety of goals. Simple repetitive “action,” itmight be argued, isn’t really action. To act, you must decide how toallocate a means between competing ends.
If this view is right, then the “extra principles” are really part of
the action axiom. But, I’m not sure that this view is right. What do
you think?
In exactly the same way that we know the action axiom is true,
we know the extra principles are true. They are obviously true,
common-sense propositions. It is not a conjecture, to be confirmed
by careful experiment, that there are a variety of resources. It’s
something of which we are certain.

1.

The action axiom is a necessary truth. Are the extra principles necessary truths? (You might find it helpful to lookagain at Chapter One.)We have different goals. How do we choose between them?
Should I now move from Point A to Point B, eat a gallon of ice
cream, or toss this book out the window, assuming that I would liketo do all three? The time available, we assume, allows me to do onlyone.
The answer, I’m afraid, sounds trivially obvious. You rank thegoals: which, of the three, would you most like to obtain? (Guesswhich one I would pick!) Having done so, you act to achieve yourmost highly-valued goal.
As usual, we have to avoid a false step. We are not saying this:you measure the goals on a numerical scale of satisfaction, and then

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An Introduction to Economic Reasoning

pick the one that scores highest. Eating ice cream gives ten units ofsatisfaction, while tossing the book out the window rates only athree. (Moving to Point B is only slightly above the vanishingpoint.) This approach, measuring the goals on a scale of satisfaction, and picking the top scorer, is our old friend psychologicalhedonism. This is a speculative theory whose truth we do notassume in Austrian economics.
But if we rule out measurement on a scale, how can we rank ourgoals? Easy: we do it as follows: first goal, second goal, . . . etc. We
use an ordinal, rather than a cardinal ranking. Compare the following: Mount Everest is taller than Mont Blanc, which is taller thanthe Hollywood Hills (ordinal ranking). Mount Everest stands x feettall. Mont Blanc stands y feettall (cardinal ranking). Thisshould make the distinction
clear.
In this connection, theBritish economist Lord Lionel
Robbins compared utility to love.
You can usually tell whether you
love one person more thananother, but you can’t measure“how much” in definable units.
Now, we know what kind of
ranking we are looking for. But
what determines how the goals
rank? Which goal ranks first?
The answer may prove a disappointment to those in search ofcomplicated theory: the actor
himself decides which goal heLionel Robbins
1898–1984

Chapter 2: Action and Preference, Part 1

ranks highest. He is the one who acts, after all; what counts in the
explanation of what he does is his personal rank order of goals. In
economics, preferences are subjective.

1.

Some people believe that there are objective values in
ethics. What does this mean? Is this view consistent with
our statement that in economics, preferences are subjective?

2.

“You haven’t refuted the theory that goals are ranked cardinally on a scale of satisfaction. For all you have shown,goals are ranked this way.” Evaluate. (In this connection,
reread the discussion of psychological hedonism.)

I’m afraid we must now face another problem. We have said
that an actor always chooses his most highly valued goal. But how
do we know this is true? Suppose someone says, “My second highest goal is good enough for me; I’ll do that first.” Is this incoherent?
Is our claim that an actor always acts to secure his most highly valued goal another extra principle, adopted because it is convenientand defended as obvious? Or can it be deduced from the principles
we have already acknowledged? This question we shall address inthe next chapter, where the discussion of action and preference continues.

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33

Chapter 3
Action and PreferencePart 2
THE HIGHEST VALUED GOALA

s you will recall, the last chapter ended with a question. How
do we know an actor always acts to secure his most highly valued goal? Remember, in economics our aim (our most highly valued goal) is to deduce important results from the action axiom.
(What is the action axiom? Of course you know, but go back to theprevious chapter and read the section on the axiom again.) Does it
follow from the action axiom that an actor always will act to secure
his most highly valued goal?
It’s quite easy to see the answer is yes. Suppose you have a
choice between watching a wrestling match between Hulk Hogan
and The Undertaker, on the one hand, and listening to Hillary
Clinton explain what’s good for us on the other. You would rather
watch the wrestling match. What should you do?
Obviously, you should watch the wrestling match. It wouldn’t
make sense for you to choose to listen to Hillary, given that you
would rather have the alternative. (Remember, we’re not concernedin economics with what you should choose. Our problem is: given
your preference scale, how will you act?)
1.

The principle that you always act to secure your mosthighly valued goal is not obviously true. In fact, it is false.
I’d rather stay healthy for the next ten years than go to the

37

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An Introduction to Economic Reasoning

movies. But I may choose going to the movies over doing
pushups or other things that I believe will make me healthier. Why is this a poor objection to the principle?
2.

Don’t people often choose not to seek their highest valued
goals? Suppose you can get an easy “A” on your next
math test by copying the exam written by Norman Nerd,
the student sitting next to you. (Norman always gets 100
percent on math tests.) You won’t be caught because yourteacher is nearsighted. You of course resist temptation,even though you want an “A.” (If you get one, you will
receive $1,000 from your parents.) Aren’t you here refusing to go after your most highly valued goal?

THE TAUTOLOGY OBJECTION
We hope you spotted what was wrong with the last objection. If
you think it is wrong to cheat on math exams (economics exams areof course another issue), then you prefer not cheating to cheating.
If this preference outranks your desire to get an “A” on the test,
then by not copying from Norman’s paper, you are getting yourhighest preference. True enough, you may not get an “A” if you
don’t cheat; but this is not relevant. Of course you want an “A,” but
you want to be a non-cheater even more. Hence you don’t cheat.
Some writers who oppose Austrian economics use this answer tohelp launch another objection. “If you say that you must prefer notcheating, since you chose not to cheat,” they claim, “then all you aredoing is defining your highest preference as what you in factchoose. You aren’t saying anything new.”
We may put this objection a little more formally this way:

Chapter 3: Action and Preference, Part 2

39

If (1) highest preference = what you choosethen (2) you always choose your highest preference since (3) you
always choose what you choose
To prove (2), all you have to do is substitute “what you choose”
for “your highest preference” as (1) says you can. You then arrive at
the identity (3). But this is trivial: it tells us nothing.
This objection says that a key Austrian claim is trivial. And theobjection can be extended. Parallel arguments can be used to claimthat other key Austrian principles tell us nothing new. It is thus far
from trivial that we refute this objection.

1.

Construct a parallel argument with the one given abovethat claims the action axiom is trivial. (If you need help,
see the discussion of the action axiom in the preceding
chapter.)2.

Construct a parallel argument for the triviality of any otherof the principles we have so far discussed.

3.

Are there any results we have so far arrived at that are notvulnerable to this objection?

?

THE TAUTOLOGY OBJECTION ANSWERED
Essentially, any argument can be countered in two ways: we canfind something wrong with the argument, or claim that the argument’s conclusion does not matter. The philosopher Morris Cohensummed this up in a memorable way. In reply to a student, he said:“In the first place you’re wrong; and, in the second place, even if
you were right, so what?”

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An Introduction to Economic Reasoning

Both sorts of reply can be used against the tautology objection.
First, the objection just isn’t right. We did not define “your highest
preference” as “what you in fact choose.” Rather, we claimed something importantly true about what you choose—namely you will
select your highest ranking preference.
But if we didn’t define highest preference in this way, how do weknow the principle is true? Well, the answer is so simple it is hard
to explain in other terms: we just study the principle and see that it
must be true. Why would you choose something other than yourhighest preference?

?

1.

Many philosophers and economists dislike appeals to“self-evident” arguments. Why do you suppose they takethis attitude?

THE TAUTOLOGY OBJECTION CONSIDERED FURTHER
But suppose the objection is right. Then, our principle, “youalways act to get your most highly-valued goal” is trivial, a tautology. So what? Why is this a consideration against it? (Rememberthat a tautology is a statement, e.g., a definition, that is true just by
the meaning of the words in it.)
“What do you mean, so what? A tautology is just playing withwords! If our principle is trivial, is this not an extremely damaging
point against it?” This response confuses two senses of the term
“trivial.” In the first, the term designates what is unimportant. If
our principle, or other principles of Austrian economics, is trivial inthis way, that is indeed a damaging criticism. But, taken this way,
the objection fails. As we’ll see in the rest of the book, the principle
is not useless: it is crucial for the development of economics.

Chapter 3: Action and Preference, Part 2

41

In the other sense of “trivial,” the word is just a synonym for“tautology.” We have argued that the principle is not a tautology;
but suppose that it is one. Then, it would be “trivial” in this second
sense. But it does not follow that it is trivial in the first sense.
Some tautologies are important; others are not. Many philosophers think that mathematics consists of tautologies. It hardly follows, if they are right, that mathematics consists of trivialities. The
subject would be much easier if it did.

1.

Give examples of tautologies that are trivial in the first
sense.

2.

What determines whether a tautology is trivial in thissense?

?

MARGINAL UTILITY
Exactly how untrivial our principle is, we shall now see. Suppose
you have five different goals, which you rank in this order: (1)drinking a glass of orange juice; (2) eating the whole orange; (3)stomping an orange into the ground; (4) eating an orange peel; (5)collecting all the pips in an orange to add to your orange pip collection. (Remember you rank these goals ordinally; you are notmeasuring them using a common unit. Also, we assume that one
complete orange is required to satisfy each of these goals.)
Further, suppose you have only one orange. What will you dowith it? The answer will be apparent to anyone except a hermeneutician. You will use the orange for orange juice, since this is yourmost highly-valued use.
Now, what if you have two oranges? Just as obviously, you will
use the oranges for your first two most highly valued uses. The

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An Introduction to Economic Reasoning

more oranges you have, the lower you can go on your preference
scale.
Let’s look at the same phenomenon from another angle.
Suppose you have five oranges, which you intend to use for the fivegoals specified above. The oranges are equal in quality and serviceability. Now, disaster strikes. Johnny Orangeseed steals one of youroranges, leaving you with only four. What do you do, as far as theuse of the oranges is concerned?
The answer is once again apparent. Your pip collection will
have to do without the addition you hoped to contribute to it. Since
adding to the collection is your least valued use, you will give it up
first. Note that this is true regardless of which orange Johnny steals.
Suppose, e.g., that he takes the orange you had planned to squash
into the ground. You will then shift the orange from the pip collection to be stomped. Regardless of which orange is taken away, youwill give up your least valued use. The unit of the good (in this case,oranges) that is devoted to the use you value least is called the marginal unit. As we shall see in the next chapter, this concept plays acrucial role in the explanation of prices.

?

1.

Show that the explanation just given of what you would do
if you lost one orange follows from the principle that you
always select your highest valued preference.

2.

The analysis just given doesn’t work. It wrongly assumes
that you have a list of preferences in your head before you
choose. But in fact your preferences exist only at the
moment of choice. Is this objection right?

Chapter 3: Action and Preference, Part 2

43

THE INDIFFERENCE OBJECTION
You might object to our analysis in this way. We assumed thatyou could rank all five uses of an orange in order from first to fifth.
But what if you can’t? Suppose, for example, that you cannot makeup your mind between eating an orange and stomping it into theground. You are indifferent between these two alternatives. Then
what will you do with your second orange if you have two of them?
Your preference scale does not dictate a choice.
Let’s examine the situation more closely. You have one orange,out of which you have made orange juice. (This is your highest valued use.) You now acquire a second orange but cannot make up
your mind between your second and third choices.
Should you simply go on to choice four, or, overcome withindecision, toss away the new orange? Certainly not. You would
rather either eat the orange or stomp it than eat the orange peel(alternative four). As to tossing the orange away, then you would
not realize any of your preferences. This would be an especiallyfoolish thing to do.
The comments just given rest on a brilliant analysis of the problem of “Buridan’s ass,” given by Murray Rothbard. Buridan, a great
scholastic logician, imagined a perfectly rational donkey. The donkey never acts unless there is sufficient reason to do so. He has achoice of eating one of two bales of hay, identical in all relevant
properties. Buridan imagined that the donkey, unable to find a reason to choose between the two bales, would do nothing and thus
starve.
Rothbard pointed out that Buridan’s account of the situation
was incomplete. The alternatives facing the donkey are not just (1)eat bale of hay A, and (2) eat bale B. They include also (3) do noteat either bale and starve. Since, presumably, the donkey ranks (3)below either (1) or (2), he will not, as Buridan has it, choose (3). To

44

An Introduction to Economic Reasoning

do so would involve a violation of our fundamental principle: anactor always prefers a higher ranking goal to a lower ranking one.

?

1.

Look up the section on Buridan in Rothbard’s Economic
Thought Before Adam Smith (Cheltenham, U.K.: Edward
Elgar, 1995), and give a brief report on his work.

2.

How might a supporter of Buridan’s argument reply to
Rothbard?

MORE ON INDIFFERENCE
A chooser, then, faced with two alternatives that seem to him“about the same” must somehow make up his mind between them.
He will, e.g., flip a coin to determine whether to eat the orange orsquash it. And once he has chosen, his choice counts as a preference
as much as an act based on the most ardent conceivable desire. You
cannot demonstrate indifference in action: given two alternatives,
you must pick one or the other.
And of course it is action that we are concerned to analyze ineconomics. Indifference, then, plays no part in our discipline. But,
you will object, what if, as in our example, you do not have a marked
preference for either alternative? (Before continuing, see whether
you can answer this objection.)
The key to the problem, once more, brings in a point from theprevious chapter. Remember, the scale of preference is an ordinalscale: we rank alternatives only as first, second, third, . . . etc. We
do not take the alternatives as containing more or less of some common unit. More generally, all we are concerned with is the fact ofpreference: the strength of the preference does not for our purposes matter. Thus, a preference established by flipping a coin is still aChapter 3: Action and Preference, Part 2

45

preference. The psychological state in which you decide is irrelevant for us as economists.
Because we do not use the concept of indifference inAustrian economics, we get a bonus. Mainstream neoclassical economics relies heavily on indifference curves, Edgeworth boxes, andother complicated mathematical constructions that we do not haveto bother with. Austrian economics is in this way much easier tolearn than this rival system.

1.

You can too demonstrate indifference in action! Flipping acoin to decide between two alternatives is just a demonstration of indifference in action. Evaluate this objection.

?

EXTRA-CREDIT—MORE ON BURIDAN’S ASS
We have shown that Buridan’s ass is not rational: if he were, hewould choose not to starve (given that he prefers eating to starving).
But, Buridan might object, what is his hapless donkey to do? Hemust have a sufficient reason to choose this bale rather than thatone: and given that the two are by hypothesis identical in all relevant qualities, he cannot do so. Perhaps then there is no rational
alternative available and the paradox proves that in the situation
described, there cannot be a perfectly rational agent.
We suggest that the example does not show so drastic a consequence. Rather, what it brings into question is the assumption thata perfectly rational agent must have a sufficient reason for deciding
between two alternatives, under any description of these alternatives. The donkey does not have to be able to come up with a reason for choosing one bale over the other, in order to be rational. In
this case, in fact, he would be irrational to waste time in a futile

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An Introduction to Economic Reasoning

attempt to do so. (Don’t worry if you find this section difficult: it is
not essential and is included here just because the topic is interesting.)

DEMONSTRATED PREFERENCE ONCE MORE
Because demonstrated preference is so important in Austrian
economics, let’s return to it one more time. From the viewpoint of
someone watching someone else act, every action shows a preference. If I see you throw down this book in disgust, then I know thatdoing so is your most highly preferred alternative.
From the “outside” viewpoint of another actor, the concept of
indifference doesn’t arise. All that one sees are particular actions,never a state of indifference.

THE BASIS OF MARGINAL UTILITY
If we were to acquire more and more units of a good, we would
put them to less and less valuable uses. Another way of saying thisis that the usefulness, or utility, of the last unit of a good decreases,
the more units of a good we have at a given time. This principle isthe famous law of diminishing marginal utility. (The marginal unit,
to repeat, is the last unit.)
Unfortunately, some economists misunderstand the reasoningthat establishes the principle of diminishing marginal utility. They
think it rests on a psychological law, called the satiation of wants.
Imagine that you have a sudden craving for ice cream. You accordingly march off to your favorite ice cream store and proceed to gulp
down one ice cream after another. Eventually, you will find that thejoy of more ice cream wears off. If you keep eating ice cream, youwill sooner or later reach a point at which you don’t want any more.
(People who work in ice cream stores, who can have as much ice
cream as they want, often get thoroughly sick of it.)

Chapter 3: Action and Preference, Part 2

According to some economists, the lessening of wants explains
diminishing marginal utility. As you get more of a good, you will
derive less pleasure, or utility, from it. The nineteenth-century
economist Heinrich Gossen, whom Werner Sombart termed a“brilliant idiot,” was one of the first to develop this line of thought.
By now, you should be able to give the Austrian response. In
praxeology, we are trying to deduce what follows from the conceptof action. “Satiation of wants,” if true, is a psychological generalization about people. It does not follow from the concept of action thatyour desire for ice cream will, after a while, diminish and fade away.
Whether this “law” obtains is an empirical matter: to find out
about it, we would have to investigate the preferences of various
people through psychological analysis. If we did, we would find thatthe law of diminishing marginal utility often turns out to be false.
You might find that you get more of a “high” from the second or
third ice cream than from the first. (In my own case, diminishingsatisfaction would set in only at a very much larger number, if ever.)In any event, psychological considerations of this sort do not concern us in economics. Diminishing marginal utility follows from thepraxeological principle that people satisfy
their most highly-valued ends first. It is
not dependent on the results of any
empirical investigations.
1. Look up the treatment of Gossen in
Joseph Schumpeter’s History of
Economic Analysis (Oxford: Oxford
University Press, 1996), and give a
brief report about him.

Joseph Schumpeter
1883–1950

2. What would the “Chicago School”
economists say about the basis of
this law of diminishing marginalutility?

?

47

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An Introduction to Economic Reasoning

AN OBJECTION ANSWERED
We hope that you noticed that one comment made above aboutsatiation of wants raises a problem. We said that you might get
more enjoyment from a second ice cream than from your initial
indulgence. Doesn’t this contradict diminishing marginal utility,
which tells us that the utility of the last unit of a good always
decreases?
No, it does not. I’m afraid we must be repetitious once again.
What we have been considering are the uses to which an actor proposes, at a particular time, to put different units of a good. These
uses are ranked ordinally. (Aren’t you getting sick of my saying
this? You’d be surprised how many people don’t get it.)Psychological estimates of pleasure—how much of a “bang” you
get out of particular acts of consumption—don’t concern us at all.
Let’s apply this point to the ice cream example. Each time you
face the decision to eat another ice cream, you obviously have twoalternatives before you. (We assume that you don’t have other uses
for ice cream besides eating it.) At each time, you will act to satisfy your most highly valued preference. How “satiated” or full you
feel may well affect what choice you make: but satiation is notdirectly part of the analysis of marginal utility at all. In fact, sinceby hypothesis there is only one use for each unit of ice cream, theexample probably isn’t a very good one to illustrate marginal utility.
A better example would be one in which you had several different uses of the ice cream on your scale of preferences, in addition to eating the ice cream now: e.g., storing it, giving it to afriend, etc. With each additional unit, you will satisfy a less highly
ranked preference. Of course, there is a complication. Your preference scale might look something like this:Chapter 3: Action and Preference, Part 2

49• EAT TWO ICE CREAMS• EAT ONE ICE CREAM AND STORE ONE• EAT ONE ICE CREAM• STORE ONE ICE CREAM

The alternative uses of the good do not have to describe qualitatively different uses. All you need for a preference scale is a specification of uses of a good. In this scale, two units of ice cream aretreated, for the first two preferences, as a single use.

THE RELEVANT UNIT
What is crucial, then, is the uses to which you propose to put agood. These uses are subjective: they depend on your preferences.
If you didn’t have a preference scale like the one just given, butinstead just considered each new decision whether to eat a new ice
cream as a separate choice, then you would always be concernedwith one unit of ice cream. (In suggesting that the ice cream casewas not a good one to illustrate the diminishing marginal utility, wewere assuming that the actor considered only single units of ice
cream, with a single use. It is this fact that “lops off” the scale ofpreference.)
It is important not to fall into fallacy here. Because the uses ofa good depend on subjective preferences, and because these uses
determine what you will consider relevant amounts of the good, it
does not follow that the good itself is subjective.
You have certain uses for ice cream. But ice cream is a real physical good, “out there” in the world. You don’t create it by your actof preference. In like manner, two units of ice cream, are, for partof the scales of preference that I gave, the relevant alternative to
be chosen. But this preference scale does not determine what

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An Introduction to Economic Reasoning

constitutes a physical quantity of ice cream. That, once more, is amatter of fact.
Some supposed Austrians, the so-called “radical subjectivists,”
get this point wrong. They think that because preferences are subjective, the good itself—the object of the preference—is also subjective. This of course does not follow. A few goods are states ofmind—e.g., particular feelings that one aims to induce; but mosteconomic goods are “physical items”—“stuff,” if you will.
(Complications that arise with money and credit are here ignored.)?

1.

Examine Israel Kirzner’s account of property acquisition,
in his Opportunity, Perception, and Profit (Chicago:
University of Chicago Press, 1979), using the point madein the section above. Does the discovery of a new use fora good create the good?

EXTENSION OF MARGINAL UTILITY
The section just given was rather complicated. Let’s get back tosomething simple—oranges. In the example of different uses oforanges, we were concerned, of course, with a single good. All of
our examples have so far been of this sort.
But an actor usually does not have to decide on alternative usesof one good. He normally has a variety of goods at his disposal thatmust be assigned to varying uses. Given, say, that he has a choice
between acquiring an orange, an apple, and a set of brass knuckles,
what will he do?
The answer is straightforward. He will put the alternative usesof all the different goods on a single preference scale. Faced with aChapter 3: Action and Preference, Part 2

51

decision to acquire various units of different goods, he will in eachcase act to satisfy his highest ranking preference.
For each good, the law of diminishing marginal utility will
apply. As more units of a good are acquired at a given time, they will
be assigned to less valuable uses.

TWO KINDS OF EXCHANGE
The example we have been concerned with so far involves only
one person. We have spoken, e.g., of an individual’s scale of preferences. This part of economics is called Crusoe economics, after thecharacter Robinson Crusoe in Daniel Defoe’s novel. (Please do notcall this “Caruso economics.”)
Most economics, however, consists of studying actions thatinvolve relations among two or more people. Here a distinction is
crucial. One way you can deal with someone is by force or its threat.
You want my giant stuffed teddy bear, so you grab it from me. Or
you threaten to clobber me if I don’t hand it over to you. In a related way, you might use fraud to obtain what you want. You might tellme that you will give me a real bear if I hand over the teddy bear,
when you in fact have no intention of doing so.
As we’ll see later, some parts of economics deal with force andfraud (the chapter on the monetary system will make this clear). But
the main body of economics deals with voluntary, uncoerced action—action that does not involve force, the threat of force, or fraud.
1.

To see the complexity of coercion, have a look at Robert
Nozick’s article “Coercion.” This is available in his
Socratic Puzzles (Princeton, N.J.: Harvard University
Press, 1997).

?

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An Introduction to Economic Reasoning

MUTUAL BENEFIT FROM TRADE
If an action among two or more people is voluntary, a crucial
fact about it at once follows. Since an actor always chooses his mosthighly valued alternative, he will not voluntarily engage in an action
unless he would rather do so than refrain.
The preceding paragraph was too textbooky. Let’s try again.
Suppose I have an orange and you have an apple. I propose that we
exchange our possessions: I will give you my orange if you will giveme your apple.
If I propose doing this, I would rather exchange my orange foryour apple than keep my orange. If you accept, you would rather
exchange your apple for my orange than retain your apple.
For most purposes, we can assume that neither you nor I attach
special value to the act of exchange as such. What each of us wantsfrom our exchange are the goods he will get. If so, we can simplify
the preferences in our case. I would rather have an apple than anorange and you would rather have an orange than an apple. In any
voluntary exchange, the parties rank the goods exchanged in a different order on their preference scales. Suppose both our preference scales looked like this:
1 ORANGE
1 APPLE

Obviously, no exchange would take place. Suppose my preference scale looks like this:1 APPLE
1 ORANGE

Chapter 3: Action and Preference, Part 2Then, if you have the reverse preference, I have oranges, and you
have apples, a mutually beneficial trade can take place. No voluntary trade will take place unless all parties to the trade expect tobenefit. And to benefit from an exchange, the parties must ordertheir preferences differently. As we shall see in the next chapter,these facts play a crucial role in explaining prices.

53

Chapter 4
Demand and SupplyL

ong before now, you will have thought that this is a very strange
economics book. Everybody knows that economics can be
reduced to a pair of words: “demand” and “supply.” Yet we have so
far said nothing about them. Is this book a fraud?
In fact, we have not forgotten about demand and supply. (Youprobably guessed this if you read the chapter title.) These two concepts indeed are vital to economics, but you will be able to understand them much better now that you know something about utility.
Let’s return to our favorite example: suppose I offer you one
apple in exchange for one orange. We know that I would rather haveone orange than one apple: otherwise, it would be foolish for me tooffer an exchange. Similarly, you prefer one apple to one orange.
But we have so far left a key question without an answer. Why
does one apple exchange for one orange? Why not one apple fortwo oranges? Or three apples for two oranges? (Obviously, thequestion we wish to pose is: why do exchanges take place in the realworld at the ratio they do? The one apple–one orange exchange isjust an example we have made up.)1.

To reiterate, the problem is this: I have apples, and you
have oranges. I prefer one orange to one apple, and you
have the reverse preference. Each of us can benefit froman exchange. But what determines the ratio at which an
exchange will take place?

57

?

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An Introduction to Economic Reasoning

The answer to our question may disappoint you. In theexample, we lack enough information to tell at what ratio the goods
will exchange. True enough, both you and I will benefit if we
exchange one apple for one orange. But suppose you ask for two
apples in return for giving up an orange? As long as you value
apples, you will be better off with two apples than one. I, of course,
would rather surrender only one apple, so long as I value apples.
(Remember, I did not say that I don’t value apples, but rather that I
prefer one orange to one apple.)
Your demand for two apples poses a problem for me. Would I
rather have one orange than two apples? If I would, then I may
accept your offer: if not, I will reject it. But, I may think, why should
the terms of trade be shifted to your advantage in this way? Why
not exchange one apple for two oranges? Or three?
A crucial asymmetry arises. Consider any suggested exchange
ratio. If you would rather keep what you have than trade underthese terms, no exchange will take place. But, if you would rather
have the good you are offered, it does not follow that an exchange
will take place at that ratio.
Confused? Let’s try again. Someone proposes an exchange:
1 apple for 1 orange(You have oranges)

If you would rather have one orange than one apple, no trade willtake place. If you would rather have one apple than one orange, a
trade will take place. But, the trade may not be at that ratio.
1 apple for 1 orange

2 apples for 1 orange

1 apple for 2 oranges

2 apples for 10 oranges

Chapter 4: Demand and Supply

All of these ratios are consistent with your preferring one apple toone orange. We can’t tell just from this preference how many apples
it will take to get one orange.
1.

In the last sentence, why don’t we need to add “or how
many oranges it will take to get one apple” in order to becomplete?

2.

Give examples from your own experience in which you
have traded one thing for another. If you traded one egg
for one box of BB-gun pellets, would you expect
exchanges of these items by your classmates to take placeon the same terms?

So far, economic theory hasn’t told us much. We know that an
exchange will take place if, and only if, both parties to it expect tobenefit. Is that all? Fortunately, we can often go further. Let’s getback to apples and oranges. It might turn out that you have a moredetailed preference scale:
2 apples
1 apple2 oranges
1 orange
Let’s also suppose that you have four oranges and zero apples.
Let’s further assume that whenever you have a choice between
acquiring one apple or one orange, you prefer the apple. I have fourapples and zero oranges. I now offer to exchange apples for oranges
with you at the rate of one apple for one orange. Obviously, you will
be better off trading all your oranges for apples at this price. (Byprice, we mean the amount of a good you must give up to obtain

?

59

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An Introduction to Economic Reasoning

one unit of another good that you want. It is vital to realize thatprice does not just mean what you as a buyer have to give up to getwhat you want. The goods that the seller receives are his price.
Each party to an exchange is both “buyer” and “seller.”) Can we
now say that you and I will trade apples for oranges on a one-forone basis?
If you answered that this follows, you have not been paying
attention.

?

1.

See whether you can anticipate why we can’t draw thisconclusion about the ratio of exchange.

2.

If you are given the apple price of oranges, show how you
can at once obtain the orange price of apples.

As you have no doubt anticipated, the case just given follows thesame pattern as our earlier discussion. We know that, at a ratio of
one apple for one orange, you will be better off (given your preference scale) to trade all your oranges for apples.
It’s crucial to note the parentheses “(given your preference
scale).” Remember, when you exchange, you are concerned with themarginal unit: would you rather have one apple or one orange? (Weassume you are exchanging only single oranges and single apples.)As you add more apples, the value of each added apple tends tofall. (Remember the law of diminishing marginal utility.) In likemanner, as you surrender oranges, you will have to give up more
and more valuable uses for your oranges. The value of the marginal unit will tend to go up, as your stock of oranges goes down.
Thus, the law of diminishing marginal utility plays a key role infixing the limits of exchange. I have assumed that you always value

Chapter 4: Demand and Supply

one apple over one orange just to simplify the example. But, toreturn to our example, why should you accept the offered terms of
exchange? Why not demand two apples for each orange?
Remember, you value oranges: other things being equal, you will
prefer to retain as many oranges as you can.

1.

“Sure, you can try for a better price. But then nothing
stops the apple seller from trying to get a price morefavorable to him. Given your preference scale, bargaining
will tend toward a one-for-one price.” What’s wrong withthis response?

Well, so what? We have made a fuss about describing your preferences in more detail, but we seem to have made no progress. We
still don’t know what the price is. Will it help if my preference scaleis filled in? Not in this example:
2 oranges
1 orange
2 apples
1 appleHere my preferences are exactly the reverse of yours. I will bebetter off if I trade all my apples for your oranges; and you will bebetter off if you trade your oranges for my apples; but we do notknow at what price the exchange will take place.
In this example, the ratio of exchange is indeterminate: any pricethat results in your getting all the apples and my getting all theoranges will make us both better off.

?

61

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An Introduction to Economic Reasoning?

1.

Economic theory can’t tell us what the price will be, incases like this. How do you suppose the price is actually
determined?

2.

What is meant by calling someone a good bargainer? Incases of indeterminate pricing, how can you obtain theratio of exchange that is to your best advantage?

Again, you may ask: What’s the point? We still have not comeup with a way to determine price. But bringing in your preference
scale has told us something. We know how many apples you will
exchange for oranges, at a given price.
And sometimes, we can go further. Suppose the preference
scales are as follows (As before, you start with four oranges and I
with four apples):YOU

2 APPLES
1 APPLE
2 ORANGES
1 ORANGE

2 ORANGES
2 APPLES
1 ORANGE
1 APPLEME

Just as before, I will be better off trading all my apples for youroranges at a ratio of one apple for one orange, and so will you.
(Remember, we are using as assumption here: you always prefer one
apple to one orange and I always prefer one orange for one apple.)
But suppose you are not content. You demand two apples for eachorange. Since I would rather have two apples than one orange, I will
refuse to sell you any apples at this price. We can thus get a limit to
the ratio of exchange. The apple price of oranges will be below two.
Our scales allow some room for bargaining, but less than in the previous example.

Chapter 4: Demand and Supply

1.

In the example, can we derive a limit to the orange priceof apples? That is, if I demand two oranges for each apple,
will I “price myself out of the market”? How about threeoranges for each apple?

Now matters become more interesting. (I realize this is not astrong claim.) Suppose that, while you and I have immersed ourselves in apples and oranges, other pairs of your classmates havebeen doing so as well. (Haven’t they got anything better to do?
They should be studying economics!) Each ratio of exchange ofapples and oranges will depend on the preference scales of the twoparties involved in it. Remember that the exchange-ratio may not
be fully determined by these preference scales.
If we confine ourselves to separate two-person exchanges, theprices are likely to differ. Suppose I despise apples and would, if
necessary, give them away. Your classmate Billy Carter, who also
starts with four apples, just barely is willing to surrender an apple inorder to get an orange. It is likely that I will be willing to give you
more apples to get an orange than Billy will give to his trading partner, Colonel Kadaffi, for the same purpose.
Now for the good part. What happens once all these prices
become known? I have been willing to give up four apples to get
one orange; but I find that your friendly classmate, the Colonel,
asks only one apple in return for one orange. I will shift my business to him. For similar reasons, though, he will shift from tradingwith Billy to trading with me (no doubt driving Billy to drink). Each
person will shift trading partners until he can no longer secure abetter price by doing so. In each market (an area in which buyers
and sellers have ready access to each other and the various rates of
exchange are known to all) a process of competition between people anxious to secure trade will tend to bring about a single price for

?

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An Introduction to Economic Reasoning

each good. This is termed the law of one
price and is a basic principle of economics.
In real world markets, somethingelse usually speeds this process of adjustment along. Some people are good atspotting differences in exchange ratios.
By taking advantage of these discrepancies, they can secure gains for themselves. Suppose that someone, call him
Arthur Arbitrageur, sees the difference
in exchange ratios in the example justgiven.
Arthur, we assume, starts with apples and has no interest in
exchanging any of them for oranges. (Oranges just don’t do it forhim.) He sees, though, that if he can somehow get his hands onoranges at the Colonel’s price, he is in luck. Once he does so, he canthen come to me and exchange his oranges for apples. Suppose hestarts with one apple. He exchanges it with the Colonel for one
orange. He then buttonholes me and gets four apples for the orange
he did not want for its own sake. He in effect has the use of amachine for transforming one apple into four.
Alas for him he cannot use the machine indefinitely. Other people will get into the act; and, in a way that we will examine in moredetail below, a price will be established at which these gains cannot
be obtained. These gains are called arbitrage profits, and persons
who engage in them are called arbitrageurs.

?

1.

Suppose I anticipate Arthur’s scheme. I lower the number
of apples I am prepared to offer for one orange. How will
the law of one price be affected?

2.

Suppose a market has no arbitrageurs. Will the law of one
price still operate?

Chapter 4: Demand and Supply

We have sketched, in a general way, how a price is determined,
given a number of exchangers, each of whom has a preference scale
for various quantities of two goods. Let’s look at the process inmore detail. Before doing so, I must issue a warning: here thosedread monsters, demand and supply curves, enter the scene. (Since
I am ungeometrical to an acute degree, they will not long detain us.)
Before doing so, though, we need to recall two principles: (1)you prefer more of a good to less; and (2) as you acquire more unitsof a good, you will put them to less valuable uses. (The second principle is the law of marginal utility.)
Now to the main business: given your preference scale, we canlist how much of a good you will want at a given price. Here is an
example:At a price of five apples per orange, you want zero oranges
At a price of four apples per orange, you want one orange
At a price of three apples per orange, you want two oranges
At a price of two apples per orange, you want three oranges
At a price of one apple per orange, you want four oranges
1.

Construct a preference scale that is consistent with this
list.

2.

For any good you would like to acquire (e.g., a BB gun, aposter of Michael Jordan) construct a schedule of prices
like the one above.

Since this list tells how many oranges you want at each (apple)
price, it is called the demand schedule for oranges. The example wasjust made-up; but we were not free to use just any numbers. All demandschedules must display certain general properties.

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65

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An Introduction to Economic Reasoning

Why? Obviously, because the demand schedule is derived froma preference scale; and the preference scale must obey certain laws.
(What are they?) If the preference scale must have certain characteristics, this causes the demand schedule to have certain othercharacteristics.
Put in another way; if a given demand schedule is possible, thenthere must be a possible preference schedule from which it can bederived. Some demand schedules do not meet this requirement.
Therefore, they are not possible.

?

1.

Sketch the argument type followed by the reasoning of thelast paragraph. Is this form of argument valid? (Look at
Chapter One for an explanation of what “valid” means.)

Let’s look at an example. Suppose this is your demand schedule:
At a price of five apples per orange, you want five oranges
At a price of four apples per orange, you want four oranges
At a price of three apples per orange, you want three oranges
Is this demand schedule possible? Well, what preference schedulewould underlie it?
It would be one in which the more apples you had to give up to
get an orange, the more oranges you would want. That is, on yourscale, as you surrender more apples in trade, the value of apples toyou falls. If you have to give up five apples to obtain one orange,
then you will give up twenty-five apples to obtain five oranges,
since on your preference scale, at this price:Chapter 4: Demand and Supply

5 oranges
25 apples1.

Explain why this ranking must be part of your preference
scale, in the indicated circumstances.

But if you need give up only three apples to obtain one orange,
you will want only three oranges. On your scale, at this price:
6 apples5 oranges
This ranking holds because at the indicated price you will notmake the trade. You prefer three oranges to fifteen apples, at a threeapples per one orange price, but no more.
Thus, as you give up more apples, the value of apples falls. But
this contradicts the law of diminishing marginal utility. As you gain
more units of a good, the value of the last unit decreases, since you
will put it to a less valuable use. Thus, as you lose units of a good,the value of the units you have left rises. Then, contrary to ourhypothesis, as the price of oranges rises, you should be willing togive up fewer apples, not more.
And there is an easier way to demonstrate that this demandschedule contradicts the law of diminishing marginal utility. As you
get more oranges, they will be demoted to less valuable uses. Then,as you obtain more oranges, you should be willing to give up less forthem. But, on the rogue demand schedule, you want more oranges

?

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An Introduction to Economic Reasoning

the higher the price. That is, you are willing to give up more for an
orange when you get more oranges. And this cannot be true.

There is a much easier way to demonstrate that theassumed demand schedule is impossible. We first havethe preference:
5 oranges
25 apples?

But we also have the preference
16 apples
5 oranges
We thus obtain:
16 apples
25 apples
But this is impossible, so long as oranges are a good at all.
You always prefer more of a good to less. What is wrong
with this argument? (Hint: How do you derive the last preference?)

EXTRA-CREDIT SECTION
Even if the argument just given did show an inconsistency in thepreference scale, this would not suffice to show a logical contradiction. A preference is not an assertion; and it is not contradictory to
hold inconsistent preferences. (It’s usually not a good idea to do so,though.) If you prefer 5 oranges to 25 apples, but 16 apples to 5oranges, at the same price, you commit no logical fallacy.

Chapter 4: Demand and Supply

1.

Look up the discussion of intransitive preferences in
Human Action.

69?

LAW OF DEMAND
We have gone to a lot of trouble, but the result of our inquiry
can be summed up very simply. At a lower price, the quantity
demanded will be greater. This is the law of demand.
Now for that bitter pill, geometry. On a diagram with price andquantity demanded of a good as the coordinates, we can show whatquantity will be demanded at a given price, and vice-versa.

5

XApples per Orange

4

X

3

X

2

X

1

X
1

2

3

4

Quantity: Oranges

Figure 1. Price and Quantity

5

An Introduction to Economic Reasoning

Here is an example:
In this diagram, at a price of five apples, one orange will be
demanded; at a price of four apples, two oranges, etc. If we connect
the points, we obtain the famous demand curve:

5

X

4Apples per Orange

70

X

3

X

2

X

1

X
1

2

3

4

5

Quantity: Oranges

Figure 2. Demand Curve

You will see diagrams like this in practically all books about economic theory. But one note of caution is necessary. The points havebeen connected just because it is often convenient for purposes ofillustration to do this. People make price–quantity decisions only inresponse to discrete units of a good; thus many points on the curve
do not represent actual preferences of the demander. The question,e.g., how many apples will someone give up for one orange plus anundetectably small part of another orange may have no answer.

Chapter 4: Demand and Supply

We have looked at things from the standpoint of the owner ofapples who demands oranges. But what about the person who owns
oranges and responds to this demand? He supplies oranges to thedemanders.
Just as we did for the demander, so we can draw up a supply
schedule, e.g.;
At a price of five apples per orange, I will supply five oranges
At a price of four apples per orange, I will supply four oranges
At a price of three apples per orange, I will supply three oranges
The higher the price, the more oranges I will make available: this is
an instance of the law of supply.

1.

Why is the Law of Supply true?

?

I hope you found the easy way to answer this question. You
could go through the same complicated rigmarole I did earlier,bringing in the Law of Marginal Utility. But you don’t have to.
Once we know the law of demand is true, it follows that the law ofsupply is true also. My supply schedule for oranges fixes my demandschedule for apples, and vice-versa. If I will supply five oranges at a
price of five apples per orange, then I will demand five apples at a
price of 1 to 5 orange per apple. These are just two ways of stating
the identical exchange ratio.

1.

Work out the supply schedule for all the values of thedemand schedule given in the example.

2.

Give an example of an impossible supply schedule.

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An Introduction to Economic Reasoning

A supply curve can be drawn:

5
Apples per Orange

72

X

4

X

3

X

2
1

X
X
1

2

3

4

5

Quantity: Oranges

Figure 3: Supply Curve

The higher the price, the greater the quantity supplied. (Thesame warnings about the artificial nature of the curve that we mentioned earlier also apply here.)
Demand and supply curves do not have to curve just like theones we have drawn here. Sometimes demand does not changemuch as price goes down:Chapter 4: Demand and Supply

This is termed an inelastic demand curve.

5Apples per Orange

X
4

X
3

X

2

X

1

X
1

2

3

4

5

Quantity: Oranges

Figure 4. Inelastic Demand Curve

Similarly, supply can be fairly non-responsive to price changes.
And the opposite circumstance may also obtain. The quantity
demanded (and supplied) may be very responsive to price changes.
Here, a slight decline in price sharply increases quantity
demanded; and a slight decline in price radically decreases quantity
supplied. These are called elastic curves.

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An Introduction to Economic Reasoning

Apples per Orange

5

X
X

4

X

3

X

2

X

1

1

2

3

4

5

Quantity: Oranges
Figure 5. Elastic Demand Curve

5

Apples per Orange

74

X

4

X

3

X
X

2
1

X
1

2

3

4

Quantity: Oranges
Figure 6. Elastic Supply Curve

5

Chapter 4: Demand and Supply

1.

Give examples of goods for which the demand curve islikely to be inelastic (i.e., you won’t want much more if theprice goes down) and elastic (i.e., you will want a lot more
if the price goes down).

2.

Give examples of goods with elastic and inelastic supply
curves.

3.

Extra-credit: Can a demand curve be perfectly elastic?

We won’t be going into much detail about the curvature of thedemand and supply curves. But if you forget all else, you need tokeep in mind two fundamental rules: the demand curve cannot
slope downwards to the left, and the supply curve cannot slope
downward to the right.
This can only be a demand curve, and

5

X

Price

4

X

3

X

2

X

1

X
1

2

3

4

Quantity
Figure 7. Demand Curve

5

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75

An Introduction to Economic Reasoning

and this can only be a supply curve.
5

X

Price

4

X

3

X

2

X

1

1

2

3

4

5

Quantity
Figure 8. Supply Demand Curve
Now we can complicate matters in an interesting way. Suppose
we put the demand and supply curve for oranges, as priced in apples,on a single diagram. Then, we might get something like this:

X

X

5

S
X

4

Price

76

X
X

X

3

P

2

X

X

1

X

X
1

D
2

3

4

Quantity
Figure 9. Demand and Supply Curve

5

Chapter 4: Demand and Supply

Here the demand and supply curves intersect at point P.
So what? Here quantity demanded equals quantity supplied. At
higher prices, more will be supplied than is demanded. Since thesupplier would like to sell his excess stock, he will have an incentive
to lower his price.
Similarly, at a price lower than the point of intersection, more
will be demanded than will be supplied. Demanders would like to
get more of the good than they are able to and will tend to bid up
the price.
Only at the point of intersection will there be no tendency to bid
the price up or down. This point is called the equilibrium, or market clearing, price.

1.

In what circumstances will suppliers like to sell theirexcess stock, given that to do so they must lower theirasking price? They will sell more units at the lower price;
but they will gain less per unit. When will this be to theiradvantage?

So far, we have given demand and supply curves for individuals —my demand curve for apples, your demand curve for oranges, etc. But
we can now apply a result that we reached earlier in this chapter.
Remember our old friend Arthur Arbitrageur? (Actually, he is no
more than a passing acquaintance of mine.) We showed that on a market, a single price tends to be established: this is the law of one price.
Do not be confused by the phrase “law of one price.” The “law”
does not act as some mysterious entity that establishes a single
price. Rather, the law is a consequence of competition. Because the

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An Introduction to Economic Reasoning

demanders compete by bidding for the same good, we can add theirdemands competition produces the law of one price.
One fact that usually speeds up getting to one price is expectations. Buyers want to avoid excess demand, and sellers have a parallel aversion to excess supply. They both will have an incentive tooffer what they expect to be the market-clearing price. No law
guarantees their expectations will be accurate; but, on a free market, experienced traders tend to be good at their jobs.
Because of this law, we can construct demand and supply curves
that differ from those we have learned about. For each demander
and supplier in the market, we have a demand and supply schedule.
These schedules tell us how much a person will demand or supply
at a given price.
We can add together the demand and supply schedules toobtain total demand and supply schedules for the market. Fromthese, we can derive demand and supply curves, just as we did forindividuals’ demand and supply curves. Why can we do this? Since
we know that all the exchangers will end up at the same price, we
can treat the buyers and sellers as if they were all part of a single
giant purchase and sale.
These demand and supply curves differ in a crucial respect fromthe demand and supply curves we have previously studied.
Individuals’ demand and supply schedules, the bases for drawing the
curves, are determined by scales of preference. But there is no preference scale that corresponds to the sums of the demand and supply
curves. The price is in fact close to the preferences of the marginal
buyer and seller; but they are particular individuals. A preference
scale corresponds only to the demand and supply of persons.

?

1.

Construct some sample demand and supply schedules.
Add these up and construct new supply and demand
curves to fit the amalgamated schedules.

Chapter 4: Demand and Supply

2.

Extra-credit: See whether you can set out explicitly thesteps in the justification for adding together the demandand supply schedules. Note that for the argument to go
through, you must assume that people’s preferences do
not change during arbitrage transactions.

Now that we have explained demand and supply, you may be
tempted to close this book. After all, economics is “supply anddemand”—isn’t it?—so what more is left? Do not give in to temptation; you need to grasp a crucial fallacy. This fallacy is easy to fall
into; but, fortunately, you can readily avoid it.
The demand curve slopes downward to the right: if at a lower
price, demand is greater. Perfectly true: but here lies danger. Whatis greater is the quantity of the good demanded. But an increase indemand may also designate a shift of the entire demand curve. A
diagram will show this:

S1

5

Price

4

S2

P1

3

P2

2
1

D
1

2

3

4

Quantity
Figure 10. Supply Curve Shift

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An Introduction to Economic Reasoning

In the first diagram, the price has been lowered from p1 to p2.
At p2, the quantity demanded is greater than at p1. But the demand
curve, as a whole, has stayed constant; it is the supply curve that has
shifted. In the second diagram, by contrast, the entire demand
curve has shifted to the right, and the supply curve is unchanged.
Note that this increase in demand results in a higher price, not alower one. To avoid ambiguity, an increase in demand should be
used only to designate a movement of the whole curve; the otherchange is one in quantity demanded.

S

5
4

(2)

Price

80

P2

3

P1

2
1

1

2

3

D

D1

4

5

Quantity

Figure 11. Demand Curve Shift

To sum up in an easy-to-remember catchphrase: Don’t confuse
movement along the demand (or supply) curve with a shift of theentire curve.

Chapter 4: Demand and Supply

1.

Diagram the distinctions between (1) a fall in quantity
demanded and a lowering of the entire demand curve; (2)a rise or fall in quantity supplied and the appropriate shift
in the supply curve. (You knew this was coming, didn’t
you?)

81

?
SUMMARY

This chapter, I fear, has been rather long and tedious. If you
remember only one thing in it, let it be this: Value is subjective.
Individuals’ assessments of goods determine prices.
In the next chapter, we shall see what happens to economics if
this point is ignored.

Chapter 5
The Labor Theory of ValueThe discussion of the previous chapter generates a major problem. In the first part of the chapter, bargaining on price as subject to few constraints was presented. If you would rather have anapple of mine than an orange of yours, and my preference is thereverse, then an exchange will benefit us both. But, we found, little
could be said about the ratio of exchange. It might be one apple forone orange, two apples for one orange, three oranges for one apple,
etc. Almost all was left in darkness.
But, later in the chapter, things seemed different. Here, determining the price appeared easy: you simply draw the demand curve,
draw the supply curve, and see where they intersect. What could beeasier?
Do we have a contradiction? Let’s have a closer look:
1. Apart from the results of bargaining by those actuallyengaged in an exchange, we cannot determine the ratio at which theitems exchange.
2. Given the demand and supply curves of the exchangers, we
can easily determine the exchange ratio: it is the point at which thecurves intersect.

1.

How about it? Is there a contradiction? Reread the discussion of the law of noncontradiction in Chapter One.

85

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An Introduction to Economic Reasoning

WHY THERE IS NO CONTRADICTION
Fortunately for me, the two statements do not contradict eachother. The first statement is categorical: it says that the ratio of
exchange cannot be determined apart from the bargaining of theexchangers. The second statement, by contrast, is hypothetical: itsays that if the demand and supply curves are given, then the pricecan be determined.
This enables us to escape contradiction. So long as the if-clauseof the hypothetical is not realized, both statements can be true consistently.
Let’s go over this again. (If you don’t need to, feel free to omit
this paragraph.) The hypothetical says what will happen if thedemand and supply curves are given. It does not say that the curves
are given. So long as the curves are not given, the statement makes
no claim about how easy it is to determine the ratio of exchange.
Thus it does not contradict the claim that the ratio is undetermined.

?

1.

“But if the if-clause is never realized, the proposition isalways false. Therefore, you have escaped contradiction
only by withdrawing one of the statements you first
made.” What is wrong with this argument?

2.

What would you have to add to the two statements to generate a contradiction?

3.

Give other examples of two statements that (1) appear to
be contradictory; (2) but in fact are not, because one ofthem is a hypothetical whose “if” clause is not realized.

Chapter 5: The Labor Theory of Value

87

DEMAND AND SUPPLY CURVES REVISITED
The solution to our paradox of course raises a new question.
Why aren’t demand and supply curves given in the real world? To
answer this is easy, once we remember how demand and supply
curves are constructed. As you will recall, to get a demand or supply curve, you must first have a demand or supply schedule.
Therefore, if the demand or supply schedule is not fixed, neither isthe demand or supply curve.
But we now face a new question. Why aren’t the demand andsupply schedules given in advance of bargaining? To answer this, wemust return once more to praxeology. Remember what our aim is
as students of economics. We are attempting to derive propositions
from the axiom of action that illuminate our subject.
It does not follow from the action axiom that the demand andsupply schedules must be fixed in advance. Perhaps you do know,
before you start exchanging apples and oranges, how much of eachgood you will want at each price; but nothing requires this.
Can you see how this last remark requires a modification ofwhat has gone before? It is not entirely right to say either that theratio of exchange is indeterminate or that it is never the case thatthe demand and supply schedules cannot be fixed in advance.
Rather, what we should say is that nothing requires these schedules
to be fixed, from the standpoint of praxeology. We can then maintain, once more from the standpoint of praxeology, both of thestatements we have insisted on: (1) the ratio of exchange is indeterminate (according to praxeology); and (2) if the supply and demand
curves are given, the price is determined.
Another point reinforces our conclusion. Suppose you own
peanuts, which you want to trade for my pictures of wrestling stars.
(I’m tired of apples and oranges, aren’t you?) You may (or may not)have in mind a schedule of how many peanuts you will offer for88

An Introduction to Economic Reasoning

pictures of various wrestling stars. Either is consistent with theaction axiom. Similarly, I may or may not have a schedule of proposed trades in my mind. But you cannot determine, by praxeology, whether I have such a schedule. If you have one, it does not follow that I do; and if you do not, I may have one all the same.
In Austrian economics, the preferences that we are concernedwith are those demonstrated in action. If I offer one picture of Hulk
Hogan for ten peanuts, then I prefer ten peanuts to one picture of
the Hulkster; my offer shows this. The relative rankings of othercombinations are, from the point of view of praxeology, irrelevant.
What counts are the preferences actually expressed on the market:
the others, “like the flowers that bloom in the spring, tra-la/Havenothing to do with the case.”
Of course, you know whether you have a fixed preference scale,just as I know whether I have one. But neither scale is given, just byreasoning from the action axiom. From that point of view, one canjust as well as assume that neither you nor I has a fixed scale of preferences.
Thus, all our talk of demand and supply curves is hypothetical.
All that we are really given, strictly speaking, is the point at which
the curves intersect: that is to say, the actual price in the purchasesale transaction. (A famous British economist, Sir Dennis
Robertson, emphasized this.)If the curves are hypothetical, why use them? You should know
the answer by now. Hypothetical reasoning is often extremely useful in science; in economics it is indispensable.
We so far have stressed that the curves are not really “outthere”: fixed preference scales, we have learned, need not exist. But
we must not push the point too far. Some economists think that
preferences do not exist except at the moment of action. (James
Buchanan, a Nobel laureate in economics, holds this view.) We are
not committed to it.

Chapter 5: The Labor Theory of Value89

EXTRA-CREDIT SECTION
There is a misunderstanding that is easy to fall into here. In fact,
I fell into it myself. Fortunately, an eminent Austrian economist
called this to my attention. Go back to the apparent contradiction on
the first page of this chapter. Note that it concerns whether we candetermine the rate of exchange to two commodities.
If, as was argued above, an outside observer cannot determine
this rate, it does not follow that the rate is indeterminate. Instead,
it may be the case that the rate is fixed; but outside observers cannot know this.
The eminent economist who pointed this out to me contends
that at the moment a trade takes place, the preference scales of all
individuals involved are fixed. In his view, an individual may himself
be unaware of his latent preference scale.
I’m not sure whether this is right: but the argument in the text
does not exclude this position. Even if preference scales latently
exist, we can only observe the results of bargaining. These scales areinaccessible.
Can you see why not? Once more, praxeology does not require
the denial of this position. The claim that preferences are not “in themind” but are to be found only in behavior is a philosophical doctrine. Whether it is true is not our function as economists to determine. Once more, we want to know what follows from the action
axiom. Controversial philosophical theories should be avoided.
1.

Are market demand and supply curves also hypothetical?
What argument shows this?

2.

“It doesn’t follow that action is always demonstrated in
preference. Sometimes you do things, even though you
really don’t want to.” How would an Austrian respond to
this contention?

?

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An Introduction to Economic Reasoning

Adam Smith
1723–1790

Karl Marx
1818–1883

ANOTHER ECONOMICS?
The approach to price and value that we have so far discussed, thesubjective theory of value, has been developed since the 1870s. (Itwas advanced in the Middle Ages and Renaissance, but fell into
eclipse during the nineteenth century.) Some economists look at
value in a different way: these are members of the so-called classical school, which includes Adam Smith and David Ricardo.
In order to understand Austrian economics better, you will findit a big help to look at the classical doctrine. After we have done so,
we shall then examine the radically different way Austrians look at
the key element in the classical theory—cost of production.
We shall look at the classical theory in the form given it by its
most controversial exponent—Karl Marx, the founder of “scientific socialism.” He argued very systematically for his theory. We shallbe able to use what we know already to help us see what is wrong
with Marx’s theory. And our examination brings with it anotherbenefit. For much of the twentieth century, communist governments dominated a great part of the world. These regimes based
themselves explicitly on Marx’s theories. Wrong theories have an
immense power to do damage.

Chapter 5: The Labor Theory of Value

1.

2.

Do a brief report on the life of Karl Marx. From what you
can discover about his life, does he strike you as someone
sincerely concerned with the welfare of humanity? You willfind it useful to look at Paul Johnson’s book, Intellectuals(New York: Harper Collins, 1990).
Identify the following and what they did: Friedrich Engels,
Karl Kautsky, V.I. Lenin.

91?

THE MARXIST ABCs
As we have learned, to say that exchange ratios, or prices, aredetermined by supply and demand leaves us with much up in the
air. The supply and demand curves depend on individual preferences: they are fixed only to the extent the latter are.
Marx maintained that to be satisfied with this is the sign ofsuperficial, “vulgar,” economics. The task of theory is to discover
the laws that underlie economic behavior.
He did not reject the subjective theory entirely. On one point,
the theory was right. In order to have economic value, a good has
to have utility. We wouldn’t exchange apples and oranges (sorry—
they are back again) unless we valued at least one of these goods. If
kumquats have no use to me, I will not trade for them. So much
Marx admitted; he was not, for once, bereft of common sense.
This fact enables us to see the fallacy in a common argument
against Marx’s theory. As we’ll soon see, Marx explained the economic value of a good by the labor-hours needed to produce it. But
what if someone spent an enormous amount of time making mudpies? No matter how much time he spent laboring on the mudpies,
they are worthless: no one wants mudpies.

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An Introduction to Economic Reasoning

This objection leaves Marx unmoved. In order to be valuable, agood must have utility, or as Marx and the classics called it, usevalue. Since mudpies have no utility, they are without economic
value. This holds both for the Austrian and Marxist theories of value.

?

1.

“If Marx admitted that only things with utility had economic value, then he is really a subjective value theorist
too.” What is wrong with this objection?

WHY MARX IS NOT A SUBJECTIVISTThe answer to our inquiry is straightforward. Marx thought thatin order to have economic value, a good must have utility. So far, heand the subjective school are at one. But now, Marx parts company
from Austrian economics. Once a good passes the utility test, subjective value exits the scene. It has nothing more to do with determining the value of the good.
Why did Marx take this step? Oddly, he did so because he fully
realized a basic truth we have already learned about subjective
value. Subjective values are ordinal: I can say that I prefer one
orange to one apple, but I can’t say how much I prefer it. I cannot
say one orange has so-and-so many more units of utility than one
apple. Further, it is impossible to compare my preference fororanges with your preference: we can’t make interpersonal utility
comparisons.
Do you see why not? Each preference scale gives only the ordinal rankings of one individual:Chapter 5: The Labor Theory of Value

ME

YOU

2 oranges

2 apples1 orange

1 apple2 apples2 oranges

1 apple1 orange

The question, how does my ranking of two oranges comparewith your ranking of one apple? makes no sense. As we have defined
preference, this question breaks the rules.
But just here is where the problem lies, according to Marx.
Because use value is subjective, it cannot be the basis of a science ofvalue. The purpose of science is to come up with objectively true
laws: subjective value cannot fill the requirement. Thus, out with it!

1.

What basic error did Marx make about science in this lineof reasoning?

2.

Behaviorism, a movement in psychology, is analogous toMarx’s rejection of subjectivism. Write a brief report on
this movement.

3.

“Since Marx admits that only goods with use value haveeconomic value, he has not banished subjectivism fromhis own theory. Thus, his theory fails by its own stan dards.” How would Marx reply to this objection?

?

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An Introduction to Economic Reasoning

MARX’S SOLUTION TO HIS PROBLEM
How, then, can one arrive at a science of economic value?
According to Marx, economic goods have another property besides
use-value: exchange-value. If I own one apple, the apple not only
meets certain wants of mine directly. It can be used to obtain othergoods. Perhaps I can obtain one orange with it. (If I can’t, many ofthis book’s examples will be ruined.)
Exchange value, according to Marx, gives us the basis for a true
science of value. Suppose one apple exchanges for one orange.
Then, one apple = one orange. Here, to Marx, is the indispensable
first step of science.

?

1.

Using what you have already learned, identify the fundamental fallacy in Marx’s reasoning.

MARX’S BASIC MISTAKEAs I hope you have already spotted, the initial step of Marx’s
argument is mistaken. An exchange is not an equality, but a double
inequality. If I trade one of my apples for one of your oranges, thenI value one orange more than one apple, and you value one apple
more than one orange. Otherwise, no exchange would take place.
Marx might counter our objection in this way. Granted that
there is a double inequality, this applies only to use value. But use
value does not explain economic value. That task falls to exchange
value, and here there must be an equality.

Chapter 5: The Labor Theory of Value

95

This reply exposes another basic mistake that Marx made. He
assumes, wrongly, that exchange value exists entirely apart from use
value. In fact it does not. Why does an apple have an exchange
value? Because with it, I can secure an orange. And the extent ofthat value depends on how much I want oranges, and how muchyou want apples. Exchange value comes from use value or utility: it
is not some sort of mystical entity that exists in its own right.

1.

How might Marx reply to this objection? How in turn would
an Austrian respond?

2.

What basic principles of praxeology does Marx’s theory
violate?

?

MARX’S ERRORS ABOUT SCIENCEMarx would probably respond to our point in this way: We are
begging the question in favor of the subjective theory of value. But
in fact we have not done so. We explained how exchange-value arises from subjective-value. What justification does Marx have for
conjuring up “exchange-value” as an independent entity? This has
not been derived from the axiom of action.
But is this a good objection against Marx? He, after all, makes
no claim to be a praxeologist. Why should he be bound by that discipline’s requirements? This line of defense, I am afraid, gives Marx
no hope. Whatever his views about praxeology, he confronts a basic
problem: he must justify his claim that exchange value exists apartfrom use value. And this he has not done.

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MORE MARXIST MISTAKES
Marx might answer us this way: “You’re looking in the wrong
place. The justification for exchange value just is that it enables me
to come up with exact laws of value. I don’t need any other support
for introducing the concept.”
Unfortunately for Marx, his attempt to derive exact laws ofvalue fails. Let’s go back to basics, i.e., apples and oranges. We have:
One apple = one orange.
According to Marx, this means that one apple is identical to one
orange. But, obviously, an apple is very different from an orange.
How then can Marx assert that they are identical?
Nothing (or at least very little) was beyond Marx. He knew perfectly well that an apple is not identical with an orange: but there
must be, he thought, some underlying entity in the apple and orangethat is the same in both. Otherwise, there would be no equality: andwithout an equality, we could not derive laws of exchange.
Very well, then: one apple and one orange contain an identicalelement. What is it? According to Marx, it can only be labor. One
apple exchanges for one orange because the same quantity ofhuman labor is required to produce each of them.

BÖHM-BAWERK’S CRITICISMS
Eugen von Böhm-Bawerk, an outstanding Austrian economist
who also served as Austrian Finance Minister in the early twentiethcentury, subjected Marx’s argument to withering assault. He devoted two main works to Marx’s economics: part of a chapter in his
great treatise Capital and Interest and a separate short book called
Karl Marx and the Close of His System.

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97

Böhm-Bawerk located a gap in Marx’s argument.
Suppose we concede to Marx that there is an equality
involved in exchange. And suppose we grant him that theequality entails an identity. Why does the identical element have to be labor? Why can’t the common element besomething else?
And labor seems an unpromising choice for the supposed common element. The value of some goods seems
clearly not to depend on the labor time needed to produce them. Böhm-Bawerk noted that wine often increases in value the longer it is stored. The labor required togather the grapes and turn them into wine contributes
very little to the price of wine.

Eugen von Böhm-Bawerk
1851–1914

1.

Extra-credit: Give examples of other goods besides wine
whose value doesn’t depend on the labor required to produce them.

2.

Marx argued that if there is an equality in an exchange,
there must be an underlying identity that explains it. Was
he right?

?

ANOTHER FALLACY
Böhm-Bawerk pointed out an even more important fallacy inMarx’s argument. Everyone knows that some people are much
more efficient workers than others. You might be able to build awooden bookend in a few hours, but it would take me several years
to do it. Will my bookend be worth several times more than yours?
Of course not! Economic value, then, does not depend on the labortime required to produce something.

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Marx knew this. But, as we have already sufficiently seen, healmost never gave up one of his pet theories.To meet the difficulty,
he said that it was not the labor required to produce a particular
good that determined its value; rather, it was the labor “socially necessary” to produce items of that class. My bookend would not be
unusually valuable, however long I took to construct it, because
bookends typically do not require several years to make.
Here Böhm-Bawerk launched his criticism. What determines
whether the amount of labor is socially necessary? Sometimes, as in
my bookend example, the answer is obvious: we don’t use the workof an incompetent as a criterion. But often it isn’t obvious what tocount as socially necessary. Should we adopt the least possible time
it takes anyone to produce something as the standard? If not that,
what?
Böhm-Bawerk noted that to solve this problem, Marx needed
actual market prices. “Socially necessary” labor was the labor needed to produce goods at the market price. Those who required morelabor than this to produce a good were not performing labor thatwas “socially necessary.”
Can you see the flaw in Marx’s method? As Böhm-Bawerk
pointed out, Marx has reasoned in a circle. He claims that the market price of a good is determined by the labor socially necessary to
produce it. He cannot then appeal to the good’s market price inorder to find out how much labor is socially necessary.
And the identical fallacy infects a related part of the theory.
How can the labor hours required to produce one hour of a goodbe compared with the labor hours needed to make a good of a completely different type? How can my labor on this book be comparedwith Michael Jordan’s labor on the basketball court? (And why does
the result of the comparison have to place me at such a disadvantage?) How do you compare a surgeon’s labor with a bricklayer’s?
Unless Marx can arrive at a common measure of labor, he will
not have a labor theory of value. He will be left with distinct types

Chapter 5: The Labor Theory of Value99of labor, and he will be unable to explain how the ratio of exchange
is determined when a good produced by one sort of labor is
exchanged for a good produced by another.
See whether you can guess Marx’s “solution.” That’s right: heargued that the many different varieties of labor could indeed be
reduced to a common measure. And how was this to be done? Why,by reference to the market prices of the types of labor, of course!
(Fortunately, I’m not going to explain the complicated way he tried
to do this.)Once more, Böhm-Bawerk identified the fallacy. To use market
prices to reduce the types of labor to a common measure blatantly
reasons in a circle. The fallacy Marx commits is exactly the same as
the one of which he was guilty in defining “socially necessary”
labor.

1.

Set out in detail the steps of the argument showing that
Marx is guilty of circular reasoning in his account of
measuring socially necessary labor.

2.

Given the fallacies of Marx’s theory, why do you think headvanced it? Couldn’t he see the obvious difficulties of thetheory?

?

A FINAL ANOMALY
We have discussed a great many problems with Marx’s labor
theory. (If anyone says here, “Too many, and at too great length”
the teacher should banish him from the classroom.) But suppose,
for a moment, we put all these problems aside. What would thenhappen?

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Strangely enough, we would still not have a theory that adequately explained price. And of this Marx was fully aware. He knew full well,and explicitly said, that goods do not in a capitalist economy exchange
at their labor values! (His reasons, unfortunately, cannot be
explained now because they involve parts of economics that haven’t
yet been covered here.)
The situation is almost too much to believe. Marx has gone toelaborate lengths to arrive at an allegedly scientific theory that will
explain why goods exchange at the ratios they do. But his theory, on
his own admission, does not do this. What gives?
Marx answered as follows: true, the labor theory does not
explain actual prices. But given labor prices, the theory can show
how actual prices are derived. Thus the theory is vindicated: it does
explain price after all. Once more Marx met his nemesis in BöhmBawerk. In a way that we won’t explain here, he showed that Marx’s
attempted derivation of real prices from labor values fails: thedetails just don’t add up.
Rather than go into the technical details of Marx’s derivation
and Böhm-Bawerk’s criticism, let us raise a more general issue.
Suppose Marx could derive real prices from labor values. That is tosay, suppose Marx’s arithmetic was right: how much difference
would this make? Marx’s claim is that he can show what the “lawsof motion” of capitalism really are. Others may linger at the surface:
he will plumb the depths.
But how does deriving one figure from another meet this exacting requirement? An example will illustrate the problem.
(Naturally, we return to oranges and apples):One orange exchanges for one apple
In this circumstance, a 1:1 exchange ratio, the apple price of
one orange is one apple. Given the apple price of oranges, we canChapter 5: The Labor Theory of Valueat once derive the orange price of apples. But, in doing so, we havenot shown that the apple price of oranges somehow underlies, ismore basic than, the orange price of apples. To get a genuine explanation, more than a numerical derivation is needed.
As I hope you are convinced, the labor theory of value does notoffer an acceptable alternative to the Austrian theory.

1.

What notion of scientific explanation did Marx rely on in
his theory? Do you think his view was correct? Why not?

2.

Look at the first few chapters of Marx’s Capital, volume
one, to get some idea of how elaborate his theory is.

3.

How does praxeology respond to the issue of what constitutes a genuine explanation?

?

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Chapter 6
Price Controls
WHAT GOOD IS ECONOMICS?

L

ong before now, you will probably have thought: Why botherwith economics? In fact, some of you may have thrown thisbook aside. If so, get it back: we’ll see in this chapter how economic theory helps us analyze policy issues.

1.

“Prices are too high.” What do you think this common
complaint means?

2.

“Wages are too low.” How does this frequent statement
relate to the previous complaint?

?

INTERFERENCE WITH THE MARKET“Gasoline prices are outrageous: why not compel the oil companies to sell more cheaply? After all, they make vast sums in profit: it’s not as if cutting their gains will send their stockholders to thepoorhouse.”
What will happen if, say, gasoline prices are lowered from $1.30
per gallon (the market price) to $1.00 per gallon? At the market
price, every buyer can find a seller; and every seller a buyer.
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Can you see from our previous chapters why this is true? One
way to show this appeals to a special type of argument called a
reductio. In a reductio, we assume that the contradictory of what wewant to prove is true. We then show that this hypothesis leads to acontradiction. If so, the contradictory of our original hypothesis istrue.
Confused? You should be. Let’s have another look:(1) We want to prove statement p.
(2) We show that not -p leads to a contradiction.
(3) This proves that p is true.

?

1.

What principle of logic does a reductio proof depend on?

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WHAT IF BUYERS AND SELLERS DON’T MATCH?
We can use a reductio proof to show that at the market price,
every buyer finds a seller and every seller a buyer. Suppose that at
the market price of gasoline, $1.30 per gallon, there are more buyers than sellers (not-p). More people want to buy gasoline at thatprice than can be supplied. What will happen?
Obviously, the buyers will scramble to try to get the gasoline.
This is why when there are “price wars” among gas stations, you
usually have to wait in long lines. You will not be surprised to learn
that people do not like to wait in line. Some buyers will then offer
a higher price.
What happens at the new offer? Fewer buyers will want gasoline at the higher price but more sellers will be willing to offer gasoline for purchase. Eventually, supply and demand will balance.

1.

Extra-credit: which buyers will bid up the price?

2.

“The analysis given in the text does not work. In mostmarket transactions, buyers do not offer a price. The seller sets the price. Unless the seller increases prices, then,prices will not rise.” What’s wrong with this objection?
Show:(a) why the alleged fact that buyers do notraise prices is false;(b) why even if the alleged fact were true,
the conclusion would not follow.

3.

Super-extra credit. Is the argument given in the text a strict
reductio proof or just analogous to such a proof? If you cananswer this question you are probably a ringer.

?

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A BASIC RULE OF ECONOMICS
I have good news for you. If you have found the discussion of
reductio proof confusing, you can understand the fundamental economic principal without explicit reference to it. All you have toremember is this: if there are more buyers than sellers at a given price,
the price will rise; if there are more sellers than buyers at a given price,
the price will fall. The market tends to balance buyers and sellers.

MARGINAL BUYERS AND SELLERS
All right: if there are more buyers than sellers, buyers will bid
up the price (just to keep your hand in, state the analogous proposition that is true when there are more sellers than buyers).
But which buyers will do this? Obviously, economic theory cannot identify the specific buyers who will do this: it does not tell youthat John Jones or John Elway will bid up the price.

?

1.

Why not? Recall the discussion in an earlier chapter about
praxeology. Economic theory deals in general propositions, not propositions about specific people. In economic
history, we apply the general truths to specific situations
by “filling in the blanks.” We thus use theory to help us
understand history; but history and theory are very different things.

MARGINAL BUYERS AND SELLERS, CONTINUED
Economic theory, though, can tell us something about whichbuyers will bid up the price. Let’s suppose that the price of gasoline
is $1.00 per gallon and, at this price, more buyers than sellers exist.

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109

Some buyers at the price of $1.00 per gallon will not be willingto pay higher prices. $1.00 per gallon is their limit. These are called
marginal buyers. The buyers who offer higher prices will be those
who are willing to pay more than $1.00 per gallon to get gasoline.
As prices rise, marginal buyers are driven out.
As you might expect, a quite similar phenomenon holds true forsupply. Suppose that at a price of $1.00 per gallon, there are more
sellers than buyers: more people are willing to sell at that price than
are willing to buy. What will happen? (Before reading the next
paragraph, see whether you can work out the analysis yourself.)
At the price of $1.00 per gallon, we suppose, some sellers will
not find buyers. Some sellers will be willing to sell at a lower price:
they would be better off disposing of the gasoline at less than $1.00
per gallon, than not being able to sell all their gasoline at the higher price. Others, the marginal sellers, will exit the market. If theycannot get at least $1.00 per gallon, they don’t want to sell gasoline.
Once again, the market matches buyers and sellers. At the new,lower price, say 80¢ per gallon (why not? it’s my example and I’mfree to make up the figures), there are neither sellers nor buyers
who cannot trade as they wish.

1.

The marginal buyers and sellers, we have said, are those
who, given an unfavorable small change in price, prefer
not to trade. By what standard is this assessed? Whodetermines that someone would be better off trading than
not trading?

?

ENTER THE VILLAIN
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high.” It imposes a price ceiling of $1.00 per gallon. It is illegal tocharge more than this for gasoline. The market price, we suppose,is $1.30 per gallon.
What will happen? At the $1.00 per gallon price, more buyers
than sellers exist. Not everyone who wishes to purchase gasoline
can do so. The result is a shortage of gasoline.
If the free market were allowed to operate, the price would rise
until the market price was reached. At $1.30 per gallon, the numberof buyers and sellers would be equal.

?

1.

Extra-credit: Do cases exist in which a price ceiling will
not cause a shortage?

CEILINGS AND SHORTAGES, CONTINUED
Oddly enough, the answer to the question just posed is yes.
Suppose the price ceiling is higher than the market price. For example, the market price is $1.30 per gallon of gasoline and the government imposes a price ceiling of $1.60 per gallon. What will be
the result?
That’s right, nothing at all. The price ceiling will not stop buyers and sellers from reaching the market price. Thus, we can saythat a price ceiling will either be useless or cause a shortage.

?

1.

Why do you think that the government would ever imposea price ceiling above the market price?

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YET ANOTHER COMPLICATIONAs you have no doubt by this time discovered, I like complications. It is not always true that a price ceiling above the market pricehas no effect. Can you see why not?
Buyers and sellers care not only about prices now, but also
about their estimates of future price changes. Suppose I think thatthe market price of gasoline, absent government interference, willrise from its present $1.30 to $1.65. My expectations of the pricechange may influence how I now act. If I think that the expected
rise will be blocked by the price ceiling, my course of action may
well be different. Fortunately, you don’t have to worry about this inintroductory economics.

AND ANOTHER COMPLICATION

There is another case in which a price ceiling will not cause ashortage. Suppose, as before, that the government imposes a priceceiling of $1.00, when the market price is $1.30. A possible state ofaffairs is that preferences shift, so that the number of buyers andsellers match at $1.00 instead of $1.30. In other words, the ceiling
induces shifts in preferences that “justify” it.
But we have only to mention this to see how unlikely this is tohappen. Why would the government’s action have this effect? Once
more, we should keep the main point in mind, (while not ignoring
the complications). A price ceiling will either be useless or cause ashortage.
1.

Extra-credit: Can you work out a circumstance in which a
price ceiling will induce a surplus (more sellers than buyers, at that price)?

?

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THE ETHICAL POINT
Price ceilings cause shortages; therefore, the government
should not institute them. What could be more evident?
Well, the premise is true; the conclusion (in the author’s judgment) is also true. But the conclusion does not follow from thepremise.

?

1.

Give other examples of arguments with true premises anda true conclusion, where the premises do not entail theconclusion. Note that in order to reason correctly, the conclusion must be validly deduced from the premises.

ETHICS CONTINUED
But wait a minute. Doesn’t the conclusion follow the premises?
Surely, shortages are bad; and if a government program causes a badstate of affairs to happen, it is bad. Therefore, price ceilings are badand the government ought to avoid them.

?

1.

Using the previous discussion, can you see why the newargument does not show that the conclusion follows fromthe previously stated premises?

EVEN MORE ETHICS
The answer should be obvious. The new argument does notshow that the conclusion, the government shouldn’t impose pricecontrols, follows from the original premises because we have added
a new premise. What is it?

Chapter 6: Price Control

113“Shortages are bad.” It is this that enables us to move frompremises to conclusion. In general, you need an ought statement in
the premises to justify an ought judgment in the conclusion. A value
judgment will also do the trick.
1.

Give examples of value judgments.

2.

“Since value judgments are subjective, no ought statements can be backed up by reason.” Evaluate this claim.

3.

Some philosophers deny that you always need an “ought”
in one of your premises to get to an “ought” in the conclusion. Find out who some of these thinkers are, and givea brief account of their arguments. Why wouldn’t theirviews require us to modify our conclusion about what follows from “price controls cause shortages?”?

MUCH ADO ABOUT VERY LITTLE?
Haven’t we made too much fuss over a very minor point? Afterall, who doubts that shortages are bad? Perhaps some misanthrope
enjoys depriving others of the goods they want; but, barring exceptional cases such as this, aren’t we home free?
Indeed, don’t we have here a partial solution to the so-calledfact-value gap? Just add an obviously true value judgment. Compare
the following:• (1) YOU DO NOT WANT TO DIE BY POISONING• (2) THAT GLASS OVER THERE CONTAINS POISON• (3) YOU SHOULD NOT DRINK THE CONTENTS OF THAT GLASS

Premise (1) is a value judgment, but it is none the worse for that.

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WHY WE ARE NOT HOME FREE
Unfortunately, we have not yet arrived at a good argument
against price control. Can you see the problem? From “shortages
are bad” and “price controls cause shortages,” it does not follow thatprice control ought not to be instituted.
Why not? Let’s consider a parallel argument:• (1) DENTISTRY CAUSES PAIN
• (2) PAIN IS BAD• (3) DENTISTRY OUGHT TO BE OUTLAWED

Obviously, something has gone wrong. Even though somethinghas some bad results, it may still be worth doing. Its good consequences may outweigh its bad consequences. Thus, few advocates of
price controls will welcome shortages. But they may think that thebadness of shortages is outweighed by the alleged good effects of lower
prices. Or they may try to cope with the shortages by other means.
An example of this strategy emerges in justifications of rationing.
During wartime, consumer goods are in short supply. Some people
think it is “unfair” to allow prices to rise; and to prevent shortages,
the government issues ration books. You must have a ration card, in
addition to the requisite money, in order to purchase what you want.

?

1.

How did rationing work during World War II in the UnitedStates?

2.

A useful technique to help analyze arguments is to construct a parallel argument: Give some examples of thistechnique.

3.

Is it “unfair” to allow prices to be bid up to the market
price?

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115

HAVE WE PAINTED OURSELVES INTO A CORNER?
As you will long since have gathered, I support the free market
and, as such, oppose price controls. But what am I now to do? It
appears that our point against price controls—they lead to shortages—does not of itself suffice. Must opposition to price controls beclassed as simply an arbitrary value judgment?
One might in response elaborate a political philosophy showingthat the judgment is not arbitrary. Fortunately, we do not have tofollow this complicated path here.

1.

Read Murray Rothbard’s, Ethics of Liberty (New York: NewYork University Press, 1998). How would the rights framework elaborated in that book handle the morality of pricecontrols?

?

LUDWIG VON MISES TO THE RESCUE
Ludwig von Mises discovered a way out. As he
noted, those who complain that prices are “too high”
do not think that shortages are a suitable “price” topay for lower prices. They contend that prices can belowered without shortages.
And here economic theory shows them mistaken.
Thus, we can say that price controls, from the point ofview of its own supporters, fails to achieve its goals. It
is thus irrational.

Ludwig von Mises
1881–1973

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An Introduction to Economic Reasoning?

1.

How does Mises’s argument apply to rationing? (Hint:
rationing is a measure to limit consumption.)2.

Why is it a strong argument against a view that it cannot
secure the aims of its advocates?

Chapter 7
Minimum Wages and Wage ControlT

his chapter is really unnecessary. If you studied the previous
chapter on “Price Controls” carefully, this chapter will hold few
surprises for you. But wages are such a “hot” topic that an extended treatment of the subject is needed.
With prices, the usual complaint is that they are “too high.”
With wages the case is different. They are “too low”: the rich getricher and the poor get poorer. You have no doubt heard of thealleged “income gap.” Is this a real problem? As we shall see, youhave already learned enough to assess the economic impact of interference in wage bargains by the government.
1.

Before reading the rest of this chapter, try to analyze theeffect of minimum wage legislation. (Hint: does the factthat we are dealing with a price floor—wages cannot go
below a certain amount—rather than a price ceilingchange the basic points of our analysis?)?

A DIGRESSION ON EQUALITY
This is an economics textbook, not a philosophy treatise—much as I’d like to forget it. But it will help you in your study of
economics if you look at an often unexamined philosophicalassumption. When people complain about the gap between the rich
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and the poor, they take for granted that the ideal state of affairs isequality. We can’t have absolute equality, most people concede, but
we should get as close to it as we can without sacrificing too muchin productivity. Arthur Okun, a leading leftist economist, speaks ofan “equality-efficiency tradeoff.”?

1.

Why do people think that there is a tradeoff between
equality and efficiency? Why can’t we maximize both
equality and efficiency?

2.

Have a look at John Rawls’s A Theory of Justice(Cambridge, Mass.: Belknap Press, 1999). This is themost influential book of twentieth-century political theory.
Look up what Rawls says about the “difference principle.”

MORE ON EQUALITY
But why is equality taken to be an uncontested good thing? You
might think the answer is obvious. Suppose someone is homelessand starving, and a multi-millionaire passes him by “in silent contempt.” Isn’t this unfair?

?

1.

Extra-credit: Can you apply a technique of argument you
have already learned to help you analyze this example?

A POORLY-CHOSEN EXAMPLE
A good philosophy example helps us understand exactly theissue in dispute. A bad example confuses us: it mixes together two
or more different points.

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121

Remember, what we are interested in now is the (alleged) valueof equality. An example that aims to show that equality is important
should concern itself with equality—nothing else.
By this criterion, the example about the millionaire and the
beggar doesn’t fare very well. Can you see why not? This example
illicitly appeals to another moral view we may share—i.e., it isundesirable that people be very badly off.
But even if we share this view, this does not show that equality
is a good thing. To see this, we can change the example so that only
equality is involved. Consider two people, a millionaire and billionaire. Is there an ethical problem just because the billionaire isimmensely more rich than the poor millionaire? If you don’t thinkso, what does this tell us about the importance of equality?

1.

“There’s no use arguing about equality. It’s just a subjective value judgment that many people, especially those on
the left of center, share.” How would you respond?

2.

“We don’t need to argue for equality. It is a self-evident
truth, as a glance at the Declaration of Independence suffices to show. Why do we need to justify equality throughsome further principle?” Evaluate.

?

BACK TO ECONOMICS
What determines wages rates on the free market? A standard
joke among economists is that the correct answer to any question
about the subject is “demand and supply.” (As you can see, economists don’t have very good jokes.)
However poor the joke, the answer is perfectly apt. A wage is a
price for labor services of a certain kind. (Remember, there is not
one wage rate: each type of work has a separate price.)

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Suppose that the market price for professional stilt-walkers is$10.00 per hour. (Stilt-walkers don’t come steep.) At this rate, all those
who want to accept employment at that price can do so; and all those
who wish to purchase stilt-walkers’ services at that price can do so
as well. Demand and supply balance. I hope you’re not surprised.
What happens if the government enacts a law that forbids stiltwalkers to be employed at less than $12.00 per hour?

?

1.

What does happen? Can you figure it out?

THE MYSTERY UNVEILED
At the new price of $12.00 per hour, more people than before
will want to be stilt-walkers. (Certainly, for $12.00 per hour, I’dbecome a stilt-walker.) But some employers will no longer want toavail themselves of the stilt-walkers’ services any longer.

Chapter 7: Minimum Wages and Wage Control

123

Which ones? Obviously, those who found the value of stiltwalkers just slightly higher than $10.00. Faced with the requirement that they pay $12.00 per hour, they will no longer find it
worth their while to do so. These marginal buyers will bid the stiltwalkers a swift farewell.
What then, is the upshot? At the new price, $12.00 per hour,more workers are willing to work than at the $10.00 per hour price.
But fewer employers wish to purchase labor at this price. Supply
and demand no longer balance. Put another way, minimum wage
laws cause unemployment.

1.

Extra-credit. Both here and in the previous chapter, We’ve
spoken of “marginal” buyers or sellers. These are people
who “just barely” find a transaction worth making at themarket price and will be driven out of the market should
the price change in a way unfavorable to them. Is the useof this concept consistent with the Austrian claim that
preference is ordinal and cannot be measured?

?
EXCEPTIONS

We can come up with a few exceptional cases in which minimum wage laws do not cause unemployment. Suppose that stiltwalkers earn $10.00 per hour, and the minimum wage is $5.00. It issafe to predict that this minimum wage regulation will have little
effect on unemployment.
1.

Draw a demand and supply curve for stilt-walkers, with
$10.00 as the market wage. Show how a minimum wageof $5.00 will leave price determination untouched.

?

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AN EXCEPTION
Or will it? As you might have already guessed, there’s an exception. The market for workers is affected not only by the prevailingwage rate, but by expectations about future wages. If an employer
thinks that the market wage for stilt-walkers will soon fall to $3.00,
he will make plans accordingly. If the minimum wage interfereswith his plans, his demand schedule will alter.

?

1.

Show why the exception isn’t really an exception. (Hint:
the minimum wage will have an impact on future demand.)2.

What about a minimum wage rate so low it has no effecton either present or expected wages?

THE MINIMUM WAGE RULE
In general, then, we can say: a minimum wage will either be useless or will cause unemployment. Once again, there is another exception: the minimum wage “justifies” itself by changing preference
schedules so that the minimum wage becomes the market wage. But
why should this happen?

ETHICSNo, I can’t stay away from philosophy for long; but, as we havealready covered the essentials, we can be brief. The minimum wage
rule does not by itself suffice to show that minimum wages are bad.
It is a descriptive, not a normative claim.

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125

Further, to justify a negative verdict on minimum wage legislation,
it is not enough just to add the non-controversial value-judgment,“unemployment is bad.” A supporter of minimum wages could
claim that the increased wages for some workers outweighs theunemployment of others.

MISES TO THE RESCUE AGAIN
Once more, Ludwig von Mises offers a way out. Advocates ofminimum wages do not characteristically claim that the advantagesof higher wages for some justify unemployment for others. Rather,
they claim that minimum wage legislation will increase wages without causing unemployment. And this economic theory shows to befalse. (If this chapter sounds like a repetition of the last chapter, youhave learned your lessons well. If it doesn’t, please reread the previous chapter.)

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1.

“We’re talking about human lives here! The economic
principles that determine the price of ordinary goods andservices don’t apply to human labor.” Evaluate.

2.

Without minimum wages, employers would be free to pay“starvation wages.” Evaluate.

3.

Why are minimum wages usually quite low? Why not a$20.00 per hour minimum wage?

THE ZONE OF INDETERMINACY
Some labor economists will say that the foregoing analysis is
crude and oversimplified. (They would say that, wouldn’t they?) We
have assumed that the free market fixes wages at a certain point:
above or below this point, there will be either shortage or surplus.
But why assume this? Perhaps wages are fixed by the market
in a zone, rather than at a point. Suppose that the market wage ofstilt-walkers is $10.00 per hour. A minimum wage now requires thatstilt-walkers be paid $12.00 per hour.
Must unemployment result? Not necessarily. Suppose employers demand exactly the same number of stilt-walkers at $12.00 as at$10.00; and workers prove no more likely to practice “nonsense on
stilts” than at the higher price. In other words, neither demand nor
supply respond very much to small shifts in price. If so, the minimum wage will not cause unemployment.
Supporters of this view have not offered much evidence in its
defense. Why assume that the labor market operates differently fromother markets? We don’t usually talk about zones of indeterminacy inthe price of wheat—or, for that matter, of stilts. Why stilt-walkers?

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127

Further, if there is such a zone, why assume that workers willtend to come out at the low end of it? And, if they do, why is this asituation that requires state intervention?

1.

Why does minimum wage legislation hit teenagers andminorities especially hard?

2.

List various summer jobs that you have had. Wouldchanges in wage rates have led you to change jobs?

?

A COMMONLY MISSED POINT
You may be thinking, “as usual, he’s making too much fuss overa point that isn’t all that important. Perhaps minimum wage laws docause unemployment. But, after all, most people earn substantiallyabove minimum wage. Aside from teenagers—and they surely don’tmatter—minimum wages do not have that much impact.”
But this objection construes “wages” too narrowly. Your wage is
not only the amount of money you get, but your total benefit package. If you have a pension plan, health insurance, paid vacation, etc.,
these are all part of wages.
Why? Well, when you are considering a job, don’t you takethese into account? And when an employer offers you a job, hemust calculate the cost of all of these benefits.
In many cases, the government requires that employees beoffered a certain benefit package. In the most famous instance,
employers must contribute certain premium payments toward theemployee’s Social Security account. These payments should be considered extensions of minimum wage legislation. Practically everyone is affected by them, and by other governmentally mandated
benefits.

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1.

For various jobs, list the components of the “total benefit
package.”

2.

Do you think that workers would prefer more choice intheir benefit package, rather than have the government
mandate what they must have?

LABOR UNIONSAs usual in this book, government has been the villain. But
another sort of pressure can raise wages for some at the expense ofothers. Suppose Sam Stiltwalker says: “I don’t think $10.00 per
hour is adequate recompense for my services. I want $25.00.” Well,he can say this—it’s a free country—but if $10.00 is the market
price, he will find few takers.
Imagine, now, that Sam is a little smarter. He organizes a groupof his fellow stilt-walkers and tells his employer, “Unless you raise
our wages from $10.00 to $25.00 per hour, we will strike.”
Sam has been too clever by half. Remember, at the market
price, all those who wish to purchase labor can find sellers. Sam andhis friends will quickly be replaced. They have priced themselves
out of the market.
Sam’s only hope lies in coercion. If he can prevent the employer from hiring replacements, he has a much better chance of getting
the wages he wants.
Among ways that labor unions try to block replacements arelegislation that forbids firing strikers and the use of force against
replacements.

Chapter 7: Minimum Wages and Wage Control

1.

Read The Kohler Strike by Sylvester Petro (Chicago: Henry
Regnery, 1961) for an account of labor unions in action.

2.

Replacement workers are often called “scabs”. In whose
interest is this pejorative language?

3.

Why do you think labor unions usually support minimum
wage legislation?

?

129

Chapter 8
Money: Part 1
THE ORIGIN OF MONEYM

uch of economics consists of going over what we have alreadylearned before. The principal reason for this is not that this isan excellent way to learn—though that is true enough. Nor is it that
I have little new to offer—of that I am not the best judge. Rather,
the genius of Austrian economics consists, in large part, in drawing
out the implications of simple principles. To do this, one must constantly revert to these principles.

133

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One of the most basic of these principles we have had continued occasion to stress. A trade will take place if it is mutually beneficial to the parties. If I have three apples and two oranges and you
have two apples and three oranges, what will happen if we each prefer to change our fruit portfolios? (Aren’t you getting tired of apples
and oranges? One of the best features of this chapter is that we’ll get
to talk about something else.)
Suppose I would rather have two apples and three oranges; and,you, conveniently enough, want three apples and two oranges. If
you and I exchange one apple for one orange, we shall each be better off. Other things being equal, then, the trade will be made.
So far, so good. But what happens if I want to trade one apple
for one orange, but you do not? Selfish pomologist that you are,you refuse to surrender one of your apples. What am I to do?
You might think the problem has an easy solution. Our principle tells us that a trade will take place if it is to the advantage of theparties engaged in it. If you do not want to give up an apple, thetrade is not to your advantage. I cannot then claim by the principlethat a trade will take place. I appear to be unable to get an apple
from you.

?

1.

“We can’t conclude that a trade won’t take place either.
All that follows is that one can’t appeal to this principle tosupport the claim that a trade will take place.” What’s
wrong with this objection?

2.

What is the difference between a necessary and a sufficient condition?

3.

Can you give a stronger principle of trade than the one
mentioned in the text?

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135

MORE ON EXCHANGE
If you have answered the questions at the end of the previous
discussion correctly, then you will realize that my quest for an apple
seems doomed. Unless you would rather have one more orange andone fewer apple than you now have, you will not be willing to trade.
Do you see why this is a stronger conclusion than our previous
result? Before, we showed that the principle justifying trade—you
will make a trade if it makes you better off—does not generate support for the exchange I want.
Now we claim that unless both parties are better off, no trade
will take place. A trade will take place, if and only if both parties
expect to benefit from it.
By now, it should be old hat to you to show why this stronger
principle is true. Each person chooses the action, of those alternatives available to him, that will maximize his utility. If a trade will notmake you better off, then you will not engage in it. If it will (and you
have no still better choice available), then you will make the trade.

1.

Give examples in which “If a, then b” is true but “b only
if a” is false.

2.

Give examples in which “b only if a” is true but “if a, thenb” is false.

?

INDIRECT EXCHANGE
But how am I to get my apple? I must have it! I might attempt to
ask someone else to trade with me, if you will not. Surely someone in136

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the class will be willing to part with an apple. (Remember the oldmotto, “An apple a day keeps the textbook writer away.”)
But suppose that no one who owns apples is willing to exchange
them for oranges. Does it follow that I cannot obtain apples
through exchange? Surprisingly, it does not.
What gives us our room to maneuver? Doesn’t the principle
given in the previous section rule out my getting apples throughexchange? Can you find the loophole?
The answer depends on a subtle distinction. From “I cannot
obtain apples by exchanging them for oranges” it does not followthat “I cannot obtain apples by exchange.” This is a stronger conclusion than the premise. What if I can obtain apples by some other typeof exchange?
But, once more, how is this possible, given that no one who owns
apples will part with them for oranges? Well, suppose that you willtrade an apple for a copy of a book—say, Keynes’s General Theory. (Tomake this example more realistic, we need to suppose that you would
surrender only a rotten apple for this book.)
Now, I have only to obtain a copy of the book and I can have
my apple. (Obviously, if I owned the book already, no problem
would arise.) Now, we face a new problem: how can I get it?
Fortunately, someone who owns a copy of Keynes’s masterwork
is willing to part with it in exchange for an orange. (Since it’s my
example, I am free to postulate whatever preferences I want.) Once
I obtain the book, I can next offer my copy of the book to you; andat last I shall obtain my coveted apple.
You may object to the solution in this way. In order to trade oneorange for one book, I must prefer having the book to the orange.
(Why? If you can’t answer even after so much repetition, yourchances of passing this course are dim.)But suppose I don’t like the book—in point of fact, I don’t likethe volume in question. Then, doesn’t it follow that I won’t makeChapter 8: Money, Part 1

137

the exchange? In that case, I cannot use the proposed solution to
get the apple I want. If I had a copy of the book, I could thenexchange it with you for one apple; but, given my dislike for thebook, it appears that I cannot obtain one by exchange for an orange.
I do like oranges.

1.

See whether you can anticipate the next section. What iswrong with the argument just presented?

?

INDIRECT EXCHANGE CONTINUED
When I said that I didn’t like the book General Theory, what did I
mean? Basically, I mean that I do not value the book for its own sake. I
would not give up an orange to get the book, if I had to keep the book.
And there exactly lies the flaw in the argument presented justbefore. I don’t have to keep the book—I can use it to trade forsomething else, an apple. If I obtain a copy of General Theory, I can
get something I do want to keep. Thus, it is false that the book hasless value to me than the orange, even though, just looking at theorange and the book by themselves, I would rather have the orange.
If a good can be used to get other goods that I want, its value tome increases. In this way, other people’s preferences affect my own.
Because you want a copy of General Theory and will give an apple toget it, the book becomes more valuable to me than an orange.

1.

How does our analysis relate to the distinction that Adam
Smith and David Ricardo made between use value andexchange value?

?

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STILL MORE ON INDIRECT EXCHANGE
You can readily see why exchange of this kind is sometimes
called “triangular” instead of a direct exchange like this:orangeA

B
apple

Figure 11. Direct Exchange
We have two exchanges:

C bookA
orange[book]

B
apple
Figure 12. Two Exchanges

Chapter 8: Money, Part 1

139(Note that our “triangle” does not require a further exchange
between B and C.)
Once given this basic pattern, more and more complicated patterns can be constructed. Suppose no one who has a copy ofGeneral Theory wants an orange. Perhaps a book owner wants a waffle iron, and I know someone who will exchange a waffle iron for an
orange. I first exchange my orange for a waffle iron; next, I
exchange the waffle iron for a copy of the book; and, at last, I
exchange the book for the apple.

1.

Construct some chains of exchanges. How complicated aseries do you think could exist in the real world?

2.

Consider the first indirect exchange. Can’t my devious
scheme to obtain an apple be thwarted by the bookowner? All he has to do is exchange his book with theapple owner. What is wrong with this objection?

?

LIMITS OF INDIRECT EXCHANGE
You can have a lot of fun making up complicated chains of
exchanges. (I don’t think this is much fun; but, who knows? Maybe
you do.) But you can readily see that people who try to use the indirect exchange method to get what they want will encounter difficulties.
What are these? First of all, wherever you take a step in the
chain, you must find someone who wants what you then have. This
is of course a requirement of all exchanges: it is called the problemof “double coincidence of wants.” The more steps in a chain of
trade you have to make, the more difficult this problem becomes.

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Further, at each step in the chain disaster threatens to strike.
Suppose I miscalculate: I think, e.g., that if only I can get a statue ofa pink hippopotamus, I can then secure a copy of General Theory,
enabling me at last to get the apple I want. Unfortunately for me,
the owner of General Theory shrinks in horror at the statue; and I am
stuck with it. Since I would much rather have an orange than thestatue, I have lost out on the deal.
But suppose I have calculated all the steps in the chain correctly—
textbook authors, after all, are immune from error. Have I then founda good way to get more of what I want? The matter is not so simple.
Even if I line up a series of trades, making no mistakes in doing
so, I cannot count the process one of pure gain. Setting up the procedure takes time and effort. This is called “transactions cost”.
Against the gain I hope to achieve at the end of the process must be
set the cost of engaging in it.

?

1.

How is the “cost” in “transactions cost” to be assessed?

2.

“Since transactions costs are an economic ‘bad’, our aim,
both as individual actors and policymakers, should be tominimize transactions costs.” What’s wrong with this picture?

THE PROBLEM OF INDIRECT EXCHANGE COMPOUNDED
To reiterate, there are two main “first-level” problems in indirect exchange: the series of exchanges must be coordinated, anderrors may leave you with goods you do not want. Even if you cansolve these difficulties, your attempt to do so generates a “secondlevel” problem: you are confronted with transactions costs.

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141

One way to deal with these problems is to abandon indirect
exchange altogether. But then you are limited to what you can getin direct exchange (or, of course, produce yourself). This is obviously a drastic limitation.
The difficulties of indirect exchange suggest a related problem
for direct exchange. If you produce something that many people
want, e.g., apples, you will probably find it easy to make anexchange.
But what if you produce something few people want? Suppose
you are a violin maker, or a writer of economics textbooks. Then,
you may have to search far and wide in order to solve the problemof double coincidence of wants. You may have extensive transactions costs even if you engage only in direct exchange.

1.

What is the problem of double coincidence of wants? (Youshould get it right this time.)

2.

Given the problem of double coincidence of wants, why do
you think people engage in jobs like writing economics
textbooks? (“Because they are stupid” is not a goodanswer.)?

TOWARD A SOLUTION
How do we solve all these problems? You have the material foran answer already to hand. Recall our earlier statement: if you produce goods like apples that many people want, you will find it easy
to make an exchange. This should at once suggest a way around all
our difficulties.
Suppose you acquire goods that most people want. Then you
don’t have to worry about complicated chains of trade, and you have

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reduced transactions costs. Also, if you produce something few people want, you can solve the double coincidence of wants problem by
the same means. Once you trade in your ability to write economics
textbooks for apples or oranges, your troubles are over.

?

1.

Evaluate this objection: “The ‘solution’ just suggested
doesn’t work. Of course, if you have goods other people
want, you will improve your bargaining position. But why
will someone with a good in demand surrender what hehas for something few people want? The problem isn’t
solved at all.”IS OUR SOLUTION A PSEUDO-SOLUTION?
I hope you didn’t make the mistake of failing to read the discussion question above. I cunningly put important points in these
sections, as well as questions for review and application. This is one
instance where I have done this.
The objection raises two valid concerns. First, someone who
trades a good more in demand as an instrument for further trade forone less in demand is, other things being equal, suffering a loss. But
it does not follow that no such exchanges will take place. Rather, theperson with the good more highly in demand earns a premium. If I
want to obtain oranges in return for writing an economics textbook,
I shall probably have to be satisfied with getting fewer than I would
have obtained had more people been ready to take the use of myskill in exchange for what they want.
The second valid concern raised in the objection is this.
Someone who has a good not much in demand for further tradecannot conjure double coincidence of wants out of existence. Even

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143

given our solution, he must still find someone who wants what hehas for sale. And that person must have a good more in demand forfurther trade than his own. But if he can overcome this initial hurdle, he is on his way.

HOW A MEDIUM OF EXCHANGE ARISES
A good like oranges thus has two components that determine its
value: (1) its use to consumers and producers—people who want to
eat oranges, make virtual pets of them, hang them as wall decorations, use them to make juice, etc. and (2) its use as a medium of
exchange.
The second use is a bit complicated, and it will be helpful to goover it again. Because oranges are much in demand for further
trade, the value of oranges rises. One of the uses of oranges is thatpeople think they can be used to get other things that people want.
What happens if a good gains value because it is thought by
most people to be in general demand of this kind? People will thenprobably expect that in the future, the good will be even more in
demand, increasing its value even further.
Let’s look at this in more detail.
At the start, t1, consumers value oranges for purposes of consumption. Then, at t2, consumers who see that many people tradefor oranges will value oranges more highly than they otherwise
would have done.
Next, at t3, consumers who see that even more people than
before trade for oranges will tend to value oranges still more highly than before. By this, I mean that they value oranges (1) more
highly than they would have without considering the exchange
value of oranges at all; and (2) more highly than they would have
had they added only the exchange value of oranges at t1 to theirestimation of oranges’ value.

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If you found the previous paragraph convoluted, imagine howdifficult it was to write it! You don’t really have to worry about thedetails. What you do need to remember is the basic principle: A
good that people think will be accepted readily in exchange will gain invalue. Imprint this on your brain.

?

1.

How does the discussion in the previous few pages raise aproblem for praxeology? Are all of the steps in the reasoning presented strictly deductive?

CONVERGENCE
So far, we know that some goods are more heavily in demand
for trade than others. Because of this, these goods find their values
enhanced.
We can now go further. What happens when market actors seethat some goods are more valued than others, in part because of the
expectation that they will be highly valued? It seems likely that the
goods in the highly valued class (oranges, apples, ice cream) will not
be equally in demand for their use in further exchanges. Some will
be more valued for this purpose than others.
What will now happen? When people see that some goods are
more highly valued than others, their demand as exchange goods
will increase. This will be true even if the goods are only slightly
more highly valued for exchange than others. If apples are expected
to be even more in general demand than oranges, people will wantapples rather than oranges.

Chapter 8: Money, Part 1

1.

Evaluate this objection: “What has just been said may betrue, but it is not praxeology. According to praxeology, ourconclusions have to follow necessarily from the action
axiom, the subsidiary postulates, or conclusions drawn
from any of these. This has not been accomplished here.”
Review the chapter on praxeology to help you prepare youranswer.

145?

PRAXEOLOGY AND CONVERGENCE
Contrary to the objection just suggested, the reasoning of ourprevious section conforms to praxeological law. (A good thing thatit does, too, or I would be out of business.) Remember, we are concerned here only with a good’s exchange value—its use, as a goodbelieved in general demand, to obtain whatever other goods I want.
Given this fact, even small differences in expected exchange
value count for a great deal. I shall always tend to choose, otherthings being equal, the good I think likely to have the highest
chance of general acceptance by others. Otherwise, I shall not bechoosing my highest valued alternative. And we have already shownthat Ialways do choose my highest valued alternative. You willprobably find it helpful now to review the discussion of alternatives
and choices. (Teachers, please make sure your students act on thissuggestion.)

EXTRA-CREDIT SECTION:
FURTHER PROBLEMS FOR PRAXEOLOGY
We are not yet out of the woods, as far as praxeology is concerned.
How does it follow from the fact that in the indicated circumstances,

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I shall always choose the good I expect to have the highest exchange
value, that I shall choose the good that has had in the past the highest exchange value? And how do we know that goods must have differing exchange values? These are difficult questions, and in part too
advanced for this book.

?

1.

Solve the problems just discussed. Then mail the answers
to me.

MONEY AND BANKINGLong before now, you have probably thought this is a strange
chapter. It is supposed to be about money and banking; but so far,it seems, we have said nothing about these subjects. As you will seein the following chapter, however, we have taken the essential steps
toward understanding this difficult topic.

Chapter 9
Money: Part 2
CONVERGENCE ONCE MOREIn the last chapter, we argued that economic actors in search of a
medium of exchange will tend to converge on a few goods. People
who want to obtain goods that they think will always be accepted byothers will tend to choose the same goods, more or less.
Can we go further? What properties will the goods they selecthave? Here we take a temporary leave of absence from praxeology
and engage in historical inquiry of a sort.
We are asking: what properties does it seem reasonable to wantin a medium of exchange? To put the question another way, what
will people tend to choose as money? We shall define money as agood almost universally accepted in a market for purposes of exchange. If
you want to exchange what you have produced at all, you will most
likely accept money for it.

1.

Must a good be universally accepted to count as money?
Suppose someone will accept only a particular spider inexchange for his copy of General Theory and not themoney to buy the spider he wants. Must we conclude that
because of this person, money does not exist in his society?

149

?

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PROPERTIES OF A MEDIUM OF EXCHANGE
Historically, all sorts of things have served as money, ranging
from cattle to sea shells to sugar. In prison camps during WorldWar II, cigarettes were used as money.
But most societies that have allowed a market in money todevelop have converged on gold and silver as the commodities used
for media of exchange.
First of all, the medium of exchange should be durable. Ice
cream, however desirable, would not be a good medium of
exchange because it is perishable. True, you can keep it in the freezer; but this is costly. And how would you carry it around to
exchange it for other things?

Chapter 9: Money, Part 2

Austrian Hundert SchillingThis leads to a related property that money is likely to have. It
should be readily divisible into small units. Can you see why elephants would not be a good choice as money? Suppose you want tobuy a candy bar. How could you do so, if one elephant were thesmallest unit of currency? Gold and silver, by contrast, can easily be
cut into small units. (In countries on a gold or silver standard, metals of less value, such as nickel or copper, are often used for thesmallest denominations of coin.)
The third quality follows from our discussion in the previous
chapter. The medium of exchange must have qualities that make it
widely acceptable. The beauty of gold and silver has made these
metals widely desirable in a great many societies.
To sum up, with a free market, we may expect gold or silver (orboth) to be adopted as the medium of exchange.
1.

Give examples of different commodities that have been
adopted as money by various societies.

2.

Why do you think that many writers have criticized thedesire to amass gold? (Murray N. Rothbard and Dr. Joseph
Salerno have termed this phenomenon “aureophobia.”)

?

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An Introduction to Economic Reasoning

MONEY AS A STORE OF VALUE
We have now completed our first historical excursion. We shallassume that a society has adopted gold as its medium of exchange;
and, proceeding by praxeological reasoning, ask what follows fromthis fact.
One advantage of a gold (or silver) standard follows at once fromone of its physical properties. Because gold is durable, people who
own it need not make their exchanges all at once. If I own gold, I
can save it until I find something that I want to buy with it.
As we have seen already, a medium of exchange extends our ability to obtain different goods. If I wish to trade economic textbooks
for ice cream (I’m sick of apples), I must find an ice cream owner who
wants a textbook. If I have gold, I have the much easier task of finding an ice cream owner who wants gold. And of course the task ismuch easier in large part because he wants the gold so that he can buy
the things he wants. (Have I repeated this idea enough times yet?)Now we see that the gold not only extends the space of goods
available to me. It also extends the time in which I can purchasethem. In doing so gold acts as a store of value: this is one of themain functions of money.

?

1.

Extra-credit: By extending the time in which someone canpurchase goods, how does gold also extend the space ofgoods available? Notice that “time” is used literally here
but “space” figuratively.

MONEY’S EFFECT ON OTHER GOODSAs always, let’s review. We started with direct exchange: I trade
one orange for one apple. From this we moved to indirectChapter 9: Money, Part 2

exchange. Since you don’t want my orange but do want a copy ofGeneral Theory, I trade my orange for the book and then trade thebook for the apple. Goods in general demand for further trade, wesaw, will have their value enhanced by their being perceived to bein wide demand. People in a market society will tend to converge
on one or two goods, almost always gold or silver, as the medium of
exchange.
Now we must attend to a rather more subtle point, often overlooked. Remember, that before gold was adopted as the medium of
exchange in our model market, we had several goods, e.g., oranges,
whose value increased because of their being perceived to be in general demand. People wanted oranges, among other goods, in part
because they thought that other people would take oranges in trade.
The question that now arises is this. Once gold has become thegenerally accepted medium of exchange, what happens to the partof the value of oranges that rested on oranges’ exchange value?
Before you try to answer, let’s make sure that you understand thequestion. Before gold became accepted as money, oranges increasedin value because people wished to use them as a medium of
exchange. Once gold is accepted, what happens to this part of thevalue of oranges?
Fairly obviously, it decreases; depending on circumstances, it
may lose this part of its value altogether. People who want toexchange what they produce for a good that will be generally
acceptable to others will now want gold, not oranges. Once a goodis adopted as the medium of exchange, it becomes the main goodwhose value is determined by its general acceptability.

1.

If gold is the medium of exchange, will the component oforanges’ value that depends on its general acceptability
always fall to zero? Can you think of circumstances inwhich it will not?

?

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THE MONEY REGRESSION THEOREM
I fear I must now issue a warning. The following section isamong the most difficult in the book. It cannot be consigned to thelimbo of extra-credit because it deals with one of the key theoremsof economics.
Money, as we have explained, did not arise through the command of the state. Neither did it arise through an explicit agreement. People did not say: “From this day forward, commodity x
shall be the medium of exchange.”
Rather, money arose through the spontaneous processes of themarket. First, gold was valued as a consumption good. It is mainly
used for jewelry but can also be employed in other areas. For example, it can be used to fill teeth, or for certain special industrial
processes, etc.
Next, gold gained value because people thought it would be
generally accepted in exchange. And when people saw that it had
this property to a greater extent than other goods, people valued it for
exchange purposes even more than before. Thus gold became money.
A few points about money need special stress. These are notespecially difficult to grasp, but theorists outside the Austrian campoften ignore them. To begin with, the value of gold is due almost
wholly to its services as a medium of exchange. But gold did not begin
as a medium of exchange. It began as an ordinary commodity, withutility for purpose other than exchange.
Carl Menger, the founder of the Austrian School of Economics,
pioneered this account of the origin of money in his Principles of
Economics. In so doing, he achieved a crucial breakthrough in economic theory. Before him, people often thought that money aroseby an explicit agreement to accept a given substance as money. John
Locke, a great political theorist but a not-so-great economist, held
this view. Menger showed that Locke and those who thought as hedid were in this instance wrong.

Chapter 9: Money, Part 2

1.

See if you can find out the origin of the phrase “the resultof human action but not of human design.”

2.

“Once again, praxeology has been abandoned. Menger’s
analysis is simply a historical account. There is nothingnecessary about it.” Discuss this objection.

3.

Do a report on F.A. Hayek’s work on spontaneous order.
Suggested reading:Hayek’s 3 volume work, Law, Legislation& Liberty (Chicago: University of Chicago Press, 1978).

155?

MISES ON MONEY REGRESSION
I have so far failed to fulfill a promise; and you are probably
glad. The material on money regression was supposed to be hard,but so far (I hope) it hasn’t been. Now the fun begins.
How does the market determine the value of an ordinary commodity, e.g., ice cream? As you will recall from previous chapters,
those magic words demand and supply answer the question. And
what, in turn, determines demand and supply? The preferences ofthe demanders and suppliers of ice cream.
Money, on Menger’s account, is a commodity; so the same
analysis should apply to it. The value of gold, then, depends on the
demand and supply of gold. The demand and supply schedules, further, rest on the utilities of the demanders and suppliers of gold.

AT LAST WE GET TO MISES
So far, so good. But now a problem looms. The demand for gold
depends on the utility of gold. But what determines this?
Remember, the utility of gold resides almost entirely in its use as a
medium of exchange. People want gold because they can use it to get
whatever else they want.

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Can you see why this poses a problem? We are attempting todetermine the value, i.e., the utility of gold. But the utility of gold
depends on its purchasing-power, its value in obtaining other goods. We
appear to be engaged in circular reasoning. That is, we are explaining
something in terms of itself. And this is a major logical no-no.

?

1.

Give examples of circular reasoning.

2.

Is circular reasoning always wrong? Aren’t some statements self-explanatory?

It appears then that money is the great exception in value theory. We cannot use conventional utility theory to explain the valueof gold, since the utility of gold depends on the value of gold.
Hence we must look elsewhere. (I warned you this was tough!)Chapter 9: Money, Part 2

157

Ludwig von Mises showed in The Theory of Money and Credit (1912)
that the value of money can be accounted for by ordinary utility theory. The attempt to do so need not involve reasoning in a circle.
How did Mises find a way out of the circle? He noted that thevalue of money today depends on the value of money yesterday.
When people are trying to value gold, they must estimate thepurchasing power of gold. Their only basis for doing so is the valueof money yesterday.
Note that Mises did not mean that the value of money today
equals its value yesterday. If that were his contention, Mises’s theory would be false. It would have the consequence that the value ofmoney never changes (can you see why?), which is contrary to obvious fact. Mises is saying that people must use the value of money
yesterday as the basis for estimating its value today.

1.

Extra-credit: In an extra-credit section in the previous
chapter, I raised a problem that involved praxeology.
People will tend to converge on one or two goods as a
medium of exchange. In doing so, they choose the goodthey think most likely to have the highest exchange value.
The problem raised was this: is it necessarily true that
their estimates depend on which item has been most valued as an instrument of exchange? Mises’s analysis of thevalue of money appears to solve this difficulty.

?

HAS MISES SOLVED HIS PROBLEM?
It appears that he has not really done so. True, he has avoided
the circle: He does not explain the value of money by the value ofmoney. He explains the value of money today by its value yesterday.

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But is this really an improvement? What explains the value ofmoney yesterday? Obviously, the value of money on the day before
yesterday. And the value of that? Its value on the day before that,and so on. We appear to have exchanged a circle for a regress. In a
regress, we say: A depends on B, B depends on C, C depends on D
. . . and we never reach a term that is not dependent on some previous term. Although this can be disputed, it seems that a fully satisfactory explanation cannot take this form.
Here precisely lies Mises’s genius as a monetary theorist. He
showed that his account of the value of money by its value on theprevious day does not entail an unsatisfactory regress. What happens when we keep pushing back the explanation? The value ofgold at t depends on its value at t-1, which depends on its value at
t-2 . . . Eventually, we reach a day in which gold had no value as an
instrument for obtaining other commodities. The purchasing
power component of its value drops out, and the value of gold on“day one” depends entirely on its use for non-monetary purposes.
Mises thus integrated the explanation of money’s value into general utility theory. Money is not an exception: its value can be
explained by the same theory as other commodities. The purchasing
power of money just makes the explanation rather more complicated.
Do you see a crucial premise needed if Mises’s explanation is towork? There must be a day one in which the monetary commodity’s value is not determined at all by estimates of its purchasing
power. Otherwise, we shall not have escaped the regress. Of course
gold, the example I used to explain Mises’s argument, does have anon-purchasing power value. But Mises does not contend that gold(or silver) must be adopted as a society’s requirement. Nevertheless,money must originate as a non-monetary commodity.
Can you see why it must? Without a value on day one, there
would be no means available by which people could estimate thepurchasing power of money. And it is essential that they be able todo this in order for money to serve as a medium of exchange.

Chapter 9: Money, Part 2

An assortment of paper money

To Mises’s argument there is an obvious objection. What about
paper money? Some paper money is merely a claim receipt for
gold, but other paper money is not. This type of money, called fiatmoney, is simply declared to be money by the government. Absent
this declaration, its value would be nil. The fiat money would thenjust be worthless pieces of paper.
Regardless of whether the government should issue fiat money,
it very often does so. Is this not a refutation of Mises’s account? Hesays that money must originate as a commodity. But fiat money does
not so originate. Hence Mises’s theory collapses; “A beautiful theory, ruined by a stubborn fact.”
In fact, Mises’s theory does not have the consequences our supposed refutation imputes to it. Mises does not deny the possibilityof fiat money. Rather, he claims that fiat money is parasitic on commodity money. In the absence of commodity money, people would
have no way to estimate the purchasing power of fiat money, andthis sort of money could not exist.

159

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An Introduction to Economic Reasoning?

1.

Why does the existence of money require that people beable to estimate its purchasing power?

2.

“Mises gives an account of the value of money, but hedoes not show that any competing account is impossible.
Hence he does not show that money must originate as acommodity.” Evaluate this objection.

Chapter 10
The Gold StandardM

oney, we have seen, begins as a commodity—otherwise people would not know what value to give it. But, what commodity? As mentioned in the previous chapter, this is not something we can determine by a priori reasoning. Many different goods
have served as money—including cows and cigarettes.
But, I am sure you will recall, although we cannot figure out
which good a society must adopt as money, we can establish some
general principles that narrow the range of choice. A good canbecome money only if it is widely accepted by people in a society.
Further, people must believe that it will be accepted if offered in
exchange.

1.

Why is the latter requirement needed? Why isn’t it enoughif the members of a society accept a good in exchange?
Why must people also believe that it will be accepted?

2.

It’s easy to understand how a society could adopt cows asmoney: think of an agricultural community where cows
feature prominently. But how can cigarettes get to bemoney?

?

AN UNUSUAL CHOICE
The group that chose cigarettes was in an extraordinary situation.
It consisted of soldiers in a prisoner of war camp. Since everyone
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realized that (nearly) everyone else wanted cigarettes, then, no
doubt to the dismay of the American Medical Association, cigarettes were a highly demanded good. They became money in theway the money regression theorem indicates.

?

1.

“Doesn’t the cigarette example really disprove the regression theorem? Didn’t people in the camp agree among
themselves that cigarettes would be considered money?
But the regression theorem says money isn’t establishedby agreement.” What is wrong with this objection? Hint:
does it follow from the theorem that the evolution ofmoney must take place slowly?

THE USUAL CHOICE
Were you able to figure out the answer to the last question?
Remember, the regression theorem says that the value of the money
commodity cannot be determined just by decision. But if people
know that cigarettes will be generally accepted, and are aware,through trades, of the price of other goods in terms of cigarettes,
things can move very fast.
In most societies, cigarettes are not the medium of exchange. As
mentioned before we digressed onto cigarettes, there are some general principles that limit the range of goods that will be chosen as
money. These principles, as you will recall from the previous chapter, have led most societies with access to gold or silver to adopt oneof these metals, or both, as money.

?

1.

Review the properties of money that make gold and silver
desirable mediums of exchange.

Chapter 10: The Gold Standard

2.

165

If gold and silver are in fact so useful as money, why isn’t
the United States on the gold standard?

Sometimes, a society will use both gold and silver as money.
Usually, silver will be used for smaller transactions, gold for larger.
A monetary system with two metals at once poses a problem. We
will have some prices of goods given in gold and others given in silver.

1.

How may these prices be compared with each other?

2.

Extra-credit: Why does the answer to the first problem
suggest a further problem about the prices of othergoods? How can this difficulty be resolved?

?

THE MARKET SOLUTION
The key to our first problem is straightforward. Gold and silver
are commodities, just like apples and oranges. They can then tradeagainst each other. For example, the market may establish thisprice: 1 ounce of gold exchanges for 16 ounces of silver. Suppose
this ratio is chosen, will it always remain constant? That is, willgold and silver always exchange according to the formula justgiven?
As I hope you have realized, the answer is no. The ratio is a
price; and just like other prices, it is determined by demand andsupply. These, in turn, depend on the utilities of the buyers and seller. (Go back to the chapters on utility and demand and supply for a

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review. You cannot go over these basic principles too many times.
To understand economics, you must know demand and supply.)Let’s assume that more silver is mined while the amount of gold
stays the same. As more silver enters the market, the marginal utility of silver decreases. (Why?) What will be the effect on theexchange ratio of gold and silver?
People will now have to give up more silver than before to get
an ounce of gold. We will have a new ratio of exchange, e.g., 1
ounce of gold exchanges for 16.5 ounces of silver.

?

1.

Draw supply and demand diagrams to illustrate thechange just described. (Of course, I could have put themin the book! But it’s much better that you, the student,
construct them for yourself. Besides, it’s easier for me.)

Chapter 10: The Gold Standard

2.

167

?

Draw supply and demand diagrams showing the effect of
an increase in the supply of both metals; a decrease inboth; and an increase in one accompanied by a decreasein the supply of the other. I really make you work, don’t I?

OTHER GOODS
The market has established an exchange ratio, say 16 to 1,
between ounces of silver and gold. Is everything now all right?
No, not necessarily. Some goods will be priced in gold and others in silver. These prices, of course, will be determined by thedemand and supply of these goods, relative to the demand and supply of gold and silver, respectively. For example, 1000 oranges may
exchange for 2 ounce of silver.

1.

What do you think the gold price of 1000 oranges wouldbe, given the silver price just quoted?

?

OTHER GOODS CONTINUED
In the market, we will have all sorts of different exchange ratios,or prices, some stated in terms of gold, some in terms of silver. All
these prices must “match” the gold–silver exchange ratio.
What does this mean? Suppose someone wants to buy oranges but
doesn’t have any silver. He asks the orange grower, “How much gold
must I give you for your 1000 oranges?” (Speakers in economics

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textbooks often express themselves in stilted sentences.) Our
Orangeman is no dummy; he replies, “c ounce of gold.” Theowner of gold, eager to secure the oranges, accepts. Can you see theproblem that now arises? We have the following exchange ratios:
16 ounces of silver exchanges for 1 ounce of gold
2 ounce of silver exchanges for 1000 oranges
c ounce of gold exchanges for 1000 oranges
As Lord Tennyson the great British poet, says, in “The Chargeof the Light Brigade,” “Someone had blundered.” You should easily discern who it is: it’s the sap who gave up c ounce of gold to get1000 oranges.
The fortunate Orangeman now has c ounce of gold. We can
now obtain 2 ounces of silver for his gold. (Why?) After doing so,
he can buy 4000 oranges. (If he is even more lucky, he can start theround again, this time getting 2 ounce of gold from the sap for4000 oranges.)
Unfortunately for the Orangeman, but fortunately for the sap,
this situation will soon come to an end. Other Orangemen willattempt to get in on the good deal. They want the gold for themselves: they will not act as United Orangemen. But the sap has only
a limited amount of gold to offer for oranges. How can each
Orangeman get as much as possible for himself? He will offer thesap a better deal. He will, say, offer 2000 oranges for c ounce of
gold.

?

1.

Why will he do so? The sap will give up 1/8 ounce of goldfor 1000 oranges. Why offer an extra 1000?

Chapter 10: The Gold Standard

169

THE SAP GETS WISE
If he didn’t offer more oranges, what would happen? He might
be shut out of the market. His fellow Orangemen would all be trying to get the gold; and there is not enough to go around. If heoffers 2000 oranges, his chances to get gold increase. The sap
prefers to get 2000 oranges rather than 1000 oranges for his counce of gold. (He isn’t that idiotic.) The Orangeman will makeless profit than before, but it is still well worth it for him to up his
offer.

1.

Work through the exchange ratios to show why it is still tothe advantage of the Orangeman to get 1/8 ounce of goldfor 2000 oranges. How high do you think the bidding willgo?

2.

What do you think the sap will do when he sees
Orangemen bidding up the price?

?

THE SAP GETS WISE, PART 2
More and more Orangemen will see the opportunity to make akilling in the market. And perhaps others, who do not now own
oranges, will see the advantage to be gained by purchasing them.
Once they have the oranges in hand, they can attempt to secure
gold from the sap.
Meanwhile, the sap sees that his gold is in demand. (Even idiocy is usually not of infinite extent.) He will suspect that he has beenoffering too much gold and will lower his offer.

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Thus, our exchange ratio of c ounce gold for 1000 oranges
faces pressure on two fronts. Orangemen offer more oranges andthe sap offers fewer ounces of gold. How long will this go on? Until
no profits from a series of trades can be obtained. Gains from aseries of trades, based on price discrepancies, are called arbitrage
gains. We considered them in an earlier chapter, where we discussed the law of one price. Here we see that there is nothing special about money. Gold and silver, just as much as oranges andapples, obey the law of one price.

?

1.

If gold and silver behave like regular commodities, why do
you think that many people regard money as subject tocompletely different economic laws from other goods?

ENTER THE STATESuppose, once more, that silver and gold exchange at a 16 to 1
ratio. In the way I have just explained, all prices of goods on themarket “match”: no gains are to be had from arbitrage transactions.
“All well and good,” certain economic reformers will say, “butthe balance is easily upset. As soon as the quantity of gold or silverchanges, the ratio of 16 to 1 is outdated and must be altered. But ittakes time to do so. Meanwhile, the possibility of arbitrage is present. Why not make calculation of prices easier? To do so, let us
make the 16 to 1 ratio permanent. Then, we never have to worry
about arbitrage in money again.”?

1.

What ethical assumptions about arbitrage and calculation
does our imagined reformer make? Are these assumptions
justifiable?

Chapter 10: The Gold Standard

171

DIGRESSION ON ETHICS
One of the themes of this book emerges here with crystal clarity. It is very easy to assume that certain ethical views, or “value
judgments” should be adopted, even though examination showsthem to be controversial and in need of justification.
Our reformer has made two such controversial assumptions.
First, he correctly notes that changes in supply and demand taketime before they affect prices. Even though the 16 to 1 ratio nolonger corresponds to the actors’ present utilities, it remains inplace until changed.
But why should we think that something is wrong with this?
Why should adjustment of prices to changes in demand and supply
be instantaneous, or at any rate, faster than the market accomplishes by itself? Be careful not to make an unjustified assumption about
what I am saying here. We do not contend that the ideal of instantaneous price adjustments is misplaced.
Rather, I wish all readers to note that an ethical assumption has
been made by the reformer. If he moves from (1) price adjustment
takes time; to (2) price adjustment takes too much time, he hastaken a step that requires argument in its support.
And our reformer has smuggled in another unexaminedassumption: adjustments that take place through arbitrage are“bad.” What is wrong with arbitrage? Our reformer must tell us.
Once more, we have not assumed that arbitrage is morally all right;
we have wished merely to call attention to a burden of proof too
often overlooked.

1.

Give other examples in which proposals for economic
reform contain smuggled-in value judgments.

?

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GRESHAM’S LAW
We shall not, for the moment, take our discussion of ethics further. Here we shall restrict ourselves to “positive” economics.
(Recall the distinction between positive and normative statements,
discussed earlier.)
Suppose, once again, that the market has established the 16 to
1 ratio. New gold mines in Patagonia are discovered, and anincreased quantity of gold has come onto the market. Assumingthat utilities otherwise remain unchanged, the price of gold will fall.
One ounce of gold will be able to command only 15 ounces of silver in exchange, for example.
But the state has imposed a 16 to 1 ratio. If you have one ounceof gold, you will be able to get 16 ounces of silver for it in the market. You would have been willing, by hypothesis, to take 15 ouncesof silver for your gold; but you certainly have no objections to getting an extra ounce.
Silver dealers will prove more recalcitrant. The 16 to 1 ratio nolonger reflects the market price. If it is enforced, silver dealers willbe less willing than before to offer silver on the market. Gold willtend to become the exclusive medium of exchange.
Why will these results ensue? We must, as always, revert to abasic principle. Money is a commodity.

?

1.

How does this principle enable us to analyze the effects ofa fixed exchange ratio?

SURPLUSES AND SHORTAGES
We hope that you answered the question by reference to surpluses and shortages. Remember the effect of a maximum priceChapter 10: The Gold Standard

173

below the market price? There will be a greater quantity of thegood demanded at the artificially lower price than will be offered
for sale. In brief, there will be a shortage. This is exactly what has
happened in our example. The price of silver is artificially low. Its
market value is 1/15 ounce of gold, but its state-mandated price isonly 1/16 ounce of gold. Hence a shortage.
Looked at from the opposite angle, the price of gold is artificially high. There is a surplus of gold at the artificially enforced
ratio. Purchasers of gold demand a lesser quantity of gold at the 16
to 1 ratio than suppliers offer at that price.
In sum, money overvalued by the state will tend to drive money
under valued by the state off the market. This is Gresham’s Law,
usually stated as “bad money drives out good.” Our formulation,
which comes from Murray Rothbard, is preferable to the traditional one. It tells us what “bad” and “good” money are.

A SINGLE METAL STANDARD
As we have learned in this chapter, the free market can readily handle a system with both gold and silver as money. So long as the state
does not impose price controls, both metals will circulate as money.
But people’s preferences may change. They may find two sorts ofmoney, with frequently fluctuating exchange ratios, to be inconvenient. In that case the market stands ready with a solution. If enoughpeople stop using one of the metals as money, it will cease to bemoney. Remember the money regression theorem? The demonetization process goes exactly in reverse from the path it delineates.
A commodity that grows more and more in demand as a medium of exchange gains extra value by this fact. Silver, e.g., becomes
valuable not only for its use in rings or teeth, but for its services inmaking exchange easier.

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If some people stop accepting silver in exchange, then it willlose its value as a medium of exchange. As it loses value, it becomeseven less demanded by market exchangers. A spiral-like effectoccurs, just the opposite of the process by which money is created.
If a commodity loses all (or nearly all) of its value as a medium
of exchange, it has been demonetized. Its value is now determinedjust like that of any other non-monetary good. Though this is not a
praxeological law, it is safe to predict that a free market will tend to
supplant a two-metals currency with a single-metal standard, forconvenience. The metal chosen will normally be gold.

?

1.

Why will a free market tend to establish a gold rather thana silver standard?

ConclusionIn this book, we have tried to convey one fundamental lesson. It is
possible to think in a systematic, logical way about economics.
You need not accept statements just because “the book says so,” andyou do not have to wait until graduate school to find out the basis
for what you are asked to believe.
To understand economics requires only careful attention to reasoning, in some cases perhaps a little diffiult and abstract. (I didn’t
mention this feature at the start, in order not to scare anyone off.)
At least, this is the case if the economics in question is Austrian economics, the type we have endeavored to present to you.
In it, we begin with the action axiom and deduce from it powerful theorems, such as the law of diminishing marginal utility concentrated on the application of Austrian reasoning to two key areas,
price and the nature of money.
What is the law of demand? What is wrong with Marx’s labor
theory of value? Why must money originate from a non-monetarycommodity? These are a few of the questions you should now beable to answer, if you have made it through my bad jokes.
Further, I hope you will now realize how prices coordinate
demand and supply without government interference. Measures ofintervention, such as price and wage controls, fail to achieve thepurposes their advocates profess. In like manner, the government
cannot originate money by fiat, out of thin air.
Of course, if you conclude from this that government “should”
not intervene, you have made a normative judgment. I hope that you
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now understand how judgments of value differ from descriptive statements, as well as how knowledge of matters of fact help us makeinformed policy decisions.
If you have studied this book carefully, you should be ready toread for yourselves such great Austrian economists as Carl Menger,
Eugen von Böhm-Bawerk, Ludwig von Mises, and Murray N.
Rothbard. I am well content to be, as John Locke said in anothercontext, their underlaborer.

Glossary
Arbitrage: gains that come from taking advantage of differences inprices in local markets. Arbitrageurs see these differences andbring about a single price for each good.
Arbitrageurs: those who take advantage of price discrepancies in
the market for a good.
Austrian Economics: a type of economics based upon deduction
from the nature of human action, especially stressing the subjective nature of value.
Austrian School: a group of economists including Menger, BöhmBawerk, Mises, and Rothbard, whose work is based on the subjective theory of value.
Axiom: a foundational principle, taken to be evident and not inneed of derivation.

Barter: exchange of goods not involving money.

Capital: (1) goods used in production. These goods are not valued
for the immediate satisfactions they provide, but for their help
in transforming goods into finished products.
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An Introduction to Economic Reasoning(2) the monetary value of goods just described. Warning:
Do not confuse these two senses.
Capitalism: an economic system characterized by private ownership of the means of production.
Categorical syllogism: a deductive argument of certain type (seesyllogism), all the premises of which are assertions.
Commodities: goods bought and sold on the market.
Communism: a synonym for socialism, usually of a radical kind.
Cost: the utility of the highest valued alternative not chosen.
Cost of production: the value of the highest alternative foregone
in order to produce something.

Deduction: the process of reasoning from premises to a conclusion, in accord with the laws of logic.
Deduction: a type of reasoning which draws conclusions frompremises.
Deflation: a decrease in the supply of money in an economic system.
Demand: in economics, the amount of one good offered to purchase another good. Not the bare desire for a good, as often
used in ordinary English.

Glossary

Demand and supply: the basic determinants of price. Demand is
the quantity of goods consumers are willing to offer for a particular quantity of a commodity. Supply is the quantity of thecommodity sellers are willing to offer at a given price.
Demand schedule: a table of the quantity of a good consumers
wish to buy at various prices.
Diminishing marginal utility, law of: a basic principle of praxeology, according to which the supply of a good is devoted toincreasingly less-valued uses.
Double coincidence of wants: a necessary condition for exchange.
Each exchanger must prefer what the other offers to what healready has.

Equality: the assumption that goods exchange are in some sense
identical.
Equilibrium: a situation in which buyers and sellers can make nomutually beneficial exchanges.
Ethical assumption: a statement that something morally ought tobe the case.
Exchange: the trade of one economic good for another.
Exchange ratios: statements of what quantity of any good will
exchange for what quantity of another, e.g., if one apple
exchanges for one orange, and apples and oranges are in a 1:1
exchange ratio.
Exchange-value: the worth of an economic good in trade.

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Expectations: assumptions about future economic conditions,especially prices.

Fiat money: money issued by the state, without any commodity
backing.
Fixed costs: costs that, at the time an economic decision is made,have already been expended.
Fluctuating exchange ratios: exchange ratios, especially ofmoney, which are determined by the market and hence vary.
Frational reserve banking: a system in which a bank can issue
multiple receipts for the monetary commodity it has on hand.

Gold standard: a monetary system in which gold is the generally
accepted monetary commodity.
Gresham’s Law: the principle that money overvalued by the state
will tend to drive out money undervalued by the state.

Hedonism: an ethical system that ranks choices by the amount ofpleasurable sensations to which they give rise.
Hermeneutician: someone who uses or advocates hermeneutics.

Glossary

Hermeneutics: a view that human action cannot be understood byscientific laws, but must be grasped in an act of intuitive apprehension.
Historicism: the doctrine that there are no universally valid economic laws. Economic principles apply, at most, to particular
historical periods.
Hypothesis: an assumption, usually in the form “if A, then B.”

If-clause: the part of a hypothetical that states a certain condition.
Imputation: the process by which the value of consumer goods istransferred backward to the goods that produce them.
Indirect exchange: trade that does not secure the commodity
desired in a single exchange, but proceeds by one or moreintermediate steps.
Inflation: an increase in the supply of money in an economic system.
Interest rate: the premium that must be paid to obtain the use ofmoney or capital. Principally determined by the rate of time
preference.
Intransitive preferences: preferences of the form: A is preferred
to B; B is preferred to C; but it is not the case that A is preferred
to C.

Labor: human expenditure of effort in production.

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Law of marginal utility: the principle that the units of a good will
be directed to satisfy the highest ranking preferences not yet
satisfied.
Law of one price: the tendency for a uniform price for a given
commodity to prevail on the market.
Labor theory of value: the view that the value of a good is thelabor time required to make it.
Logic: the normative science of reasoning.

Marginal buyers: buyers who, at a slightly higher price than themarket price, would exit the market.
Marginal unit: the unit of a good devoted to the lowest ranked
preference of the preferences that the good satisfies.
Marginal utility: the value of the last unit of a commodity.
Alternatively, the value of a unit or a good, if one unit of thegood had to be given up.
Market: the setting in which economic exchanges take place.
Market clearing price: the price at which the quantity of a gooddemanded equals the quantity supplied.
Marxism: a system of economics devised by Karl Marx (1818–
1883) based on the labor theory of value. It calls for the
replacement of capitalism with socialism.
Medium of exchange: a good used to facilitate the exchange ofother goods.

Glossary

Minimum wage legislation: a law forbidding the offer of employment at a wage below a specified rate.
Money: a commodity whose principal use is to facilitate theexchange of other commodities. It is demanded because each
person knows that others will accept it in exchange.
Money regression theorem: an argument, developed by Menger
and Mises, that the purchasing power of money must originate
from the use of the money commodity as a non-monetary
good.

Neoclassical economics: a type of economics that makes extensive
use of equilibrium assumptions, is heavily mathematical, and isincompletely subjectivist.

One-hundred percent reserve banking: a banking system inwhich all money certificates must be fully backed by the monetary commodity.
Ought-statement: a statement of what should be the case, as
opposed to what is the case.

Pareto optimal situation: a state of affairs in which no person insociety can have his utility increased by redistribution of
resources without making someone else worse off.

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Praxeology: a deductive science that examines the implications of
the axiom that human beings act.
Preference: a ranking of available alternatives: if S chooses A overB, then S prefers A to B.
Premises: statements from which conclusions are drawn.
Price: the ratio of exchange between two commodities.
Price ceiling: a legally imposed maximum price.
Price controls: forcible interference, usually by the state, withmarket prices determined by supply and demand.
Price determination: the process by which the price of a commodity in a market is fixed.
Purchasing power of money: the amount of commodities a unitof money is able to buy.

Rationing: a system for distributing goods when demand exceeds
supply under a governmentally mandated price.
Reductio: a proof that shows that denial of the desired conclusion
leads to a contradiction.
Regression theorem: the principle that the value of money ultimately stems from the m money commodity’s nonmonetaryuse.
Rent: the price paid for the use of an asset that belongs to someone
else.

Glossary

Scientific socialism: a synonym for Marxism, based on a Marxist
belief that the onset of socialism is probably inevitable.
Shortage: a situation in which the quantity of a good demanded
exceeds the quantity supplied.
Social Security: a governmentally mandated system in which
workers and employees are taxed and retired workers receive apension. Not equivalent to a private insurance plan.
Socialism: a system of production based on central ownership ofthe means of production.
Spontaneous processes: a series of events that generates an organized outcome without central direction.
Strike: an organized work stoppage, aimed at inducing an employer to offer better conditions of work.
Subjective theory of value: the view that economic value is determined by the choices of actors in the market.
Supply: a good offered for sale in the market.
Surplus: a situation in which the quantity of a good supplied
exceeds the quantity demanded.
Syllogism: a form of reasoning in which a conclusion is deduced
from a major and minor premise.
Symbolic logic: a system of logic not restricted to the subjectpredicate statements of ordinary language.

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An Introduction to Economic Reasoning

Tautology: a statement, e.g., a definition or part of a definition thatis true solely because of the meaning of the terms it contains.
Time preference rate: the rate by which people prefer goods inthe present to goods in the future. This rate principally determines the rate of interest.
Transaction: a purchase or sale of any commodity.
Transactions cost: the expenses that come about because a transaction takes place; e.g., bargaining cost.

Unemployment: a state of affairs in which a worker’s services are
not in demand at a given wage rate.
Utilitarianism: a system of ethics that maintains that the good iswhatever maximizes happiness.
Utility: the value of a good to a consumer.

Value: the attribute of a good that fits for use, or enables it tosecure other goods in exchange on the market.
Value, subjective theory of: the view, developed by the Austrian
School, that economic value is not an inherent property of agood. Rather, it is determined by the preferences of those whowish to acquire the good.

Recommended
Readings
Everyone who reads this book should also read Henry Hazlitt,
Economics in One Lesson (Arlington House, 1979), which is mucheasier to understand than the present work. It is a superb account of
how economic theory applies to the real world.
You will also find extremely helpful Murray Rothbard’s brilliant, and very short book What Has Government Done to Our
Money? (Ludwig von Mises Institute, 1990). This is a very clear
presentation of Austrian monetary theory. If you want to know how
the current U.S. monetary system got started, the same author’s The
Case Against the Fed (Ludwig von Mises Institute, 1994) is a goodplace to begin.
The two greatest twentieth-century works of the Austrian
School are Ludwig von Mises’s, Human Action (Ludwig von Mises
Institute, [1949] 1998) and Murray Rothbard’s, Man, Economy, andState (Ludwig von Mises Institute, [1962] 1993). You will probably
find them hard going, however, and you should be satisfied withreading whatever interests you in them. Rothbard is much easierthan most parts of Human Action.
Probably the best way to get the flavor of Mises is to start withessays in his Planning for Freedom (Libertarian Press, 1980) and theessay “Planned Chaos” in Socialism (LibertyClassics, 1982).

About the AuthorDr. David Gordon is a Senior Fellow at the Ludwig von Mises
Institute, and editor of The Mises Review. He was educated at
UCLA, where he earned his PhD in intellectual history, and is theauthor of Resurrecting Marx: The Analytical Marxists on Exploitation,
Freedom and Justice; The Philosophical Origins of Austrian Economics,
and Critics of Marx. He is also editor of Secession, State & Liberty, andco-editor of H.B. Acton’s Morals of Markets and Other Essays. Dr.
Gordon is a contributor to such journals as Analysis, The International
Philosophic Quarterly, The Journal of Libertarian Studies, and The
Quarterly Journal of Austrian Economics.

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