 Okay, welcome everybody. This is the second installment of our tour of Man Economy and State. So this is lecture one of the course entitled Production in the Market Process where we're covering the middle section of Man Economy and State. And today's lecture is on chapter five. For those of you who just joined us, we have these PowerPoint slides are available in the chat box. So you can get them there if you want to have it locally. Okay, as far as the course description, I always do this in the opening lecture, but with you guys I'll be very brief because I'm thinking just about all of you must have taken me. Well, no, actually that's not true. I think at least one person in here, this is his first-ever Mises Academy course. So let me just very quickly give the format. I'm going to give lectures Wednesday nights typically as we're doing right now. So those are live. They're going to be recorded. So if you ever miss it, you just log back into Moodle and you can get access to it. Okay, actually there's lots of people. Okay, I didn't realize that. All right, several of you this first time. Great. Well, welcome. So you, as I say, Wednesdays at this time you're going to have the normal live session but it will be recorded in case you miss it. And then typically on Saturdays I'll have an office hours session. So what's going to happen is usually by late Thursday I'll send out an email to all of you telling you when the office hours for that week will be because it's the different times of day depending on my schedule. And also I like to move it around to cater to different people in different time zones. So usually on Thursday I'll send out the email and it'll also remind you that if you're taking the course for credit the multiple choice quizzes will go online early Friday morning and then it'll be open for seven days. So just within that week you'll have to do the online multiple choice quiz if you're taking the course for credit. And then at the end of the class there's a, anyway I'll remind you of all the stuff that comes along and you'll get emails. So make sure, incidentally, if you're never getting any emails from me and you want to get them, well then tell somebody. Make sure that we know about that. And I'm not sure who are the TAs for this course. Why don't you guys say who you are in the chat box because I forgot to check on that to see who the TAs for this class are. But anyway, if you have technical issues, okay, so Danny Sanchez saying that, Julie Land, Julie Lawn, I don't know how to pronounce that, sorry Matt, is the TA for this class also. One other thing, Danny, who do they send the email to? Can they use the generic address? Okay, yeah, I wanted to check before I set it out loud. So if you ever have any kind of technical issue like you can't log in to Moodle or something, send it to TAatmises.com. Okay, and then there's somebody with technical glitches in the chat box if you guys can address their concerns. I'm trying to think if there's any other generic things. So yeah, basically this, you'll pick it up pretty quickly. Oh, let me say this. It's okay if you didn't do it for the first week because I know some people just registered and are just getting in right now. In general, though, the, in general, the classroom lectures will make more sense to you. I think you'll get more out of it if you do the assigned reading beforehand. So like I said, I know some of you didn't know you were even supposed to, so you wouldn't have done it for tonight. So if you can, after today's lecture try to obviously read Chapter 5, but then get ahead and try to read the first half of Chapter 6 for next week, too, so that by the time we meet again next week, you will have gotten that week's material under your belt. Because what will happen is if you try to read it once, you might hit some stumbling blocks, and then when I go through it, it'll make a lot more sense. Whereas if you're hearing me go through it for the first time, you might not even know what I'm talking about and it'll be tricky. Having said that, I do try to make the lectures stand alone in the sense that if you're real busy and all you can do is tune in to the lectures, you know you're not going to have time to read. I try to make the lectures such that you'll still get something out of it. The last thing is a compromise. If you know you're not going to be able to read Rothbard because you just know you can't do 60 pages in a week, which sometimes it works out to be. But you can do a little bit, well, then at least try to read my study guide. So in case you don't know, that's free online as a PDF. You don't need to buy anything. My study guide to man economy and state is, well, a study guide. It tries to summarize Rothbard's argument down to their essentials. So if you can put in a little bit of reading time, but you can't do the whole thing, at least try to read my study guide sections before the lectures and I think you'll get a lot more out of it. Okay. Why don't we move on? I see people are concerned about the lighting in here. I can try to for next time try to come up with having an alternate lighting source, but right now I can't and also it seems like some of you don't have video at all. So I'm wondering if maybe it's on your end, but as far as the lighting in here, I just know I can do about right now. Okay. So going through, so now we're on a slide to review. So here Rothbard in the beginning of part five, so he's in the first four chapters, he gave an introduction to praxeology and the way Austrians view economic theory and he also reviewed the basic theory of good and he also even got into some of the principles of pricing. So he did a lot of stuff already in the first four chapters. Now what we're starting and this is a big chunk of what we're going to do in this Mises Academy course is to go through and study the principles governing production. We want to get a sense of how is production handled in a market economy and the way Rothbard's going to tackle this is he's going to start with some very, some simplifying assumptions. So we're going to start like we're going to be peeling off the layers of an onion. So we're going to start out and do things very simple, make a lot of simplifying assumptions and then think about production and how incomes are distributed and so forth in that very simplified setting and then we're going to one by one start relaxing those assumptions to make it more realistic. So that by the time we're done you're if you've kept up with the reading and you've tuned in the lectures and so on you're going to just have a vision of how the market economy works and in particular how the production structure is organized and how it responds to consumer preferences and that sort of thing. So that's where we're going but before we start down that path Rothbard in the beginning of chapter five goes through and just does a quick review of some of the stuff that he's already covered in the first four chapters. For our purposes here I don't want to spend too much time on that stuff. The one thing I do want to talk about is Rothbard goes over the definition of a stock or a supply of a good. So what he means is he's refreshing our memory as to in terms of subjective value theory which is what the Austrians embrace and Carl Manger was one of the pioneers in developing it and subjective value theory what does it mean when we talk about when we say for example that someone has 50 units of a good and then if he buys three more now he's got 53 units what exactly do we mean by that? So what we mean is the person has units that are homogeneous with respect to the ends that that individual could put the good. Okay so for example let's say we're talking about water and we might say that okay the unit we're thinking about is a liter of water and the person has 2,000 units of that. So now what do we mean because if you think about it from a chemical or a physical point of view what we're calling successive units of the same thing namely units of water wouldn't be the same thing right somebody from CSI or something you know they could they could look at what we're calling the 17th and the 27th units of water and we're saying oh those are both liters of water and they could say well actually they're different they might measure them very carefully and say oh to see this thing right here this is actually 0.98 liters of water and this one over here that you're saying is the same thing actually we looked at it carefully and it's 1.01 liters of water so clearly these are different things and also we looked at the salinity or something of the one and we see that actually it's you know this one has more this one's more saline than this one over here okay and this one we looked at and it has the certain chemical in it the measurement here is one part per million and this other one over here it's actually 0.7 parts per million so they're gonna say clearly these are different things and yet you economists are calling them successive units of the same good so so that's the that's the issue right so what does it mean in terms of subjective value theory when we want to bundle a bunch of physically distinct things and call them all successive units of the same good what it means again is repeating myself is that those distinct physical things could all be interchangeable with respect to the ends to which the consumer might put them so even though what I was calling the 17th unit of water in the 27th unit even though a chemist might look at them and say no their volumes are slightly different for whatever purposes I'm going to use that whether it's 0.98 liters or 1.01 liters it doesn't matter to me that's not going to be a reason for me to prefer one over the other now if I'm doing a sophisticated scientific experiment then maybe those won't be interchangeable you know if I'm doing something that really that if I'm putting it into a machine that has a capacity for exactly one liter of water and if I put in 1.01 it's going to blow up well then those things aren't interchangeable but for the purposes for which most people are going to use water it's fine to say that this particular thing over here since it's 0.98 is interchangeable with this other one that's 1.01 liters okay now don't get confused I'm not saying that people have to be have to value them the same when I say that they're interchangeable from the point of view the actor that because that's not true because we know from the law of diminishing marginal utility that as you keep adding more and more units the margining utility goes down because what's happening so here these three examples the presumably for most people given their preferences the first units that are going to be devoted to drinking so that's the top left then you keep adding more and more units of water and so after you quench your thirst and maybe you'll set some aside for you being thirsty down the future but at some point you keep giving me leaders and leaders of water at some point okay I've got plenty water to drink let me do something else with this water and then you might say all right well I can bathe with it or you might cook with it first as it depends on the circumstances but maybe say okay now that I've taken care of not dying of thirst I'm gonna use further units of water to things that are less important to me like not being dirty myself and so you take a shower so that in case people don't know what this is that's a the famous shower scene from Psycho where they you know there's a crazy guy killing the girl in the shower okay so so that's true and then keep giving me more units of water at some point I'm gonna use it to wash my car so that's the bottom right picture all right so the point is those you know the the ten thousandth liter of water that I have the marginal utility of that is very low but I'm gonna because I'm gonna devote it to relatively unimportant things like washing my car or watering my lawn whereas the first few units of water the first few liters the margin utility is very high because I need it to avoid dying of thirst so the reason market has yeah the reason the market price of water is so low the reason a given unit liter of water doesn't have a very high exchange value is that for most people the quantity of water is very high meaning they devoted to all sorts of and such that on the margin one more or one fewer liters of water isn't going to be a big deal because the end you could satisfy with it is not that important to you because you've already satisfied all sorts of things okay so what does it mean now to say though that these are all units of water again if they're interchangeable for the purposes you could use them for so what I mean is what I'm right now calling the first liter of water that I'm drinking and what I'm calling the 15 thousandth liter of water that I'm using to wash my car if those are really units of the same good stock but you know part of the same stockpile of good then I could swap them what I'm now calling the 15 thousandth liter of water I could actually not take that put it in my drinking cup and the water that I was about to pour into my drinking cup I could use in the car wash so I could interchange them that way that's what I mean that they're equally serviceable so that's what I mean so we're not saying that the use to which I put that 15 thousandth liter is interchangeable to me with the use that I put the first no they're not that's why we have diminishing margin utility but the point is to say that this is a 15 thousandth unit of water which is the same good as the first unit that I'm drinking we mean the physical things are all interchangeable among themselves that for all the things I could use water drinking bathing washing my car a physical substance they could do all of that stuff from my point of view is water okay that's that's the idea and again just to drive home the point remember these things really aren't identical the point is though that as long as they're close enough to each other that for the purposes that I want to use them they're interchangeable then it's fine okay Rothbard talks about the evenly rotating economy and this is going to be a very crucial concept in Austria and economics and so let's spend some time discussing this so what it is it's an it's an equilibrium concept and it's what Mises calls an artificial construct so this we never see this in the real world this is an imaginary construct actually I think that's the term Mises use an imaginary construct right so this is never manifested in the real world and I think well as we go on Rothbard will I believe talk about different equilibrium concepts Mises does it in human action I'm pretty sure Rothbard does it in man economy and state but so far we haven't hit it yet so anyway let's just talk about the ERE for right now so ERE is short for evenly rotating economy okay so let me just read this slide the definition so in the ERE all the variables or parameters that affect the economic outcomes are held fixed so you got subjective preferences resource supplies technological know-how population those are all constant in the ERE things do change but it's in a very predictable regular pattern so you still have over time as time passes raw materials and labor and so where they're transformed into retail goods which are then consumed so you do have higher order lower order goods that you know things are they're taking apples are picked from trees they're shipped to a processing plant they're smushed up into juice the juice is then combined with plastic and put into a bottle and then that's put on a truck and the truck goes to the grocery store people go in and they buy bottles of apple juice so that still happens so there is that process there is the passage of time but the point is once you define a certain cycle period like a year every year forever after is identical the same stuff happens over and over again so that's why big Mises called it the evenly rotating economy right so I don't know if it was clear but Mises invented this concept and Rothbard adopted it is just using it himself all right so this is a static equilibrium and in particular every but everything is perfectly predictable in the ERE because nothing ever changes significantly like I say things do change in the sense that if you follow the life cycle of a given apple yeah it starts out as a seed it grows into a tree and then it comes out as an apple and they take it makes mush it up and it turns into apple juice and people consume it and then we know what happens from it at that point but the point is looking at the economy as a whole the output of apples is always the same year after year the stockpile of trees is the same the population is the same now Mises at one point says you can relax certain things so for example depending on what you want to use it for if it's okay to have people grow old and die in the ERE so you don't need to assume that people are immortal and that they don't age you can have people being born and then growing up and working for a while and then retiring and dying that's fine but it has to be such that the the population distribution is always the same so that for one thing for everybody that dies in a certain year there are that many new infants born and so the total population stays the same and then also you know the the cohorts of the different age groups has to be the same too because you wouldn't want in one period for there to be more workers relative to retirees and then later on the amount of retirees per worker goes up you can't have that okay so anything that could possibly affect economic outcomes can't change in the ERE over the course of a cycle so that when the cycle completes itself you're right back to where you started originally that's the idea so why are we what do we use this for what's the point of this what's the analytical function of eating the rotating economy well one thing is it abstracts away from change and so there's no uncertainty and so it allows the economist to focus on the equilibrium relationships among various parts of the economy so for example if you want to figure out the determination of wage rates well if you try to do it in reference to the real world you're always plagued by the problem that the entrepreneur might make a mistake but in the ERE there is no there are no mistakes that are made because everything's perfectly predictable so the worker in the ERE his wage is exactly equal to his marginal product so the ERE when we're trying to figure out principles like gee in a market economy what are the forces that affect the level of workers wages and so on if you first start in the ERE that's a very simple baseline case that you can work out some of the general principles and so you figure out okay in the ERE yeah a professional athlete who contributes two million dollars to the to the team's bottom line it's going to have a salary of two million dollars that that's the only stable equilibrium result that's possible that's the only thing that could repeat itself year after year is that somebody who contributes exactly two million dollars to the firm is going to get paid two million dollars whereas in the real world you don't know necessarily that the athlete is going to get paid that because again there could be a mistake made in estimating how much the person's worth or maybe it takes maybe there maybe the employer knows full well how much the employee is worth but it's paying him less and competitors don't realize that fact where there's it takes you know a long time for them to find each other where there's transaction costs and so forth but none of that stuff can happen in the ERE that stuff is all whittled away okay the other thing and this is this is a question that I often ask it meets his university so I'm giving you guys a little inside tip if you go there and you want to you know you get to the written exam you take the oral exams at the end of the week we'll say what's one of the purposes of the ERE what do we use it for what two things do we distinguish in the ERE because this is something that Mises talks about specifically he said the main thing that we use the ERE for is to distinguish between interest and profit now as we go on in this course well these things will make more sense to you okay so if you're if you're not sure what I'm talking about right now don't worry about it but just take my word for it the primary function of the ERE according to Mises is that it allows us as economic theorists to mentally isolate and distinguish the concepts of interest and profit because interest is due to time preference interest is due to the fact and again we're gonna we're gonna get into this so don't worry you know it's not that you should understand us right now but interest capitalists earn interest income over time as what are future goods mature into present goods because present goods are more valuable than future goods so if you make investments in what at that moment are future goods and then you wait as time passes as the time of maturity gets closer and closer and now they've turned into present goods they possess a higher market value than the market value of what you put into them to acquire them in the first place okay so that that difference in market value the fact the market value of that asset grows over time because of the passage of time is interest so there's still interest income in the evenly rotating economy capitalists still earn interest in the evenly rotating economy however the entrepreneurs do not earn pure profits because in the Austrian vision pure entrepreneurial profit is reaped by people who forecast the future better than others the way you earn a profit is you saw something the other people missed that you changed the direction of the market economy and you took advantage of missed pricing that people didn't correctly anticipate the future you saw the future more clearly than your peers did and so because of that part you know the the gain in market value of what you end up with due to your superior foresight that is pure profit and that's what you earn specifically as you're in your capacity as an entrepreneur in the Austrian vision so Mises is saying in the evenly rotating economy that's not happening because there's no uncertainty since everything always repeats itself everybody agrees with everybody else about what's going to happen in the future so since that the case there can't be any profit and there also can't be any loss right so there's still incomes workers still get paid wages landowners still earn rents from their land and capitalists still earn interest income but there's no pure profits being reaped by entrepreneurs right so that's that's what the function of the ERE is and you'll notice well you won't notice if you notice the classical economists they would often use the terms profit and interest interchangeably because in their mind people spent a certain amount of money on the factors of production and then the time would pass they would make the finished good and sell it to their customers and get revenue and typically the revenue would be higher than the total monetary expenses of the inputs and so the classical economists would often refer to that as just profit but as economics developed we got more refined and we started to isolate the components of that of that gross returning so well no you shouldn't call that whole gross return profit because some of that should just be considered the interest on the invested capital that you that you were gonna you you you could have just invested in a very safe bond for example rather than going into a business venture and so we don't want to call the whole thing just profit we want to make up two categories to isolate conceptually the different reasons for you earning that income and so the the one thing is just the return on your capital that's standard because of the passage of time and that's interest that's pure interest income and then the other part of it you could earn even more than that but that's because you had superior foresight so the idea is just to give you one quick example then we'll move on here the idea is that let's say I take I have a million dollars and I and I think that there's a there's good business opportunity and so I spend it on hiring workers and buying resources and other things and they're they're processing it over the course of a year and then when all of a sudden done I take that product and I sell it for one point one million dollars so I have earned a hundred thousand dollars and in terms of accounting you know that would be called profit but in terms of economic theory we say well wait a minute maybe I could have bought a very safe one-year bond at five percent interest so it it's not really right to say that I earned a hundred thousand dollars in profit really fifty thousand of that is just due to the fact that I was willing to defer consumption for a year so because I saved I was able to earn interest of fifty thousand dollars now the fifty thousand I earned over and above that that may be due to my superior foresight and the way we know that is to say these other people who put their money into the safe five percent bond why didn't they go into the thing that I went into they had a ten percent return and so if we decided because they just didn't realize it would work whereas I did then when we say okay I earned ten percent on my capital these other guys only earn five percent so it would be wrong to say my entire ten percent return is due to profit because you know five percent of it anybody could have earned five percent just that was the prevailing rate of interest but I earned ten percent because I saw something that other people missed so they were all content to put their money out at interest earning five percent I saw this opportunity and got a return of ten percent so of that we decompose it and say five of it is just my standard return on interest but the other five percent is due to my superior entrepreneurial foresight okay so again I'm just jumping ahead this is the kind of stuff that we're going to look at very carefully over the coming weeks when all is said and done you're going to have a very crisp understanding of the principles I'm talking about right now I'm just trying to give you a big picture idea of where we're going but for right now again in the ere we can easily separate those things because there is no change there's no uncertainty so there can be no pure profit you can't have one entrepreneur with better foresight than somebody else so that's all zero but yet capitalists can still earn interest income and by week three you will totally have that under your belt in this course the how capitalists can earn interest income in the evenly rotating economy because we'll go through Ropper's got some great diagrams to illustrate this with numerical examples I mean it's really great stuff and that's why I'm glad somebody you signed up for this course because this is really the heart and soul of a major part of the Austrian vision of how the market works okay the problems how how is it or what are some problems with the ERE let's list a few of them so one major problem is in the ERE there's no reason for people to hold money that Mises talks about that the fact that if you if interest if there are positive interest rates which he thinks there would be an evenly rotating economy and you know what all of your expenditures are going to be from now until the end of the time right because everything repeats itself over and over well then why would you carry cash balances that would be silly what you should do is lend your money out at various maturities so that you get it back precisely when you were planning on spending it to buy something okay so if I know you know I get my paycheck and I know that okay of this thousand dollar paycheck I'm going to spend a hundred dollars of this two weeks from now going off to dinner well instead of carrying it around your cash balances you should go out and and lend it to somebody for two weeks by a very short-term bond because then you can earn interest but the point is if everybody's doing this then nobody wants to hold cash and so you would have money prices would just go up to infinity that the demand to hold money would basically go down to zero or near zero and also just more generally the reason we need money in the first place is to help coordinate exchanges to help you know do sophisticated things where one person is going to trade something somebody else he's going to trade something somebody else and that person is going to trade someone else and then finally they might trade with me we might all be better off of that complex system of trades but in direct exchange we wouldn't do that right however if we're in an evenly rotating economy and we all know what's going on we all know exactly what goods i'm going to produce and what goods i'm going to consume from now until eternity well then that coordination problem that money in the real world solves kind of falls away there's no there's no doubt about who i'm what i'm producing and who's going to consume it and so you would think that we could come up with all sorts of ways to economize on holding our cash balances and again lending it out at interest so the so the point here is if we took the e re seriously and thought through the full ramifications of it there would be very little scope for people to hold money in their cash balances where it doesn't earn interest so in the real world we have we understand why people hold money but it's partly because you're actually not sure what you're going to spend it on whereas in the e re you know exactly what you're going to spend your money on so it sort of takes away the need to have money in the first place so why is that a problem well because we're using the e re to explain the formation of money prices and so it's a little bit weird that we kind of have to assume people are holding money and the people workers are getting paid in terms of money and then they're using the money to go out buy stuff if money really serves no role in the e re so that's one problem another big problem with the e re is right if you remember for those of you who are here for the first class early on in man economy and state rothward explained that one of the prerequisites to action is uncertainty because he said if the if the future is certain well then you can change what happens and so why would you act and then but yet the in the e re you know we we kind of think there's action right we're using it as a as a benchmark to to explain the market economy and so I mean I guess depending on their philosophy austrians might go one way or the other on this but the point is there it looks like there wouldn't be action in the e re and so it's a little bit weird that we're using that as a way to understand the market economy to understand human action just like it's a little bit weird that we're using the e re to understand market prices when people wouldn't hold money in the e re or they wouldn't need to hold much of it okay so just to make sure you guys understand what's going on here it's not that I am as an outsider and criticizing the e re nieces himself is fully aware of these sorts of problems and but he just says hey there's no way around this that we for the limited purposes uh that i'm going to use it for the e re is useful and it's indispensable but he says we got to be careful uh and not to not to rely too heavily on it because it does have these problems right so there are just so you know i'm not going to get into it now because we got to move on there are some austrians who say we we should drop the e re did they say that it's a bogus concept and austrians of all economists shouldn't be using what they themselves admit is an unrealistic construct weren't we austrians supposed to be the realistic ones don't we chastise the neoclassicals for starting off with false assumptions and building their models you know on these false assumptions and then justifying it by saying well it helps us interpret the real world so how can we austrians use the e re aren't we doing the same thing so there there are those strands of criticism out there uh but for our purposes we're just going through man economy and state right now where he definitely uses the e re all right robert has some good criticisms of mathematical economics let me just point out a few of his arguments and make sure you follow what's going on so one thing he says is he contrasts mathematical economics with more logical verbal analysis and he says that the um he says a lot of stuff but let me just paraphrase one of the arguments one of the arguments goes like this he says you don't gain anything by taking a logical verbal philosophical type of argument translating it into mathematical symbols then doing some operations on the symbols and then when you get the answer that's in symbolic form when you you don't know what that means so you have to turn it back into english or whatever your spoken language is so robert is saying that why go through all that rigmarole because ultimately in order for you as an economist to be able to draw conclusions from the analysis you have to start out with logical verbal if you will premises and concepts and then turn them into the math and then when all of a sudden done take the math and turn it back into the spoken language so why do that why not just stick with the spoken language and derive things in that realm because he said there's there's there's a danger there that if you go into the math you might do something there that's actually invalid according to standard logical analysis but you won't realize it because you're going to get distracted by all the math and you're going to you're going to lose your moorings you're going to forget the simplifications that you made in order to translate the problem into math and then you might do something that's correct mathematically but it's wrong economically but you won't know it because you're in the realm of the math model and then you'll come back and reach an absurdity whereas if you had just stuck with the realistic logical verbal analysis you wouldn't have made that mistake all right because that's the that's what he's saying or that's one of his arguments let me just in terms of devil's advocate let me just give the obvious response to that and again i'm not taken side just want you to to be aware somebody a mathematical economist would say no ross where it's the exact opposite of what you're saying the reason we want to translate stuff into symbolism is precisely to make sure our arguments are valid because when you when you do it in math you can be sure that you're not um you can you can spell the argument out more clearly it's more obvious if you're making an invalid leap in your arguments if it's in symbolic form whereas if you're doing it in words you your argument might turn on the fact that you're being a little bit ambiguous about what a term means whereas if you translate it into math there's no ambiguity in what you're saying it's very precise and so that's why we do it okay so i'll get this that's the um that's what they would would say so again i'm not taking a stand at one way or the other i'm just explaining what rophards particular argument what is and what a mainstream economist would say so so for example i'm just trying to make this more realistic or more concrete for you guys let's say uh oh i'm trying to think of a good example okay something like in the in the area of or this concept of predatory pricing that that this one will work okay so the issue of predatory pricing where the claim is that in a market economy sometimes people will sell like one firm might sell below cost and drive everybody else out of business and then it it takes over the whole market or virtually the whole market but then once it knocks out all its competitors it jacks up the price to well above cost and so the idea is it can do that so yeah it's losing money in the short term but it's doing it knowing that once it knocks out its competitors it'll be able to jack up prices so that's the idea now a lot of economists say and including Rothbard say oh that's a silly objection because that wouldn't work that once that that new firm you know once the firm had knocked out its rivals and jack at the price well by construction you're saying they're earning above you know they're charging a much higher price than they would need to in terms of the cost of production that sort of thing they're earning a much higher return on their capital at that point than other industries are so why wouldn't people newcomers rush into that industry yeah maybe they're the old guys have been knocked out during the period of so-called predatory pricing but what you can't stop newcomers from coming in and then they just stop there they move on but the problem is and a lot of mainstream game theorists have looked at this sort of thing and they say well wait a minute that's not a good argument because if that first firm is serious and it has a reputation and people believe that it will keep doing that why would an outsider come in they might look at the firm and say yeah right now they're charging above average returns or prices and we would make a lot of money if we went into that sector but if we did that they would just go back to predatory pricing and knock us out and so why am I going to spend a year competing with them because I know ultimately they're going to drive me out of business so why would I waste my time doing that so so the firm you know knowing that it might have the power to do that that might actually make sense strategically okay so the point is it now and so now you know Murray Rothbard if he had lived to hear that game theorist argument he might come back and say oh well the reason that wouldn't work is because but you know the the mainstream theorist is going to say look at this point this we're we're not going to get anywhere with words because you know you it's not clear that you're spelling out all your assumptions that what you're saying is internally consistent and so we need to just make a little simple model so let's come up with a production function and let's put in some numbers here and yeah when we're all you know when you're done formalizing your argument and see if you can create a situation where there's an equilibrium where one firm really can take over like that or an equilibrium where no that wouldn't work because you'd always have rivals who would find it in their own interest to come into the industry and undercut the monopolist you know go ahead and do that and then when you're done with your argument the rest of us will look at what you did your little model there with numbers plugged in and we'll tell you if we think that's a good argument or you know if you're missing some big issue and so you know maybe you forget you're leaving out interest rates oh you got to have interest rates in there so let's put that in there and see if we you know so that that's good so that but they're going to say there's no way we can settle this issue of whether predatory pricing makes sense at a theoretical strategic level if we're just slinging paragraphs back and forth the only way to really roll up our sleeves and solve this is to start making simple models with numbers in them or at least with you know algebra like to say suppose the cost of production is C and that C is a certain you know relationship to the revenues R and so forth but just talking in words we're not really going to be able to solve this problem that so that's the kind of thing they're getting at and again my point obviously is not to tell you that they're right i just want you to be aware of the case for formal mathematical models okay another argument that Rothbard gets into is this issue of causality versus mutual determination so and this was specifically there was a mainstream economist who had criticized bombard on this issue and made it look like bombard was this obsolete buddy daddy and so uh yeah with Stigler so uh in Stigler says something like bombard clings to this quaint notion of causality and a cause and effect whereas the more modern approach understands that you know economics is the situation of simultaneous or mutual determination so let me um just make sure you get that distinction so in the Austrian school they do talk about causality cause and effect so what causes market prices oh well it's ultimately consumers subjective preferences that's what causes market prices to be what they are that's the source of market prices that um logically in order for us to explain market prices we first have to posit the existence of preferences before we can then start talking about prices and or uh you know interest what is the cause of interest oh it's ultimately due to the higher valuation of present goods versus future goods that's what causes interest okay so that's the way Austrians talk whereas what Stigler is getting at is he wants to say that no that's that's an old-fashioned quaint way of looking at it now we realize that everything is it's just a matter of the equilibrium of the system and that no one thing causes something else and an analogy I think Marshall made up this analogy and specifically the context for Marshall was he was saying because there were two camps one camp was like the old classical school that was saying prices were ultimately determined by cost and then these newfangled subjectivists were saying no no no prices are determined by subjective preferences so one way of putting it sort of crudely is to say one camp thought prices were determined by supply and the other side thought prices were determined by demand and so Marshall says no no prices are determined by the interaction of supply and demand that it's not one or the other it's the two things working in conjunction but you can't just look at one thing or the other and he said it's sort of like picture a bowl filled with marbles and if I point one of the marbles in the bowl and say what determines its position what you know why is that red marble that's you know halfway deep and in the center of the bowl why is its position right where it is right there you just well it's because that's where all the other marbles are too I mean it doesn't make sense to say that the blue marble is causing the red marble to be where it is because in turn the red marbles causing the blue marble to be where it is and you know you have to look at the whole system and understand the forces they all exert on each other and understand how equilibrium is established and why now the bowl at rest is sitting there the marbles are all perfectly balanced with gravity and against each other to talk about you know the final position resting point of that system and that's the way Marshall thought about the economy that yeah you've got subjective preferences but you also have real cost considerations meaning you know it takes a certain amount of labor hours to get these minerals out of the ground it takes a certain amount of inputs to transform this stuff into steel and so on and so forth and then it's the interaction of those things that yields the equilibrium outcomes. Okay let me pick up the pace here we're now getting into the heart of chapter five and we're getting into the good stuff where Rothbard is going to start explaining the structure of production so again I'm repeating myself in the beginning to get us warmed up he's going to make some very simplifying assumptions and then and then once we get those down and understand pricing and distribution of income with these very restrictive assumptions he's going to start relaxing them one by one okay so the first thing is he's assuming completely specific factors so let me make sure you understand what what that means okay I'm just doing a test right now can you guys see an arrow moving around okay probably 30 people are going to say yes okay I got it guys thanks so this diagram now along back up so completely specific factors means there are different consumption goods there are different finished goods you know there's apple juice there's orange juice there's stuff like that okay so we're not talking about one type of output good there are many different goods but the point is the resources including labor that go into making those goods are completely specific so every productive resource so every worker and the labor he produces every particular capital good and every natural resource is only useful in the production of one particular consumer good so it's not the same consumer good right each they all map to different or they may map to different ones but the point is focus on any particular worker and you say what can he do and that word is it oh I can only make whatever so maybe one worker the only thing his labor is useful for is in the production of apple juice but some other worker the only thing he's good at is in the production of orange juice and so on okay and it's actually even a little bit more specific than that there's some worker out there the only thing he's good at is producing apples and there's another worker the only thing he's good at producing is the the carton that holds apple juice if you ask him oh well why don't you make a carton that holds orange juice he's gonna I don't know how to do that my labor is completely ineffective in making cartons that hold orange juice but I'm a you know a whiz in making cartons that can hold apple juice okay so so there are different stages of production and and so some of the goods that we're talking about here are themselves capital goods so keep that in mind so some workers all they are good at is producing one particular type of capital good some other worker the only thing he's good at is producing a finished consumption good but keep in mind he works in conjunction with other factors okay so now we're ready to look at this diagram so here this p at the top stands for production this c down here stands for consumption so this one means it's a first order good or it's like the or no for first yeah the two is the second order good and the three is the third order good okay so what's going on here is at this at the bottom here the c for consumption so this a is some consumption good and this b is a different consumption good so a maybe is a carton of apple juice and b is a carton of berry juice let's say intended for the consumer so now up here at three we've got all these different potential inputs these things up here so the idea is that these three people one two three maybe this first dot i'm just making this up maybe this first dot is a worker and maybe the second dot is an apple tree and maybe this third dot is a guy who owns a ladder and so they all combine in order to make the second order good which is um piles of apples that are in a big container okay and you see you see how it works and then this thing over here these people maybe what they're making is uh the something that's to squish the apples with like maybe they make a big hammer and that's what's going to be down here and so then you combine these two things and so this is the smushed up apples and then these people over here they're uh making the carton and then these people over here they make the the label and then down here we've got the apple juice carton with the with the label on it and then finally the last thing is these come together down here where you put the um you know the the smushed up apple juice into the carton and seal it up and give it to the consumer all right that's the idea okay so the point is so notice time flows downward that's what these arrows are showing okay why don't we move on okay now that now we're starting to get to the really fun diagrams so now off we're going to say let's assume so we discussed the the production structure the technology if you will right in this society right now to keep things really simple we're just assuming that everybody who is a worker or who owns some natural resource is only good at doing one creating one particular type of good it might be a capital good or it might be a consumer good now we're going to start talking about the earning of income in this type of world and we're going to so we're going to make another simplifying assumption just to get the ball rolling and then again later on we're going to relax this so for right now robert is saying let's assume that all the people who work on a particular the production of a particular good that they're all joint owners of it all right that then we'll make more perhaps more sense in a minute okay so here i'm trying to think of where to start with the diagrams just to let you know you really want to make sure you get this diagram because it's going to get a little bit more complicated when we go into the next chapter and that the the diagram when this gets to be one more level of complexity that's going to be the workhorse for interest in capital theory and change and so for you to understand the business cycle we're not going to actually do the business cycle on this course but you're going to learn everything you need to know and then at that point understanding the business cycle is going to be a piece of cake but the hard stuff is what we're going to cover this course the real intricate stuff about the how does the cap the capital structure production structure of the economy change based on savings and investment and changes in the interest rate and then once you have that down and understand how it works works properly it'll be really simple to understand how things can get screwed up so just to give you an analogy let's say you're studying the human body and you spend a bunch of time learning about respiration and how oh yeah you know for a healthy person under normal circumstances the person breathes in and then the oxygen comes in and the blood flows through the lungs and somehow the oxygen gets into the blood stream and then that carries it around and you get how that works and you understand you know at the cellular level like why do we need oxygen and you understand how that stuff all works so once you get how the body works now if i say oh when somebody comes along and puts a you know puts a pillow on my face and holds it there until i die well you understand pretty easily how why that can kill me my pillow on my face can kill me because you understand how oxygen you know how respiration works you get i'm saying so the hard part there is to understand how a healthy functioning human body works and then once you get how complex that is and how that the body is internal regulatory system and all that stuff then you can see why if somebody comes along and stops my ability to breathe why oh yeah that would really screw everything up and you would die so what we're like i say what we're doing here in this chapter and then in chapter six and i think chapter seven is uh well it's the chapter that says production entrepreneurship and change i don't remember if that's chapter seven or later one but when we go through all that you're going to see how people will be in an initial equilibrium then people will start saving more and that will change the structure of production and you'll see how we transition then to a new equilibrium with a higher ultimately a higher level of output and higher standard of living so we're going to see how savings and investment lead to the growth of the economy in a sustainable way and then once we understand that the way it works in a free market when all the prices are correct and the interest rate drops because there's more saving then it's going to be a piece of cake to see oh what if the interest rate drops because the central bank just prints up a bunch of new money and gives it to the bankers well then you're going to see how that gets all screwed up okay but before we get to there you need to understand the healthy functioning of a market economy okay so that's what we're working up to but right now so this is a simplified diagram and so all that was a big commercial to tell you why you really want to understand this particular diagram because we're going to it's going to get a little bit more complicated when we bring the capitalists in in the next chapter but then once you if you can understand that then you're set that's all you need to know to then illustrate savings and investment and capital accumulation okay so here we're assuming joint ownership so let me just walk you through this diagram okay at the bottom we've got consumer expenditures this one stands for the first order two is the second order third order fourth order good fifth order good sixth order good so remember in the mangarian framework after Carl Manger he viewed the whole economy the whole function or the whole rationale for an economy is consumption that's the whole reason we work and all that stuff and we do everything is ultimately to produce consumer goods so that is the the foundation of the system that's why they're called first order goods and then everything else is derived from them so this sort of goes back to the causality argument how is it that we know how do we explain as Austrian the price of land that can grow grapes that can be used to make champagne we start from the fact that consumers value the champagne and so that's how we explain the price of the champagne and then we work backwards and we say oh because the champagne has this price that means the grapes that make the champagne have a certain price and then that means people who own land that is useful for growing those grapes they can rent it out for a certain price and so on and so that the causality flows from consumer prices back up through the structure or production so that's why the consumer goods get a one and then a two is the thing that is used in the step right before making the consumer good in a three a third order good is a capital good that's useful in the construction of a second order capital good and so on okay so let's see here um big picture what what this diagram is talking about is an economy where there are a hundred ounces of income every period and likewise an expenditure of a hundred ounces on consumption here the way you interpret this and what what's going on with these shadings in this last step here what happens is the producers that the people who make the final consumption good what they do is they spend 80 ounces of gold because remember the money in this world is gold they spend 80 ounces of gold buying a capital good from the second order producers okay so there are people who are in business they're the people in the second stage remember they're all working collectively and they sell a second order capital good and the people in the first stage and again they're all like on a team because remember this is the only thing they're good for the people in the first stage the only thing they're useful for is producing the finished consumer good so but they to help them they use this capital good so they purchase the capital good from the second order people for 80 ounces of gold and then they also sorry and then they contribute their land you know their their natural resources whatever you know so if it involves agriculture or physical land they do that if there's some workers involved you know part of this is labor but they contribute a certain amount of labor to it now they turn around and sell a thing for 100 ounces so of that revenue of the 100 ounces that they earn 80 of it they have to use to to get a second order good to start the cycle again the next period but 20 of it they get to keep that their income for their own contributions okay so let me say that again so every period when they let's let's say we start the period right before they sell the thing to their to the customers okay so they have the stockpile of the consumer good they sell it to the consumers and they earn 100 ounces of gold but now if they want to repeat this process next period what do they do 80 of that they have to turn right around and use to buy the second order capital good because that's what you know given its price and how many units they're going to buy um then that's what maybe that I guess they just buy one unit probably I think that's what Rockford has in mind I'm not sure okay but they buy not necessarily they could buy multiple ones all right but they collectively spend 80 ounces buying capital goods from the second order producer and for simplicity just assume it's one good just keep things simple and so all that 100 ounces that means the remaining 20 now is the income earned by this people you know in team one because remember there's some landowners but in land in the generic sense meaning natural resources and there's some workers and they're only good at producing good one and they use this capital good to second order capital good to help them okay so so that's their 20 ounces now the second order so the people now on team two the people who are only good at producing that second order capital good every period what do they do well they sell their you know again let's start the analysis right when they have the finished product so they have their capital good their second order capital good they sell it to team one and they get 80 ounces of gold from them but 60 of those ounces they have to turn right around and give it to team three because they use a third order capital good you know team two uses a third order capital good they don't just use their bare hands and raw resources from nature they also use a good in process or you know a tool or something that team three makes the team three specializes in making okay and that costs them 60 ounces so of the 80 that they receive from team one they turn right around and spend 60 of it on team three meaning the remaining 20 is what they pocket as their own income and notice these 20s they have a little arrows above them it's that shooting you up here okay and we'll see what that means in a minute see let me just zip through this now okay so now team three of the 60 well in turn they gotta spend 45 of it on team four and they only pocket 15 and then team four of the 45 they get revenue they have to spend 30 on team five's output of a fifth order capital then they only pocket 15 and so on finally we reach the highest stage so the team five every period you know they get their 30 and then 20 of it they use to buy a sixth order capital good but finally we reached the top of the period we've traced it all the way back the structural production all the way back team six they don't use capital goods they just use the raw natural resources you know gifts of nature that some people own and labor power and so team six every period they use their bare hands and the direct contra gifts of nature in order to make something that they then you know to make a sixth order capital good which they then sell to team five for 20 ounces of gold okay so every period what that means is the 20 ounces in revenue the team six earns they get to pocket it that's their income free and clear because they don't have to spend it acquiring capital goods from anybody else so notice now how this works so team six their income every period is 20 team five is 10 team fours is 15 and so on and if you add all those up it adds up to 100 the 20 plus 10 plus 15 and so on so that's what roper was putting those arrows up because he was showing up here if you sum it across the different stages you know 20 10 15 15 20 and 20 it adds up to 100 and that's not a coincidence because the consumers in this world are the owners they're the same group of people so every period if the consumers have 20 ounces that down here they're spending on the consumer goods the first order goods you know that's the only consumer good that exists and so that's got to be the 100 ounces that they're earning collectively all right so it's so it's kind of a neat little diagram that's a neat little system once you understand what it's saying it's and it's similar to what's called the circular flow diagram which you get which if you've taken if you guys have taken a a mainstream principles of economics class you may have seen such a thing called a circular flow showing how consumers spend money buying products from businesses and then businesses take that and you know give dividends to the capitalist and give wages to the workers and give rental payments to the landowners and so on and then you know that money just cycles right around again because those people spend it in their capacity as consumers so it's just showing how money goes one way around the economy while goods go the other way and it's just like a big circular flow right and that's partly why Mises talks about the evenly rotating economy all right so this this economy right here that we just described is in an evenly rotating state that this thing this process keeps repeating itself period after period and so once it gets to this position it just it just repeats so notice to get the ball rolling take six periods because in the beginning you got to wait that these people team six has to first start working in order to create a a sixth order capital good and then only next period can team five come online and start working with the sixth order capital good to create the fifth order capital good so now at the start of the third period team four can finally start working and then the next period these guys so you see what I'm saying so if you started from nothing and there were no capital goods it would take one two I guess six periods before the first consumer goods that start shooting out of the pipeline but the point is once we settle down in the equilibrium or in the evenly rotating equilibrium then every period 100 ounces worth of consumer goods shoot out of the pipeline okay so so that's how that diagram works and the crucial thing here is there's no interest income that we're explicitly modeling here and that's what this little side note means that here rockbird is assuming there's not a separate class of capitalists what's happening is that the workers and the natural resource owners they have to wait here you know these guys the team six for example they use their bare hands and they start taking the natural resources and they're working on it and depending on how long these stages are I mean maybe this represents a year so maybe it takes them a year of working with their bare hands and using the gifts of nature in order to create sixth order capital goods which they then turn around and sell to team five for 20 ounces of gold so the point is these team six during that year had to just work and not receive anything for it they're all collectively joint owners so they know once the product is made and they sell at the team five they're all going to be the owners of that 20 ounces but the point is they have to wait for it because initially they have nothing to show for it you know it takes time for them to create the sixth order capital good so that that observation might actually make more sense to you once we see the role of the capitalist because that's what we're going to do in the next chapter is we're going to introduce capitalists who advance payments to the landowners and the workers and so that's going to give scope for an explicit portion of this being due to interest income but right now we don't see it I mean technically interest income is being earned here but it's all getting wrapped up into the payment to the land and labor factor we're not splicing it out okay why don't we uh well I think that's the last slide okay great so we got about 10 minutes left let me go check the questions for the professor okay Anthony says when Rothbard talks about the evenly rotating economy is this the same thing is the general equilibrium theory of wall Ross I have heard there is some disagreement within the Austrian school with some economists like Hayek and Schumpeter focusing more on analyzing general equilibrium whereas Mises and Rothbard were more skeptical of this approach is this an accurate impression and if so could you comment on it uh that's kind of a tricky question well it depends what you mean when you say is the same thing I mean because in you could have a wall raise in general equilibrium that's not an evenly rotating economy that you could um I'm trying to think of an example so I don't know that wall Ross himself dealt with this but what I'm saying is you could imagine if you if you took if you went to grad school right now and you were you know studying general equilibrium theory you could model something like a pool of oil that was being drawn down over time and you could talk about you know what would the what would the the general equilibrium price vector of that oil have to be over time and you know the answer is it would the spot price of oil would rise with the rate of interest because you know the owner of an oil of the oil if it's a fine thing it's just a pool you know he's got a he's got a million barrels of oil and if he sells a thousand barrels today then that means he has that you know he only has 999 thousand barrels left to sell in the future you know if that's the guy's trade off so he wants to maximize the present market value discounted market value of his asset if you work out the equation that what it turns out to is he's got to given the demand for oil he's got to draw it down such that the spot price of oil rises at this you know with the interest rate so that like if the interest rate is 10% and right now the price of oil is $100 a barrel well then next year the price of oil has to be $110 a barrel and then the reason the price goes up is because it becomes more scarce alright so that has to be true in equilibrium so my point is you can model that sort of thing and you would be using of all-raising general equilibrium framework and that wouldn't be an evenly rotating economy because the relative price of oil would be changing compared to the price of apples which is not a finite resource you know there's not a fixed amount of apples that every time we eat one apple today there's fewer apples for future generations so there's no reason that the spot price of apples has to constantly go up whereas in certain modeling assumptions of a general equilibrium model a finite resource like oil if we're not finding new stock new deposits of it we just have what we have in our drawing it down then yeah the spot price is supposed to go up over time so so no I think they're actually different concepts specifically an evenly rotating economy there's no so they're the same in the sense that there's no pure profit opportunities and either one but a general equilibrium framework you can handle things changing over time like give you a silly example if the seasons change and the you know the amount of so the the market value of the revenues earned by a ski resort would change it's from summer to winter strictly speaking in the evenly rotating economy I mean I guess if you looked it over the course of a year you could average it out but stuff like that gets a little bit tricky with the with the way the evenly rotating economy is generally described all right so so to answer your question no but beyond the obvious that the evenly rotating economy has usually done in a verbal description and while raging general equilibrium is usually done in a mathematical approach with a bunch of equations pinning down what the equilibrium price vector is and so forth beyond that even conceptually I think that they're they're different and then you're asking Hayek and Schumpeter focus more on general equilibrium while Mises and Rother were skeptical of it well yeah I think that's true but well I'm not sure Mises and Rother were definitely skeptical yeah yeah I guess I would agree with that statement but there just be careful the difference is not you don't want to say oh Mises and Rother adhered to the ERE rather than while raging general equilibrium and so that's why they were skeptical of general equilibrium no that's that's not right if you're going to go that route with it Mises and Rother are skeptical of general equilibrium theorists because they tended to take the equilibrium too seriously they didn't realize the real world was actually in this equilibrium and they ignored the important equilibrating processes of the market so there it so it wasn't that Mises and Rother would be suspicious of while we're raging theorists because they don't like their particular equilibrium construct and they said no don't use that use the ERE that that wouldn't be the issue the issue would be by focusing on the equations characterizing a general equilibrium in the while raging sense they were overlooking the actual function that market prices serve in the real world so for example in the socialist calculation debate the market socialists were basically relying on general equilibrium theory to try to come up with the central planner's solutions to planning the economy and so Mises and Rothbard well on Hyatt too there would be very skeptical of that but it wouldn't be because they were saying oh you should use the ERE instead it's just them saying you guys are assuming the planner would have all the information that you're plugging into these equations when no he wouldn't have that information that's partly what a decentralized market economy does in practice we're still okay here so let me handle one more question and then i'm not going to be able to get to all the questions here so i'll i'll catch up over the next day or two okay lewis says dr murphy and your study guide you ask whether or not a landowner can earn interest in the ERE is it correct to say yes since time preference is a universal fact that holds even when the future is certain i mean there's still a rate of preference for preference for present goods over future goods right yes you are you are right that's funny i think you were the tricky part of that question wasn't whether interest can be earned at all yeah i mean the point of the ERE is to show the capitalist earn interest income but the entrepreneurs don't earn pure profit so the point of the ERE is to conceptually isolate the concepts of interest and profit but where i was why question 10 there was tricky as i was saying can a landowner earn interest because normally we think that a landowner earns rent and we think oh the capitalist earns interest but what i was getting at there is that no actually even a landowner earns interest in the following sense that if you have because because that the the asset that he owns is capitalized that that's the the trick so if the landowner owns a farm that's worth a million dollars right it has a market price of a million dollars and he earns a rental income of uh $50,000 then you could say is he earning interest and i want to argue although a lot of austrians don't discuss this i think it's undeniable to say that yes he is earning a rental income that you know the marginal productivity of his land is the explanation for why sharecroppers are willing to pay him $50,000 a year for the use of his arable land that's true but i said also conceptually that $50,000 is interest on his financial capital because um the the market price of his farm will be determined by the interest rate and the annual rents that it yields all right so the interest rate has to be five percent because the farm is worth a million dollars and the rental income is $50,000 a year so i'm saying in a sense he's got financial capital of a million dollars and he is earning a five percent annual return on that just as surely as if he sold his farm took the million dollars and then bought a bond that yielded five percent per year in that case he would clearly have financial capital of a million dollars and at an interest rate of five percent he'd be earning $50,000 each year an interest income so i'm saying you know economically he's still a capitalist whether he invests in bonds or in real estate he's still taking his million dollars of you know money right now that he might have in hand and then putting it either into the bond or putting it into real estate and then earning a perpetual stream of $50,000 in income forever for a five percent return so i want to say that those those should both be considered as interest okay but let me stress for everybody that's not i think that that's correct what i just said and that's why i put the question there but that's not something i have seen stressed in in other austrian's work so i like to say i think it's correct but if you ask this question to some other austrian he might not give you the same answer i did because you know and i would argue if you heard my explanation then you'd say oh yeah right bob's right that is the way we got to do it but um this is this is something that i found an Irving Fisher and i've been you know and i stress when i teach it means as you and stuff but this is not standard a standard point that people bring up in terms of austrian economics but again i think it's correct that's why i'm saying it but it's uh just just be careful that that's that's not boiler boilerplate praxeology okay well we're a little bit over time and i taught the earlier class today so i'm kind of wiped out myself so why don't we stop there and like i say i will catch up on your uh questions and for those of you again who are new to this just be looking out for an email that i will send thursday at some point perhaps in the evening explain to you that the you know when you have to take the quiz if you're taking a class for credit and so on okay so thanks everybody and i will see you next time