Austrian Supply & Demand

1. Austrian Supply & Demand By Paul F. Cwik, Ph. D.Mount Olive College & The Foundation for Economic Education

2. What is Economics? • Economics is NOT about how to get rich or how to invest your money. • Rather studying economics is about learning problem solving techniques to help us understand the everyday world around us. • Economics is a science, a social science, but a science nonetheless. • There is a different methodology between economics and the natural sciences.

3. Scientific Method: Observe data/event Recognize correlations Speculate Causation (Construct a Theory) Create a Hypothesis (Yes/No) Test—Controlled Experiment Revise Theory Austrian Economics is different. We use Axiomatic Deductivism: Axiom Laws Theorems Models Thought Experiments Economic Methodology Does the Scientific Method work for the Social Sciences? So what do we do? Give up? Remember: We need to use the ceteris paribus condition. These thought experiments allow us to hold everything else constant.

4. Economic Methodology continued • Thought Experiments are used to hold all else equal. Otherwise analysis becomes impossible. • Imagine trying to analyze oil prices by looking at all the factors that influence the price. • In the natural sciences nobody asks the rock or the pen why it falls. However in the social sciences, we can engage in introspection. • We are able to perform a self-examination and ask ourselves, “why?”

5. Some Definitions: • Methodological Individualism—people are influenced by others, but action can only be undertaken by individuals. Therefore, the analysis must always be centered on the individual. Be careful of the use of collective nouns. • Axiom of Human Action—is purposeful behavior by humans over economic (scarce) goods. To satisfy our wants and desires, we act. However, not all goals or wants can be satisfied at once. This is due to Scarcity. • Praxeology—is the science of human action. Economics is the most developed branch. • An Observation: we live in a world of Scarcity. • Scarcity—is the condition whereby the resources, goods and services available to individuals and society are limited relative to the wants and desires for them. How do we know that this is an axiom? Try to deny it and what are you doing? Purposefully trying to show that people do not behave purposefully.

6. Economic vs. Non-economic Goods • Economic Goods and Services are scarce. • Due to the scarcity of resources (and even time), we must choose. • Thus, we construct an Ends/Means framework. We set goals and must choose which means we’ll apply to which ends. • Thus, we have to choose NOT to do some things. • These costs are called opportunity costs (but more on this later). They are everywhere and unavoidable. There is even an opportunity cost associated with time. • Non-economic goods are not scarce. • These are sometimes referred to as Free Goods and Services (i.e., those goods and services that are available in sufficient amounts and provide all the people want at zero cost). • Due to the fact of Scarcity, we are not able to enjoy all the things that want. Therefore, we must choose. • But how?

7. How do individuals choose? We are not really concerned with what they choose, but we do know some things about how people choose. Individuals create Preference Scales. They rank preferences from most to least. So let’s make a Preference Scale… Things to do next week Friday… Go to a Concert Go Dancing Go to a Friend’s place Watch a DVD Go to a play … Study Choice & Preference Scales Notice that ALL of these preferences are subjective. Opportunity Cost is the next best alternative that is NOT done. If you can only do two things, what is your opportunity cost?

8. Value / Utility A B C D Q Quantity Demonstrating Diminishing Marginal Utility Utility is a measure of satisfaction that the consumption of goods or services yields an individual. It’s a level of happiness. We can see the value of each of the ends on this chart. Things to do next week Friday... • Go to a Concert • Go Dancing • Go to a Friend’s place • Watch a DVD • Go to a play • … • Study However, what really matters is Marginal Utility, not Total Utility. As we add means, Total Utility increases. Total Utility is the blue area of the bars. The height of the bars is the Marginal Utility. So as Q increases, Total Utility increases. You can see that as we add more, the Total Utility increases, but the Marginal Utility decreases.

9. Utility is not directly observable. We use price as a proxy for value. When we use price, we get the Law of Demand: The price of a product or service and the amount consumers are willing and able to purchase are inversely related, all other things held constant. When we present it graphically, we get the Demand Curve. The Demand Curve does not actually exist. It is a mental tool used to helps us think about the world around us. A B C D Q The Law of Demand Price Utility The Demand Curve Quantity

10. P P P P P P P Q Q Q Q Q Q Q Which of these are legitimate demand curves? Yes Yes Yes D D D D No Yes No Yes D D D

11. Factors Affecting Demand • What moves the demand curve? Or, what creates a change in demand? • Anything OTHER THAN PRICE, such as consumer income and preferences, that determines the amount of a product or service that consumers are willing and able to purchase. • Shift Factors: • Change in income; • Normal Goods • Inferior Goods • Change in Tastes and Preferences; • Changes in Related Goods; • Substitutes • Complements • Expectations Price Supply P1 Po D’ Demand Q1 Qo Quantity

12. From Individual to Market Demand • Market Demand—The total amount consumers are willing and able to purchase of a product at all possible prices, obtained by summing the quantities demanded at each price over all buyers. (Summed Horizontally) Price D Market D Ivan D Ben D Sheldon Quantity

13. The Law of Supply(Also known as the Law of Reservation Demand) What we see here is The Law of Increasing Opportunity Costs Again, we cannot measure Utility directly, so we use price as a proxy. When we do this, we get the Law of Supply. If one of the sacks is lost in the night, what will be sacrificed? • We will create another preference scale, but this time we will use it in reverse. • In 1886, Böhm-Bawerk used an example with of sacks of grain. So if it’s good enough for him…  • We start with 6 sacks of grain. • Preference Scale • Feed Family • Feed Cow • Feed Horse • Feed Pigs • Feed Chickens • Make Whiskey Suppose a second sack is lost. Now what will be sacrificed? What if is was sack A? We can again connect the dots and create a Supply Curve. Price Supply Curve Utility C F E D B A Quantity

14. P P P P P P P Q Q Q Q Q Q Q Which of these are legitimate supply curves? S S S Yes Yes Yes S Yes No S S YES S Yes

15. Factors Affecting Supply • What moves the supply curve? Or, what creates a change in supply? • Anything OTHER THAN PRICE, such as consumer income and preferences, that determines the amount of a product or service that consumers are willing and able to purchase. • Shift Factors: • Changes in Production Costs • Technology • Input Costs • Expectations • Taxes and Subsidies • Change in Population Size Price Supply S’ Po P1 Demand Q1 Qo Quantity

16. Market is the interaction of buyers and sellers producing and buying goods and services. The market is NOT a person; automatic; a mechanism or machine; or a place. The market is a process. Mechanics of Price Determination: Suppose the price is at P1. What is the result? We have a shortage, QD > QS. The price is too high. Suppose the price is at P2. What is the result? We have a surplus, QS > QD. The price is too low. Economic Harmony / Equilibrium Price Supply P2 P1 Demand QS QS QD QD Quantity Surplus Shortage

17. Free markets have a tendency to clear through the continuous exchange between suppliers and demanders. Buyers compete with buyers. Sellers compete with sellers. Notice that buyers do not compete with sellers. Markets do not require economists to make the market clear. Coordination and market clearing are the unintended consequences of each person acting in one’s own self-interest. Market Harmony Price Supply Pe Demand Qe Quantity

18. What We’ve Covered so Far… • We start with an Axiom that people act purposefully, and we have an assumption that there is scarcity in the world. • From this starting point, we are able to deduce the Law of Diminishing Marginal Returns AND the Law of Increasing Opportunity Costs. • Notice that they are the same principle. They are just coming from different directions. • Next, we replace utility with price and create the laws of demand and supply. • Finally, we are able to create a model of a market, where we can maintain the ceteris paribus restriction.

19. Mainstream vs. Austrian Construction of the Demand Curve • So doesn’t this just get you to where every other basic textbook goes? • What’s so significant about Austrian economics if they take you to the same end? • Actually, it isn’t the same end. For example, in the Austrian formulation, there are no perfectly elastic (or perfectly inelastic) demand curves. • Moreover, there are also no such thing as Giffen goods. • What’s a Giffen good? • A Giffen good is one where you want less when the price falls. • More fundamentally, Austrians are marginal theorists who place the marginality on utility, while the mainstream places the marginality on the unit.

20. Neo-Classical Conception of Demand Curves Quantity of All other Goods ? The slope is the price ratio. The Neo-Classicals are comparing two levels of Total Utility. Next, we pick a second price. It changes our budget constraint. First, we create a budget constraint. Where is Marginal Utility in all of this? U1 U1 Indifference Curve U0 Indifference Curve U0 Q2 Q1 Quantity of Good A Price of Good A And now we have our first point. P1 P2 The Demand Curve Q2 Q1 Quantity of Good A

21. Are Neo-Classicals Marginal Utility Theorists? • The Neo-Classical economists are looking at the Marginal Rate of Substitution. • This is not looking at amount of additional utility the next unit of the good provides, which is what the Austrians are looking at. • Can the Neo-Classicals claim to be heirs of the Marginalist Revolution? • Not in the same sense that the Austrians make the claim. • For the Neo-Classical, the word “Marginal” applies to the unit, not the utility. • Finally, the Austrians claim that a Giffen good is only possible in the Neo-Classical framework because they are comparing one good relative to a bundle of goods. • Austrians look at goods as means and rank the ends (uses). It is the marginal utility of the next end that is important, not the marginal unit of the means.

22. Why does picking an approach matter? • Suppose that an economist proposes a tax on gasoline in an attempt to get people to reduce gasoline consumption. • This tax has two effects: • First, people will have to pay higher prices and reduce their consumption of gasoline. • Secondly, the consumers’ real income is damaged by this tax. • So the economist says that the money collected from the tax will be used to reimburse the loss of income from the higher tax. • Thus, he claims that he gets a lower rate of gasoline consumption (via the substitution effect), but doesn’t harm any one because he compensates everyone through the income effect. • While this may seem like hocus pocus (and it is), it doesn’t stop actual, real live (Neo-Classical) economists from making this proposal.

23. For Further Reading: • My “For Further Readings” list is very heavy on the praxeology side of the lecture. • Here are the ones you should start with: • Callahan, Gene (2002). Appendix B, “Praxeological Economics and Mathematical Economics,” Economics for Real People: An Introduction to the Austrian School, pp. 315-322. http://mises.org/books/econforrealpeople.pdf • Gordon, David (2000). An Introduction to Economic Reasoning, Chapters 1-4, pp 1-81. http://mises.org/books/EconReasoning.pdf • Rothbard, Murray N. (1993). Man, Economy and State, Chapter 1, pp. 1-66. http://mises.org/books/mespm.pdf • Selgin, George A. (1990). Praxeology and Understanding: An Analysis of the Controversy in Austrian Economics. http://mises.org/books/prax-and-understanding.pdf • Smart, William (1891). An Introduction to the Theory of Value, pp. 1-34 & 47-66. http://mises.org/books/value.pdf • Taylor, Thomas C. (1980). An Introduction to Austrian Economics, Chapter 4, pp. 40-51. http://mises.org/books/introtoaustrian.pdf