praxeology, supply & demand for freedom university by paul f. cwik, ph. d. mount olive college...
TRANSCRIPT
Praxeology, Supply & Demand
for Freedom University
By Paul F. Cwik, Ph. D.Mount Olive College & The Foundation for Economic Education
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.
Economic Methodology
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 ExperimentsRemember: We need to use
the ceteris paribus condition.These thought experiments allow us to hold everything else constant.
Does the Scientific Method work for the Social Sciences?
So what do we do? Give up?
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?”
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.
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?
Choice & Preference Scales
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…A. Go to a ConcertB. Go DancingC. Go to a Friend’s placeD. Watch a DVDE. Go to a playF. …
Q. Study
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?
Things to do next week Friday...A. Go to a ConcertB. Go DancingC. Go to a Friend’s placeD. Watch a DVDE. Go to a playF. …
Q. Study
However, what really matters is Marginal Utility, not Total Utility.
Demonstrating Diminishing Marginal Utility
A B C D Q
As we add means, Total Utility increases.
Total Utility is the blue area of the bars.
So as Q increases, Total Utility increases.
The height of the bars is the Marginal Utility.
You can see that as we add more, the Total Utility increases, but the Marginal Utility decreases.
We can see the value of each of the ends on this chart.Value /
Utility
Quantity
Utility is a measure of satisfaction that the consumption of goods or services yields an individual. It’s a level of happiness.
The Law of Demand
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
Utility
Quantity
Price
The Demand Curve
Which of these are legitimate demand curves?
P
Q
P
Q
P
Q
P
Q
P
Q
P
Q
P
Q
D
D
D
D D
DD
Yes
YesYes
Yes Yes
NoNo
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:1. Change in income;
Normal Goods Inferior Goods
2. Change in Tastes and Preferences;3. Changes in Related Goods;
Substitutes Complements
4. Expectations
Supply
Demand
Price
Quantity
Po
Qo
D’
P1
Q1
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)
D Sheldon
Price
Quantity
D IvanD Ben
D Market
The Law of Supply(Also known as the Law of Reservation Demand) 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
A. Feed FamilyB. Feed CowC. Feed HorseD. Feed PigsE. Feed ChickensF. Make Whiskey
F E D C A
Utility
QuantityB
If one of the sacks is lost in the night, what will be sacrificed?
What if is was sack A?Suppose a second sack is lost. Now what will be sacrificed?
Again, we cannot measure Utility directly, so we use price as a proxy. When we do this, we get the Law of Supply.
Price
We can again connect the dots and create a Supply Curve.
Supply Curve
What we see here is The Law of Increasing Opportunity Costs
Which of these are legitimate supply curves?
P
Q
P
Q
P
Q
P
Q
P
Q
P
Q
P
Q
S
S
S
S S
SSYes
Yes
Yes
Yes Yes
NoYES
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:1. Changes in Production Costs
Technology Input Costs
2. Expectations3. Taxes and Subsidies
4. Change in Population Size
Supply
Demand
Price
Quantity
Po
Qo
S’
P1
Q1
Economic Harmony / Equilibrium
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.
Supply
Demand
Price
Quantity
P2
QS
P1
QDQSQD
ShortageSurplus
Market Harmony 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.
Qe
Pe
Supply
Demand
Price
Quantity
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.
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.
U1Indifference Curve U0
The Neo-Classicals are comparing two levels of Total Utility.
Neo-Classical Conception of Demand Curves
Price of Good A
Quantity of Good A
Quantity of Good A
Quantity of All other Goods The slope is the
price ratio.
Q1
P1
Q1
Indifference Curve U0
And now we have our first point.
P2
Q2
Q2
U1
The Demand Curve
First, we create a budget constraint.
Next, we pick a second price. It changes our budget constraint.
Where is Marginal Utility in all of this?
?
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.
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.
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
