I'm Peter Klein, and it's a pleasure to be with you this morning.
Let me start by saying how delighted I am to be able to participate in this series on
Fundamentals of Economic Analysis, a Causal Realistic Approach.
As you may know, Professor Salerno gave a similar set of lectures last year by himself,
and so it was decided that I should join him this year to add a little rigor to the analysis.
I'm just kidding.
Actually, Joe's not in here, that was for his benefit.
The truth is that Joe and I share a belief that the kind of causal, realistic analysis that we'll be discussing this week is not only fundamental to Austrian economics, the core in a sense of Austrian economic thinking, but also that it has been unduly neglected, shall we say, not only by mainstream economists, but even by many who call themselves Austrian economists.
So really what we hope to achieve with the seminar and ultimately with a written version that will come out in book form in the not too distant future is to help to encourage sort of a revival of this kind of analysis within the Austrian school and hopefully to initiate some changes that may spread beyond the Austrian school as well.
We've already had two introductory lectures yesterday on the basics of value and exchange, demand and so on.
So today we're going to build on that analysis and move on to thinking about the determination of prices.
We think about prices in monetary terms.
So imagine that we have an economy with multiple individuals who are interested in participating in exchange.
There is a common medium of exchange in this economy.
So goods and services can be exchanged in numbers, determined in monetary terms, so there are money prices in this economy.
Let's try to understand, as Carl Menger did, and as Menger's successors did, what determines the prices that are actually paid in market transactions day to day.
Okay. Again, just to remind you of sort of the institutional and informational assumptions of our analysis, right?
So we assume that buyers and sellers are aware of at least some feasible trades.
So they know that there are other agents in the economy who may have goods and services that they wish to buy or to sell.
Market participants understand that participating in the division of labor will bring them benefits.
Okay, so they're not just sort of mindlessly, robotically acting in a pre-programmed fashion or in a manner determined by evolution in any sort of narrow sense.
But they have some cognitive faculty of awareness. They want to be in the division of labor.
We make some very simple assumptions about people's preferences. Sellers prefer higher profits to lower profits.
And we can add a very simple assumption about learning, namely that buyers and sellers have the capacity to learn from their mistakes.
And we'll see what that means in more concrete terms in just a moment.
The point is we do have some assumptions about people's abilities, but they're pretty mild assumptions.
We're not making any kind of strong assumptions about, for example, perfect knowledge, as in the textbook model of perfectly competitive general equilibrium,
where all agents are perfectly informed about the existence of all other agents and all feasible trades and all resource attributes and so on.
We're not making an assumption that strong.
We're not assuming, as in the perfectly competitive model, infinitely large numbers of buyers and sellers where sellers are facing a perfectly elastic demand curve and so on.
Joe talked about this yesterday.
We're not assuming that the goods and services being exchanged are infinitely divisible or perfectly divisible.
So you won't see any partial derivatives in the discussion today.
There's not only no need to apply the calculus notion of infinitely small adjustments, but also no...
Also doing so would be illegitimate in the world of real action because human agents think in discrete terms.
You think about buying a Coke or you think about buying an automobile.
Automobile. You don't think about buying one nth of an automobile as n goes to infinity
and so on. Okay? Here's what we're going to do. We'll walk through a series of different
scenarios from the most simple to the most complicated. So we'll start with a simple
case of two-person exchange. Then we'll go on to a setting where you have many potential
There are multiple buyers of one single commodity, think of an auction, an art market or something like that.
There's one painting and several people who are potentially interested in buying.
Then we'll think about a situation with one buyer and multiple sellers competing for the same buyer,
working our way up to an analysis of bilateral competition or multiple buyers and multiple sellers.
And of course I'm thinking about this with a specific example.
I used to do with my car, the radio on my car, more specifically the CD player on my car.
I drive an old Nissan Maxima. There's a picture of it right there.
That's actually the stock photo. That's not my car, although it does look like the grounds of my estate in the background.
The radio looks like that. Now what happened is a CD jammed in the radio.
So I was listening to a CD and I pressed eject and it wouldn't come out.
It's one of those, you know, it slides in and then it kind of goes down. So you can't reach it.
Of course, there's only a teeny little slot. So this happened while I was out on the road somewhere.
I wasn't home, you know, like with tools. So I'm, I can't remember, I'm in a parking lot or on the side of the road.
And I'm trying to figure out how the heck am I gonna get the CD out of there because I don't want to lose it,
number one, and I still had another hour's drive ahead of me.
I didn't want to be without, you know, without anything to listen to. Tried to stick my fingers in there.
Of course, it didn't work. I think I found, like, I had a pocket knife or a screwdriver or something, tried to stick it in there.
That didn't work.
I had the brilliant idea, I said,
well, the only implement I have that is the right size
to go in there where I can sort of twiddle and wiggle
and maybe hope to pry it loose is another CD, right?
So I took another CD and kind of stuck it in there.
Okay, I'm a professor, I'm not very practical.
And I tried to wiggle and jiggle, and of course,
what happened is the CD player sucked that one in too.
So now there's two CDs jammed in there.
Okay, so being very clever, I said to myself,
yeah, I just need to replace the whole unit,
But when I went to the dealer and said,
how much will it cost to get a new factory radio?
I mean, it's some ridiculous 500 bucks or something.
I thought, well, I'll go to Circuit City or Best Buy
and get an aftermarket radio.
But then I'll look like one of those people who invests a lot
in his car stereo, and I don't want people to think
that I'm putting a lot of time into this.
Of course, I've already put in many, many hours at this point.
I said, I'll just go onto eBay and see
if I can find a replacement for my factory original radio.
And in fact, if you go to eBay, it turns out there's a whole bunch of people selling radios very similar to mine.
Some of these are exactly the right model, some of them are pretty close.
And it turns out, if you're clever, you can even purchase from certain vendors on the web
instructions for how to pull the unit out yourself and replace it and stick it back in.
So I can do all this without having to pay, without participating in the division of labor
and paying somebody to put it in for me, I could do it all myself and wouldn't that be fun?
Then I started to look at these radios and they turned out to be a little bit more expensive than I was anticipating.
You can see some of these have a buy it now price between $100, $150, some of them are up to $200.
I watched some of the auctions to see where the market would clear eventually and they all cleared at a price a little higher than what I had in mind.
So the point is I'm still driving around with busted radio, but I'm determined to figure this out at some point.
Now back to our story, what determines the prices at which these radios will sell, right?
Why are some of them more expensive than others?
How does the design of the sort of selling institution, the market as designed here by eBay, affect the price that will be determined, that will prevail and so on?
Okay, so let's go back to our story for a second.
Okay, start with a simple case in which there's only one radio available for sale, okay, and there's only one potential buyer of that radio, okay, so we can think about each person, right, each buyer and seller has a subjectively determined preference ordering or value scale, as Joe described yesterday, right, where they rank the possession of a radio in relation to the possession of various dollar amounts, okay, so imagine that we can define what we call the reservation prices,
Meaning for the buyer, the highest price that he would willingly pay and still acquire the radio.
Okay, so assume that the buyer's reservation price is $250.
He would not pay more than $250 for a radio, but he would pay up to $250.
Okay, it doesn't mean that he prefers to pay $250.
He'd prefer to pay $10.
Okay, but he'd be willing to pay as much as $250, but he would rank $250 higher than,
$251 would be higher on his preference ordering than possession of a radio.
Likewise, the seller has what we call a reservation price, the lowest price that he would be willing to go and still be willing to sell the radio.
So imagine that the buyer's reservation price is $250, the seller's reservation price is $200.
Well, there's a feasible trade here. There's room for mutual benefit for gains from trade.
They could exchange this one radio at any price between $200 and $250, greater than $200, less than $250, and each would be better off than he was before.
Okay, so what we can say in a case like this is that the equilibrium price could lie anywhere below the buyer's subjective valuation and above the seller's subjective valuation.
So notice that in this case we can't explain exactly what the price will be. Will it be $225? Will it be $201? Will it be $249?
Well it depends on the relative bargaining abilities of the two parties. It might depend on some aspect of institutional design that isn't explicitly addressed here.
So in terms of sort of deriving exact laws of economics, the way Joe described them yesterday, the most we can say is that the price will lie somewhere in this interval.
in this interval, okay?
This is pretty straightforward.
Slightly more complicated case.
Suppose there is one radio available for sale
and five potential buyers, okay, B1 through five.
And each one has a different reservation price.
So the first buyer values the radio
as much as $300, but not more.
The second buyer values the radio
as much as 275, but not more, and so on, okay?
What can we say here?
Well, there's, given the numbers in this example, there are opportunities for mutual gain, right, and in this case, we can say the good will go to the most capable buyer, meaning the buyer with the highest reservation price, the greatest willingness to pay, at a price between his reservation price and the reservation price of the next most capable buyer, assuming that those are above the seller's reservation price, okay?
So the point is, if the radio were offered for sale at $270, there are two potential buyers but buyer one is willing to pay more than $275 and buyer two isn't.
So buyer one would offer to outbid buyer two by offering $276.
So the price can be no lower than $275.
Otherwise, we would not have resolved which buyer is going to get the radio, and the price can't be greater than 300, otherwise no one's interested in buying, can't be below 200, otherwise the seller is not interested in selling.
So again, we can establish precisely a range for the equilibrium price, no higher than the most capable, what von Boehm-Bawerk calls the most capable buyer, the buyer with the highest willingness to buy, and no lower than the price of the willingness to pay of the next most capable buyer.
So again, we're establishing a range, not an exact number, and we can say the equilibrium quantity Q star is one, there will be one unit exchanged, and the equilibrium price P star will lie between 275 and 300.
Pretty straightforward stuff.
Here's a slightly different case. Suppose that we have the same competition among buyers, but suppose that the seller's reservation price is greater than the reservation price of the most capable buyer.
Well, here there are no feasible gains from trade. No buyer is willing to pay as much as the seller requires, so the equilibrium quantity here is zero.
Okay, so there will be no exchange in a case like this.
So just to remind you, there's a caveat, right?
No matter what the rank ordering of preferences among buyers,
there has to be at least one buyer
who is willing to pay what the seller asks, okay?
Now, reverse case, one-sided competition among sellers.
So imagine there's a single buyer for this radio, me,
but there's five different sellers on eBay,
each of whom has a radio for sale, right?
Will I end up buying one at all?
And if so, which one will I buy?
Well, if you imagine that the reservation prices are arranged like this, where the most I'm willing to pay is 250, okay, and we can arrange the sellers from what we would call the most capable seller, meaning the seller with the lowest reservation price, down to the least capable seller, the one with the highest reservation price, okay, so S1 would take anything more than 150 for the radio, S2 would require at least 170 and so on, okay. Well, given that I'm willing to pay as much as
Competition Among Sellers assures that the equilibrium price will be no lower than $150 and no greater than $170.
Okay, so one unit of the good, one radio will be purchased at a price somewhere between $150 and $170.
Okay, so far so good.
It's not terribly profound, is it?
Okay, but we'll see, it gets a little bit more interesting and complicated.
Now, suppose we have multiple buyers and multiple sellers, or bilateral competition.
This is where we get into the somewhat misunderstood and frequently blind analysis from Boehm-Bawerk of what he called the marginal pairs.
Boehm-Bawerk's analysis of the marginal pairs.
There's no, as an aside, if you read Human Action, Mises does not go into a lot of detail about the mechanics of price setting.
Rather, he simply mentions, almost in passing, that, of course, prices in markets are determined by the marginal payers, as Boehm-Bawerk has explained.
and then he goes on and does the rest of his analysis and to your contemporary
readers, marginal payers, what's he talking about? What's that? Where are the supply
and demand curves in Mises? Where are the little tables explaining who exchanges
what? Well Mises takes for granted that the educated reader is first completely
familiar with von Boehm-Bawerk's analysis which most modern readers no
matter how well educated they may be are not. Okay so let's spend a little bit of
There's no time going through exactly what Boehm-Bawerk had in mind.
Okay, so here we have two-sided competition, right?
There are five potential buyers with their valuations,
or the highest prices they're willing to pay, arranged as follows.
And there are five possible sellers, okay, with their valuations arranged as follows.
So notice, we're assuming here that, I mean, how many units of the good are available for potential transactions?
How many units are out there in the marketplace that could be exchanged?
Five.
Yeah, five, right?
I mean, the point is there are five sellers, so to be a seller, meaning you currently possess the good, and you might be willing to give it up for money.
There are five people who want it, meaning they don't currently possess the good, but they would be willing to give up some money to get it.
So, key assumption, there are five units that exist, five units that are available at this moment.
The question is, who will end up having them?
So you can imagine a set of circumstances under which there's no trade at all,
and at the end of the day, at the end of the trading period, the five sellers still have the five radios.
There were no transactions.
Or, at the end of the day, none of the sellers has a radio anymore, and all five of the buyers have a radio.
Five transactions. So we can see that the range of equilibrium quantities is from zero to five. It can't be more than five because there's only five radios.
So how do we solve for what the price will be, what's the equilibrium price in this case, and what's the equilibrium quantity, how many units will be exchanged?
Well, there are a couple different ways we can think about it, and let's walk through a few of them.
Okay, one is to imagine that we sort of pair these guys up.
Okay, so imagine that, you know, they're arranged where buyer one meets seller one and buyer two meets seller two,
and they just sort of pair off, right?
And if they happen to be paired off in this order, what do you say?
Well, I mean, there are potential gains from trade between B1 and S1, right?
Because B1 values a lot more than S1 does, so they could arrange a trade somewhere between 300 and 150.
Feasible gains from trade in the second pair, the third pair could make a deal, the fourth pair could make a deal, the fifth pair couldn't.
Okay, so when we get down to B5 and S5, the buyer values it less than the seller, so there's no possible price that would lead to a transaction in that case.
Okay, well that tells us that, makes us think, well maybe there are going to be four transactions, but not five.
Right, but this doesn't tell us what determines which buyer gets paired up with which seller, and if we're imagining a market for a homogeneous good, right, nobody would want to pay more for the good than somebody else in the market is paying for that good.
Right, so if we want to explain the emergence of a uniform price in this market, where everyone is transacting at the same price, simply doing it this way doesn't help us.
Another way we could think about it, is what if we just line up all the buyers' valuations and all the sellers' valuations and mash them into the same column?
In other words, regardless of whether you're a buyer or a seller, what if we just put you all in a list like this?
So we rank everybody based on their valuation of the good in monetary terms.
So notice that it goes B1, B2, B3, S5, then B4, S4, B5, S3, S2, S1. So we've got buyers and sellers mixed up in here.
But think of the market this way. Again, at the beginning of the day, there were five sellers, each of whom had a radio, and five buyers, none of whom had a radio.
If we imagine some process in which radios end up in the hands of those who value them the most,
at the end of the day, who's going to have the five radios?
Well, the five radios will end up in the hands of the five individuals who value them the most.
And notice that that's one, two, three, four buyers and one seller.
So at the end of the day, four of the radios have changed hands,
But one of them remains in the hands of its original possessor.
So again, that tells us that the equilibrium quantity in this market has got to be four.
There will be four trades, but not a fifth.
Now, how does Boehm-Bawerk analyze it?
The more standard way that you may have seen this before is in the analysis of the marginal pairs.
The way it's done in the reading by Percy Greaves,
If you had a chance to look at his, in his book, Understanding the Dollar Crisis, the early chapters on value and exchange and pricing provide the same kind of analysis, but in a slightly more complicated version than my simple one.
Okay, so go back to our original layout of the buyers and sellers, right?
If you just sort of mark in blue the five highest valuations, identify the five participants with the highest valuations, you see the four buyers and that one seller.
So what can we say about the price that will be paid on the market if there is a uniform price for all of these trades?
Well, the price can't be, so the first buyer is willing to pay at least $300, the second buyer is willing to pay at least $275 and so on.
Okay, well notice that B5, think of B5 as the first buyer who says, I'm out.
Okay, so the first four buyers all buy, by the time we get to the fifth buyer he says, sorry that's too rich for my blood, I don't want to participate.
So B5 is the first buyer who doesn't participate, who doesn't exchange, or if you look at the sellers, the first four most capable sellers do exchange, so at the end of the day they don't have a radio anymore.
S5 is the first seller who says, no, wait a minute, I need at least $2.30 to be willing to let go of this good, I'm not going to participate unless I get at least $2.30.
So the equilibrium price must lie somewhere between $200, the valuation of the first buyer who's priced out, and $230, the valuation of the first seller who's priced out.
So again, we can establish a range of possible equilibrium prices somewhere between $200 and $230.
Why those numbers? If the price were below 200, then the fifth buyer would want to buy one.
But at a price below 200, there are no other radios available for him to buy.
They've all been sold already.
Likewise, if the price were above $230, then the fifth seller would say, I want to sell too.
But there are no buyers available for him to sell to, that all the buyers have already purchased at that price who are willing to purchase at that price.
Okay, so to maximize the gains from trade, to maximize the number of transactions, the price must lie between 200 and 230.
In Boehm-Bawerk's language, if you think of pairing off, you know, B1, S1, B2, S2, B3 and S3 and so on, right?
Right, the pair B4 and S4, right, that's the last pair that does end up participating in exchange, right, and the pair B5 and S5, that's the last pair that ends up not participating in exchange, right, and that's what Boehm-Bawerk calls the marginal pairs, okay, so the B4-S4 pair and the B5-S5 pair, those are the marginal pairs, and it's their valuations, or more precisely the valuations
The first set of potential traders who are excluded that establish a feasible range on the equilibrium price.
Okay.
We could look at this graphically if we wanted to.
Okay.
Here's one way to do it.
Suppose we just, we take all of our ten market participants and we arrange them from highest valuation to lowest valuation,
ndependent of whether you're a buyer or a seller, okay, and we just put them all on the same diagram, right, again we've got the guys in blue are the ones who at the end of the day end up with a radio, the five with the highest valuations, and the ones in black are the ones with the end of the day end up without a radio, okay, so notice that all the sellers except for S5 go home with cash instead of radio, all the buyers except for B5 go home with radio instead of cash,
And you can see the range established between 230 and 200, so here's 200 and here's 230, just a little bit above 225.
And so S5 is the valuation of the first seller who's priced out, B5 is the valuation of the first buyer who's priced out.
Equality Price Doubt. So you can see that our range for the equilibrium price will lie somewhere between $230 and $200.
And notice that there only exist five units of the good. So here's one, two, three, four, five, the five units of the good.
If we were to sort of connect the dots, we could represent this as a total demand curve,
Meaning a demand curve that incorporates not only the willingness to pay of potential buyers who want the good,
but also the sort of willingness to sell of the potential sellers who have the good.
Okay, so if we aggregate the buyers and sellers into a single demand curve,
we could connect the dots and have something like this.
This is the analysis of total demand that comes from Wicksteed.
Something that's illuminating about thinking of the total demand curve as including the valuations of both buyers and sellers is that it reminds us that sellers are participating in this market for the same reason as buyers, namely because they seek to substitute more highly valued goods and services for less highly valued goods and services, where we include not only radios but also sums of money as entries
in the Individuals' Value Scales.
Okay, so the point is sellers have a demand for the good too, right?
At a certain price, they would prefer to keep the good rather than sell the good.
Well, that's simply another way of saying the sellers have a demand for money
at which they would exchange the good or reciprocal demand for the good
at which they, for which they would exchange money and so on.
Okay, so buyers and sellers both have demands and they're both determined
by the subjective valuations they attach
to the good and service, good or service in question.
Okay?
So what in the, we'll get to this in a moment,
what in the standard Marshallian analysis
is two completely separate
and independent determinants of price,
the demand side and the supply side
in causal realistic analysis
are two different dimensions of the same side of the market.
Okay, it's all demand driven.
Okay, so notice that we have the demand curve interacting with a fixed stock of the good in question, okay?
There's another way we could represent the same diagram.
Suppose you said, well, let's separate the buyer, sorry, another way to represent the same information.
Suppose we were to separate the buyers and sellers and put them in two separate, you know, two separate sets.
Okay, so we put all the buyers, we plot the valuations of all the buyers and we plot the valuations of all the sellers and look at them separately.
Okay, so again, notice that we have the five most capable buyers and obviously I just made up these numbers and I've made them, so you have straight lines here, no reason why they would have to be straight lines.
And then we have the sellers from most willing to sell to least willing to sell.
Right, and if you think about, again, feasible gains from trade in terms of the marginal pairs, right, here's the first pair where there are potential gains from trade,
second pair, third pair, fourth pair, but the fifth pair, right, would not exchange, right, so the marginal pairs are these, this pair, and this pair, right,
Right? So we know that the equilibrium quantity cannot exceed the valuations of this fourth pair.
Okay? So that's why we know the equilibrium quantity of exchange is four.
Okay? And the, so at five here we have a vertical line representing the number of radios that's available, the fixed stock of radios that's available.
Let me just back up to the previous slide, something I forgot to mention is
One drawback of Wicksteed's total demand analysis is that you can't sort of tell at a glance what the equilibrium quantity will be.
You have to sort of look at the B's and S's and notice that the top five guys include four B's and one S.
So there must have been four trades but not a fifth.
In other words, knowing where the total demand curve intersects the fixed stock of the good doesn't tell you the equilibrium quantity because that includes some sellers as well.
So some of those who are in this part of the total demand curve, the part before you get to the fixed stock, some of these may be sellers.
So you have to actually look at each individual valuation and see who it is, okay, to get the four.
You can't sort of tell at a glance, whereas if we separate the potential buyers, give them one demand curve, and give the potential sellers another demand curve, what Wichita calls the inverse demand curve, or reciprocal demand curve,
then you can look at where they cross, which is what we like to do when we teach economics classes, right? Look where things cross, and see that, oh, well, the equilibrium quantity can't be five.
Okay, it can be no more than four because you can look at where they cross.
You can see the equilibrium price and equilibrium quantity more easily in this version than in the previous version.
Okay, but otherwise they contain the same information.
Okay, excuse me.
Let's do a little further simplification of the diagram.
Well, first let me show you one more case, sorry.
Notice we've assumed here that sellers' valuations are such that there's at least one seller, B5, whose valuation is higher than that of the least capable buyer, B5.
But suppose that isn't the case. I mean, suppose all of these sellers, as is in the case on my eBay auction, a lot of the sellers are junkyard dealers.
Right? I mean, they don't particularly desire to consume the services of the radio.
The only reason they would hold on to it is if they think they can get a higher price at some point in the future.
We'll get to that point in just a moment.
But let's assume that none of the sellers value these radios particularly highly.
So if we change the numbers in my example, suppose we have a picture that looks something like this.
Suppose the least capable seller, S5, still values the good less than the least capable buyer, B5.
In this case, all five radios are going to be exchanged.
No seller is going to go home at the end of the day with a radio.
Actually, I just noticed now when I drew these diagrams, I should have made B5 blue and S4 and S5 black.
I forgot to do that. Joe, make a note to remind me to do that later, please.
please. My assistant is in the back of the room. Anyway, the point is, right, if even the least capable seller values the good at a price less than that of the least capable buyer, then the equilibrium quantity will be where the demand curve intersects the fixed stock of the good. Okay, so then the equilibrium quantity in this case would be five with an equilibrium price of 200. Okay, again,
There's a little subtlety here. I don't want to look like I'm engaging any sleight of hand, but most of the diagrams that you see drawn, for example, in the diagrams in the Shapiro book, assume this kind of a setup.
Okay, though if you don't watch carefully, you might miss how it got there. Right, so now if we take this diagram and simplify it, okay, so I took out all the little dots and just had the lines.
Okay, so we've got, there are five units of the good, okay, and so what I've traced as the sort of supply curve is the fixed stock of the good,
but then remember at a price below, whatever this is, 170 I think, some of the sellers would prefer to hold on to the good rather than offer it for sale.
Okay, so at a price below 170, not all five units are going to be available, are going to be offered on the market.
Okay, but assuming that we can meet the least capable seller's reservation price, all five units will be available for exchange, right?
And then the demand curve represents the valuations of the buyers, right?
And where the demand curve and the supply curve intersect gives us our equilibrium price of $200, our equilibrium quantity of five, namely the entire stock of the good.
Okay, so this is kind of a, so think of this as just basic supply and demand analysis, supply and demand curves.
Yes?
Two graphs back, where you have the marginal buyer and seller at 230 and 200, so that transaction won't occur.
So why would the price not be limited to B4's reservation price of 2.5 or whatever that is, as opposed to 230?
And vice versa, why wouldn't S4 be the bottom limit?
Okay, you're saying why isn't the range from $2.20 or $2.10 or whatever it is to $2.25?
Right, well, I mean, go back to this diagram here, okay?
So the point is, is there a feasible trade at a price above $2.25 but below, say, $2.26?
So, yeah, I mean, I know, I'm sorry, you said...
Yes, so at $2.26.
What would happen at $226? Could we have a fourth transaction at a price of $236?
Not between these two, but between these two. That's a good point.
Remember, we're pairing these guys up in order.
Exactly. So at a price lower than $2.30 but greater than $2.25, you wouldn't get an additional transaction, it'd just be a different transactor.
You'd have switching places among the sellers. That's a good question. Does everybody get that? That's a good question.
Okay, so now here we have this, again, our supply and demand curves in the case of bilateral competition.
Case two, in other words, one where the seller's evaluations are less than that of the least capable buyer.
Let's just sort of step back from the diagrams for a moment and think about sort of the big picture. What does it mean?
And key points to remember that the equilibrium price in this analysis is determined exclusively by individual subjective valuations.
Note that we have said nothing about the cost of production. We haven't said anything about sort of objective labor cost or objective cost of materials.
In the sort of more standard Marshallian analysis, you might have heard the expression, the two blades of the scissors, meaning the supply and demand curves.
There's a subjectively determined demand side, or one blade of the scissors, but you also need the objectively determined cost side to provide the other blade so that you can cut.
Notice in our analysis we haven't made any reference to objective cost whatsoever.
And I'll come back to this point in a little bit more detail in a few more slides.
But notice that we've assumed that a Marshallian might object and say, but wait a minute,
but you've assumed that there are only five radios in existence.
So, yeah, this analysis might apply to a case of a pure exchange economy where there's a fixed stock of goods or services available for exchange, but can't we produce more?
Well, sure we can, but not instantaneously.
So, it may very well be the case, and we haven't yet explained how there came to be only five radios in existence in the first place, okay?
But, if our objective is to explain the price that obtains in this market transaction for Peter Klein replacement radio, okay?
How the five radios came to be there is irrelevant. It's a moot point at this moment.
We're interested in explaining the moment-to-moment prices that do obtain on the market.
Obviously, there had to be some prior mechanism causing the fact that there are only five radios in existence.
Some radio producers and people in the wholesale market and people who operate junkyards and so on
made some decisions in the past that got us to this point today.
But right now, bygones are bygones.
Right? The fact is, however it happened, there are only five radios existence right now and we can't just magically produce a sixth if we wanted to.
Okay? So there's a temporal dimension to the supply analysis in the standard diagram that is not relevant for explaining the determination of the price today with a couple of caveats that I'll get to in just a moment.
Okay. This is sort of another common misperception. It's the belief that, well, sure, valuations are important, but it's really only the sellers who decide what the price is.
Sellers set the price. Well, I mean, it's easy to have this misconception because when you go down to the grocery store, if I go down to the Super Walmart to purchase what was it that Salerno bought yesterday?
Toothpaste, and I saw there was a Def Leppard album in there. You can really see his age there.
You know, I don't go to the, I don't get the Def Leppard album and take it down to the sales clerk and start bargaining, right?
I mean, there's a posted price and they scan it and I either pay that price or I don't.
So what role do I have in determining the price? Isn't it just given to me by the sellers?
Okay, well we certainly see in the analysis that we've shown here, in our analysis here, that right, it isn't the case that sellers can just ask any price they want, right, because obviously people wouldn't be willing to buy, okay, you know, if I had to pay a thousand bucks to get the original equipment replacement radio, you can be sure I would just break down and have a gaping hole in my dashboard, right, or just go to Best Buy and get some replacement radio or whatever, okay.
Well, it's the same thing with Walmart. Again, if you think about it, if Walmart could simply set the price, well, I mean, why are they charging $249 for a tube of toothpaste?
Why not $24.99 or $249 or a gazillion dollars? Okay, so obviously there must be some limits on sellers' ability to set price unilaterally.
People understand that Walmart can't set the price at a gazillion dollars for a tube of toothpaste, but they think, well, within a range, can't they just set $2.50, $3, $4, who cares?
But the point is, the price that they set, even for small adjustments of a penny here or a penny there, affect the amount of revenue they receive.
It may not be the case that every buyer drops out if the tube of toothpaste is $2.50 instead of $2.49, but some buyers will.
So the total quantity transacted at a price of $2.50 is going to be different.
It's going to be lower than the total quantity transacted at a price of $2.49.
Does that mean they shouldn't raise the price from $2.49 to $2.50?
to see if you're on your toes yesterday.
The answer is it depends, and it depends on what?
That Professor Salerno talked about.
Elasticity.
Yeah, this concept of elasticity, right?
So whether increasing the price leads to an increase
in total revenue or a decrease in total revenue
depends on the characteristics of the market demand curve.
But the point is, buyers affect the elasticity
of the market demand curve.
Indeed, it is nothing other than a construct
The point is that sellers don't unilaterally set the price, even really big sellers.
Another thing to notice about our analysis is that what we're trying to explain,
and what Menger was trying to explain in his 1871 book was the prices that are actually paid in real transactions on the market.
In other words, we're not trying to explain some sort of hypothetical artificial price,
Such as the Perfectly Competitive Price
Okay, if you learn price theory in a typical microeconomics course, the instructor will explain, well, we'll start with the perfectly competitive market
Which of course is unrealistic. No market is really perfectly competitive because perfect competition assumes an
infinite numbers of infinite numbers of buyers and sellers, perfectly divisible good, perfect knowledge,
Barriers to Entry, and so on.
So we set up all these artificial, deliberately artificial assumptions, solve for the price
that would emerge in that hypothetical construct, and say, okay, well now we've done price theory.
Well Menger's objective was not to explain some imaginary price, but the actual price,
the real price.
It isn't to say that Austrian economists, or that causal realist economists, do not
employ hypothetical constructs.
Okay, we'll talk a little bit today and some more later about Mises' concept of the final
price, or the price that emerges in the final, what he calls the final state of rest.
Think of that as kind of a long run equilibrium price.
Well, we might employ a hypothetical construct like that in our reasoning, say, well, let's
Let's imagine a situation where the following things happen, what price would emerge in
that situation?
We may get some insight from that analysis, but that analysis isn't explaining any actual
prices.
The problem for the causal realist economist, the problem with the analysis of perfect competition,
is that it doesn't provide any useful information about the real process of price formation.
It's purely artificial and doesn't serve any instrumental function in our analysis of the market.
Again, that's the realist part of the causal realist definition.
Now, here's a slightly more subtle point.
What about the assumption of perfect information?
Aren't we making some rather strong assumptions about the ability of buyers and sellers
and Sellers to sort of think through this process in advance
and realize that, okay, well, the equilibrium quantity is going to be four,
the equilibrium price is going to be between 200 and 230,
so if somebody offers me less than 200, I should say no.
Well, in fact, we can change our story slightly
and include expectations of future prices that will emerge.
We can include what we would call speculative demands in our analysis.
Go back to our original story, okay, here's the numbers that we used before, right?
And we said the equilibrium price will be something between 200 and 230.
Well, suppose that S1, the first seller, believes, erroneously,
say he believes somehow the equilibrium price is going to be 250.
Or maybe he believes that tomorrow, in tomorrow's market, the equilibrium price will be $250, okay?
So, you know, in the absence of that belief, he would be willing to part with his radio for $150,
but he believes there's somebody out there who'd be willing to pay $250, right?
Well, don't we have to rule that case out to be able to do this sort of analysis?
The answer is no, we can handle it in a very simple way, right?
If it's the case that S1 thinks that at some point in the future he can get $250 for a radio,
well, what is his reservation price in the market today? $250.
Right? We just say, well, in that case, his reservation price isn't $150, but it's $250.
He belongs down here as S5.
And we sort of change the numbers and do the analysis again.
In other words, the point is, the numbers that we write down,
or the valuations that buyers and sellers have, their reservation prices,
include their beliefs about what future market conditions might be.
Are those beliefs necessarily correct or incorrect?
Well, we can't say.
All we can say is that if the price that emerges in the market today is, say, $215,
we can explain it using this analysis.
Now, where did these numbers come from?
Where did the 150 and the 170 and the 190 come from?
Well, I mean, we don't know.
We simply, all we can do from the point of view
of deriving exact laws is take that as given, okay?
Now, there might be other scientific disciplines
like psychology that might seek to explain
where do these different preferences come from?
Why does one person value a radio at $300
and another person values it at only $275?
Does it have something to do with his childhood?
and you know my father had a radio of a certain type or you know I was dropped on my head who knows I mean there might be some information that we can provide but that's beyond the domain of economic analysis right the analysis of human action says given the preferences that people have how will they then behave okay now let's go back to our diagram this is the last sort of simplified diagram that we had right now all I've done here is I've extended the
the demand curve beyond the fixed stock of the good.
It was Q equals five in our last diagram.
This is just the same as the last diagram that we drew,
except I extended the demand curve a little bit farther on down.
Okay, so again, remember the vertical part of the supply curve
represents the fixed stock of the good that is in existence
at the moment of exchange.
And there's this little diagonal part at the bottom,
which represents the prices below which sellers
draw some of their supply.
Now, if you looked at the diagrams in the Shapiro book,
his are essentially like this, but with one slight twist.
He makes the further simplifying assumption
that below the least capable seller's reservation price,
everybody, all sellers drop out.
Okay, so he draws something like this.
So there's some point below which
there are no units available for sale.
So you could just leave this blank.
He draws a dashed line, right?
So again, we're assuming that below,
I think it was 170 in our last example,
assume that no seller would be willing to sell
at a price that low, okay?
If we just, again, for the sake of simplicity
in drawing our diagrams, if we just said,
well, let's just forget about that,
assume that every seller is willing to get rid
of his good at some price, sorry.
We could just, we can really ignore what happens below P1.
Okay, so assume that the equilibrium price
that obtains here exceeds the highest valued seller
or the least capable seller's reservation price, okay?
So how can we explain changes in prices, price changes?
Okay, so imagine that we're in a situation like this
and the price that has emerged is this price P1.
Suppose that there's a change in demand. Say there's an increase in the demand for the good.
Well, Joe explained yesterday what it means to talk about an increase in demand as opposed to an increase in the quantity demanded.
In other words, there's a change in people's value scales.
Okay, so at every possible price, the total quantity demanded on the market is higher than it was before.
Right, how would we represent that in our diagram? Well, simply by shifting the demand curve out and to the right.
Okay, change in preferences, the change in the relative rankings of goods and services on individuals' preference orderings.
Okay, so they value some things relative to money more highly than they did before, okay?
Again, remember just the terminology.
When we talk about a change in demand or an increase in demand, we mean an entire shift,
a change in the entire demand schedule or shifting out of the demand curve,
as opposed to a change in the quantity demanded,
which would refer to moving along a particular,
moving up or down a given demand schedule
or moving along a demand curve, okay?
So what happens?
Well, we started out at an equilibrium price of P1, right?
But with this new high, greater demand,
the demand curve D prime rather than D, right?
At a price of P1, what happens?
Well, the quantity demanded at a price of P1,
It now exceeds the quantity, the available stock.
Okay, so the supply curve represents
the available stock of radios.
At a price of P1, now there are more buyers
wanting to buy radios than radios are available.
Okay, what that implies is that the equilibrium price
can no longer be P1, right?
Buyers and sellers must adjust their behavior
up to a point where the price is something like P2.
Okay, so at a price of P2, once again, the market clears,
meaning that at that price, all buyers who value the good
more highly than that price are able to obtain one
in exchange for that price, okay?
And some of you have seen this kind of analysis before.
Note that if the price were to remain at P1,
we would have a shortage of the good in question, right?
Meaning at that price, the total quantity demanded
Exceeds the Available Stock Given by the Vertical Part of the Supply Curve
Again, just sort of terminology here.
The word shortage sort of sounds similar to, but is not the same as the more general concept of scarcity.
Remember we talked about scarcity as a general condition of human action, right?
Namely, that for a given good or service, the available supply of this good or service is less than that that would satisfy all actual human demands for that good or service, okay?
It's a little bit unfortunate, you know, in English we use sometimes sort of an everyday language, you talk about something being more or less scarce, okay, you know, because of some oil fields were destroyed in the Middle East,
What we mean is, at the price of P1, the quantity demanded exceeds the quantity supplied.
So by shortage, we don't mean there isn't enough that everybody in the universe could have one.
That's scarcity. What we mean is, at this given price, the quantity demanded exceeds the available supply.
This is a good place to think, to stop for a moment and think about some kinds of artificial restriction on the market, right?
Like, oh, sorry, okay, before we do that, one more thing.
Okay, again, why would the demand curve shift?
Well, one, some of these textbooks typically ignore us.
You could have a change in the money supply.
So an increase in the supply of money which lowers the purchasing power of the monetary unit
causes a change in people's value scales where, you know, the money is denominated in nominal terms, right?
So my willingness to pay in dollar terms for, you know, a car radio would go down if there's an increase in the quantity of money, okay?
Because the purchasing power of the dollar is less than it was before, okay?
So we could imagine an increase in the money supply leading to a leftward shift in the demand curve.
We could have a change, more generally, a change in the relative rankings of goods and services on the market.
Again, it could be the preferences people have for this good relative to money, or it could be relative to some other good.
You know, I was thinking, as we all do, I've been thinking a lot lately about Paris Hilton.
You know, I remember reading something that recently that her stint in prison,
I guess she got out and they made her go back and
totally paid attention, but I mean,
for someone in her position, someone in her industry,
a sort of celebrity for being a celebrity,
In my day, the quintessential example is George Plimpton,
a guy who was sort of famous for being famous,
but nobody could tell you exactly what he was famous for.
Paris is sort of like that.
And for somebody like that, you know, the additional publicity
that comes with being sentenced to jail,
I mean, this could be the greatest thing for her career.
This happened in a long time.
So, you know, Paris Hilton is in, she's an actress in some movies.
I don't think she has a CD out, does she?
I don't know if she sings like Jessica Simpson or someone like that, but, you know, suppose that she's an actress in movies, right?
It may be that more people want to go see a movie that Paris Hilton is in. They're more interested in her now because they saw her on jail or crying in the car or whatever it was, okay?
So it could be that there's a change in people's tastes and preferences where they value Paris Hilton more highly than they did before, okay?
for a reason that we as economists would simply take as given.
So there could be some reason why change in musical preferences,
where having a particular type of car radio gives people more satisfaction than they did before,
that would change the demand for car radios of that particular type.
Again, a purely subjective phenomenon.
The price went up from P1 to P2.
Isn't there a sense in which higher prices are bad?
I mean, well, not for sellers, that's right.
But aren't sellers rich, kind of greedy, rapacious capitalists,
and buyers are ordinary good people like you and me,
and don't we want the price to be lower?
That's obviously silly, right?
But I mean, again, if you have the view that we previously
discussed, that sellers kind of unilaterally set the price,
you might think that raising the price isn't fair.
It places a disproportionate burden
on the less well advantaged in society.
Isn't it taking advantage of people
who otherwise couldn't fend for themselves?
Well, I mean, we've obviously seen
that we couldn't support that in our analysis at all.
But more fundamentally, our analysis so far
has been completely value free.
We haven't said what's just and fair,
because concepts like justice and fairness
are fundamentally extra economic concepts.
Okay, we're explaining what the price is.
We're not explaining whether that price is just or fair.
You know, there's a sort of medieval scholastic tradition
of writing about the just price.
Although it turns out, if you look in that literature,
it's not quite the way it's been portrayed.
Many scholastics use the term just price
to refer somebody to the market price.
But more generally, one might have a sort of a normative
theory of what the price ought to be.
Not necessarily a correct theory, but if so, that's something that economic analysis per se does not address, okay, what prices are fair or just.
Now, we can say something about social welfare under conditions of market prices versus some other kind of prices.
We can make some very limited statements about that, which we'll come to in a moment, but we're really not interested in things about the just price.
Related is the issue of price gouging, all these gasoline stations across the U.S., mom and pop gas station owners are being fined and threatened with jail sentences for gouging their consumers.
Again, what does price gouging mean? Well, it means that sellers, it means that there are markets in which the equilibrium price has gone up.
What does this mean to gouge, right?
I mean, obviously gouging is not a scientific value neutral term.
It's a smear, you know, like you gouge somebody's eyes out.
It's a real aggressive, mean and nasty thing to do.
And the idea is that sellers who raise their prices,
for example, under conditions of increased demand,
are taking advantage of hapless buyers.
Again, there's always an increase in the demand
for gasoline in the summertime,
when more people go on vacation.
You know, we could analyze it this way, right?
I mean, suppose the demand for gasoline goes up in this fashion.
Well, the market price will rise from P1 to B2.
Is this bad?
Is this unfair?
Is this evil on the part of sellers?
Well, I mean, there's nothing in our analysis here
that could support that whatsoever.
I mean, this whole concept of price gouging
is sort of a non-scientific,
it's kind of an aesthetic preference
that certain people have to say,
well, I don't like this price, I do like this price.
There's no scientific support for that kind of a statement, that kind of analysis whatsoever.
Now we get to some government interference in the price mechanism.
Imagine that the government, perhaps responding to concerns about price gouging, sets a legally binding maximum price.
So in the case like the one we just looked at, the government says the price cannot be higher than P2.
I mean, I always think of this, you know, the first example that comes to my mind is rent control, government-controlled prices of housing.
Having lived formerly in Berkeley, California, a city with very aggressive rent control policies, there's some first-hand knowledge of the effects of rent control, which we'll talk about in just a moment.
Right, so, I mean, again, imagine that, you know, we're looking at the market for rental housing in a particular community in Auburn, Alabama or Berkeley, California,
and say that the market price, the market clearing price, the equilibrium price is P1, you know, $500 a month for an apartment, three-bedroom apartment, apartment of a particular type.
Okay, again, we're assuming that we're dealing with homogeneous units of the good, so units of the good that are equally serviceable, right?
That's a precondition for the notion of a supply, the supply of a good, right?
But the government, some do-gooders on the city council say, well, $500 a month is too high. No one should be able to charge more than 350.
and we'll get those nasty, greedy, rapacious landlords and we'll make the citizens better off by forcing the price to be lower than it otherwise would be.
We'll notice what happens at a price of P2.
The immediate effect of a legal restriction on the price, a price ceiling below the equilibrium price, is to create a shortage, just as we saw a couple slides back.
So at a price of P2, the number of people wanting to rent an apartment exceeds the number of apartments available.
So there's a shortage of housing at a price below the equilibrium price.
Is that bad? Well, I mean, look, think of it this way.
At the rent control price, there aren't enough apartments to go around.
Who's gonna get them?
Okay
In our previous analysis of the marginal payers, you know who ends up with the five radios at the end of the day?
Well, it's the five market participants who have what?
Yeah, well we say who have the highest
Valuations because we haven't said how much money they have like in their bank account
But those who have the greatest willingness to pay for the good people who value the good the most highly
I meant the most money, four of the three.
If the available supply of apartments get allocated among this larger set of buyers who are willing to pay at the rent-controlled price, well, it's mostly political.
It's who you know. When I was in Berkeley, all the good rent-controlled apartments around campus were sort of legacy apartments,
meaning you had an older sibling who had that apartment and they passed it on to you, or you have a personal connection with the landlord, or you're in a fraternity, or you have to have some personal connection.
In many cases, under conditions of a shortage, the available stock is allocated according to some other allocation rule like willingness to wait online.
Okay, so, you know, when the Xbox 360 first went on sale, and at the price that they charged, I don't have one, so I don't know what the price was, $3.99 or something, right, I mean, partly to create a buzz, right, sometimes the sellers will set a price below the equilibrium or market clearing price on that initial day, right, because they want the
I want pictures on TV of people camping out, these really nerdy people who spend 48 hours in line to be the first one to get an Xbox or whatever.
So if I wanted an Xbox 360 on the first day and was willing to pay a thousand bucks to get one, I might have a hard time getting one if I'm not willing to spend 48 hours camping out in a line of people who haven't taken a shower in a long time.
So, I mean, the point is that rent control doesn't magically increase the stock of apartments, you know, to this level here.
There's still only this many apartments, and they've got to be allocated somehow.
And if it can't be by willingness to pay, it must be by some other mechanism.
It's hard to think of a reason why allocation by that other mechanism would be preferable.
You see, we can think of this as a misallocation of the stocks of the good.
I mean, units of the good are not going to the highest valued users, but rather being allocated by some other criterion, right?
And if we were to extend our analysis to some kind of long run situation, right, we can imagine the long run, well, I mean,
building owners are getting less money for their units than they could get in an unregulated market.
Their incomes go down, their willingness to maintain the stock, maintain the quality of apartments, to invest in upkeep and maintenance and so on, those incentives are attenuated.
So there's a long run deterioration of the housing stock. And of course you can see this if you go to any rent controlled community in America.
You'll see a stock of dilapidated apartments, dilapidated units, because there's little incentive for sellers to maintain them.
One of the interesting sort of political economy aspects of this, I get a critical point that there's a different allocation mechanism being used under rent control.
It creates these sort of weird coalitions. And one of the things that used to frustrate me greatly when I was in this situation is that I had moved out to Berkeley to start graduate school,
School, and I didn't know other people in the community. I didn't have access to sort of a legacy apartment. But I would have been willing to pay more than what some of the current residents were paying in their rent controlled units. Now who were the current residents? Well, some of them were students who had a personal connection and were able to get their hands on one of the desirable units close to campus. But a lot of them were 40 and 50 year old guys who hadn't been students for a long time. You know, the guys you see down on telegraph
of Avenue, selling incense, and ex-hippie types who had been students there 20 or 30 years back and had never moved out.
I mean, they had a sweet meal on a very inexpensive apartment. Why would they ever move?
So the point is I couldn't dislodge these people even if I wanted to.
So what frustrated me is in the newspaper coverage of rent control issues or in the policy debate,
Analyst would always describe the two factions as landlords and tenants, right?
So the pro-tenant faction is the group that wants to keep rent control in place,
and the pro-landlord faction is the group that wants to eliminate rent control or raise the rent control prices.
Say, well, wait a minute. Tenants are not a homogeneous group.
I was a tenant, and I wanted them to abolish the stupid restrictions.
Okay, so it's a fallacy to think that a price ceiling benefits buyers and hurts sellers simply isn't the case.
It benefits some buyers, those who are still able to obtain the good at the lower price, at the expense of other buyers.
Buyers who are unable to obtain a unit even though they would have been willing to pay a higher price.
Okay, so you get all kinds of weird political dynamics to another reason to be very suspicious of this type of policy.
Policy. Okay. We've looked at changes in demand. How about changes in supply? Suppose that there is an increase in the available stock of the good. Now, notice that this can't happen instantaneously, right? But suppose that, you know, on this eBay auction, right? I mean, suppose that, you know, today there are a certain number of radios available because junkyard dealers have found them and put them on eBay, and then
The sellers decide that well maybe there's more demand out there than we thought
and some dealers who previously hadn't made their radios available on eBay
or people go out into the junkyard and they pull radios out of trashed cars
and they make them available for sale.
So imagine that the next day or in the next sales period
the stock of available radios is greater than it was.
We could represent this with a movement in the supply schedule or the supply curve.
So imagine that the stock of good has increased from one period to the next, from the original vertical supply curve S to a new one S prime.
Again, distinction between change in supply and change in quantity supplied.
In the textbook treatment, you had sort of the same thing of moving along a supply curve versus shifting a supply curve.
Remember here what we're calling the supply curve represents the stock of the good that's available.
So it really doesn't make sense to talk about moving up and down a given supply curve,
because it's not really a supply schedule in the same sense that the demand curve represents a demand schedule.
All we're saying here is there's an increase in the stock of the good.
If the price were to remain at P1, what would happen? Well, at a price of P1, the available stock exceeds the quantity demanded at a price of P1.
So buyers and sellers have an incentive to lower the price to the new market clearing or equilibrium price P2.
At a price of P1, the quantity available exceeds the quantity demanded, which we call a surplus.
Okay. Some radios end up unsold at the end of the day. Okay. We could do another analysis of intervention here with what we call a price floor, meaning a legally mandated minimum price.
Good example would be the labor market. Okay. So imagine that there is a stock of available labor and there's some demand for that labor.
Now we'll talk tomorrow in a little bit more detail about where the demand for labor comes from, but remember the demanders of labor are employers.
So just take it as given for the moment that there exists some demand for labor represented by this demand curve.
If the market wage is P1, but the government says it's illegal to pay anyone less than P2, what will happen?
Well, at a price of P2, only this much labor will be hired by employers.
And so these additional units of labor, if you think of them as workers, will be unemployed.
So there's unemployed labor, a surplus of labor.
That's what unemployment is by definition, is at the given wage rates, the quantity supplied,
quantity available of labor exceeds the quantity demanded.
So notice that it doesn't even make sense to talk about unemployment without reference to a wage rate.
Unemployment at a particular wage rate is a meaningful concept.
Without talking about the wage rate, we don't know whether labor is unemployed or not.
We have the same sort of thing here. We have a misallocation of labor.
So people who get jobs are not those who have the highest valuations of money relative to their labor time.
People who are the most willing to work, but rather the people who know somebody or have a connection or whatever.
You may be willing to work at a price less than P2.
Maybe you're a teenager who's just entering the labor force for the first time,
and you value the experience for your resume more than you value the cash in hand.
You're unable to underbid somebody and take a job away from someone who's employed at the minimum wage.
So there's a misallocation of labor.
Labor is not being used and it's not being put to its most highly valued use.
and we can imagine long run consequences as well.
We think of people who can choose
to enter the labor force or not.
Students, people whose spouses work full time,
people who enter the labor force,
attracted by the higher government minimum wage,
who otherwise would not be in the labor force.
We have sort of additional long run misallocations.
People drop out of school,
who otherwise would be in school and so on.
And we can talk about this in some more detail later.
Okay, so I want to go ahead and summarize so that we can have time for some more questions.
You know, what then is it that prices do in a market economy?
Will prices allocate resources to their highest valued users?
Right, that's a kind of rationing mechanism, right?
Price controls lead to misallocations of resources, meaning rationing by some mechanism other than willingness,
other than subjective valuations of the good,
willingness to buy, willingness to sell, okay?
Market prices provide feedback to entrepreneurs
about the quality or reliability of the decisions
that they have made in the past, right?
So the stock of available radios today
depends on decisions made by entrepreneurs in the past
and by seeing at what price people are willing to buy
Radios. By seeing what the equilibrium prices and quantities are, entrepreneurs can get
some feedback on the quality of those forecasts that they made in the past. Otherwise, they
would, under price controls or government interference with the price system, there's
no way for entrepreneurs to know whether their price forecasts have been validated by consumer
or Preferences or not.
It's a somewhat subtle point is,
you know, there's a whole field in contemporary economics
devoted to the analysis of welfare,
so-called welfare economics.
And under causal realistic, causal realist analysis,
much of that would be regarded as incoherent
or not nonsensical.
Right, but there is at least one powerful sense
of Welfare Maximization that does make sense, right?
And that's this idea that the allocation of resources
that does obtain under market competition,
in other words, these sort of very mundane, everyday,
what Mises would call plain state of rest prices,
the ones that obtained from the analysis
that we've just described, right?
You know, leads to an allocation of resources
that is welfare maximizing
in really the only meaningful sense of that term,
Meaning that goods and services are allocated to individuals, those individuals with the highest subjective valuations for the good.
It's a very simple notion of welfare maximization, which is really the only one that is scientifically meaningful under causal realist analysis.
I want to make two more points before we quit. One has to do with sort of the standard textbook upward sloping supply curve.
Those of you who have had economics courses before will notice that one of the seeming peculiarities,
picadillos, if you will, of this style of presentation is this insistence on drawing these vertical supply curves.
But aren't supply curves upward sloping? At a higher price, won't more units of the good or service be brought to market?
Well, the problem with the standard Marshallian analysis of quantity supplied increasing with the price
is that the diagram combines two different components
that exist in a different time dimension, okay?
In other words, demands, right,
reflect subjective preferences that exist instantaneously,
right, you can instantaneously decide
that you like Paris Hilton more or less than you did before,
okay, whereas stocks of goods and services,
physical units that are available for consumption,
cannot be instantaneously increased, okay?
They can only be increased over time.
There's some production period.
There's some investment and so on that must be made.
Okay, Shapiro calls this the next time around dimension.
Okay, he refers to the vertical supply curves
that we've been drawing as the ex-post supply curves
and the upward sloping curves you see
in the standard textbooks as ex-ante curves.
We're presenting producers sort of ex-ante
are ahead of time decisions.
Yeah, if I thought I could get this price,
I would want to produce this many units.
But again, that's a forward looking decision, fine.
But when it comes to the moment of exchange,
those decisions have already been made
and can instantaneously be adjusted.
Right, now there is one sense in which we can talk about
an upward sloping supply curve.
But it is not an analysis that describes actual prices paid,
but rather an imaginary construct in Mises language, or a hypothetical construct, describing prices that would exist in a kind of, sort of a long run dimension, what Mises calls the final state of rest.
And we can illustrate that with a simple diagram here.
So imagine we have the story we had before where the market is in equilibrium at a price of P1 and there's an increase in demand and a new equilibrium price of P2.
That's day one. In biblical terms, there was morning and evening and the first day.
Now it's the second day. Sorry, I don't know why I said that.
Suppliers say, well, wait a minute, gosh, the price is higher than we thought it was going to be.
At a price of P2, we would be willing to bring additional units to market.
So during the next sales period, so after this, at the end of this day, they go off and produce some more units.
And then the next day, they have some additional units available, right?
So the next day, they have S prime units available.
Can you see the light gray?
It's hard to tell on my screen what's going to show up on the projector here.
Right, so in day two, there's a greater stock of the good available.
And so there's a price P3 that's not as high as P2, but greater than P1.
Okay, so here we are at the start of the second day, and then the buyers think,
wow, we, you know, we, you know, yesterday when the price was P2, the price now is P3.
And let's say that there's another increase in demand.
Now we like Paris Hilton even more than we did before, right?
So there's another outward shift of demand,
price rising all the way to P4.
And so that's the second day.
So then what happens in the third day?
Well, sellers bring even more units to market.
And so now there's a price of P5 and so on.
Right, so if we think of a supply curve
that shifts out over time in response
to increases in demands, right?
And then if we were to sort of plot all of those prices that obtain after the new, after
the supply curve has shifted out, P1, P3 and P5, we could sort of, we could connect the
dots and call that a long-run supply curve, okay?
And say yes, in response to a set of increases in demand, sellers might subsequently response
by increasing their stocks over time, leading to this sort of upward supply curve over time,
okay?
There's no guarantee, starting from the beginning of our diagram, that this particular set of
prices P1, P3 and P5 would obtain in reality.
We're simply saying, if there is a steady increase in demand over time, no other changes
in market conditions and sellers are able to increase their stocks of goods over time
in response to these changes in demand, then we would see equilibrium prices and quantities
that rise over time, okay. But again, this is, we'll get to this in more detail later
in the week, but this is what Mises calls an imaginary construct. It's an aid to reasoning
what would happen under the following circumstances, but we aren't saying that this describes the
prices that are actually paid, okay. Final thoughts before we stop. There's a tradition
in the Austrian economics literature, associated primarily with Hayek and his very influential
1945 article, The Use of Knowledge in Society, of thinking about the role of prices primarily
as signals or transmitters of knowledge or information.
And this is even filtered down into many of the standard textbooks where there's a discussion
of the role of prices in disseminating knowledge or information throughout the economy, prices
is providing signals to market participants.
Well, I mean, there is a sense in which that is true.
Gate prices do embody knowledge about present
or more technically immediate past market conditions, right?
So the fact that Joe was willing to pay 10.49
for the Def Leppard CD or whatever
does provide some useful feedback to Walmart
about consumer demands for goods and services.
But that isn't sufficient for explaining the broader process of production and exchange.
In other words, the fact that buyers are willing to pay a certain price for CDs today is not sufficient to explain entrepreneurs' production decisions,
because those production decisions are guided not only by their experience of the present or the immediate past, prices that have just now been paid,
but also their expectations about the prices that will obtain in the future.
Okay, so prices provide some information but not sufficient information for entrepreneurs to make decisions about the allocation of resources.
So, you know, there's some truth in this but we want to be careful not to overstate it.
Another way to think about it, prices are the product of, but not, are not the antecedent to human action.
and Action. It isn't the case that agents sort of mindlessly or blindly follow price signals leading to an efficient allocation of resources, which is a view that is sort of a misreading of this Hayekian point, I think, that has that implication.
We also might make a notion about the notion of price that you hear sometimes in contemporary economic discourse.
There's kind of a broader notion of price, meaning not specifically prices paid on the market like this,
but what I call pseudo prices, meaning sort of any sort of constraint that market participants face.
For example, in the literature on the economics of crime, some economists will say,
well, you know, if you're caught speeding, you have to pay a $300 fine.
And then in this other city, in Auburn it's $300, in Opelika it's $500.
So the price of speeding is higher in Opelika than it is in Auburn.
And so we expect there to be less speeding in Opelika than in Auburn.
And if the court decides to impose a higher price,
If there's a price, then that's going to affect the, then the amount of speeding will be reduced.
Well, I mean, okay, there's a sense in which the anticipated fine from speeding affects the decision makers, the driver's decision about how fast to drive.
But again, those aren't prices in the sense that we've been talking about today.
Many of those aren't prices that emerge from the voluntary interactions of buyers and sellers reflecting their subjective valuations and so on.
It's just an artificial price made up by the court, you know, which people then, of course, do take into account in making their decisions.
Same thing within a firm, right? I mean, a firm might have an incentive plan where, you know, we have workers who are on an assembly line,
and they're producing unit, they're producing widgets or whatever, and if we pay them a piece rate, you know, they get so many dollars per unit produced,
In a metaphorical sense, that may be okay, but we have to remember, those aren't real prices in the sense that we're talking about, you think of them as sort of pseudo-prices, meaning that we cannot make these sort of overall statements that, oh, well, the prices paid for speeding tickets lead to a maximum price increase, and then we increase the piece rate, we would expect workers to respond by producing more, and sometimes economists will say, well, it's like we increased the price that they receive for selling their output.
and Maximization of Consumer Welfare can't make any sort of statement like that because the process by which these prices emerge is sort of purely arbitrary relative to the process that we've described here.
Okay, well, I've already talked longer than I wanted to.
Are there any questions that have not come up yet?
Okay, I'm sorry, let me go with Fred, and then Dan, and then...
Peter, if you just review the impact on prices of inflation, or increase in the money supply...
Sure. I'll just comment very briefly about it now, because we have some lectures on Thursday, I think, devoted specifically to inflation.
But in the context that we're talking about here, if we think of inflation, meaning increasing the stock of money,
as reducing the buying power of each dollar, right?
Then people will adjust their valuations, right?
Remember the guy who was willing to pay $200 for the radio.
If we were to write out his value scale, right?
We would put $200 and then radio above it.
He values the radio more than the $200, right?
If there's an increase in the monetary unit, right?
And now I know that each dollar purchases
Fewer goods and services than it did before, right?
Then I would, in the new, you know,
after the change in the money supply,
maybe $200 would rank higher than the radio, okay?
But excuse me, lower than the radio, right?
Meaning that now I value a radio more than 250
of the newer dollars relative to 200 of the older dollars.
Right, so it changes people's value scales
where the value scale includes the units
of the Good or Service, and dollar amounts
as in the ones that Joe showed us yesterday.
Dan?
I was just curious about the last 100 that you made
in regard to the speed of buying
and not necessarily being too expensive
because they don't have any, like, emerging quality
as a result of bargaining or expressing significant value.
But earlier you said that we get kind of deluded
I think that sellers set prices because we don't bargain necessarily when we go to a store, so I'm a little confused as to why we're okay in saying that pointing out a cost difference between speed fines in different cities is a component of a price that we're not necessarily certain about.
Let me see if I understand the question. I'm sorry, I should have repeated Fred's question for people who are listening at home.
The first question was about inflation. You probably figured that out.
The question here is, I said earlier that sellers don't unilaterally set the price, but that buyers can impact the prices that are set through their willingness to buy or not to buy.
How can I then say that because the court simply decides that a speeding ticket is going to be $300 to $500, that how is that any less?
How is the process essentially different in that case?
Well, I mean, I think, look, if what you have in mind is, you could say that, well, I mean, the city of Auburn sets the speeding ticket, the price of speeding tickets at $500, and they discover, well, gosh, nobody's speeding.
Right? That fine is so high that everybody's totally scared off, and we're not earning any revenues in speeding fines, so maybe the price is too high, we need to lower the price.
There's a sense in which the actions of drivers can provide some feedback to the government in that case and can induce them to change the price, sure.
But that's still very different from the kind of price setting process that we've been describing here.
First of all, we don't know what the objectives of the city are.
Are they to maximize revenue? Are they to eliminate speeding? Is it to get good PR?
The point is that the city official would be free to say, well, I don't care how people drive, I'm going to set the price whenever I want.
Now, drivers could adjust their behavior so that no actual speeding fines are collected, but the price of the ticket is still $500.
$500. There's nothing that buyers can do to make that price change, sorry, that drivers
can do to make them lower the price.
Right, but I don't think it's fair to say that $500 is the price of speeding. $500 is
the price of a ticket. It's just one small cost component of driving.
Well, I want to move on, but that's why I call it a pseudo-price. I mean, it has some
characteristics that are analogous to a price, but it's different from a market price. That's
That's all I'm saying.
I guess we should stop for our lunch break because we're already a few minutes over.
So thank you very much.