 OK, welcome to the first lecture of Mises University on the birth of the Austrian school. This lecture really sets the tone for the rest of the week. Because it shows that the Austrian school is unique. It was when it was born, and it is still today. So what about the birth of the Austrian school? It was born during a very interesting and really unprecedented intellectual episode known as the Marginalist Revolution, which I will explain later. And really, what it involves is a simultaneous co-discovery by three different people in different countries of what we now call the law of margin utility, which I will explain later on in the lecture. The Marginalist Revolutionaries, as they were called, were Karl Manger, wrote a book in 1871. And that book introduced the concept of margin utility, as well as subjective value and other important concepts. At the same time, William Stanley Jevons in Great Britain wrote a book in which he introduced the concept. He called it final utility. Karl Manger did not give a name to it, by the way. It was a student Freiburg von Wieser that called it margin utility. And then finally, Leonville Ross, three years later, but again, not being familiar with the previous two books in which the concept was introduced, wrote a book that was a mathematical treatise, but it did introduce the concept of margin utility, which he called rarité. So those are the terms, and here are the people. So that's William Stanley Jevons. He's kind of dashing ladies' man type when he's young. If you look at him when he's old, though, he looks like a weird old guy that sits on a bench and feeds the pigeons. That is Leonville Ross, the Swiss French writer. Again, he's kind of dark and mysterious when he's younger, when he's older, he's like your grandfather. And here's Karl Manger. He's dashing ladies' man when he's young, and he's very distinguished when he's old. So unlike the other two, he aged very well. That's continued, isn't it? That's sort of a theme. So Jevons of all Ross thought that utility, which for the time being, think of as satisfaction, the satisfaction that an individual achieves from consuming a good. They treated it as if it were a quantity that could be added, subtracted, multiplied. They treated it in mathematical terms, but Manger completely avoided that and treated it as the result of an actor's judgment about how important a good was to his or her wants. So for example, if someone is approaching a vending machine and has $2, they're faced with an array of choices. And according to Manger, because their resources, which we'll talk about, are scarce, they have to economize. That is, they have to make a choice among numerous alternatives. And they therefore have to rank their choices. And notice that the choices are ranked. The bottle of water has a higher utility according to Manger than according to the person who is acting, than the can of Coke. And the can of Coke has a higher utility than the granola bar. This person would not spend the $2 on a granola bar because that's a waste of resources. The cost of spending the $2 on the granola bar is something that has a higher value. It's a bottle of water. So that person would economize. He would use or she would use those $2 only for the most important want. Now, can that person say, well, I like a bottle of water three times the amount of, or gives me three times the amount of satisfaction or utility that a can of Coke gives me. And therefore, I'm going to choose that. No, they don't have to do that. And there's no unit in which they can measure utility. Economists, you may have seen this in your textbooks. They talk about a utile. Well, a utile is a quantity of satisfaction. Well, what the heck is a utile? Doesn't exist. There is no definition of what a utile is. So Manger was always focused on action and wants and people striving to satisfy their wants. And so he really discovered much more than this principle of marginal utility. He really developed an entire system of economics that was based on subjective value, people valuing different things in different ways, and on choice, individual choice among alternatives in a world where the means are scarce. Means are, in other words, for goods, as we'll see. He also was really a creative genius. He drew on many different streams of thought, earlier German economists, French and Italian economists. He had a huge library. And he saw everything that we see out here, if you look around the world, if you look at New York City and all the activities that are going on, what Hans, Professor Hoppel, as I call the silent acts, you'll see that that whole array or network is connected, and Manger saw that, and it's motivated by people striving to achieve their wants. The whole economy grows up as a result of that. And this was really a revolutionary insight. Economists used to think that production was a creation of goods until 1802 when JB Say, a French economist, set them straight and said, human beings can't create anything. Only God can create. Human beings can only transform things that are less useful into things that are more useful to them. But human beings can create thoughts. They can create systems of thought. That is the one act of creation that is permitted to us in this world. And Manger created a whole system of economics. He did fill in all the gaps, as we'll see. Obviously, his students and followers and later Austrians are still expanding the whole system of economics. But many of the great historians of thought saw that Manger's achievement was something that was worth mentioning, worth emphasizing. And I'll just read Ludwig von Mises here says, what is known as the Austrian School of Economics started in 1871 when Karl Manger published a slender volume under the title Principles of Economics. Until the end of the 70s, the 1870s, there was no Austrian school. There was only Karl Manger. So Manger was truly the father of the Austrian school. And Hayek pointed out what is common to the members of the Austrian school, what constitutes their peculiarity and provided the foundations for their later contributions, is their acceptance of the teaching of Karl Manger. So we are all Mangerians. If you're an Austrian, your foundations lie in this slender book, as Mises put it, that was published in 1871. And really just sprung the vision almost full grown out of the so-called brow of Zeus. It just came out of Manger's head. Of course, he had a lot of influences, as I said. So when Manger came on the scene, the dominant school of economics, or then called political economy, was classical economics. And some of the famous names that you may have seen, if you've taken history of thought classes, or even in your principles classes, were British economists. David Hume and Adam Smith were Scottish. And David Ricardo. They said some very interesting and important things. They added a lot to economics, or they actually, in some sense, created the science of economics. And they introduced the idea that people calculate that on the market, because you can use prices, you can calculate your costs and benefits. So they introduced that. And Manger certainly didn't object to that. But his idea was not to overthrow the classical school, but to correct a lot of the mistakes that they made. And we'll talk about one very big mistake that they made. So what did a classical school do that was good? Well, they showed that prices aren't arbitrary. They're just not a big companies can't just set a price. And they're not accidental. Prices have an explanation. We can explain why a price is exactly what it is in scientific terms. Secondly, they pointed out that supply and demand determine prices. They didn't quite explain the laws of supply and demand correctly, but they did have the concepts. And finally, they did point out that businessmen use prices to calculate, to determine profits and losses, and then to allocate their resources to determine what to produce, how to produce, where to produce, according to prices. So that was all well and good. And Manger completely accepted that. But here was their fatal flaw. And this is why the classical school failed, and then really disappeared from the scene. First, what they tried to do was to explain value in prices in terms of broad and abstract classes of goods. They talked about cotton, iron, beef, and so on. Water, diamonds. And they couldn't explain. They had a problem explaining why, for example, bread, which was extremely useful, but had a very low price on the market, a low exchange value. Why that had a low exchange value, a low price, compared to a pound of bread, comparing that to a pound of diamonds? Why the pound of diamonds cost so much more when diamonds were merely a conspicuous display of wealth or just ornamentation that really had no important function in keeping people alive, whereas bread did. So this was the diamond water paradox, even though I'm using bread as the example here. So what Manger pointed out was that human beings had concrete wants. They had different wants for every good. There were different uses for bread. There were different uses for beef, and so on and so forth. And there were different units. Manger pointed out that there were concrete units of goods, and then there were concrete wants that these goods served or satisfied. And I'll get to that. So unfortunately, the classical school got bogged down in what we call the water diamond paradox. So as it says there, diamonds have a very high exchange value but a very low use value in everyday life. They have a high price on the market but serve as mere ornamentation or as a way to impress your neighbors that you're rich and so on. Water has a relatively low exchange value but a very high use value to human beings. Without water, you can't go more than two or three days without water, without your vital organs shutting down. But it has a low market price. How do we explain that? Well, if you're talking about broad and abstract classes, water versus diamonds, you can explain it. So here's an example. This diamond sold for $46 million at auction in 2010. And there's been a few cents that have actually sold for more than that. So they were stuck. So what they did was they split value theory into two. They said, well, there's reproducible goods and there are goods that are not reproducible like diamonds or paintings. Bread can be produced and reproduced. Therefore, they said, they split use value and exchange value. They said, exchange value, that is prices on the market can be determined or can be explained by the cost of production. It costs a lot of money to go and mine a diamond. Therefore, a diamond is much more expensive than a loaf of bread. Things like paintings by long dead painters are not reproducible. And economics isn't really concerned with them. Supplying demand does determine the prices of those things. But they're sort of a minor class of goods. We're going to focus on exchange value. And we're going to forget about use value. Now, when you do that, when you just talk about exchange value, about goods that whose costs of production determine their prices, who is the main actor there? Well, it's not the consumer. Consumers is concerned with his or her own wants and using goods in a way that satisfies the most important of those wants. It's the business person. The business decision maker, the entrepreneur, was the main actor for the classical school. They bought where things were cheap, and they sold in markets that were expensive. They bought factors of production, resources. They combined them at the lowest possible cost, and then they sold them at the highest possible price. So what was economics then? Economics was the science of wealth. Because if you focus on the business decision maker, the business decision maker wants to acquire wealth. The question is never asked, of course, to what end? Why are they acquiring wealth? Menger, on the other hand, pointed out that this is all wrong, that the focus should be on the consumer. The person who is surveying their wants, whose wants are continually changing, are continually reappearing, and which they are then continually striving to satisfy. So Menger came up with what we call a realistic price theory. And he says this right in the first few paragraphs of his book. He says, I have devoted special attention to the investigation of the causal connections, and that's going to be very important, causal, between economic phenomena involving products and the corresponding agents of production, not only for the purpose of establishing a price theory based on reality and placing all price phenomena together under one unified point of view. So Menger was a journalist before he became an economist. And he used to write about the commodity markets, the stock markets, and so on. And he noticed that prices changed every minute. Prices didn't just change when the costs of production changed. Prices of a given stock or commodity could be different today than it was yesterday, or even now than it was five minutes ago. So Menger said, this can't be a realistic price theory that doesn't take this into account, that prices are continually changing. So he developed what we call a causal-realist tradition in economics. He wanted to set out the causes of prices, of actual real prices, and he wanted it to be realistic. OK? So for Menger and for Austrians, economic theory is the investigation of the causes of prices, wage rates, rents, and interest actually paid on real markets. OK? So before he wrote his book, he wrote out a number of notes for himself, which constituted the core of his book. So he wrote, quote, man himself is the beginning and the end of every economy. So he's starting with man, and specifically, man's wants, which is in the second bullet point. Our science is the theory of human being's ability to deal with his wants. It's not the science of wealth, OK? It's not the science of costs of production, of business action. That's explained in the science, but it's focused on human wants. And finally, all things are subject to the law of cause and effect. He wanted to explain real things and the causes of real things. So Menger recognized that every action embodies both subject developments, OK, people's wants, their plans for satisfying these wants, their expectations of the means or the goods that they'll have at their disposal, and so on. So there were subjective elements, pervading economics and action, and objective elements. We don't want to forget that human beings are in a world in which there's an external environment, which there are elements that help them achieve their purposes or stop them from achieving their purposes. So he wrote out a trinity of cause and effect. Ends, people's ends, cause them to look around for the means or to acquire the means to realize their ends. When those means are consumed, they realize the ends. So the means cause the satisfaction of the ends. So there's a circle of causality there. Well, it's not a circle. It begins with ends, OK, which causes people to acquire or to produce means, which they believe will then help them realize their ends. And he wrote it in another way. He wrote, man, external world, man has wants, looks around the external world, finds elements, and transforms them into things that will cause that man's subsistence and the man that will exist in the real world. And finally, he wrote out, wants good satisfaction, OK? Wants stimulate people to produce, acquire goods, and the goods, once they're consumed, satisfy the wants, OK, cause the satisfaction of the wants. So everything is cause and effect to manger. OK, let's look at an example of this. These buttons are neat. All right, so here's a guy who's hungry, right? That hunger is the cause of his acquiring, buying, producing, looking for, and finding means. The means are the goods, OK, means, or another word for goods, the ham, the mustard, the cheese, bread, knife, and so on. He then combines those things. Remember, he can't create anything. He combines those things, transforms them into something that is useful in satisfying his hunger. When he consumes that ham sandwich, which he has not created, but produced by transforming resources, he's no longer hungry. So the hunger is the original cause, but it's the last effect. That is satisfying that hunger is the last effect. OK, so manger came up with a theory of what a good is, what are the preconditions of a good. He said, before there can be a good, and this was his first chapter was theory of the good, there must be human need. Somebody must need something or want something, want to satisfy their hunger, or want to satisfy their want for a luxury car. Whatever it may be, the action is always stimulated from manger by a want or a need. The second precondition is the thing must be capable of being brought into causal connection with the satisfaction of the need. So when you buy the Maserati, that Maserati, you're imagining, before you purchase it, will cause the satisfaction of your want for luxury transportation. And then there must be human knowledge of this causal connection. So there must be objectively causal connection and then human knowledge of the causal connection. And there must be command of the thing sufficient to direct it to the satisfaction of the end. And that command of the thing means ownership or control of the thing. Now, manger made a mistake. Numbers two and three shouldn't be there. Mises corrected this. All that's needed is the belief that a thing can be brought into causal connection with the satisfaction of the end or the satisfaction of human need. To give you an example, people pay prices for weight loss pills on QVC, which are crazy. People pay for the services, and these things are valuable because they're paying for them. And then value the services of psychics who allow them to talk to dead relatives and friends and so on. So that's what Mises is getting at here. People pay for the New York Times. It supposedly gives you the news. Now, manger actually was not that naive. A few pages later, he says, well, there are imaginary goods, like the New York Times, that really don't serve the purpose. But Mises pointed out that it doesn't matter whether things are imaginary or not. People will pay prices, so you have to take them into account as goods. So services of psychics and New York Times, they are goods, sad to say. Now, menger went further and said there's what we call economic goods. Air is a good according to mangarian terminology. But air is not worth one penny in this room, one cent. Not only that, we don't value air. In a normal situation, such as the setting in this room, air has absolutely no value. And the reason, as we'll see, if we lost a cubic foot of air from this room, nobody's wants would be impaired. Nobody's wants would be, no one will be deprived of air, because there's a super abundance of air in this room. As we'll see, menger understood that. So what is an economic good to menger? An economic good is a good whose supply, remember, menger realized that goods did not come big abstract classes. They came in units, pounds of bread, carrots of diamonds, particular automobiles, and so on and so forth. So because the supply of some things in this world are insufficient to satisfy all human wants, those things are scarce. And because they're scarce, we have to choose how to use them. And before we can choose, we have to rank the uses of those goods. That is, we have a lot of different wants for bread, for diamonds, for many things. We have differentiated wants. And if they're scarce, we can only use them for the most important wants. That is what menger called economizing. So for the classical economists, the economic man, the homo economicus, was simply someone who wanted to gain as much wealth as possible. But menger replaced the economic man with the economizing man. Someone who wants to get the most satisfaction, wants to satisfy the most important wants with the limited means at his or her disposal. So economics to menger was not about businessmen making decisions about where to buy and where to sell, though it, of course, explains all that. It's about satisfying the most important wants. And here we come to the law of modern utility, which I've sort of been hinting at during this talk. Now, he didn't use the word, but his point was that the value of a good is determined by its marginal utility. And what we mean by marginal utility is utility means satisfaction, and marginal means relevant. So the satisfaction from the least important or lowest rank and served by the available supply of the good. So therefore, as a supply of a good increases, the value of that good falls. The reason why it falls is because you have more units of the good, so you can use it to satisfy lower and lower wants. OK, and I'm going to give you an example of this. I'll give you a preliminary example. Let's say a family has three cars, there's three people. There's a primary breadwinner, let's say the dad. The mom has a part-time job, runs errands. So she uses the second car for that. And then there's Junior, who just wants to drive around, waste gas, see his friends, and so on. And let's say all three cars are pretty much identical. They're all interchangeable. And let's say the dad cracks up his car. Who loses the car? Does he give up his job and stay home? No, Junior loses the car. Now, what has happened to the value of a car to that family? It's gone up, no matter which of the three cars you lose, the margin utility of the car is a satisfaction from Junior driving around. That's the lowest-ranked satisfaction. If the first car gets into an accident, the one that serves the highest-ranked end, you don't give up that highest-ranked end, that would be waste. You want to economize. So you reallocate it to the higher use. And now the car is more valuable to that family, because now if there's an accident, if the car stops operating, you're giving up a part-time job and doing errands for the family. So the value goes up. So let's give the Austrians love to talk about Robinson Crusoe and the Robinson Crusoe economy, and Marxist charge Austrians with starting from this unrealistic imaginary construct of someone who's alone on an island. But it's important because it points out some of the very basic laws of action, which then go into explaining how people interact and how we have an economy of many people. So let's say that Robinson Crusoe is alone on an island, and this island is some wheat growing, and he knows how to harvest the wheat, and he harvest the wheat. And let's say that he has five sacks of wheat. How's he going to use those sacks of wheat? Well, he's going to economize. And so we have here his value scale. The most important use of, let's say, one sack of wheat is to transform it into bread and to sustain his life. It'll just keep him alive for that one year until the next harvest. The second bread will really keep him healthy and vigorous and allow him to achieve other ends. The third most important use of the sack of wheat is to use it so that he can stay alive another year. He can use it as seed for the next harvest. The fourth is to vary his diet by if he finds some wild goats on the island, and he feeds them. And they yield milk and cheese and meat and so on. Manger put the fifth as whiskey. I put it as vodka, more favorable towards vodka. All right. So Manger solved the problem of what is the value of a sack of wheat? What is the value of that one concrete sack of wheat? And any one of those five, what is the value? Are they different? Do they differ according to what end they serve? Well, how could that be? They're identical. They have to have the same value. So Manger asked a brilliant question, and that's how he solved the problem. He said, if, let's say, vermin break in, rats break in where he's storing the wheat, and they consume the third sack of wheat, how does this person react to that? How does Robinson Crusoe react to that? Does he give up the seed for the next harvest? Does he not harvest? Of course not. What he gives up is the fifth end. He stops making vodka, or he doesn't make the vodka. So that is the margin utility. So the value of all five sacks is equal to the satisfaction of what? The lowest ranked end. No matter which sack he loses, what satisfaction does he lose? He loses the satisfaction for consuming the vodka. Very high, I would say, but still lower than the other four. On the other hand, if he finds another sack of wheat, if he finds that there's another, he didn't harvest all the wheat, and he harvested six sacks, then what happens? He has another end, and that's, let's say, to have some company. He's lonely on this island. There's no one there. So he sees parrots, so he feeds a parrot that can keep him company. Now, what happens to the value of each sack of wheat when he finds that sixth sack? What happens to the value? It drops. It's now lower because the margin utility is lower. The lowest ranked end, the marginal end, the marginal satisfaction is now lower. On the other hand, when he lost one sack and he went to four, what happened to the value of the wheat? It went up, exactly. So now I can give you a little test. So here's a farmer who has the following value scale. Now, he has three horses, three concrete units of horses. So supply of horses is three. Supply of cows are two. And he ranks the ends as follows. The first horse is the most important good that he possesses, and it's for plowing for wheat. The second horse increases the productivity of plowing because you can hitch two horses and you can dig deeper and get more wheat. The third highest end is milk, which you get from the cow that he owns. The fourth is beef, which he can get from slaughtering one of the cows. And the fifth is the third horse that he possesses will allow him to use a horse for recreational riding. Okay? Which animal has more value in that situation? Which is the higher value? No? No. Now you have to get out of the classroom because you aren't paying attention to me. It is not the horse, and it isn't the horse because the margin of utility of horses is lower. If he loses one of those horses, he only loses the satisfaction from recreational riding, which is lower than the satisfaction from the lowest ranked use of the cow, right? Which is for beef, okay? Now, let's say the barn's on fire. They ask the mangarian question and he can only say for the animals. This gives you the answer right away. Which animal does he leave in a barn that he can only say for by hypothesis? The horse. So that's the least important animal. That's the least valuable animal, okay? Okay, so now, before we get to that. So now you have the solution of the classical paradox of value. Why is the air in this room valueless but a pink diamond sells for $46 million? Or why are diamonds more valuable than water? Well, you can pose a situation in which someone's in a desert and hasn't had water for two or three days and has that diamond in his pocket. He comes upon someone who has a gallon of water. Would he trade the diamond for the water? Yeah, because now the margin utility of the water, of a gallon of water, this concrete gallon of water in this situation is his life, the value he attaches to continue living. And that is higher than the value he attaches to the $46 million diamond, okay? So what is the reason why diamonds have a higher price on the market? Is it because they cost more to produce? No. It's because they are so scarce that the last satisfaction you get from a diamond is much higher than the lowest satisfaction you get from water. If you change that situation, if you put someone in a deep sea diving suit and ask them whether or not they would pay for air, an oxygen tank, of course they would. And of course, if you were on the moon, you'd pay for air. So it's not because there's any intrinsic value in diamonds that they're more expensive, okay? It's because of the situation of wants, subjective element versus the available means. Okay, so Mengertals taught us some other and very important things. Not only are there different units of goods and is that relevant, but it's also relevant for production. Remember, we talked about human beings only being able to transform things into more useful goods, okay? So here we have something that Mengert distinguished between higher order goods and lower order goods. Lower order goods are goods that are closer to the consumer. They're closer to completion. They're closer to being consumed and yielding satisfaction, okay? So what Mengert pointed out was, if we take this example, he didn't use this example, iron ore mining, when you put the iron ore and mine and labor's together, that causes you to have iron ore. And then when you put the iron ore together in the next highest stage, which is the steel production with labor and other instruments, steel is produced. And then steel can be shaped in the next order and then it can be turned into an automobile body and then eventually the automobile is produced, okay? So production goes from the higher orders to the lowest order until it becomes a consumer goods, which is the final good according to Mengert. But how does value, how does value get attached to the iron ore mine, okay? The classical school said because these things are expensive to produce, it's the expense of producing the things that cause the value. So if we look at this example, production goes from the higher order. Now we have farm tools wheat, flour, bread, that's at the retailer and then the consumer, okay? So yes, the classical school is right about pointing out that production proceeded from the resources or the factors of production down to the consumer's good. But Mengert then added that red arrow and said, but value goes the other way. Value goes from the final good or not even the final good. It's not the car that's actually valuable. It's the satisfaction you get from driving the car and you impute, you use the word imputation, you impute that value to the car itself. And because the car is produced by labor and on steel and automobile parts and the factory, you impute the value of the cars to those things. If people didn't want cars, automobile factories would be absolutely worthless, okay? And there'll be no wages paid for people that are working in those factories and so on. So what Mengert pointed out is that higher order goods cause the production of the lower and lower order goods until you get the final good. But the final good and the satisfaction yields to the consumer causes the value of the higher order goods. And Mengert gave the following example. He said, let's take tobacco products, cigars, cigarettes, pipe tobacco, chewing tobacco and so on and so forth. He said, if people decided that that was not good for their health, what would happen to the value of cigar rolling machines, cigarette rolling machines, the factories in which they're produced, the value would fall to what? Zero, okay? Because people no longer value them, they will not purchase them. And what then would happen to the value of tobacco growing land and tobacco leaves, assuming the land can't be used for anything else? That value would fall to zero. Same thing is true with diamonds. If people suddenly realized or believed that diamonds were something that really didn't add to their satisfaction, really didn't increase their welfare in life and stop purchasing diamonds, the value of the services of people who weigh diamonds and say diamonds, that would fall to zero. And what would happen to the value of the diamond mines? That would fall to zero also, okay? So now let's look at Menger's analysis of exchange. That was the last or that was now bringing in someone in addition to Robinson Crusoe. So he used a simple example. If A, now the animals that are in parentheses are the ones that the individual A and B do not possess, the ones that are not in parentheses are the ones they possess. Menger pointed out very simply that goods do not exchange for one good doesn't exchange for another good because they're equal in value. They exchange because there's a double inequality of value to the two parties exchanging, both goods are unequal in value. So for A, A prefers a horse to a cow. A horse has a higher value to A because it serves a more important want than the cow does, okay? But A has the cow, but then he finds B and B has the horse, okay? But believes that a cow has a higher value than the horse. They will exchange, okay? Why? Because each one improves his or her welfare. Each one moves higher on their value scales. Each one serves a more important one than they would have with the good they gave up. Or to put it very simply, each one gives up a good of lower value in exchange for good of higher value. So is there any equality between the two goods, between a horse and a cow if they exchange for one another? Absolutely not. It's the exact opposite. There's a double inequality. Both individuals value these things unequally. And the same thing is true of what I have in today's world for automobiles and so on. Recently my someone on a trip and rented a Maserati for $100 a day. So for him, a day's satisfaction from driving the Maserati exceeded the $100. The car rental agency believed that the $100 had a higher value to them, to their stockholders, than the day's rental of the Maserati. So it's true in all of our actions that whatever we do, whether it's making a ham sandwich at home alone or it's purchasing, we're giving up our time and so on. We're giving up whatever we have because it has lower value to us than what we're receiving in exchange. So all life in some sense is an exchange. So I'll stop there because we're out of time. Thank you. Thank you.