Video Transcript: Markets & Prices

My topic for this morning is markets and prices. So before we hop in, I just kind  of want to think a little bit about what we want the economy to do, in a sense.  And I think that Dr Murphy did very well saying that when we think about human  action, what it's really all about is me as an individual, applying the resources I  have at my disposal to accomplish my most important goals. Right? So I have  these various purposes in mind. Some are more important than others. I have  various means at my disposal. I apply those means to attain my most important  ends. And I think it's fair to say that when we are involved in a social economy  like like, we are involved with other people, but we'd like the economy to allow  us as individuals to achieve our most important ends, right, so that that way I'm  not just bound by the resources that I individually have in my pockets or in my  house, but that if there's something say that you have that would be very  valuable to me, and I have something that would be very valuable to you, right,  we now have the opportunity to exchange these things, right, so that each of us  can fulfill a more important goal than we could if we were totally isolated, right?  So I think ultimately, the goal of the economy is for us to use all of the resources  available in our society to attain a maximum value in the eyes of us as the  people using these resources. So to suggest that the market and the pricing  system coordinates our behavior in such a way that we do actually do that. That  is we do actually apply resources to the most important goals. Now first, we  have to kind of establish what do I mean by most important goals, building on  what Dr Murphy said, Remember that value is subjective. So we could think  about something very simple, like a box of chocolates. What is a box of  chocolates really worth? Well, depends who you ask, right? If you're say,  someone like me, or I have a wife who likes chocolate, to me, a box of  chocolates is very valuable, because I can then take it and give it as a gift to my  wife, and that makes her happy, and that makes me happy, and my life is much  better. And other people may say, and a box of chocolates is worthless. It's not  really good for your health. There's all the sugar and fat and various other things in it. It's just, it's on the whole, not good. Well, different people have these  opinions. And if, as economist, what I'm interested in is people's behavior, then I  just have to accept right? The value is subjective. Different people disagree  about the value of different things. And so value is, then, in a sense, personal.  That's what I mean by being subjective. I would also add to this that how useful  a particular box of chocolates is, say, the way that I establish this is by thinking  about the order of different potential uses. So I'll just introduce, say, three  different possible uses for a box of chocolates. So the most important thing that I might be able to do with a box of chocolates is I give it to my wife as a gift. I  think she might be listening in on this. So I have to say that first, the second  most important thing might be that I eat it myself, because I also it ends up really like chocolate, right? So that may be the second most important thing to me. A  third most important thing is that I also have a couple boys, and I know my kids 

like chocolate because I'm not a very good father, so I give it to them anyway.  So I give them chocolate, and that makes them happy, and it makes my life a  little bit better for the few minutes before the caffeine kicks in. So I have these  

three different goals, one, giving a box of chocolates to my wife. Another, eating  a box of chocolates for myself. Another, giving a box of chocolates to my  children. So here we can see I've established an order of different uses, right?  And this would be the order in which I'd say rank their usefulness, right? First is  the most useful thing I can do. Second is the second most useful thing. Third is  the third most useful thing. Now, we as Austrians have a very specific technical  name for what I just said, and we'd say that utility. Utility is really just a word for  usefulness is ordinal, that is, it's all about an ordering of various uses. So  usefulness is ordinal. I have one use is more important than another, that one is  less important than some but more important than another still. Now this is  important because a lot of economists, seeing other approaches, would say that no utility is more Cardinal, which means we can assign a specific number to it,  right? So I can say that, Oh, giving a box of chocolates to my wife is worth 15,  right? Having one for myself might be worth something like 12. Giving one to my children is worth three, something like that. But what we find is, when we really  think about people's decisions, we don't have to come up with these cardinal  numbers at all. What really matters is the order in which these things are  presented. If I have one box of chocolates, what am I going to do with it doesn't  matter whether the numbers are 12, seven and three, or anything like that. What matters is what is the most important thing. So the order is sufficient for me to  explain behavior. I'd also suggest that this Cardinal approach is probably wrong.  You ask most people, what is the value to you? They might give you $1 figure  terms of what they're willing to pay for the thing, but they're not going to give you some kind of value of happiness worth 12 happiness units, or utils, as  economists might call it. So the ordinal approach is perfectly sufficient and will  get us where we need to go. So. Next, I want to touch on the law of diminishing  marginal utility. This is something that Dr Murphy did very well, presenting so  presented again. And the reason that it's important is that it helps us explain  really, why some of the very early economists, people like Adam Smith in the  late 1700s got price theory very wrong. Because what ended up happening,  we're going to show that usefulness, in the end, underlies pricing in the market  system, and this is totally divorced from the approach that Adam Smith took.  Adam Smith, he was looking at prices, he wanted to explain them, and he said,  we have this problem. Do we know that water is very useful without water, I die.  On the other hand, diamonds are basically useless. He was a good Scottish  Presbyterian. Diamonds are frippery. They're basically worthless. But at the  same time, we look at the market. Here I am in Scotland, water falls out of the  sky on a regular basis. Nobody's willing to pay for it. So it has a value of zero on  the market in terms of prices. But at the same time, people are willing to pay 

huge amounts of money for a diamond. So he said, It can't have anything to do  with usefulness. Then, if something that's vital for survival, we're unwilling to pay for, while at the same time, something that's a frippery, we're willing to pay a lot  

for, there must be a separation, according to Adam Smith, between the  exchange value, or the price and its use value, that is what I would actually use.  The painful the law of diminishing marginal utility was essential in solving this  paradox, and in fact, coming up with the answer that yes, it is usefulness that  matters. So what usefulness Exactly? Now, before I lay it out, let's just give  some of the technical conditions we talk about the law of diminishing marginal  utility. First, we have to say we're dealing with homogeneous goods. What that  means is that we have two different units of the good, right? They could be  exchanged with one another. They can fulfill the same purposes, right? So if I'm  thinking about that box of chocolates again, for me to say that these two boxes  of chocolate are homogeneous means that they are equally able to satisfy the  same list of goals, right? So I could give this one to my wife, and she'd be fine. I  give this one to my wife, it works just as well. It doesn't necessarily mean that  the contents of the box of chocolate are exactly identical, just that it satisfies the  same set of goals. So we have homogeneous goods, as long as we have that.  But we can say with great confidence, as Dr Murphy mentioned that each unit in a larger stock has a lower value within each unit in a smaller stock. Now the  reason for that is we can think, suppose that I don't have any boxes of  chocolate, I would naturally be very sad, especially because my wife is very sad. But then you give me that one box of chocolate, and suddenly my life has  improved immensely. I can fulfill that most important goal. Now, on the other  hand, if you give me three boxes of chocolate, my life has still improved  immensely. That's true, but each of these units isn't quite so important to me as  that one when I only had one. Now the reason why, let's imagine what happens  if I lose a unit, if I only have one to start with, and I lose it. Now I don't have a gift to give my wife, and then I hear again about how I never get her gifts, right? I'm  very dissatisfied with that situation. On the other hand, right? If I have three  boxes of chocolate and one of them vanishes, say, I put them in the trunk of my  van, the sun heats it up and it totally melts and is worthless for any use, I throw  that box away, then what has happened? Right? Well, we know my uses. Most  important, give the gift to my wife. I'm still going to do that. I have two boxes of  chocolate, right? Second most important, eat one myself. I'm just going to, still  going to do that. I have a second box of chocolate. The least important thing  would be giving that box to my children. That's what I'm going to give up, right?  So, right, that one box, when I look when I lost it made me lose something really important, that is the gift for my wife, whereas that third box made me lose  something that is important, but not as important as a gift for my wife. If we  apply this to things like diamonds and water, if we're thinking about Scotland, I  live in northern Ohio, which has weather or not like Scotland, where water falls 

out of the sky on a regular basis. It pools in my backyard, plenty of water. Well, I  have so much of it right that any particular unit right, say, any say, eight ounce  glass isn't that valuable to me. Now, it's true, if I didn't have any water, if I was in  the middle of the Saharan, somebody offered me an eight ounce of glass. That's very, very important. Okay, right. So we can then see why water in places like  Scotland or Northern Ohio would be basically worthless in exchange having that one additional unit, which is the unit I would be buying in exchange, it's not that  valuable to me. On the other hand, having an additional diamond which which  are not very common in northern Scotland or in Ohio for that matter, well, in that  case, having an additional unit might be very useful at this point. I believe my  wife owns exactly one diamond, and I think she'd be very happy with another  diamond. I've not yet been willing to buy it, right? But, you know, it would be very valuable, certainly more valuable than an additional glass of water, which we  can easily have 1000s of. Where I live. So we have the law of diminishing  marginal utility, which tells us then that if we have a larger stock, each individual  unit of that stock isn't that valuable compared to if we have a smaller stock. Now, following from this would be that that first unit we receive is more important than  the second unit we receive. The first unit we receive goes to the most important  thing, that first box of chocolates goes toward giving my wife a gift. Second box  of chocolates goes toward a second more important thing. In this case, me  eating myself says the law of diminishing marginal utility, as Austrians would  present it. Now this is different from the way you might hear it in, say, a  conventional economics classroom, where there they might say, open up the  box of chocolates. Have a student come to the front say, Okay, eat this piece of  chocolate. Student eats and say, Okay, how much happiness did that add to  your life? Oh, 10. Come up with some number. Okay, we give them a second  piece of chocolate. How much happiness did that add to your life? Eat? Okay, it  gives them a third piece of chocolate. How much did that add until eventually  they're eating the whole box. They're feeling sick, and they're saying, Oh, I'm  actually getting less happy the more that I eat. So we might think of this way of  proving the love diminishing Marshall utility, but this is, notably not the Austrian  way of thinking of it. It is not just that psychologically, that we react in this way to  getting more of the thing. It's that we have a list of uses, and logically, we're  going to fulfill the most important use, first with any unit that we get of the good,  and we'll move down that list as we get more units of that good. So it's not just a psychological thing. I actually did read a case where somebody did this  psychological approach and they gave the student pieces of chocolate, and they never decreased. They apparently were just a chocolate lover. They could just  eat an entire box of chocolates, and it was a 10 every time. As far as Austrians  are concerned, this would not disprove the law of diminishing marginal utility.  This is all about this list of usefulness, not about psychologically. How does it  affect your sense of well being or happiness? It's are you satisfying a more or 

less important use. Now, last point before we really get into price determination  is just pointing out that we can rank not just say the first box of chocolates  versus the second box of chocolates and the third. We can rank different goods  on a preference scale. One of the things that I hear people say all the time that  really irritates me is that you can't compare apples and oranges. Have you ever  been to a grocery store? Have you ever decided, gee, I think I'm going to buy  apples rather than oranges. If so you've compared apples and oranges, you've  decided this is, in fact, going to be more satisfying for the various quotes I have,  whether it be maintaining my budget or cooking apple pie or what have you,  than the oranges would be right? We can compare apples and oranges, which  means, then, when we think about our preference scale, we don't just put in,  say, different ranks for first, second, third box of chocolate. We could also  compare that with, say, first, second, third bag of apples. Or we could compare  that with, say, $10 $9, $8.10, I'd certainly prefer to nine, nine, I'd prefer to eight,  and so on. If you have the opposite preference, you'd rather have $8 than 10.  Talk to me afterward. We can solve that problem for you, but we prefer more  money to less, and we can compare money into oranges or money in boxes of  chocolates. In fact, we know we do this all the time, every time I go into the  grocery store and I look in the candy aisle, which happens more often than it  should, and I see, OK, that's $10 for this box of chocolates. What's really  happening is that the grocery store is asking me, which is more important to  you, this box of chocolates we're offering to give you, or the $10 you have sitting in your pocket. I'm being asked to compare money versus this particular good.  And this then feeds directly into price determination. How do prices get  determined? Well, in the end, what a price really is is just an exchange ratio  between a sum of money and a good that is being exchanged for that money.  So thinking again about that box of chocolates for $10 if I go and I say, Yes, $10  for a box of chocolates, I'm willing to do that. My wife will be very appreciative.  I'm willing to give up $10 for that box of chocolates. That is implying that, to me,  that that box of chocolates is more important to me than $10 so when I look at  my ranking of values from most important to least important, that somewhere  $10 is below that first box of chocolates, right? So there's an inequality there. At  the same time, the seller, in this case, the grocery store, by offering to sell me  this box of chocolates for $10 is indicating that they would rather have my $10  than their box of chocolates. So there's what we call a double inequality of value that is on my side of things, I consider this particular box of chocolates to be  more valuable than the money I'm giving up. On the side of the seller, they  consider that quantity of money to be more valuable than the box of chocolates  that they're giving up. Now this, it ends up, is a very important point, because  when you go back to the Smithian way of thinking about things, what then does  exchange mean? And often we saw amongst the classical economists this idea  that if we're exchanging $10 for a box of chocolate, it indicates there's an 

equality of value between the two. One of the projects I'm undertaking at the  moment, because I have very poor judgment is that I'm reading Marx's capital.  It's the third time I've attempted. I've given up at least twice before, but this time  I said, I'm going to go, I'm going to read Marx's Das Kapital and find out where  he makes his mistakes. I found the first major mistake on page four, so it didn't  take long, unfortunately, and that, I guess, provided some energy to continue  with the project. And the mistake he made was exactly the one I exactly the one  I just mentioned. He said, If we exchange a certain amount of gold, gold being  the currency at the time, right for a particular good think he was talking about  thread or yarn or something like that, that indicates there's an equality of value  between these two. And then he reasons further and says, Well, what then is  equal? Well, it must be labor. And then we end up with everything that we know  is communist theory. But that point that he makes about this equality value is  exactly wrong. It's exactly wrong because when I pay $10 for that box of  chocolate, what I'm really saying again is the box of chocolates worth more to  me than $10 they're not equal. Similarly, on the seller's side, what they're really  saying is the box of chocolate is worth less than less to them than the $10  again, they're not equal, because there is no equality of value whatsoever. In  fact, we need the inequality of value for the exchange to happen, all right. So  then keeping this in mind, right? The way we would think then about, say things  like price determination, right? We have these exchanges. Right? In each  exchange, the buyer is indicating that they value the good more than money  they're asked to give up. The seller's indicating they value the money more than  the good that they're giving up. So what is going to determine prices? We can  imagine then, in my value scale, I have my first unit, that gift that I'm giving to my wife, my second unit, we know is somewhere below the first going to say it's  also below $10 so when I see that $10 price tag, I'm willing to buy the gift for my  wife, that box of chocolates, but I'm not really willing to buy one for myself. And  down further might be some price like $8 down further, that unit for my boys,  down further, something like $3 and so what does this then indicate I'm willing to give up $10 because it's less important to get that gift for my wife. So $10 I'll buy one unit of the good if instead, when I walked into the grocery store, the price  had been something like $8 I walk in, they're saying, we'll sell you these things  for $8 a piece. I say, Well, I was willing to pay 10 for my wife's so certainly I'm  gonna buy that one for eight. That's a great deal. Not only that, but the second  unit, the one for myself is also worth more than $8 let's all go ahead and I'll buy  two units. Maybe they offer me a really low price. They're selling for $1 a piece,  something like that. In that case, I might be willing to buy not just the first and  second, but also the third. Right to Buy this gift for my children so they can have  chocolate as well. So we end up then with what I just described is really the law  of demand. It indicates that all else equal, the lower the price is, the more units  I'm willing to buy, and the reason is really just because we know that that first 

unit is going to satisfy the most important goal, so I'm willing to pay more for that first unit than I would be a second unit. For me to be convinced to buy that  second unit, you have to drop the price enough, or I'm willing to do it at the  same time. Third unit, you have to drop the price even more. And on down we  go. This is the law of demand. It ends up we can also reverse everything we've  done to come up with the law of supply. So now we imagine, say that I have a  bunch of boxes of chocolate, say three of them, and somebody's thinking about  trying to buy them from me. So we know, because I have a lot of them, right?  That last unit, the one that I would feed to my boys, isn't worth that much to me.  If they offer me, say, six or $7 that's a $6 I'm willing to sell it to them right now,  for them, though, to convince me to sell them, right, the gift that I would give to  my wife, they have to have to offer me substantially more, right? So we then end up with the relationship that to convince me to sell more of the good you have to offer me a higher price, or stated then as the law of supply, the higher the prices  that offered, all else equal, the greater quantity is going to be offered for sale by  suppliers. So demand, we have this inverse relationship between the level of  prices and the quantity that people are willing to buy. High prices, people don't  buy much. Low prices, people will buy more supply. On the other hand, we have  a direct relationship at higher prices, our suppliers are willing to sell more of the  good. So then how do we end up with prices in the economy that we have?  Well, I'd suggest that there are really three possibilities when we're first putting a price tag on an item. One possibility is that we price, in a sense, too low. So we  price really low. So we say, I don't really want to sell much of to sell much of this  good. Get rid of it for, say, $3 or something like that. But this attracts a huge  number of buyers, right? So lots of buyers want to buy lots of the good. So what  do I see? I see immediately I sell out of this good. People come say, Hey, do you have any more chocolate? No, no, we're sold out. Now in the economy, as we  learned in the United States, right? We know that we don't have much  negotiation with most of our sellers. I don't go into the grocery store and say,  let's talk down or talk up prices that are posted. We just kind of accept the  posted price. But it's very believable that the supplier is going to see that they're  regularly selling out of boxes of chocolate and say, well, might be worthwhile for  me to both or. Stock more of this good and also charge a higher price. I'm only  going to stock more if I can charge a higher price, I'm selling out so quickly.  Looks like I can get away with it. People really want this good. So if we price in  such a way that the quantity demanded is far beyond what is supplied by  suppliers, there's going to be a natural tendency for prices to rise from that point. Or we can imagine exactly the opposite. We could say, perhaps the store is very optimistic about the quantity they can sell. They say, we're willing to sell a lot as  long as the price is really high, say, $20 per box. And then they see that it just  kind of sits there. They're on the shelf, these boxes of chocolate. Nobody's  buying them because the price is simply too high. At this point, the supplier may 

say, Well, I would like to sell at least some so if I lower the price, maybe I'm  going to attract more potential buyers, right? So we put things on sale  clearance, these types of things, we lower the price either temporarily or  permanently. And that does, in fact, convince some people to go ahead and buy. If you're not asking me to give up as much, then the use that I'm fulfilling doesn't have to be as important for me to go ahead and pay the price. And so in that  case, we have these very high prices. We have lots being offered for sale, not  so much being bought. Whether there'd be a tendency for these prices to fall.  Now, the last possibility would be that maybe we price in such a way that the  quantity that is being offered for sale is basically equal to the quantity that is  being purchased in this case, right? All of our buyers and sellers are perfectly  satisfied. We don't have these lines of people waiting for chocolate that isn't  there on the shelf, right? Nor do we have chocolate on the shelf going unsold.  We have what we would call an equilibrium, right? That is where that we would  expect this to maintain, to maintain stability. There's no natural reason that  things would have to change from this point, and in the end, this is where we'd  expect prices would come from, that there is this process of demand and supply  interacting over time as we discover the prices that lead us toward that stable  point. The last point I want to turn to, we really need to talk about, because it's  very easy to say, well, this all sounds well and good for things that I as a  consumer get direct value out of. I like to give gifts of chocolate to my wife. I like  to eat it myself. My kids like to eat it, and I like to give that gift to them as well.  But what about things that are not directly useful? What about things like cocoa  beans? I've never eaten a cocoa bean, and I suspect it would not be a pleasant  experience. For me. I think they'd probably be overly bitter for me, and so I really wouldn't value this directly. So how then do we end up with prices for cocoa  beans? Because we know that they have prices. We know that machines we  use to process chocolate and like also have prices. Though it's not something I'd want to buy, to put on display in my house or anything like that doesn't have a  direct use that is satisfying my ends directly. And so how is it that we end up with these prices? Now here, Austrians appeal to what we call the theory of  imputation, which suggests that the price of something like cocoa beans or  these various machines needed to process cocoa beans into chocolate. That  price ultimately comes from the demand for the end good, in this case, the  demand for chocolate, right? So we know that cocoa beans have a number of  uses, right? We can grind them up, make turn them into chocolate bars or boxes of chocolate. We could also turn it into, say, hot chocolate mixes, which are also  valuable. We could turn it just into cocoa powder, which I may buy so I can put it  in cakes or something like that. And so we have these various uses for cocoa  beans, and each of these uses has some price based on the direct use that  consumers expect to get out of the thing, right? So then I, as an entrepreneur,  would look at these various prices, but say, Okay, if I can sell this box of 

chocolates for $10 that's going to limit what I'm willing to pay for cocoa beans,  for the machinery that I need to process these cocoa beans into chocolate and  the like, right? So the value of these various factors of production, my workers,  

the materials, the capital, the land that I build my factory on, is going to be  limited by the price that I expect to earn. And not only is it limited by it, but once  we have a competitive process, right? So we have lots of different entrepreneurs out there. Some are making cocoa powder, some are making chocolates, some  are making other things, but using the same materials. Right now, the bidding  process is going to be such that whoever thinks they can get the most value out  of this resource is going to be willing to pay the most for it. So as a result, right,  the price is then going to approach what is the value of that particular good in  that use by looking at the final good. Now here, we can note that there should  then be some kind of connection right between what is the price of the final good and what is the end cost of production, right? So if we expect to pay, if we  expect our consumers are going to pay something like $10 for that box of  chocolates, then I'm willing to pay $10 adding up all of the resources, minus a  little bit for the amount of profit, that would be reasonable, right? So I might say,  be willing to pay $9 or something like that for all of these materials. So then I  entered into a competitive process, right and if this is the most valuable use of  those resources then we'd expect the prices to get bit up to something close to  $9 right which means the resources would not go toward things that are less  valuable than that $9. Okay right, so then we'd end up resources right are going  toward the uses where people are willing to pay the most. But what I'm willing to  pay is really based on how valuable this thing is to me in terms of the goals that  it helps me to pursue. Right. Now there is kind of an opposite way of thinking of  this which I suggest is certainly fallacious is to think of um what we call the cost  of production theories  

which I think Dr Murphy did allude to. And so the cost of production Theory  would suggest that the way that prices appear on markets for goods is that  producers produce the thing right. Find out what their costs are and then add  some kind of return to it. Now in practice it may often feel this way but in the end we would know this would not actually sustainably explain prices. The reason  being we can imagine cases probably favorite case is the glass sword. Yeah  Pawn Stars if you've not watched it it's a great show about economics. It stops  being great after about a season right but it's people that run this Pawn Shop.  People come in offering to sell them weird things. And this one person came in  and said well I made this glass sword. As far as I know, it's the only one in  existence right. Someone would think in terms of diminishing marginal utility it  should be very high. Um except it ends up that even the most important use for  a glass sword isn't very important compared to most things right so I'm willing to  sell you this glass sword. And the the pawn broker just turned him down and  there's no way that I'm going to be able to resell this thing right because he 

understood right that in the end right it's really the consumer's value that  determines the price you can charge right. So it doesn't matter how much  money, how much time, how much effort you pour into producing this glass  sword you're not going to be able to charge cost plus to a consumer if they don't want the glass sword. If it doesn't help them satisfy their goals and so while we  may see a connection right. If you have resources that help you satisfy really  important goals, those resources will go or a fairly high price the reason is that  entrepreneurs are bidding up the prices of those resources because it's going to  command a high price for the product. It's not the other way around. That the  valuable resources then lead to um high prices for the good okay. So then we  can see right just kind of taking a look back right in the end it's really our uses  for the various consumer goods that determine the prices of those consumer  goods right. It's the prices of those consumer goods then determine right what  entrepreneurs are willing to pay for the factors of production and thereby we end up with factors of production going toward wherever they're going to be most  useful, that is most profitable for the entrepreneur right. So in the end we end up in this economy through the pricing system right with resources going toward the places where they will achieve the maximum value in the eyes of consumers  thank you very much.