The Origin and Decline of the Austrian School: Menger, Böhm-Bawerk, and Wieser

0:00This lecture is slightly mis-titled. This will really be the origin. Tomorrow I'll deal with the decline and then the revival. So the origin is going to deal with the three greatest personalities of the early Austrian School, all of whom were knighted. That is, all of whom were royalty, not royalty but part of the aristocracy. Carl Menger dropped the von when he was a teenager, Eugen von Boehm-Bawerk was a ridder, which is a higher level of nobility is what I was trying to say, they were all nobles, and Friedrich Freiherr von Wieser was in the lower nobility, so they were all nobles.

0:50What's interesting about the Austrian School is that all three individuals that comprise the core of the early Austrian School were working really in some sense towards the same goal, though Wieser veered off. But when I first came across the Austrian School in college, in the History of Economic Thought course, My professor was extremely enthusiastic, even though he wasn't in Austria himself, about the school. This is one of the first times in the history of intellectual development, or the history of ideas, that three such prominent thinkers self-consciously attempted to develop the same research project.

1:44a research program. Let me start with one point and that is that Carl Menger is the founder of the school. Now, Carl Menger was one of the original marginalist revolutionaries. That is, he is one of the three individuals that were credited with overthrowing classical economics. Now that's slightly inaccurate in two ways. were written two ways. Number one, he did much more than participate in the Marginal Revolution. And number two, his mission was not to overthrow classical economics, but to complete classical economics. The classical economists had done a great deal in developing price theory.

2:31That is, the law of supply and demand, at least in the short run, they saw as determining price. They considered this, to some extent, a universally valid law, they also used this law to great effect in destroying the schemes of the early utopian socialists, Mises always stresses that point, and they developed a theory of calculated action that focused on the business decision maker. So it wasn't a complete theory of human action, but it was a theory of calculated action. They pointed out that prices guided production, and they focused on the businessman, and what they did was to point out the following, that in the short run, if the demand for a product goes up, for example, if the demand for GM cars go up, and that's probably a fantasy at this point. What would occur is that there would be a much greater profit or let's say a demand for larger automobiles goes up, a much larger profit suddenly in the automobile industry, in the production of large automobiles.

3:46Prices would increase as demand increased, exceeding costs of production, so the so-called normal return to production would be exceeded according to the in the classical school when there was an increase in demand that would increase production of that particular good that is other entrepreneurs or other capitalists the classical school didn't distinguish between the capitalists and the entrepreneur other capitalists would invest their funds in producing larger automobiles which would increase the supplies of these larger automobiles that would draw resources away from other areas of the economy including let's say the production of smaller automobiles and that would to bring about a reallocation of resources. So, monetary calculation, the comparison of prices and costs, the calculation or computation of profits and losses, directed production.

4:41So, the Austrians did see this as an extremely important accomplishment of classical economics. That and their short-run theory of supply. Where the classical economists went wrong was to talk about goods as if they were abstract classes, and they had a problem then. Their value theory was the problem. The value theory is what should underlie any good theory of price. It should support it, and it should logically lead to the theory of price that you're propounding. That was not the case in the classical school. What the classical school did was talk about iron, or diamonds, or automobiles, in what Menger called abstract classes, not in concrete units.

5:38When they did that, they were unable to arrive at an explanation of how human beings valued these goods. and they were caught in a paradox, a so-called paradox of value. That is to say, the class of the economist looked around and they said, bread, the abstract class, is much more important to sustaining human life than diamonds. Its use value, as they called it, is therefore much greater than the use value of diamonds. Diamonds really go toward satisfying wants for aesthetic pleasure or for ostentation. But they certainly aren't crucial to human beings and sustaining their lives.

6:24So, why is it then that diamonds have a higher exchange value on the market than bread does per unit of weight per pound of diamonds? A pound of diamonds is much more costly to purchase than a pound of bread. Well, they never answered that question. They said, well, we're not going to worry about use value. Anything that is a good, yes, it is true, has a use value. Economics is only interested in explaining exchange value, that is, the prices of goods on the market. So we're just going to forget about use value. So they didn't attempt to solve the paradox of value. What Menger saw was that you needed to solve the paradox of value to have a consistent price theory.

7:12Unfortunately, the classical school also did the same thing with distribution theory. They didn't attempt to explain the wages or how wages were determined for a particular scientist or for a particular worker or for a particular piece of equipment. They talked about the distribution of shares to capital in general, to labor in general, and to natural resources in general. This wasn't really even economics, this was just more or less metaphysical speculation. So that was another problem with the classical school, and this led to really their final problem. They pointed out that yes, supply and demand changes in supply and demand determine price in the short run, but in the long run, there had to be something else, otherwise their theory was hanging in air.

8:06where it wasn't grounded in human action, these prices were just there, the capitalists were reacting to the changes in prices in the short run. Now, as capitalists changed resource allocation, as prices changed, prices tended towards their long run level, which according to the classical school, was the level determined by the cost of production to some class of economists, or to the number of hours of labor embodied in the product. So, in some sense, in the long run, value was inherent in the product. It wasn't the relationship between a human mind and a thing in the real world, or a service in the real world. It was inherent in the product. Almost like, as one commentator pointed out, the amount of value in a product was determined by the amount that the laborer sweat on the product.

8:59The harder it was to produce the product, the higher its cost of production and therefore the higher its price. This is how they got around the paradox of value and they explained that diamonds had a higher price, which was much more difficult in terms of labor or more expensive in terms of cost of production to bring diamonds to the surface, cut them, polish them and turn them into jewelry than it is to raise wheat and refine it into flour and bake it into bread. Manger wanted to heal that division in price theory and he wanted to ground the whole theory of economics itself, and I'll give you some quotes, in the striving of human beings to satisfy their wants.

9:50One last problem with the classical school was that they also were schizophrenic in terms of explaining how certain goods were priced versus other goods. For example, goods that could not be reproduced, goods like a Da Vinci painting or sculpture, antiques and so on, since they could not be reproduced, Their value never tended towards their cost of production. Who would ever know the cost of production in terms of the hours of labor or the cost it took Da Vinci to paint something? On the other hand, reproducible goods like bread and diamonds did have a cost of production.

10:36So they had a non-integrated price theory from two different classes of goods. Okay, so let me then talk a little bit about Menger. Menger was indeed the founder of the Austrian School of Economics proper, okay? He really did create the system of value and price theory that constitutes the core of Austrian economic theory, okay? He also originated and consistently applied what we might call the praxeological method for pursuing research in economics, okay? So that in its method, and in its core price theory, Austrian economics has always been, and it will remain in the future, Mangerian economics, and this was recognized by a number of very prominent historians of thought.

11:25For example, Schumpeter wrote, Menger is nobody's pupil and what he created stands. This is in the middle of the 1920s, over 50 years after Menger wrote. Menger's theory of value, price, and distribution is the best we have up to now." Mises wrote, What is known as the Austrian School of Economics started in 1871 when Carl Menger published a slender volume under the title Principles of Economics. Until the end of the 70s, there was no Austrian School, there was only Carl Menger. Finally, Hayek. Hayek said that the Austrian School's fundamental ideas belong fully and wholly to Carl Menger. What is common to the members of the Austrian School and constitutes their peculiarity, and provided the foundation for their contributions, is the acceptance of the teaching of Carl Menger.

12:26And as I point out, Menger was motivated by a specific aim, And that aim was of establishing a causal link between the subjective values underlying the choices of consumers, which the classical school ignored, and the objective market prices used in the economic calculations of businessmen, which the classical school did a good job of explaining. Okay, what I want to do now is to show that because of this project that Menger had in mind, He was much more than just another marginalist innovator. And let me just give you the names and the faces of those who were marginalists. In 1874, Maria Spreleon-Valras wrote a mathematical treatise in which he introduced for the first time the idea of marginal utility.

13:24He's 25 in that picture, he's 30 in that picture. He got very old very quickly for everybody calling him a Marie. But these, so that was Walras. He took marginal utility in the direction of mathematics, okay? And in the direction of general equilibrium, in which human beings are not the cause of the phenomena. The phenomena of economics are mutually determined. as in mechanics.

14:05This is Boehm-Bawerk. As I said, he wasn't noble. He served a number of times as Minister of Finance for the Austrian Government. In my view, he wasted a significant part of his life, which led ultimately to the decline of the Austrian School in government service from 1889 until 1904. 1804. His tremendous productivity occurred basically between 1881 and 1889, and I'll talk a little bit about that. After that, he still continued to write, but did not develop his system in much greater depth, though he defended it and he did refine it.

14:51And this is Friedrich von Wieser, who was, by the way, Boehm-Bawerk's brother-in-law. Von Wieser, as I said, veered off or departed from Menger's original project and attempted to use marginal utility, but to build on it a theory of the economy that was in some sense a verbal general equilibrium theory, in which he could explain how social welfare could be maximized. So, he had a quantitative view of marginal utility that was more or less absent in Menger and von Boehm-Bawerk, although they sometimes lapsed into a quantitative view of utility.

15:38They mainly avoided it. Wieser embraced it wholeheartedly. Okay, I'll talk about them later. Let me just give you some quotes from Wieser, just to show you the project that he was embarked on. This is in the preface of his seminal work, The Principles of Economics. He writes, I have devoted special attention to the investigation of the causal connections, note the word causal, between economic phenomena involving products and the corresponding agents of production.

16:29Not only for the purpose of establishing a price theory based upon reality, also note that term, and placing all price phenomena, including interest, wages, ground rent, etc. together under one unified point, but also because of the important insights we thereby gain into many other economic processes heretofore completely misunderstood. In other words, he basically said that if you have a solid foundation for economics and you have deduced a consistent theory then you can apply it to all the issues that economists are interested in. You didn't need a separate theory of distribution like the classical school did and a separate theory of pricing. In his notes that he wrote to himself when he was beginning to work on the book, he wrote, Man himself is the beginning and the end of every economy, which statements like that appear in Bastiat.

17:27I also point out that our science is a theory of a human being's ability to deal with his wants. All things are subject, this is a separate quote, that actually is in his notes, the first quote. Once again, this shows a very strong influence of the French school and the German price theorists that developed Say's theory. This whole focus on wants, on humans striving for wants. Now the very first line of his treatise, or it's actually not a treatise, it's principles, says all things are subject to the law of cause and effect. So, the very first line, he rejected the mutual determination, the mechanical mutual determination of economic quantities, which leaves out human beings, and which was the project of one of the other marginalist revolutionaries, Walras.

18:23Also, Wieser was also someone who more or less followed Walras in this respect rather than Menger. Finally, let me just give you the last, over here.

18:47It doesn't negate quantities. What we're saying is that the quantities that emerge in the market economy are the result, or are caused purely by subjective valuations of human beings. In other words, in Walras, for example, there are all these given data, including quantities of various resources and so on. And these quantities are placed into a system of simultaneous equations. And all of them, and the results, the prices, equilibrium prices and quantities that come out of that, that come out of the data, are mutually determined. Or they're mutually determined one another. And in fact here we show that Menger was not a radical subjectivist, as some Austrians have claimed.

19:32Menger recognized that there were both objective and subjective aspects to the economic process. And that the chain of causality ran from subjective wants, and this is something he got from Bastiat, through the real world, that is, man put forth efforts to produce things, to transform resources in the objective world according to technological recipes into goods that will be more useful and that will satisfy his wants. So in other words, man's motive was subjective, to satisfy his wants. His actions on the best means to satisfy those wants were also subjective. But the middle link was objective. He had to produce goods and services.

20:23He had to transform elements, existing elements of his environment in such a way that they satisfied his wants. So causality ran both ways. It ran from human wants to the effort to produce, and it ran back the other way. Once those things were produced, it satisfied the goods that were produced with the cause of the satisfaction of human wants. Human wants were the cause of the production of the goods. So he says, one's own person, moreover, and any of its states, he's talking about subjective states of satisfaction, are links in this great universal structure of relationships.

21:09It is impossible to conceive of a change of one's person from one state to another in any way other than one subject to the law of causality. If, therefore, one passes from a state of need to a state in which the need is satisfied, sufficient causes for this change must exist. There must be forces operating within one's organism that remedy the disturbed state, or there must be external things acting upon it that by their nature are capable of producing the state we call satisfaction of our needs. So, recently my wife got a new car, and that disturbed me a little bit because I didn't have a new car. have a new car and I suddenly felt the want for a new car and I went and looked around I convinced her that I needed it and I like American cars I like GM cars and I got a grand prix I promised her I'd do extra things and earn extra money and I did did so so I put out extra effort and produce the means of purchasing that car and I got a grand prix competition series G which is a

22:20very fast car, black, it's really cool looking, so that assuaged my disturbed state, okay, that material thing satisfied my want, okay, I mean, and that's, I'm being frivolous, I'm being, I'm joking in some sense, or I'm being frivolous about it, but that's true, I mean, that's the way all of us perceive the striving Now, Israel Kirzner, who I've discussed this with, claims that Menger was more subjectivist than that. He would fight with me on this, and he would claim, well, this is more Boehm-Bawerk, but this is a quote from Menger.

23:10He would fight with me on this, and he would claim, well, this is more Boehm-Bawerk, but this is a quote from Menger, okay? All right, so let me talk a little bit more about Menger and how he went about reconstructing economics.

23:29And then I'll talk about Boehm-Bawerk. One of the first things that Menger did was to develop, actually to improve on, a theory of goods. One of the great things about the German economists of the 19th century was that they started almost all of their treatises with what was called the theory of goods. This is another response to those who would claim that the early Austrian school, or at least Menger, was radically subjectivist. Well, if you're radically subjectivist, you don't start off with all things are subject to the law of cause and effect. And you don't start your treatise with a theory of goods. According to Menger, for a thing to be a good, or in his words, for a thing to have goods character, four criteria had to be met.

24:20Okay. One, there had to be a human need. Secondly, here we are. Secondly, such properties as random as the thing capable of being brought into Causal connection with the satisfaction of this need, that is, the car must have certain properties that I perceive as satisfying my need. Thirdly, there must be human knowledge of this causal connection.

25:06And fourth, the command of the thing, you must have command of the item, sufficient to direct it to the satisfaction of the need. Now let me explain what I mean here. The fourth criterion, I need a sunny day, I need the sun to be shining, to have a good time at the Metz game, okay? So that's, to have the good of watching a Metz game, which this year it is a good, you have to have the sun out, you can't have rain, but I have no control over the sun. So, if the sun doesn't come out, then the Mets game loses the quality of being a good. Even if it's drizzling and they're playing and I don't like the rain, I'm not going to go.

25:51It's no longer good to me, because of the fourth criterion being missing. Even though the other three are present. present. Now, Mises pointed out that there was a problem with Menger's Four Criteria. He said, look, Menger says that properties must objectively exist that bring the thing into causal connection with the satisfaction of the need, and that there must be human knowledge of this causal connection. But what Mises pointed out was that there has to be There can be an opinion by the subject that the good will or the thing will satisfy the need. That is ex ante, people do something because they believe their needs will be satisfied.

26:44They undertake some sort of a production activity or they purchase a good. However, ex post after the fact they may be wrong, there can be error. You can combine those two into simply, or restate them as a human need, the opinion that the thing in question will satisfy that need and control or command over the thing. In other words, you must have control in a sense that you can use the thing to actually satisfy your needs. Okay, now Menger asks the following question. Given that we know what goods are, the problem then becomes how do we actually value a good?

27:33Before you can even talk about individuals valuing a good, you must keep in mind that before individuals will strive to obtain a good, there must be an insufficiency of it. Now Menger used the word economic good versus free good. Mises said, well, if a thing is freely available like air, we never even spend any effort or time or attention on attempting to obtain air in a normal situation. Therefore, air isn't even a good at all. It's bad to call it a free good. It's simply a general condition of human welfare. Mises used that terminology. But let's stick with Menger's terminology. Menger said that for a thing to be an economic good means that there has to be an insufficient quantity to satisfy all human wants for that thing.

28:23At that point, it becomes a subject of what Menger called economizing activity. Now, Menger was not talking about, as the classical school was, homo economicus, economic man. The classical school, when they used the word economic man, meant that there was this, we might call him homunculus, this little man inside of everybody that, when they went into business, would always buy at a low price and sell at a high price. at a high price. That was economic man. But what Menger did was to generalize that to the consumer. He points out the consumers didn't calculate like the businessman did. That wasn't the meaning of economizing.

29:09What economizing meant to Menger was simply that we would always use whatever resources or goods that we possessed to satisfy our most important wants. So scarcity implies that people rank their wants. That's a much broader concept of economizing than the classical school had. Now, this was part of Menger's brilliance. He never used the word marginal utility. That was coined later by his follower, Wieser, Grenz Nutz, which was marginal utility. But Mises never used the term, though he described the concept in a very, very clear way. And one of the examples that he used, and I'll put that up here, was the following.

29:58Let's assume we have the fictional Robinson Crusoe on an island who has been stranded and has very little resources at his disposal. How will he act to economize these resources? And not only that, how will he determine the value of the resources? Now, let me just take A here. Let's say that Robinson Crusoe has a certain finite amount of grain. Okay? Sacks of grain. You can think of wheat or corn, whatever it is. And he has 20 different wants for each sack of grain. So notice what Menger is doing here is talking about concrete units. He's not talking about wheat in general. What's the value of wheat in general?

30:48If Robert de Crusoe had more than 20 units, or 20 sacks of grain, grain would no longer be an economic good and he wouldn't worry about it, to be more than enough to satisfy all his wants, assuming there's only 20 wants for grain. But let's say he has five units, and he ranks them in the following order. The first sack, the most important use would be to bake bread for sustaining his life. Second would be, that would just keep him alive for a year until the next year. The second use would be to bake bread for maintaining his health and his vitality and allowing him to strive after the satisfaction of other wants. The third would be used for seed for next year's harvest so he could live another year.

31:33The fourth would vary his diet. He'd ferment it and turn it into whiskey, produce whiskey. The fifth, he'd use it to domesticate and feed farm animals, which would yield to meat, dairy and poultry products in addition to the bread, okay? Now, he has five sacks. That's the, that's the, his scale of wants indicates the importance of the uses of each one of those sacks. Now, he asked this question, okay? First of all, what is the value of any given SAC? Well, what we do know is that every SAC, since it's interchangeable, since every SAC is identical with every other SAC, they have to have equal value.

32:25But yet they serve very differently valued wants. How do we determine the value? Is it the value of the most important want? Is it some average value, maybe the third one? Well, this is where Menger's brilliance comes in. Now, other writers before Menger in the German tradition had followed, say, and even in the French school, had come close to the notion of marginal utility. But they didn't ask the right question. And they didn't realize that marginal utility pervades human life. The question is this, if a fox or some other animal broke in and, let's say, consumed the second sack. What want would go unfulfilled?

33:12Well, obviously, because human beings economize, because they want to satisfy their most important wants, the want that would go unfulfilled is the fifth want, the least important want that can be satisfied by the current supply. So, the satisfaction from the lowest valued want that's satisfied or capable of being satisfied by the available supply becomes the marginal utility. Utility meaning satisfaction, the satisfaction of the last one. So, what Menger pointed out then was each SAC was valued according to its marginal utility. Each one had a value equal to the satisfaction from eating meat, having milk and eggs and dairy products over the course of the year.

34:06Why? Because that was what Menger called the dependent utility. No matter which sack is lost, he loses the satisfaction from the lowest valued want. So this is the theory of marginal utility. Now, what he pointed out was that, then, therefore, the value of a good depends on its marginal utility, which, as I'll show you in a moment, resolves the paradox of value. But note something. If, indeed, he lost one of the sacks, what would happen to the marginal utility and therefore the value of each of the sacks of grain? They would go up. They would be higher. He would now be reduced to a supply of four, and now a higher value would depend on the grain, on a sack of grain, and that is the whiskey, the satisfaction from whiskey, because if he lost another sack of grain, a second one, he would lose that utility.

35:05So, the law then becomes, the law of marginal utility is, the greater the number of units of a good an individual possesses, the lower its marginal utility and therefore the lower its value. Or to put it another way, as the supply of good increases, its value decreases because its marginal utility decreases. And that can be stated conversely. The fewer the units of a good, the higher the marginal utility, therefore the higher the value of the good. And now we have the resolution, as Menger went on to show us, of the paradox of value. The reason why in a normal situation, diamonds have a higher value, which is reflected in its market price than bread per unit, is precisely because diamonds are much more scarce than water in a normal situation.

36:00If you place someone in a desert who has not had water in three days and has a perfect gem, And let's say the purple diamond that Kobe Bryant bought for his wife, the eight million dollar purple diamond in order to make up for his infidelity. You would give that diamond up for a quarter of water. Why? Because water is so scarce in the desert and such that the marginal utility of water in the desert is higher than the marginal utility of a diamond. Why? Because the want that's being satisfied by water is to keep you alive for another three days, okay? Let me just make this a little bit more complicated, just slightly.

36:55Let's say that there's a farmer who possesses three horses and two cows. Now, these are different goods and the horses are interchangeable among themselves and the cows are interchangeable. Notice that the farmer would use the first two horses to plow his field, as a team. The first cow serves the third want, which is to provide milk for the farm family, and the fourth provides additional milk that could be turned into cheese and butter, and the third horse provides pleasure riding, and that's how he does it. The second cow does, and the third horse provides pleasure riding. And that's how he values these various goods or satisfactions.

37:40The question then becomes, which is the more valuable animal to this farmer? Well, according to Menger, you don't look at the top, you don't say, well, the horse is the most important. It's not. You simply ask the question, if the barn is burning and you can only save four animals, which four will you save? Obviously two horses and two cows. Why? Because horses have a lower value. The marginal utility of horses are lower. Now if that horse perishes, fifth horse, then suddenly notice the marginal utility of horses increases to the second satisfaction and therefore the horse becomes a more important animal. So you never look at the top, you look at the lowest value satisfaction that is served by a unit of a good.

38:30So he resolved that paradox and very quickly let me mention something else that he did, or actually two other points that I think are important to the stress. What he also did was to come up with what he called orders of goods. He pointed out that marginal utility and people's scales of wants determine the value of first order goods, those are the consumer goods. What determines the value of the goods that produce those consumer goods? Let's say we're talking about bread. The value of bread is determined by the marginal utility of bread to the actual consumers. But what about the flour ovens and baker's labor that go to producing that bread?

39:15That's a second-order good. Well, what Menger pointed out was that their value reflects the value of the bread whose production they cause. So he has this causality. The final good, the consumer good, causes satisfaction, production, but the second order good, the baker's labor, the ovens and so on, causes the production of the first order good, which in turn causes satisfaction. So where production goes from the resources that are further and further away from consumers down towards consumers, value travels upward. What about the third order good? The mill, the wheat, the miller's labor that goes to producing the flour that is used in in the second order industries, or above that, the farm labor, the farm tools, the farm animals that are used to produce the wheat, and so on.

40:07What Menger pointed out was that there was a theory of imputation, that value was imputed backwards, as opposed to the classical school which claimed that the value of a diamond resulted from the fact that it was very expensive to produce a diamond. That is that the laborer of the jeweler, that the laborer of the diamond workers, that the cost of the diamond mine, all of these things had a high value, therefore diamonds had a high value. Menger said, no, that's not true, it's the exact opposite. The only reason why diamond mines have value at all is because people value diamonds so highly. The marginal utility of diamonds are very, very high to individuals. So that, for example, and I always give this example to my class, if you saw the marvelous movie, Witness, which takes place in the Amish country in southeastern Pennsylvania, the Amish are also called the plain people.

41:02And they don't wear any sort of jewelry, they don't even have buttons on their clothing. They wear all black and they wear hooks because they believe even buttons show vanity. Well, what if all Americans adopted Amish values? What would happen to the value of diamonds, the marginal utility of diamonds? They would drop to nothing. In which case, what would happen to the wages paid to skilled jewelers and gem cutters? They would drop to zero. What would happen to the value of diamond mines, leaving aside the industrial uses of diamonds? Suddenly, the stock of diamond mines would fall to zero. So Menger turned the classical school on its head and showed that, in fact, it's prices that determine costs and not the other way around.

41:55And this, by the way, goes back to Kondiak, whose treatise was written in 1776. He said, oysters are not expensive, or pearls are not expensive or have a high value because divers must dive deep for them. But divers dive for pearls because they have a high value. In other words, you are willing to incur high costs or expend great efforts because the thing has such a great value. If the thing at the bottom of the sea didn't have much value, you wouldn't die for it. So you can see this subjective value tradition that began with Cantillon coming through and really being perfected in Menger.

42:49Finally, I want to mention one other thing that Menger did regarding goods, and that is, He also explained how an individual factor of production was priced, which the classical school couldn't do. They talked about labor in general, receiving a certain share of the product, and land in general, acquiring a share of the product, and so on. They didn't talk about how individual laborers, individual pieces of capital equipment, individual raw materials were priced. So Menger went beyond just saying that the value of the second order goods reflected the value of the first order goods and so on all the way back. He also pointed out that there was a simple way of determining what the price of a particular factor would be.

43:40He didn't fully explain this in the context of the market economy, but he did give us the important starting point. Take the example of wheat once more. Let's say that a farmer can produce a thousand bushels of wheat per year, and he wants to know what the value is of a hundred pounds of fertilizer. And let's say to produce a thousand bushels of wheat, you need a certain amount of horses, certain number of plows, certain amount of labor, certain amount of supervisory labor and a certain amount of fertilizer, okay? And combining all those things, we call that the production function, will give you 1,000 bushels of wheat.

44:31So, what Menger said was, what's the value, let's say someone uses 10,000 pounds of fertilizer, what's the value, or let's say 1,000 pounds of fertilizer, what's the value of 100 pounds? Well, Menger pointed out that factors, when they're combined, or resources when they're combined, can be combined in different proportions. That is unlike the production of water, which takes two atoms of hydrogen and one atom of oxygen. If you're missing the one oxygen atom, you can't get water, you can't produce water. Most production is not like production of a chemical. Most production, most things can be produced using different combinations of factors.

45:18Okay, he saw that back then, and what he said was the following. He says, what would happen if out of the thousand pounds of fertilizer, one hundred pounds were taken away, all other things equal, with the same amount of horses and plows and labor and so on? He says, well, there would be a reduction in the output. It would go, let's say, from a hundred bushels of wheat, or what I say he produced per year, a thousand. A thousand bushels of wheat, let's say, to 950 bushels of wheat, because of the reduction of fertilizer. So what Menger said was that the marginal product, the additional product that that last 100 pounds of fertilizer added gave the value to the fertilizer.

46:03So, whatever value he attached to 50 bushels of wheat is the value of the 100 pounds of fertilizer. So, and he didn't take it as far as the market economy, but let's assume each bushel of wheat was, let's say, $3 a bushel. And there was a reduction in output of 50 bushels. That's $150. He'd be willing to pay up to $150, because that would be the loss of his revenue, to purchase 100 additional pounds of fertilizer. So, Menger actually gave us the hint on how to solve the problem of pricing the factors of production. What about von Boehm-Bawerk? Well, two important points about von Boehm-Bawerk. One is that he, well, the one that he's known for is that he came up with the theory of capital and interest that was based on subjective values, that was based on people's time preferences.

46:58Now, it was adulterated with other factors, but basically he came up with the notion of time preference, that is, if I were to ask you to lend me $10,000, and you completely trusted me, there was no question that I would default, and that I would pay you back in one year, I would give you an IOU for let's say $10,000 in one year's time, okay, well, would you give me that for a firm promise, firm guarantee that I'd pay you back? Would you give me $10,000 today in exchange for $10,000 a year from now? No one would. Why? Because in the interim you'd be giving up the satisfaction from that $10,000. That's the notion of time preference.

47:44What Boehm-Bawerk pointed out was that future satisfactions have lower value than present satisfaction. A future sum of money has, dollar for dollar, a lower value than a present. present sum of money. So therefore, if I offered you $11,000 future dollars for $10,000 future dollars today, you're not exploiting me by taking $11,000 a year from now for $10,000 today. In fact, that reflects the fact that future dollars have a lower value than present dollars. Because in making the loan to me, you forego all the satisfactions that you could have attained for that year. What Boehm-Bawerk pointed out was that this is not only true in the loan market, but it's true when a capitalist invests in the structure of production, and he used the orders of goods that Menger used, and he called it stages of production.

48:44So if it takes me five years to build a car, then, or let's say I'm in the assembly stage of an automobile, And I know that I can produce a certain number of automobiles that will yield me a million dollars one year from now. Would I be willing to pay the workers, and let's forget about the raw materials and so on, let's just assume there's workers here, would I be willing to pay the workers the full one million dollars? Well, of course not. No one else would. The workers' value would be bid up to a level which reflected the time preferences in society. So, if there was about a 10% time preference on average in society, if people preferred goods today to goods a year from now by about a 10%, then the total amount of wages paid to workers would be 10% less than $1 million, that is about $900,000.

49:42So, capitalists would pay about $900,000 at the beginning of the process, let's assume they pay them right at the beginning, And in return, they would get the capital goods that the laborers worked on for the year. And at the end of the year, the capital goods would be finished automobiles, which the capital would then turn around and sell for a million dollars. He would get about, let's say, an 11% return on the $900,000 investment. So, far from being exploitative, what the capitalist does, the capitalist function in a market society, is to remove the burden of waiting for income from the workers. Think about workers that want to engage in a five-year process. They want to produce bread from scratch.

50:29Well, if you think about it, before you can even produce bread, you must have the wheat, first the flour, then the wheat before that, and before that you must have the farm tools, and before that you must have the iron ore. So it might take five years to produce bread. Now, let's say the workers could produce bread that would sell for $500,000 as a group. And let's assume there's no capitalists. They'd have to wait five years for that income. Now, how would they go about doing that? They would have to save up consumer goods in advance, or they would have to save up money in advance. That would see them over that five-year period. However, if there's a capitalist there who's already done the saving, And the capitalists invest the money, and in fact it would be a series of capitalists, different ones owning different stages.

51:18They pay the workers every two weeks, or every week, or whatever it is. So the workers don't have to wait for the five years until they get paid. They get paid every week or two. And they're willing then to take less than their marginal revenue product, less than the revenue they add to the final output. That revenue is discounted, as in the case of the auto workers, by the interest rate, so every year they get a certain salary that's, let's say, five percent per year less than they could have gotten if they were willing, among themselves, to produce a good and wait five years for the income. That's the return of the capitalist. It's not exploitative, as Marx claimed, even though the capitalist sat back and did nothing, even hired the manager of the plant. He sat in his chair and was, in Marx's term, errantiae, or Keynes's term, errantiae, Someone who just collects, clips coupons from bonds from investing and lives on that.

52:17The capitalist has done something. At some point in the past, that person who has become the capitalist was a saver first, was someone who abstained from consumption and may not have been even particularly rich, but abstained from consumption in the present and accumulated a certain capital that he then advanced to the workers before the product was ready for sale. I might mention also, not only do the capitalist investors or capitalist entrepreneurs remove the burden of waiting, also, as we see in the case every day of firms that lose money, In the case of GM, for example, or in the case of IBM, which in 1990, 1991, IBM lost $13 billion in those two years.

53:09Did any of the workers not get paid during those two years for the products that they worked on for IBM? Who lost the $13 billion? Did the workers lose a penny? No. They were paid, they may have lost their jobs after the fact, but for the product they produced that was not worth the cost of producing, they still got their full pay. So even though von Boehm-Bawerk didn't quite go that far, Mises and Rothbard did, we see that the capitalist entrepreneur also removed the burden of uncertainty in payment from the workers. and the Workers, okay? All right, so that was von Boehm-Bawerk's first important contribution, it's much broader than that.

53:56He actually developed, in effect, what Murray Rothbard has called Austrian macroeconomics, okay? He developed a version of an overall economy much before Keynes discovered macroeconomics in 1936, quote, unquote, okay? One other thing that he did, I want to just point out very quickly, is take Menger's theory of marginal utility much further and develop a theory of pricing that people really still don't realize, even Austrians, is different from the supply and demand analysis that we learn in our textbooks, even though it was in terms of supply and demand, it was much richer.

54:43I'll show you this real quickly, okay. It's interesting, if you look at Mises' Human Action, there's hardly any discussion of basic price theory. In his chapter on prices, there's a lot on how factors of production of price and a lot later on on how monopoly prices are formed, But there's only about a page and a half or something on actual prices, and he basically says, well, everyone knows by now that the prices are determined by the marginal pairs, okay? This analysis of marginal pairs that was developed by von Boehm-Bawerk, I think it's one of his most important underrated contributions.

55:34It's also one of the reasons why people like, for example, Israel Kirzner and others think, though Israel Kirzner isn't as much at fault as Lachmann, who claim that von Boehm-Bawerk is some sort of an objectivist and isn't a true Austrian. That's nonsense once we go through this example. I need my pointer. Yes, I got it. Let's assume that you have eight horses in the market and you have ten buyers. Now, I've denoted buyers as B1 through B10, sellers in the third column as S1 through S8. Under maximum buying price, I've shown you the maximum price that a particular seller will pay for a horse, let's say 260, B3 will pay up to, but no more than 260, and so on.

56:28Okay? Boehm-Bawerk called the most capable buyer that buyer that was willing to pay the highest price for a unit of the good. The least capable is the buyer that's willing to pay the lowest price. On the other hand, it's reversed with sellers, right? The most capable seller is the seller that's willing to accept the lowest price. That is, he's the first one to make an exchange, okay, as prices go up. And the least capable is the seller who will not part with his good until the highest price is reached. Okay. Now, how do we determine the equilibrium price and the equilibrium quantity? Well, von Boehm-Bawerk said it's done by the marginal pairs. And let me show you the analysis.

57:17Let's say the price starts high at $300. Well, you only have one seller there, B1, who's willing to buy, but you're going to have eight buyers, eight suppliers willing to sell because $300 exceeds the minimum selling price even of the least capable seller. That price cannot exist. In other words, the suppliers are going to be willing to lower their price, And as a lower price, what's going to happen is that you're going to get the next most capable buyer coming in, the guy who's willing to pay $2.80, and on the other hand, price is going to continue to fall until you get to a point where every buyer that wants a purchase at that price can find a seller, and every seller that wishes to sell can find the buyer.

58:06Now, in this particular case, the equilibrium price is going to fall between $210 and $215. It's got to be greater than $210 and less than $215. Let me explain why. If it's greater than $210, then buyer number six will not purchase. So you'll have a demand for five horses. If it's lower than $215, buyer or seller number six will not be willing to sell. So you'll have five buyers and five sellers at an equilibrium price. What happens if it goes up to $215?

58:53At $215, you have six people wanting the supply and only five willing to buy. What happens if it falls as low as $210? Well then, buyer number six comes in, and yet supply at 210 is only five, okay? So somewhere in between, there's a range in there between 210 and 215 in which you have the price being set, okay? So the marginal pairs refers to the following. It refers to the upper limit, the upper limit is always set at any price by the last successful buyer, in this case B5, and the first unsuccessful seller, S6.

59:50In other words, whichever is lower is going to set the upper limit, whichever of those two is lower. For example, if the B5 had a maximum buying price of 213, then the price would have to be less than 213, because otherwise he would come into the market, okay? Okay, so that's the upper limit. What about the lower limit? The lower limit has to be set by either the higher of the first unsuccessful buyer, okay, B6, or The Last Successful Seller. In this case, B6 has the higher price. And in this case, therefore, the limit is between 210 and 250.

1:00:38And let me just give you that in a more formal way. Simply, the upper limit of the equilibrium price range, in this case, it's between those two prices, is determined by the lower of the minimum price of the first unsuccessful seller and the maximum price of the last unsuccessful buyer, or the last successful buyer, excuse me. The lower limit is determined by the higher of the minimum price of the last successful seller and the maximum price of the first unsuccessful buyer. Okay, in this case, the marginal pair that actually determines it are those two. But it can be either, in either case it could be one or the other depending on which, and you can look at his example in the book.

1:01:25The reason why I bring this up is because this means that it is subjective values and subjective values alone, and I'll put up a few quotes by Boehm-Bawerk, that determines prices. And he says the following, he says, Of all the results we have attained in this chapter, and that's the chapter in which he has his fourth market, The one that is by far of greatest import is the fact that all influences which function in the determination of price have been resolved into subjective valuations and a rational appraisal of their functioning. And he goes on and says, and I do really believe we have here hit upon the simplest and most natural and indeed the most productive manner of conceiving exchange in price.

1:02:15I refer to the pricing process as a result derived from all the valuations that are present in society. And then he goes on, he says, I do not advance this as a metaphorical analogy, but as living reality, that in every market, at every moment in time, it is people's subjective valuations of buyers and sellers that determine the prices. So that, for example, when you go into a supermarket and you walk out with, let's say, two six packs of beer, two pounds of steak, five potatoes, and no more and no less, what does that mean? That means that you have purchased up to the point where the last unit of each good just exceeds the price that you're paying for it.

1:03:04So that you're benefiting. And on the other hand, the seller in return is receiving a price that he prefers to each unit of those goods. Then Boehm-Bawerk in another passage says, is the sila of vacuousness and unsatisfying vagueness and the caribda of an equally unsatisfying erroneousness. He's talking about the classical school. He said, it is now my opinion that the problem finds complete organization and solution if we introduce into the traditional frame the simple thought that price is completely and entirely the product of man's subjective evaluations. Finally, he says, this is important, he says, the prices are the result of the momentary market situation and we are beginning by regarding as a constant quantity the stocks of finished products which constitute the supply.

1:04:01That is, at any moment, and Murray Rothbard has emphasized this, at any moment there is always a certain amount of goods on the market in inventory. That's why we don't draw upward sloping cost of production curves, marginal cost curves, as do the mainstream economists. At any moment in time, the only cost of selling a good that's in stock is speculation on whether you can get a higher price in the future. And that's the only reason why supply curves might slope upward. He goes on to say, however, they are only momentarily constant, becoming a variable quantity as time goes on, as production continually keeps adding to their stocks. He's answering Marshall there. Marshall and others claim that the Austrian School only explained the value of goods that were readily available, only explained their prices.

1:04:53But that's all there are. At any moment in time, there's simply exchange of goods that already exist. exist. But beyond that, in the second sentence, what he's saying is that because we have a structure of production that is integrated and is continually giving us outputs of new goods and services, those markets are created and re-created. So new stocks are continuously falling onto the market, but just because of that dynamic fact, doesn't mean that the analysis of a given moment isn't the correct analysis. It always is the correct analysis. It's not the long run supply curve, upward sloping supply curve, which is based on long run costs of production that's relevant to price theory.

1:05:44It's always the momentary supply and the momentary demand, which depends on people's values. And something else that's interesting, which I'm working on now, and it's in Boehm-Bawerk, and I realize now it's in many other economists, including Henry Hazlitt. Mainstream economists, when they say that the demand increases, they say, well, the demand increases. At any given price, people will buy more, they'll spend more on the good, so the demand curve shifts to the right. That shifts to the right. That's not the way Boehm-Bawerk or, for example, Haslett, or even if you look closely at Rothbard, talk about it. This whole idea that an increase in demand means an increase in spending on goods. People don't just have extra money, go out and spend it on goods. What actually happens is that if there's an increase in demand, it means that, and Boehm-Bawerk was very, very specific, that if there's an increase in the demand for good, it means that people now value the good more in relation to money than they did before.

1:06:42They're always comparing the good to the marginal utility of the goods and the marginal utility of money, which means that when we talk about it, it's much more accurate to say the demand curve shifts upward or the demand curve shifts downward. And when you talk like that, spending is no longer important. Spending falls out of the whole thing. Spending is what happens after you've decided that the good is more important than you thought it was before, in which case you'll buy more units if there's a given supply. or you want to buy more units, you value it higher. That's very important because that actually now bears on monetary theory. When we say if the government increases the amount of money in the economy, there will be more spending. Well, it means that's telling us that people will still have more money.

1:07:28You'll say, hey, I have more money, I'm going to spend more. No, that's not what happens. Boehm-Bawerk actually says that if people have more money, then the value of money will fall in relation to goods And the demand curve for goods will go up, okay? On the other hand, if an individual has less money, then he will value money, the marginal utility of money will rise, and therefore the value of the money on the market will be higher, which means that the demand curve, if you're giving money away, the demand curve will fall, okay? So demand curves fall and rise. They don't move to the right or the left. Saying they move to the right or the left, really, as I'm beginning to realize in the last year, causes problems in monetary theory, okay?

1:08:15It completely blows the monetarists out of the water. I'm writing a paper I'll give later here at the Mises Institute later this summer on that. Okay, I'd rather take some questions rather than get the visa. Visa is only a few things that I can say and I'll say more about them tomorrow. These are accepted marginal utility, but for the most part departed from Menger and Boehm-Bawerk and attempted to formulate a general equilibrium system of the economy, which was more realistic than that of Walras. And there's various points at which he tried to bring in realistic data into the system.

1:09:00But there's no doubt if you read through his treatise on social economics or his earlier treatise on natural value that he started from a communist economy in which one mind controls everything and tried to treat that economy in the same way that an individual economizes in his household economy. And he believed that just as the individual can tell if he was better off by rearranging resources So, too, could that be done for the economy as a whole. But when you talk about different individuals, you're talking about adding up utilities. And he did introduce a very small, free equation system in which he tried to solve the problem of imputation.

1:09:50In other words, he didn't accept the view of Menger that you can figure out The value of factors of production by figuring out their marginal product, by subtracting. He didn't like that. He wanted to impute it through a mathematical process. And he actually comes out and I'll read this for more. He says something like, these equations are solved every day by the market. Well, I don't see anybody solving any equations in the market. I just see buying and selling. And he did influence Hayek. Okay, so I'll stop there and I'll take any questions. Yes. You've discussed the dasturians in the tradition of Balrass.

1:10:38I'm curious, how does Jevons and that tradition fit in? Jevons, I think, is better than Balrass. He wrote his treatise earlier than Balrass, the same year Menger wrote his, 1871. and he did try to rehabilitate the French school. He did have a notion of causality, but he tried to use, he quantified utility. He drew cardinal utility curves. Whatever was good in Jevons' system was rescued by Wickstede. The best stuff was taken out of it. And let's put it this way, it's all in Wickstede. Whatever is good in Jevons' is in Wickstede. Mises and Wixi, and Jevons is good, but he did take things in a mathematical direction, not as thoroughly as Walras.

1:11:36He also, since his book was really only an introduction to economics, just like Menger's was rather than a full principles book, He didn't develop his view of the entire economy. He began to write a book, he died young, he died before it was completed. He did writing of principles, whereas the other, I think, was just the theory of political economy. There are fragments collected in Gevin's Principles. That may be another reason why he did not, he didn't have an immediate followers like Menger did that developed his thought very quickly and much more broadly, okay, so. But Wixtee takes, was heavily influenced by him and took all the valuable things out of Jevons.

1:12:27Yes. What does marginalist insight look like in Mohrach in that mathematical framework? What do you mean marginalist insight? Like he was one of the founders of marginalist revolution. Right, he called it rarité, which instead of marginal utility, the relative scarcity or rareness of a good. Basically, he had that, and he just had a system of equations. I'm not a Walrass scholar. People claim Walrass was much better than his later follower Pareto. Pareto's system is what we have really today, it's not really, you know, they call it the Volrasian system, but it's Pareto's, Pareto developed the indifference curves and so on, but Volras may have been much richer, okay, he had actually a good theory of the demand to hold money, a good theory of cash holding, and there's a lot of literature on Volras, Volras has been reinterpreted in the last 20 or 30 years.

1:13:31And he probably is a better economist than I would give him credit for. I just don't know that enough about him. I know Arthur Marget, who wrote a great book on money, probably the second greatest treatise after Mises on money in 1938-1942, was a Walras scholar and the best things on Walras, the best things in Walras are in this treatise called The Theory of Prices. two volumes that came out in 1938, 1942. It's a running critique of Keynes, a devastating critique of Keynes. It's just too long, it's got footnotes to footnotes, it's very difficult to read, but there are parts that are just marvelous. He was also a Boehm-Bawerkian, he believed that the prices that we're trying to explain are prices that exist at any given moment in monetary theory.

1:14:19Yes. I was wondering if you'd offer commentary using the marginal pairing analysis on a more modern neoclassical contention of like rational identifications and winner-firsts. I don't, I mean they seem to be doing different things or aimed at different things. I mean I would like to, the theory of the marginal pairs could be used in auction theory I guess. I mean, Boehm-Bawerk, if you work through his book there, or the part of the book on pricing, starts with bilateral monopoly, meaning two people bargaining. So he sort of is the author of bargaining theory in some sense.

1:15:07And I think in Man Economy and State, Rothbard says that nothing worthwhile has been done on bargaining since Boehm-Bawerk. and Boehm-Bawerk, that's in 1962 in Man Economy and State. Now, I haven't thought about developing these marginal pairs in any deeper. Now, there's an article that John Egger, an Austrian who was also at South Royalton, sent me on marginal pairs, and it got me thinking about this, which he got into the Journal of Economic Education back in 99. I have a copy of that article if you want to look at it. He goes into a little bit more detail. Boehm-Bawerk makes a mistake, which I don't see in this, but anyway, that he didn't quite get the marginal pairs right, which I don't think is quite right.

1:15:54But anyway, you know, there hasn't been anything written on the marginal pairs in a long time, and then Egger's article is great, just to have some talking about that. I always taught it that way when I was teaching undergraduates. Now the MBA students, you know, they want to hear about marginal pairs. I mean, that's, you know, why do we have to go through all of this? But Egger tells me that he does teach MBA students this stuff and that they are interested in it, so I may introduce this and say, look, this is a better way. One thing I did want to point out is that von Boehm-Bawerk doesn't reject regular supply and demand theory. What he says is that, he says, when buyers and sellers can make continuously changing valuations, upward or downward, notice he's talking about upward and downward, as the case may be, and these valuations represent offers to buy or sell partial quantities of a market good, there's a special predilection for depicting them by means of continuously ascending or descending curves,

1:16:56and for indicating by their points of intersection the price situation which a competitive offers based on those valuations are in the process of developing. Now he says this is unobjectionable, he goes on to say, however he says, I still find it questionable whether with its resulting presentation, with its resulting unavoidable suppression of any personal point of view, this method of presentation is really capable of completely supplanting and making superfluous a description by running commentary of the determination price. By running commentary of the determination, he means looking at the buyers, looking at the sellers, showing their maximum buying prices, minimum selling prices, and focusing on the marginal pairs.

1:17:42He's saying there's nothing wrong with drawing these curves, and he does at one point, but that it's too mechanical. It doesn't show you the subjective valuations interacting to determine the price.

1:18:00He admits that it's easier to do it that way and in some cases heuristically it's better to have supply and demand curves so students can follow along and so on, and that this becomes cumbersome. It does become cumbersome when you're talking about a lot of people. But he thinks that this should be the first introduction to price. or Price Theory. Any other questions, comments?

1:18:50You have to remember that there's some uncordiality in that.

1:19:20He changes everything around to show you how, if people's, one criticism of this was by certain economists, Edgeworth in particular and some others. Well, you know, you're saying that only the marginal pairs affect the market, but that actually is not true, okay, that only the marginal pairs determine price. Everybody's valuations in the market determine price. It's simply, everybody's valuations determine where the marginal pair is. The marginal pair is determined by, if you change the number of sellers and buyers, you're going to change the marginal pair. Boehm-Bawerk admits it in the second edition or third edition, and says, okay, I wasn't as clear on that. So, be careful with the way you state it. Marginal pairs alone don't determine price.

1:20:07It's the marginal pairs that are determined by all the subjective valuations of the buyers and the sellers. If you have fewer sellers or sellers with different valuations, the marginal pairs themselves are going to change. But it is ultimately, they do establish the limits in the existing system or situation, they establish the limits of the price. And of course, where you have numerous people in the market, the marginal pairs come down just the marginal pair. Okay, that is the person who just values, the buyer just values the good more than the quantity of money and the seller who just values the quantity of money less or more, the quantity of money he's receiving more than the good he's giving up.

1:20:52Okay, so you get one point, okay, you don't get a range. And I think von Boehm-Bawerk actually shows that too, that you can get a point and not a range. Thank you, Joe.