 I'm going to tell you a story about how really one man founded an intellectual movement that is today thriving. And that man, as we'll see, was Carl Menger. Carl Menger initially started off as a journalist. And he would cover the financial markets and the commodities markets. And up to that point, as we'll see in a moment, the prevailing theory of price was that costs of production, the amount of money it costs, or in some parts of Great Britain, the amount of labor it took to produce a good, determined the price. Well, Menger is sitting there looking at the markets because he has to report on them. And he sees that prices are changing not only every day for coal and cloth and so on. They're fluctuating every second. So Menger thinks, well, this can't be due to costs of production. They're not changing with such volatility and with such rapidity. There has to be another explanation. Menger goes on to get his PhD and writes a book, or actually writes a thesis, which then became a book. And it's a small book. It's called The Principles of Economics. Now, it's not actually this small. The Mises Institute has an interesting way of making very readable pocketbooks. So it's actually a little bit bigger than this. The print tends to be small on this. So it's about 300 pages, a little bit more. And it was really only supposed to be an introduction to a full treatise on economics that was going to be three volumes. But Menger got sidetracked. So, but this book itself, Principles of Economics, was the book that then went on to revolutionize economics. Now, this revolution occurred during what was called the Marginalist Revolution, and sometimes it's confused what Menger's contribution was, is confused with the contributions of two other great economists who were not as great as Menger and who had a number of fallacies in their version of this revolution. It was called the Marginalist Revolution. And the Marginalist Revolution really refers to the simultaneous and independent discovery of the principle of marginal utility, which I will explain in a little while, by three different economists. Okay, as I point out here, they were working independently of one another. The books were published in 1871. Two of them were published in 1871, and one was published in 1874. They were published by widely disparate individuals, individuals in different locations. We had Carl Menger in Austria, the Principles of Economics. William Stanley Jevins was in Great Britain. His book was called The Theory of Political Economy. And finally, Leon Valras, who was a French economist who went to Switzerland, published Elements of Pure Economics. The latter two were mathematical to a greater or lesser extent. The third one was the most mathematical. Just to give you a sort of graphic representation of these guys, that's while Ross on the left, the guy looks like a serial killer, is William Stanley Jevins. Okay. And this was the founder of the Austrian school. Oh, I'm sorry. You'll meet him later. Very interesting gentleman. The founder of the Austrian school was Carl Menger, as I said. And here was Menger. This is why many Austrians have beards, taking after the great founder. But they had three different names for what was called, what came to be known as marginal utility. Now, Menger never gave a term to what came to be known as marginal utility. But his student, Friedrich von Wieser, called it Grenz nutsen in German, which is marginal utility. Jevins called it final utility. And Valras called it rarité. Okay. And again, I'll explain what this really was in Menger's view. But let me just say for now that for Valras and Jevins, utility was simply a quantity of satisfaction that individuals passively received from goods. So in drinking this bottle of water, I am piling up a certain amount of utility, which can be added up according to them and can be compared between people. People have water in the front row. They may only be getting 10 noodles from their bottle. I'm getting 20. He may be only getting three noodles, of course. But what the heck is a noodle? Okay. I mean, there is no unit of measurement for satisfaction. Menger understood that, and therefore for Menger utility was something active. It was the result of a judgment of the importance of different goods to a human being's well-being. Okay. Or in satisfying a human being's wants. Okay. So Menger put the individual's judgment about his well-being and his wants at the center of economic activity. Menger was a creative genius. Okay. He had many influences, both from the British economists and from the German tradition that he came out of. And some of them talked about subjective value, though they didn't develop this concept of marginal utility, which is the key to explaining prices. What Menger really wanted to do, as we'll see in a moment, was that prices using one principle, which the classical school, which we'll talk about, was unable to do. His unique way of looking at the economy as a result of individuals striving to satisfy their wants gave us a unifying principle for the entire economy. That is a principle that explained all economic phenomena from the pricing of a simple bottle of water to a very complicated input into, let's say, a tablet computer. His system explained everything. He himself didn't draw out all the implications. His students later did, and of course von Mises and Rothbard really, in a sense, completed the entire system. But the seeds were there. Let me just show you some quotes from very famous historians of economic thought about Menger. Joseph Schumpeter, who was born in Austrian, but was not a follower of the Austrian school, was not a follower of Menger, yet he said, Menger is nobody's pupil, and what he created stands. Menger's theory of value, price, and distribution is the best we have up to now. That was in the mid-1920s, after Alfred Marshall had written, after many other economists had written. Ludwig von Mises says, or said, what is known as the Austrian School of Economics started in 1871 when Karl Menger published the slender book that we talked about. Until the end of the 70s, there was no Austrian school. There was only Karl Menger. And finally, Hayek, who was Mises's student, said, the Austrian school's fundamental ideas belong fully and wholly to Karl Menger. What is common to the members of the Austrian school, what counts, what constitutes their peculiarity, in a good sense, of course, and the foundations for their later contributions is their acceptance of the teaching of Karl Menger, and I think that's still true today. Now, who were the classical economists? It was the classical school of economics to which Menger was reacting. Some people think that he wanted to completely overthrow the classical school. That's not true. They had some interesting important insights that he wanted to encompass in a greater unifying principle that explained everything. They did not, as we'll see. So the classical school was composed of basically three economists. David Hume, famous Scottish philosopher and historian and writer on economics. Adam Smith and his famous Wealth of Nations. Smith is wrongly characterized very frequently as a founder of economics. Well, certainly, he wasn't really a big figure in the founding of Austrian economics by any means. There were people that lived hundreds of years before Smith that contributed more to Austrian economics. And then David Ricardo, who lived in 1811, who wrote his great short treatise in 1811, was the third. The main problem with the classical school was their theory of value. And their theory of value presented a paradox. They were the ones that said that it's really cost of production that determines prices, at least in the long run. And they came up against something called the paradox of value. Sometimes called the diamond-water paradox. The paradox is simply, why is it the case that something like diamonds, which have a very high objective exchange value that is a price on the market, have such a low use value. They're used for bodily ornamentation to show off one's wealth, as conspicuous consumption and so on. If diamonds were all to disappear from the world, humankind wouldn't be that much worse off. On the other hand, water has a relatively low exchange value, relatively low price on the market, but yet it has an extremely high use value. If water were to disappear from the world, we would all disappear about three or four days later. So water has a very high use value, and yet, paradoxically, it has a low market value. So what solution did the classical economists come up with? They basically said, well, economics is not concerned with explaining use value. Okay, yes, yes, for good to have any value, it has to be useful to human beings, but we're not interested in explaining different degrees of use value. What's really important is that economists explain what determines price. That is exchange value. Therefore, their solution was, diamonds are much more expensive than water because it costs more money to produce, let's say, a given weight of diamonds when compared to the same weight of water. So a gallon of water, which weighs about eight pounds, is much less to produce, or costs much less to produce in either money or labor, than do diamonds of the same weight, let's say, eight pounds of gem quality diamonds. And of course, that was wrong. And Menger saw that that was wrong after he had this insight by looking at markets in the real world. So let's just talk a little bit more about the classical school. By the way, I have an interesting picture here just to show you that. That diamond is called a graph pink. It sold for $46 million at auction a few years ago. It certainly didn't cost $46 million to produce. There's an even better picture of it. Okay, how big it is. I think Kobe Bryant gave a purple diamond to his wife that was worth $10 million after she caught him in an act of infidelity. We'll talk more about exchanges in a little while, Menger's attitude toward exchange. In any case, classical school said some good things. First of all, they did say that, look, prices aren't random. They are determinate. They're caused by other things. In the short run, they did say that they were caused by supplying the man in the long run by cost of production. So in other words, they're not arbitrarily set by businesses. They're not accidents of history. They are determinate. The other thing that the classical school pointed out was that they regulate production. They allow businesses to calculate prices. The factors of production of resources compare them to prices that they can get on the market for the product, and that allows them to calculate profits and losses. So they did have a theory of calculation which was pretty sophisticated. Here's a sort of slide showing that. How prices regulate production according to the classical school. So if the demand for oil shoots up, price of oil shoots up above the average cost, and that causes high profits, which are in classical school above the normal profits. There was always some normal profit they talked about. The Austrians later on cleared that up, too, what was a normal profit. And as a result, you got a huge increase in supply. Now, today, in the last few years, we've had a tremendous amount of fracking. That is, producing a substitute for the high-priced oil so that the supply of fuels is shifting to the right. And once that happens, then you'll find the price will return towards the natural or long-run price. So the classical school always thought that price were tending towards the long-run price, which was the price that equaled the cost of production. But at least they showed the dynamics of how changes in supply resulted from changes in demand. Or, for example, when the iPad was released in 2010, and there were tremendous profits, within a few years we've had the various different kinds of tablet computers with Android systems and so on, Google, Microsoft. So the supply has increased of tablet computers. And price have begun to come down of tablet computers. The classical school was right about how prices regulated production. They just had an incorrect theory of how prices themselves were determined. So classical theory did involve a theory of calculation. Businessmen, for the most part they were all men then, were considered to be calculators. And this is where the idea of the economic man, or the homo-economicus, came into play. The classical school focused on the business decision maker and basically said that he buys in markets, he buys in markets that are cheap, sells in markets that are dear, where the prices are high. And that was correct as far as it went. But it just didn't go far enough for Menger. Also, the classical school was right in saying that the law of supply and demand and this dynamics of how prices determined production was abstract and universal. It applied to everyone. Menger liked all of those things about the classical school. What he didn't like were some of the implications of their doctrine. First of all, they attempted to explain prices in terms of classes of goods. So they talked about bread, diamonds, water, coal, iron, cotton, and so on. They talked about it in broad classes. And as we'll see, that's part of the reason for their paradox of value that they were unable to solve. The classical economists could not resolve the seeming paradox. For example, what they did notice, they were very insightful and brilliant men, what they did notice was land didn't have any cost of production. In many cases, it had a very high price. Paintings by long-dead artists, they didn't have any cost of production. They had very high prices that had no relation to what their cost of production were in the past. They couldn't explain that. There were many things that they couldn't explain. Antiques, the price of antiques could not be explained. So what they did was, they made the cardinal error of splitting the theory of value and price into two parts. And they said, well, as a theory of producible goods, most goods are producible, cotton, coal, diamonds, and so on. And in that case, the cost of production theory of value explained prices. But in the case of non-producible goods, supply and demand or monopoly, in the case of land, they believe really all landowners were monopolists pretty much. That explained prices of those types of goods. So this whole idea of being unable to resolve the paradox of value, being unable to show how the use value brought about or played a part in bringing about exchange value, made them focus on the businessman. They just forgot about use value, as I said before. The businessman became the central actor in the economic drama. And so we got something called Homo economicus. That is an economist simply focused on people who were selfish, who bought at a cheap price and sold at a high price. And that was completely incorrect from Menger's point of view, as we'll see. They also came up with an even more ridiculous cost of production theory called the labor theory of value. Ricardo did that. According to the labor theory of value, the price of a good or comparing two prices or the price of two goods, that price ratio reflected the amount of hours that were contained in each good. So for example, if a BMW costs $50,000 and a Toyota Corolla costs $20,000, well then the BMW contained two and a half times the amount of labor as a Corolla, which just looking around in the real world is not true. And so their theory of value was sort of a sweat theory of value. In other words, value was infused into the good by the laborer sweating over it. But let's say the laborer sweat over digging ditches or building a structure that no one wanted to buy. It didn't matter how many hours he labored or how much money, if you want to go to the cost of production theory, how much money was spent on building this structure, building a pyramid in the middle of London or something like that, that no one wanted. It still would not have value. So all of these things were brewing in Menger's mind when he was writing his book. Another thing that was wrong with the theory of value as presented by the classical school was that exchange indicated to them an equality of value. That is that if a bottle of water exchanged for $1.50, well then it was equal in value to $1.50. And if an automobile exchanged for $30,000, then it was equal in value to the $30,000. Because basically the price was equal to the cost of production, the cost of producing that particular item. Okay, now let's look at what Menger had to say about all of this. What Menger wanted to do, as I said before, was to come up with a theory of value and price that encompassed all economic phenomena. And he says this in a preface to his book. He says, I have devoted special attention to the investigation of the causal connections. This is very big on cause and effect, as we'll see, between economic phenomena involving products and the corresponding agents of production, meaning the resources. Not only for the purpose of establishing a price theory based upon reality, he wanted to base it on real things. And placing all price phenomena, interest, wages, ground rent, together under one unified point of view, meaning he wanted a principle that explained all prices and all things, not just consumer goods, but of capital goods and of land and labor. He says, but also because of the important insights we thereby gained into many other economic processes here to fore up to this point completely misunderstood. So his point was that all economic phenomena could be elucidated by a correct theory of price. And when he wrote notes to himself in writing his book, he pointed out the basic themes of his work. He said, look, man himself is the beginning and the end of every economy. The beginning because it's his wants that activate economic activities that bring them about and the satisfaction of those wants, which is the end of the economy. He also said, our science is the theory of a human being's ability to deal with his wants. So here you see he's putting wants at the center. He's not putting costs of production at the center. He's not putting a business decision maker at the center and he says all things are subject to the law of cause and effect. Basically goods had value because they caused the satisfaction of human wants when they were consumed and those things that caused the production of goods. So if a diamond mine and diamond workers and the gem dealer, all of these people caused the production of the final gem quality diamond, then all of those things have to have value. He also put up, it is notes, what we might call trinities of causation. So you start with ends. People have ends, that is to satisfy their wants. They need means in their external environment with which to produce and satisfy these wants and then when the means have been transformed into the things necessary to satisfy the ends, you have realization of the ends. That is also man. You start with man. You have the external world. He works on the external world and he produces his subsistence. So the beginning is always a subjective notice. The ends, the human being, the subject and the wants. There's wants, goods, satisfaction. The beginning and the end are subjective. The objective comes in the middle. It's involved in transforming the elements of our environment, the resources into the ends. So his theory of economics was subjective through and through, though he always focused on an external reality. Some Austrians, contemporary Austrians, almost lose sight of the middle. The middle is the key because we're not ghosts just floating above the earth. We have physical bodies. We have needs that arise from those physical bodies and so on. So you do need a cause and effect relationship between the subjective and the objective. And Menger saw that. He was the first to clearly see that and that's when he came up with the theory of goods. So he brought the objective into it but within the context of subjectivity. What I want to do is to show you a slide. I guess I just misplaced that slide but I'll have something to show you here. You can see it in the middle here. What was a good to Menger? What characteristics went into making up a good? There had to be a human need. There had to be such properties as rendered the thing capable of being brought into causal connection with the satisfaction of this need. There had to be something out there. You're hungry so there's bread, there's ham, there's mayonnaise, there's a knife, there's other utensils that you need, there's a place to make the ham sandwich and so on. Those things can be brought into causal connection with satisfying the need once you make the ham sandwich. And then he said, number three, there has to be human knowledge of this causal connection. People have to know about the fact that these things can be transformed into a final consumer's good. And finally, there has to be command of the thing sufficient to direct it to the satisfaction of the need. You can clone it and control it. Now, Mises pointed out, let me keep this up there, that number two and three were actually, there was an error there. In fact, Mises said you could combine two and three into one. That is, there has to be a belief that a thing can be brought into causal connection with the end and that. You and me could be wrong about that. So if you buy diet pills on QVC, okay, they don't bring about the end of getting rid of your belly fat, for example. If you seek the services of a psychic, she doesn't really put you in touch with dead relatives or friends. If you read The New York Times, you don't get the truth about the world. You watch the Rachel Maddow show. I mean, you think you're being entertained, you're really not. So, Manger actually, Manger was so smart that he couldn't let that stand. A few pages later, he said, well, there are imaginary needs. He used women's makeup as an example. They actually do have a price and a value. So he's admitting what Mises insisted on 50 years later. So Manger was brilliant. About the last point, about the control of the thing. A sunny day serves our needs when we want to go to a baseball game or we want to go on a picnic. And yet, the sun is not a good. It's not a good because we can't control it. Or let's put it this way, the weather itself is not a good. Because at least up to now, we really can't control the weather. We can't produce a sunny day. So not all things that aid in the satisfaction of our needs are goods. Only those things that we can control. And now let me just talk a little bit about economic goods. So the first chapter is on goods. Manger's trying to show that goods themselves have subjective components. And those are the characteristics that I just specified. But he said now, he went on, all goods exist in sufficient quantities to satisfy everyone's wants. That's in the second chapter. Those goods are economic goods. And therefore, they have to be economized. So Manger came up with economizing man, an active individual looking to satisfy his wants as opposed to economic man, a businessman that's mechanically reacting to buying cheaply and selling at high prices. So he displaced economic man with economizing man. Someone who's active and creative. So for Manger, here's how you economize. There aren't enough goods to go around. No one has enough resources individually to satisfy all their ends. Therefore, they have to choose which ends to satisfy. So if you can do that, you have to rank which ends are more important, which ends are less important to you. In other words, unlike Valras and Jeb, which I spoke of in the beginning, you don't just sit back and receive these utils from the goods. You have to actively compare these different things and make a judgment about how important they are to your well-being. So you're active in that sense also of the human being. As Mom Woods pointed out, the Austrian school accords human beings the dignity of being human beings, of being active. It doesn't drain them of creativity, make them mechanical reactors to prices that are out there. As we'll see, human beings are the ones who determine prices. That is, consumers determine prices that the entrepreneurs and the businessmen are reacting to. Actually, the entrepreneurs themselves have to be creative because they have to purchase goods with the anticipation that these inputs or resources they're purchasing are going to be less expensive than the goods that they produce and sell one month from now, four years from now, five years from now. Manger inserted time and uncertainty into his system. And it's been in Austrian economics ever since. So now let's give an example of how we go about economizing. And this is a famous example. Manger gave something like it in his Principles of Economics. Bumbavirk also gave something like it. This is more, I think, Bumbavirk's, Eugen von Bumbavirk was Manger's student and follower and the one who really completed his price theory. So the example I want to give here is the fictional cast away, Robinson Crusoe or Tom Hanks or wherever he was, has a certain amount of wheat on an island. It's just really his labor and he finds that he can plant maybe some seeds for growing wheat are left on the island along with him when the boat sinks. So what he wants to do is to decide how he can use the wheat so that they satisfy his most important wants. So let's say he ranks the wands as follows and each one will absorb a full, let's say, sack of wheat because he used sack. So let's say the highest valued end is the bread for sustaining life. One sack of bread will just keep him alive. It won't be too healthy, but it'll just be, it'll be enough to keep him alive for a year. A second sack of bread, if he had it, would be enough to maintain his vitality and his health so that he can move around and accomplish other ends. The third would be the seed grain for the following year's harvest. So he thinks ahead. If he had a fourth sack, he would, well, they use whiskey, I like vodka, so he would produce a year's supply of vodka. A fifth sack would satisfy his fifth most important want. These are ranked in terms of their importance. Notice there's no numbers assigned to this. Menger assigned indexes. He signed 10, 9, 8, 7, 6, but he didn't add and subtract them. But it's better just to assign cardinal numbers, because that's what he had in mind, first, second, third, fourth, so on. If he had a sixth sack, he would devote it to food for a company. Let's say he's lonely, and there are some parrots, and he can teach them to talk, so he would have a parrot. And maybe once he got to 20 sacks, they would be super abundant. They wouldn't be goods anymore. They wouldn't be economic goods in his terminology anymore. There would be more than enough to satisfy all his wants. But let's assume that he has five sacks, so he fulfills or satisfies the first five wants. Menger's question was, and he was very adept at asking questions that led to the solution of very important and troublesome problems that the classical school had. So he said, well, what's the value of a sack of wheat, given that we have these five? Is it the value of the highest ranked end? Is it some average? Is it the value of the average of ends? Well, here's where he asked the question. He said, and he put it in terms of a hypothetical example, what if all these sacks were being stored and were going to begin to be used the next day? They were just harvested. They're stored in a structure he has, and you have, let's say, vermin breaking in and devouring one of the sacks. Let's say they devour sack number two, okay? What will be the reaction of this creative individual? Will this individual simply say, okay, well, I'm devoting these sacks to my first, third, fourth, and fifth ends? No. What he would do is he would give up the expected satisfaction from the lowest ranked end, the fifth end. What he would give up then is the dairy products and meat and so on that could be had from feeding farm animals, because that's his lowest rank of the five ends that he could accomplish. So in that case then, this led to the law of marginal utility and then to the solution of the paradox of value. Utility is simply another word for satisfaction. Marginal simply means last or next. In this case, it means the last. So according to Menger, the value of each sack of wheat, no matter which one it is, if you have five sacks, is the marginal utility. The value of the lowest ranked end that could be satisfied by the existing stock of the good, by the existing supply, by the five sacks. So no matter which sack he lost, he would lose the value he attaches to having meat and dairy products during the year. And that's the law of marginal utility. And so now then we can specify it. As the supply of a good decreases, the marginal utility rises and therefore the value of the good rises. So in other words, now if he's left with four sacks, the value of each sack is higher because now if he lost one, he'd have to give up his vodka, which is higher rank than the dairy and meat products. On the other hand, if he fortuitously came across another sack of wheat, he could now satisfy his sixth end. The value of that end now is lower. So the marginal utility is falling. Each sack of wheat is valued less because he loses less utility. The marginal utility is lower. So the law is, as the supply of a good increases, the marginal utility and the value falls. An example I like to give is if there's a family that has three automobiles, and let's say they're pretty much interchangeable. One is for the primary breadwinner. That's the highest value used. The second is for, let's say, the spouse has a part-time job and uses it to get from the part-time job and run errands. And then there's junior who has a car to get around. Well, what if the old man cracks up his car? Well, I mean, he doesn't go without the car. Junior loses the car because that's the marginal utility of that supply. That's the lowest ranked end, keeping Junior off your back from continually asking for the keys and so on. Now, let me give you a little more sophisticated example to see if you understand this law. So let's say I have a farmer and he has three horses and two cows. Now, these are not interchangeable goods. They serve different ends. But still, you're still comparing them. You're always comparing goods as to how important they are, whether they're the same or different, just to your well-being. So let's say there's three horses. So the most important end is horse number one, plowing the field. Second most important end is to have a team of horses plowing the field. It makes farming much easier, more productive. The third is the milk that you could get from the first cow. The fourth end is the milk that you could get, the cheese and butter that you can get to various diet. The fifth is the pleasure riding the third horse. Which animal has a higher value? It's the cow. We don't look at the first two highest valued ends. We don't look at them at all. It's the cow that has a higher value. And the way to think about this is to ask Manga's question. If the barn's on fire and you can only say four to five animals, which animal do you leave in there? You leave a horse in there because the margin utility of horses is lower than the margin utility of cows. But once that happens, which animal is more valuable? Now you only have four. Now the horse is more valuable because the margin utility of the horse is the satisfaction that you attach to achieving the second end and for the cow is the satisfaction that you attach for the fourth end. That's how value is determined. Now we can solve the paradox of value as Manga did. So Manga pointed out that diamonds, in fact, are more valuable than water in a normal situation because diamonds have a higher margin utility. They're scarcer in relation to the ends that they can serve. If someone is in the desert and has not had access to water for three days and comes across another person that has a jug of water and has in his pocket, let's say he even has that graph pink diamond that sold for $46 million, would he exchange a diamond for the water? Yes, because the water achieves a much higher end. That is staying alive for another three days. You can go about three days without water, three or four days, whatever it is. He would trade the diamond for the water. But water is so abundant, vis-a-vis diamonds, in any normal situation that we're aware of that water has much lower value. And that is the solution to the paradox of value. That is the classical school went wrong because it focused on all the water in the world. It talked about water versus diamonds. Manger focused on the marginal units, the units that the individual was choosing between. Was he choosing a diamond in a situation where there was a lot of water or between a diamond and water in a situation, in a lifeboat situation or in a desert situation? So the Austrians always focus on concrete units because those are the units, those actual goods that we're dealing with at the moment that are the objects of choice, and therefore of human valuation. We're valuing them in relation to our welfare. Now, Manger went on and developed something called a theory of imputation. And this comes from his very idea of how value and production are interrelated. You remember those trinities of value? The value starts with the end or the want and then is imputed to the good. So if you look here, let's say bread has a value. Now notice the upward arrow. Bread is valuable because it satisfies a human want. Bread, at the wholesale level, is valuable because it's integral in the production. It causes the production of bread at the retail level when you combine it with transportation and labor. Flour is only valuable. It's not valuable directly to consumers. Consumers don't want flour. Let's assume they don't bake their own bread. Consumers don't want flour. They want the output that flour delivers to them eventually. The point is though flour helps cause the production of wholesale bread which in turn helps cause the production of retail bread. Finally, wheat is valuable because it's integral in the production of flour. So notice production comes from the top down. It comes from the inputs down. The classical school made the mistake of thinking that value and production both came from the top down. That flour was valuable because it costs a lot to buy the wheat or because it costs something to buy the wheat. And that bread was valuable because it was a cost of production of baking the bread by hiring laborers and buying or renting ovens and so on. But menger said no, no, no, they go in different directions. So the ends cause the value to begin with and the value is imputed upwards or backwards to the factors of production all the way up to land and labor. Whereas on the other hand, that's what causes the production. The fact that this perspective value in the output causes people to undertake the efforts at the higher stages of production to produce the good. So you can think of it in terms of let's say diamonds. I used to give my undergraduates the following example. Back in the old days, if you recall the movie Witness with Harrison Ford takes place in the Amish country and the Amish are known as a simple people and the simple people, they don't even have buttons on their clothing, they're just like sort of hooks and hoops that they fast their clothing with because they're against any kind of ostentation. So if all Americans or everyone adopted the values of the Amish what would be the value of diamonds? Would diamonds have a value? Diamonds wouldn't have a value because they wouldn't play any part in improving human well-being because no one would see them as satisfying a want. The wants for those things would disappear if they adopted those values. But which also means by the way that because diamonds don't have a value the things that cause the production of diamonds do not have a value. So suddenly the high salaries paid to jewelers and those who can identify high quality gems and so on the values of those skills would plummet to zero and of course the value of diamond mines assuming there's no industrial uses for diamonds would fall to zero. So a diamond isn't expensive because diamond mines are very costly and also it's very costly to mine diamonds it's rather the other way around, right? So a diamond mine is valuable only because people play such a high value on diamonds and because of the scarcity of diamonds in relation to human wants for them. So prices determine costs not the other way around and Mender used the idea of people not smoking anymore and he went through it in detail and showed that this dislike for tobacco or this abandonment of the habit of consuming tobacco in any way would bring about a zero price for rolling machines a zero price for tobacco and a zero price for tobacco land if it couldn't be used for any other good or any other type of production. So that's Mender's law of imputation. He actually took it a little further. All it tells us here is that the total amount of money spent on bread and we're forgetting about interest would be equal in value to the breaded wholesale and the total amount that you would spend on wholesale would be equal in value to the flour and so on. So in other words, you take the value of all of the things in that stage producing that good and that would attach itself to the higher stage. So the value would be attached for all what Mender called the complementary goods. All the goods in wheat would be equal in value to all the goods in flour forgetting about the interest differential and a profit there. But Mender wanted to go further. He said, wait a minute, he says that doesn't explain how each individual unit remember the unit of the goods is what is important each individual unit of a factor of production is valued and priced. We have to go a little bit further and here again he asked a very important question a very insightful question that unraveled the puzzle. Let me just give you this example. Let's say you could produce a thousand bushels of wheat this is called a production function. W is wheat, L is labor, H is horses, P is plow, A is acre, acres of land, F is pound of fertilizer. So this is a production function that is a technological recipe for producing wheat. If you had 90 hours of labor and 90 days of labor and you had two horses and you had one plow and 40 acres and 500 pounds of fertilizer then you could actually produce a thousand bushels of wheat. So Mender asked the question what is the value of a hundred sacks a hundred pounds of fertilizer? Let's say they come in a hundred pound sacks of all of those things all of those things cooperate in producing a thousand bushels of wheat how could we attach a value to one unit of all of those different things? Well, Mender simply asked the question how much would the total product decrease how much would that thousand bushels of wheat decrease if a unit of the factory production was subtracted from the process of production? If we took 100 pounds of fertilizer away from all of those other things what would be the amount of wheat produced? And this is the theory of factor pricing he never followed it completely through to money prices but here's his solution so let's assume we change delta F we change fertilizer we reduce it by 100 pounds that will cause a change in wheat let's say by 40 bushels so now you only produce 960 bushels so we call that the marginal product of 100 pounds of fertilizer it's 40 bushels of wheat therefore the value of the marginal product the value of the 100 pounds of wheat is simply the marginal utility that the farmer attaches to the 40 bushels of wheat that would not be produced if you didn't have that extra 100 pounds of fertilizer now he didn't go as far as to go into money but I will do that very quickly the monetary value of 100 pounds of fertilizer to the farmer in a money economy is called this marginal revenue product you don't have to worry about that the additional revenue earned by using an additional sack of fertilizer with a 100 pound sack so we assume that the price of a bushel of wheat is $2 well then the value of that sack is $2 times the extra 40 bushels of wheat that you could get and sell on the market for $2 a piece which is $80 he'd be willing to pay up to $80 for that bushel of wheat so up to $80 for that sack of 100 pounds of fertilizer so Manger completely solved this now this marginal productivity theory took many years to be developed and the Austrians were instrumental in developing it but Manger had the seeds of the theory he had this brilliant insight and again it was this idea of asking the appropriate question that led to the solution okay lastly Manger thought that the class of economists were all wet in saying that the value of a good is equal in value to the price of the good because in the long run cost of production equals price Manger says that's ridiculous and he gave a simple example of exchange he says if by the way the item or the animal that's in parentheses is the one that the individual does not have so A ranks a horse just look at A ranks a horse above a cow but he doesn't have a horse what does that mean? that means if he met someone who was willing to give him a horse for a cow he would make the exchange on the other hand there's a B out there who doesn't have a cow but has a horse but would prefer a cow to a horse it has a higher margin of utility to him so what Manger shows is that if they met if they knew of each other's existence they would make the exchange and he goes beyond that and he says look this is mutually beneficial each individual gives up something that he or she values less for something that they value more they receive and return something they value more than what they give up and that's the essence of exchange that's the essence of the whole economy because the whole economy the whole market economy is simply a network of voluntary exchanges whether it be someone buying an iPad or someone hiring an illegal worker doesn't matter Manger's theory covers all instances there is only one theory of price and as we'll see of exchange he doesn't go much further than that but you can see in today more modern example obviously whenever you buy anything let's say someone buys a BMW the buyer prefers the BMW to the $50,000 that he gives up whereas the seller prefers the $50,000 that is received to what the product that he's giving up now it's not to say that they can't be buyers' regret later on the buyer might say you know what this BMW is a crappy car I don't like it would have rather gotten an an Acura or a Lexus or whatever but we're not worried about that as economists at the point of exchange right before the exchange we call ex ante from the standpoint of before the exchange they both have these valuations they're called reverse valuations so not only aren't the goods equal they're not equal to either buyer there's a double to either participant in the exchange there's a double inequality of value the seller values the $50,000 more than the BMW the buyer values the BMW more than the $50,000 there's no equality anywhere to be found there I'll stop here we have I think about five minutes for questions by that clock any questions? in the back stand up I'll talk to you individually about that I think that would be better any general question or comment okay thank you very much